The Coming Tax Nightmare Over Forgiven Mortgage Debt in California

Do you think homedebtors are ready for their California tax bill on forgiven debt? That HELOC will get them.

Irvine Home Address … 74 BLUEJAY Irvine, CA 92604

Resale Home Price …… $699,900


There's a fog upon L.A.

And my friends have lost their way

We'll be over soon they said

Now they've lost themselves instead.

The Beatles — Blue Jay Way

As the fog clears over our housing market, those who have lost their debts will find their debts are seeking them. recently featured this article found on the California Franchise Tax Board's website: Foreclosures and the next wave: taxes due on canceled debt

… If their lender forecloses on their homes, or accepts an amount less than the loan balance from sale of the home, it may result in taxable gain to the homeowner. The type and treatment of the gain will depend on whether the mortgage is considered non-recourse or recourse debt.

In California, purchase money mortgages, which are mortgages where the borrowed funds are used to purchase the house, are generally treated as non-recourse debt. If the bank forecloses on a non-recourse mortgage, then the homeowner is treated as having sold the home for the amount of the outstanding debt. The difference between the outstanding debt and the homeowner's adjusted basis in the house is considered a gain or loss on the sale of the home. If the home is the taxpayer's principal residence, where they have lived for at least two of the past five years, the gain may be eligible for the gain exclusion on the sale of a principal residence. If the foreclosure results in a loss, the loss may not be taken since it resulted from the sale of a principal residence.

With the refinance craze and HELOC boom of the 00s, how many purchase money mortgages exist? In 2006, over 80% of loan originations were refinances; consequently, only the most frugal or those who bought at the peak still have purchase money mortgages. The bulk will be recourse.

If the mortgage is recourse, such as a non-purchase money mortgage or a refinanced mortgage, any foreclosure may result in a gain on the sale of the house, and/or cancellation of debt income. The difference between the fair market value of the house and the homeowner's adjusted basis will result in a gain or loss on the sale of the home. To the extent the outstanding debt exceeds the fair market value of the house, the amount is treated as cancellation of debt income. Any gain on the portion treated as the sale of a personal residence may be eligible for the exclusion on the sale of a principal residence; however, as discussed above, the loss may not be taken on the sale. The portion that is treated as cancellation of debt income is taxed as ordinary income – subject to ordinary income tax rates. Your clients with canceled or forgiven mortgage debts may receive a Form 1099-C from the lender and will be expected to pay federal and state tax on the canceled amounts, at the ordinary income tax rate.

For example, if the homeowner has a non-recourse mortgage with an outstanding balance of $250,000, and has an adjusted basis of $100,000, the house has a fair market value of $200,000. If the homeowner's lender foreclosed on the mortgage, the homeowner would have taxable gain of $150,000 ($250,000 less $100,000). If the mortgage had been recourse, the homeowner would have gain on the sale of the home of $100,000 ($200,000 less $100,000), and cancellation of debt income of $50,000 ($250,000 less $200,000).

Many renting-former-owners who have either gone through foreclosure or sold short believe they have no further responsibility to the debt. The lenders are gearing up for collection, but once they give up and begin writing down the debts, they will issue 1099s, and then the State of California will look to collect. This debt is going to linger in one form of collection or another for decades.

Tax on this seemingly "phantom" type of income is due whether the bank forecloses on the mortgage, or allows a "short sale" (allowing the defaulter to sell the house at below cost, and accepting the proceeds as payment in full). A short sale is preferable to a foreclosure only in the sense that it does less damage to the homeowner's credit rating. The difference between the amount owed to the lender, and the amount received is still considered canceled debt, and taxed at the ordinary income rate. Relief of debt is considered income because the bank gave the buyer cash to purchase the home when it issued the mortgage. This cash was not taxable because it was a loan, and the buyer promised to repay it. When the loan is forgiven or canceled, it becomes income in that year since the buyer will no longer repay it.

You must admit, the logic of the tax position is inescapable. Nobody who took out HELOC money and spent it was thinking about setting aside tax reserves.

