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Calif. Law Covers Lapse in Mortgage Forgiveness Tax Protection

JUL 22, 2014 5:04pm ET
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California Gov. Jerry Brown signed into law a measure extending state income tax relief to borrowers with canceled or forgiven mortgage debt on Monday.

Assembly Bill 1393, introduced by Henry Perea, D-Fresno, amends California's tax code so that homeowners do not have to report as income certain debt that was canceled or forgiven by a lender due to principal reduction from a loan modification.

"Requiring homeowners to pay income taxes on forgiven debt puts additional stress on people already struggling to recover from the collapse of the housing market," Perea said. "This bill will prevent this undue hardship. They can't afford to pay an additional tax on money they never received."

The new law only applies to mortgage debt canceled during the 2013 tax year. Previous federal and state legislation extended similar relief to borrowers who had their debt reduced from 2007 to 2012. But while the federal tax relief was extended to include the 2013 tax year, a pair of similar measures before the California Assembly failed during committee hearings last year—leaving California borrowers who received a reduction in 2013 owing state income tax on the amount forgiven.

The new law eliminates that obligation, which the state estimates will save taxpayers about $39 million.

"During this timeframe, several thousand Californians received principal reductions, with the average first mortgage principal reduction approximately $137,000," said Rodney Brown, president and CEO of the California Bankers Association. "Prior to the passage of AB 1393, thousands of Californians may very well have been elevated into a higher tax bracket for income tax purposes based upon forgiven mortgage debt."

Over the last several years, state and federal law has been amended to prevent "phantom" income from being taxed. Earlier this year, the Senate Finance Committee began working a bill that would extend 45 tax provisions, including a two-year extension of the federal Mortgage Debt Forgiveness Relief Act that expired on Jan. 1.

Distressed borrowers in California who sold their homes via a short sale to avoid foreclosure also benefited from an Internal Revenue Service ruling in December that stated the debt written off in a short sale does not constitute recourse debt under California law, meaning sellers are not subject to income tax liability for the portion of their debt written off in the transaction.

However, since the tax exemption in AB 1393 only applies to transactions that occurred in 2013, which means more uncertainty remains for mortgage debt forgiven this year.

"AB 1393 will provide much needed tax relief to California homeowners who were on the brink of losing their homes due to the recent mortgage crisis," said California Attorney General Kamala Harris. "AB 1393 is a critical next step to help hardworking Californians get back on their feet."

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