California homeowners who saw their properties turned into foreclosed houses this year may soon be hit by an income tax. A California law that provides temporary exemption on homeowners who lost their properties in a short-sale, foreclosure or deed in lieu of foreclosure is scheduled to expire at the end of 2009.
The California law is similar to a national one that also provides exemption to borrowers from federal taxes on canceled mortgage debt. But unlike the state law, the federal law stays in effect until 2012.
Industry analysts said that the state tax effect could just be substantial but the rules may be complex. They advise borrowers who have troubled loans to consult a tax expert. Before the exemption law, debts canceled or forgiven by lenders were taxed as income.
An exemption to the previous law is nonrecourse debt. Under nonrecourse debt, lenders have the right to take over control of the collateral of borrowers who defaulted on their loans. However, lenders are prohibited from going after other assets of the borrowers.
Industry analysts further explained that forgiven nonrecourse mortgage debts do not mean taxes on debt income that was canceled.
Normally, a home mortgage loan is a nonrecourse debt. The debt is classified as recourse if the borrowers refinance their loans and gets cash or takes out a line of credit of home equity loan. Income tax is imposed on canceled recourse debt.
Income tax exceptions are also applied to borrowers who filed for insolvency or bankruptcy. According to industry analysts, many homeowners who have troubled loans incurred recourse debts that would be taxed if forgiven. This prompted members of the U.S. Congress to pass the Mortgage Debt Relief Act of 2007.
Under the federal law, a home loan forgiven through a modification, short sale or foreclosure is temporarily exempted from federal tax. But the law specifies that the temporary waiver applies only to debts used to purchase, build or rehabilitate primary residences. It excludes home equity debts used to pay for credit card debts, cars or other purposes.
The debt exemption under the federal law has a cap of $2 million and applies to forgiven debts from 2007 to 2012.
In California, tax exemption applies to debts forgiven between 2007 and 2008, with $250,000 as the maximum amount of exclusion from state income taxes.
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