There are a couple of options for your clients who are caught in this situation:

  • Bankruptcy: Debts discharged in bankruptcies are generally not considered debt-cancellation income.
  • Insolvency: Tax will not be assessed on the phantom debt-cancellation income if your client can prove insolvency existed when the debt was discharged. Your client must prove that all assets totaled less than all debts.

If you have clients who have exhausted their options and cannot pay the additional tax on the phantom income they "accrued" through debt cancellation, remember to look into our offer-in-compromise and payment arrangement programs.

You may also want to check out the IRS new Web page devoted to foreclosure tax relief, and related FAQs.

Bankruptcy or insolvency? Those don't sound like appealing options. Of course, most debtors will claim insolvency and hope they are never asked to prove it, and many, if not most, of those will get away with the deception.

Irvine Home Address … 74 BLUEJAY Irvine, CA 92604

Resale Home Price … $699,900

Income Requirement ……. $147,074

Down Payment Needed … $139,980

20% Down Conventional

Home Purchase Price … $205,000

Home Purchase Date …. 12/23/1998

Net Gain (Loss) ………. $452,906

Percent Change ………. 241.4%

Annual Appreciation … 10.8%

Mortgage Interest Rate ………. 5.13%

Monthly Mortgage Payment … $3,050

Monthly Cash Outlays …..….… $3,800

Monthly Cost of Ownership … $2,760

Property Details for 74 BLUEJAY Irvine, CA 92604

Beds 4

Baths 3 baths

Home Size 1,960 sq ft

($357 / sq ft)

Lot Size 4,300 sq ft

Year Built 1977

Days on Market 14

Listing Updated 2/18/2010

MLS Number S605981

Property Type Single Family, Residential

Community Woodbridge

Tract Ck


Can you read that? I labor with ALL CAPS descriptions.

The date and price of ownership is unknown, but I have approximated based on available mortgage information. I may be off significantly, but that would only make the HELOC abuse even more egregious.

My view of the property records only goes back to 1998 on this property, but it may be an original 1977 owner for all I know.

  • According the records I do have, the owners had a $164,000 loan on 11/08/2002.
  • On 8/13/2003 they had a $163,000 loan.
  • On 8/13/2003 they tasted kool aid with a $40,000 HELOC.
  • On 9/10/2004 they opened a $125,000 HELOC.
  • On 11/4/2005 they opened a $250,000 HELOC.
  • On 4/17/2007 they opened a HELOC for $100,000
  • Total property debt is $510,000.
  • Total mortgage equity withdrawal is $347,000.

32 thoughts on “The Coming Tax Nightmare Over Forgiven Mortgage Debt in California

  1. Planet Reality

    This is yet another reason debtors will accept loan mods with a zero coupon government backed bond.

    They get to live in the home at or below rental parity, fixed for 30 years, and they get to call themselves home owners.

    There is little to debate, when you take it the next mile.

    1. Chuck Ponzi

      Uh… This is a nothingburger if you get it “forgiven”.,,id=179414,00.html

      Just one more reason for people to pursue foreclosure/bankruptcy rather than short sales. Debt is not by law discharged in short sales.

      the Mortgage Debt Forgiveness Act of 2007 basically gets rid of it until 2012. By then, the rapture will save everyone or we’ll have descended into the mad max abyss.

      Extend and pretend.

      1. Chuck Ponzi

        Of course, HELOCs are a double-whammy. They are not discharged in Foreclosure, and are taxable if forgiven.

        That’s the real monster in the closet. Many, many people “bought” a house with a 80/20Heloc. in 2003-2007.


        1. Planet Reality

          The beauty of it all, no matter which path is chosen, the tax payer foots the bill as the private profits are realized.

          1. Kirk

            Yeah, but some of those taxpayers should pay taxes on their ill-gotten gains. Let’s not forget that these people locked out honest people from the housing market and then borrowed tax dollars from the honest people to bailout the country that was in the toilet because of their greed. I say tax the hell out of these people. They’d just blow that money anyway.

          2. Planet Reality

            I agree, and it’s nice in theory but we all know they will never pay. When they don’t pay, guess who does? The honest people that’s who, c’est la vie.

