The Mortgage Forgiveness Debt Relief Act of 2007 was set to expire on December 31, 2012. However, the American Taxpayers Relief Act that was signed into law by President Obama just after the new year as a result of the “fiscal cliff” negotiations included a provision to extend the Mortgage Debt Relief Act until December 31, 2013.
For homeowners completing short sales in 2013, that means that the income tax impact will remain for another year such that you may be able to exclude up to $2 million of qualified principal residence indebtedness (or up to $1 million for a married person filing a separate return). Refer to the IRS article here for more details.
While this debt relief extension applies at the federal level, the California exemption expired at the end of 2012. Therefore, cancelled debt is considered taxable income at the California state level at the moment.
In response to this discrepancy between federal and California law, Senate Bill 30 (SB 30) was created to conform California state law to the federal law granting the extension of this debt relief. It has not been passed as of yet; upon passage of SB 30, the measure will be effective retroactive to January 1, 2013. This bill has gained the support of the California Association of REALTORS and others who anticipate SB 30 to pass in the near future.
One question I’ve received from homeowners in the middle of a short sale transaction right now is whether they should try to hold off a little longer before completing the short sale until after SB 30 has been passed. My answer: it depends on whether you can endure the consequence of waiting. Will it jeopardize the short sale in process? Will its passage make a difference for you from an income tax standpoint anyway? I’ve only heard that the Senate will vote on it later this month. But until it passes, there’s always that uncertainty.
Either way, make sure you understand the limits of indebtedness when calculating your debt relief amount for federal income tax purposes. Note that the debt relief act that expired at the end of 2012 for California had different exclusions than for federal — there actually was a limit on the debt relief amount, not just on the amount of indebtedness. Visit the California Franchise Tax Board website here for more info on this state tax law (prior to its expiration).
NOTE: You should always check with a tax professional and/or attorney when considering the impact of a short sale on you specifically.