A short sale occurs when you sell your property for a price that is short of the balance owed to avoid a foreclosure – with the consent of your lender. Let’s define recourse and non-recourse loans and discuss variations when the property is outside California or if you move into or out of California. Here are some Q&A Questions and Answers:
What is a Recourse Loan?
Lender can come after you for the deficiency (difference between loan balance & fair market value/sales price).
You can end up with both capital gain/loss and cancellation of debt (COD or debt relief) income.
Capital gain or loss is the difference between the sales price and the adjusted basis (cost) of your property.
Debt relief income is the difference between your property’s fair market value and outstanding loan balance.
Fair market value becomes the deemed sales price.
Debt relief is ordinary income (instead of capital gain that is taxed at lower rates).
COD becomes income in the year the lender forgives the deficiency.
Purchase money loans (meaning original loans when you bought the property) are non-recourse.
Refinanced loans and equity loans become recourse loans.
What is a Non-Recourse Loan?
Lender’s only remedy is to repossess the property used as collateral.
Lender cannot come after you for deficiency.
Foreclosure or short sale could result in either capital gain or loss.
But it does not generate COD income.
The debt is treated as part of amount realized.
Non-recourse loan states include Alaska, Arizona, California, Connecticut, Idaho, Minnesota, North Carolina, North Dakota, Oregon, Texas, Utah, and Washington State.
What if the property is located in another state?
Treatment of recourse or non-recourse loans depends on the laws of the state where the property is located.
Each state has its own set of rules concerning what a creditor/lender can do to collect a debt.
California’s rules are not binding in other states.
What if you change state of residency during the year?
Let’s start with a basic premise – a California resident is taxed on all income, regardless of it source.
A part-year resident is taxed on all income while you were a resident of this state, regardless of source, plus for any part of the taxable year the taxpayer was a nonresident for income derived from sources within this state.
A nonresident is taxed if you have California-source income.
If the lender does not discharge the indebtedness until after you have become a California resident, it would be taxable to California, regardless of where the property is located. Ouch!
What forms do lenders file with the IRS?
Form 1099A is issued when a borrower abandons secured property, or when a lender acquires property in full or partial satisfaction of a debt and the property was used as security for the debt.
Transaction is treated as a deemed sale.
Use the outstanding debt as your sales price.
Form 1099C is issued once a creditor abandons a right to collect a balance due (deficiency)
In other words, you do not have COD income until the creditor abandons the right to collect.
It is the discharge of indebtedness that results in the realization of income.
If creditor does not cancel the debt and decides to pursue collection, you would not have COD income.
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Victor Santos Sy, CPA, MBA, provides professional services in accounting and tax controversy including IRS audit defense and offers in compromise. He also advises clients on choices of entity including corporations for small businesses and LLCs for rentals. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation at 704 Mira Monte Place, Pasadena, CA 91101. The firm celebrates its 35th anniversary this year. You may email tax questions to Vic at [email protected]. You are welcome to visit our website for more than 300 tax tips at www.victorsycpa.com.