          3. Kirk

            I don’t know that. The FTB is pretty good about garnishing wages and seizing property and accounts. The bankrupt won’t pay, and that’s fine, but those who made out on walking away will eventually pay.

          4. priced_out

            I’m with Kirk. The HELOC abusers who were spending free money in 2005 ought to pay tax the way the rest of us renters were paying tax on our income. HELOC abusers share just as much of the blame for this mess as the banksters. Neither group should not be bailed out.

      2. OC HouseSitter

        Hey — IR and crew — can you help clarify something for me on this California “phantom income” tax issue?

        A bit of this still seems a bit confusing, at least in the wording on the CA Tax Franchise Board’s website…..

        Here’s what I’m un-able to quite grasp…..for someone going through Foreclosure in California right now:

        If someone originally took out an Interest-only Purchase-Money loan for a home, and it was intended to be their Primary Residence, and they actually DID live in it for over 5 years….and they DIDN’T take out a HELOC, AND they didn’t Re-finance, ever — is it the case that they WON’T get income-taxed by California on any kind of phantom debt after they go through foreclosure on their upside-down house?

        A 1099-C won’t cause California Phantom-Tax for these people?

        I understand that the Mortgage Debt Forgiveness Act of 2007 wipes out any FEDERAL Income Tax that they would have to pay on “Phantom Income”, at least through 2012….but does the “Non-Recourse” Purchase-Money-for-a-Principal-Residence Status of the loan, in effect, protect them from California income taxes?

        I guess I’m getting hung up on the significance of the wording in the CA Tax Franchise Board’s document, where it states “If the home is the taxpayer’s principal residence, where they have lived for at least two of the past five years, the gain may be eligible for the gain exclusion on the sale of a principal residence. If the foreclosure results in a loss, the loss may not be taken since it resulted from the sale of a principal residence.”

        So — long and short — for someone who bought a house to live in during the bubble years, yet was OTHERWISE responsible (catch my bitter irony here) in that they never HELOC’d or Re-financed — will they owe California any phantom income tax after their upside-down home is foreclosed on? Or does their small amount of responsible restraint grant them a status of Calfornia phantom-income-tax forgiveness / immunity?

        Thanks IR and Community!!!

        -Mike T.

        1. no tax expert

          I’m no tax expert but the statement “… If the foreclosure results in a loss, the loss may not be taken since it resulted from the sale of a principal residence” – may mean that one may not deduct the loss from his/her income if they itemized. This is different than having or not having to pay tax on forgiven debt which the Fed Act of 2007 addressed.

  2. lowrydr310

    Resale Home Price … $699,900 (2010)
    Home Purchase Price … $205,000 (1998)

    What was different in 1998? How much lower were incomes in 1998? How much higher were interest rates in 1998?

    According to the Consumer Price Index, what cost $699,900 in 2008 would have cost $532,000 in 1998. (sorry – no data beyond 2008) I don’t have time to do a complete comparison, but I’d love to see the monthly cost of this home in 1998 at 1998 interest rates compared, then adjusted for inflation to see how it compares to the current monthly cost

    I’m not going to claim that prices are going back to 1998 levels, BUT what was so different then versus now? It’s obvious that home prices were significantly lower back in 1998. Does Irvine have more jobs now than in 1998? If houses are such great investments all the time, why weren’t people snatching these up by the dozens back in 1998?

    1. wheresthebeef

      I was going to ask the same thing.

      Let’s see 1998. Clinton was president, the stock market was booming, this thing called the internet was really catching on and some terrorist group named Al Quaeda was stirring up trouble.

      If the seller gets the asking price here…that is almost 3.5x what they paid for it just 12 years ago. No housing bubble here, nothing to see…just keeping moving along folks.

    2. Planet Reality

      Hindsight is always 20 / 20, we would all like a time machine to buy Apple stock in the 80s.

      However these are excellent questions. Look to the top 20% who have seen their income go up 3 X with global expansion and look to government fiscal policy for your answers.

      1. Chris

        Buying AAPL in early 80s is too early. Try buying it when Dell said that Apple should fold and give the shareholders’ equity back to the shareholders.

    3. Walter

      Income were a little lower, interest rates were significantly higher and the gov and banks were not conspiring to hold back inventory. For the finishing touch, we now have the first time buyer credit.

      Add it up and to get today’s prices. Pull the fed pushing down rates, houses getting released to the market and lose the credit, wait 6 months for things to work in, and then lets see where prices are. Until these things change, high prices are what we have to look forward to.

      And who said the Making Homes More Expensive (MHME) programs are not working?

      1. IrvineRenter

        “Pull the fed pushing down rates, houses getting released to the market and lose the credit, wait 6 months for things to work in, and then lets see where prices are.”

        It think the fall 2010 and winter 2011 should be very interesting because your circumstances will be realized.

  3. Jeremy Hellier

    I drove by this house the other day. It basically backs to Culver and is in a somewhat run-down cul-de-sac.

    1. Walter

      Buts its only $700,000 dollars and in Irvine. Should be gone in days.

      At least I hope for them it is. If the gov does let the Making Homes More Expensive (MHME) programs run out (we shall see), these homes might not fly off the rack so fast.

  4. Woodbury Renter

    foresight would be to start shorting Apple stock now…

    IR, truly inspired song choice today…as soon as I saw Bluejay Way I immediately flashed to the Beatles and was very pleasantly surprised to see the Magical Mystery Tour theme today. I spent 45 minutes clicking through the other videos.

    Can’t believe McCartney is playing the Hollywood Bowl next month at age 67.

    Knock another $100k off this Woodbridge house and I’d be tempted to take a serious look.

  5. Lucky Victim

    Great information. I had also previously thought that people foreclosing was an easy way out. They will just be hanging and ripening up for the IRS.

  6. SoOCOwner

    Again, we have to ask ourselves “what did they do with the HELOC money?” They certainly didn’t spend it on upgrades to their property.

    1. Planet Reality

      How else were they supposed to pay for:

      inflated college tuition for their children
      inflated autombile prices
      inflated medical expenses

      You didn’t expect them to pay for these with their income did you?

    2. TO Renter

      A little of the money went to luxury items, but the lion’s share went to buying other houses on speculation.

      This will undoubtably have a multiplier effect on housing market problem especially this year.

      Another poopular money pit for HELOC was home businesses that resembled hobbies.

      I was working a real job and paying real OC rent during the whole circus. At least I can feel smarter nowadays 😉

  7. 3 Cheers for WS

    Lots of news today.
    1. Interest rate to be kept low.
    2. New Home/house sale hit low in Jan.
    3. CNBC realty check with Diana Olick, the mortage walkaway number. Really funny comment on FL RE.

    Looks like the govt. will be keeping up the Ponzi scheme to let the banksters milk every dollar out of the taxpayer.

    Will CA taxes be aligned with Fed Income tax forgiven on principle residence debt forgiveness? Will CA go after those who leave the state and what recourse will CA tax francise board have in other states? Can’t squeeze blood from a stone.

    Only $350 per sq. ft!!!!!!!! Buy before you’re priced out of the market!!!!!!!!!!!! Interest rates will never be this low!!!!!!!!!!!!!! RE talk for I want a commis.

    Still makes sense to own a home with nothing or negative down. Just don’t pay the mortgage and taxes for 2 years. Free rent. It will be close to the elections, so another FC mortorium might go into effect for pre-election show of great policies are taking effect by theFC rate going down right before the elections. Unless GW wants to get rid of BHO and replace him with a new tool.

      1. priced_out

        Why not saddle our next generation with a mountain of debt in their own name? We’ve already saddled them with a mountain of debt in our name that we’ll skip out on by dying…

  8. Housing and rates

    Fed’s next move to hit housing, mortgage rates:

    “……….. Dean Baker, co-director of the Center for Economic and Policy Research, argues that the Fed’s program and tax credit for home buyers “ended the free fall in home prices.”

    But he thinks that the removal of this support could mean that home prices could start to drop by as much as 1% a month again. He also thinks mortgage rates could climb by as much as a percentage point in the coming months….”

    This COULD be interesting.

    1. wheresthebeef

      It’s a pretty sad state of affairs when the housing market can’t function with 6% interest rates.

      Only a matter of time before it all hits the fan. All these jokers were wrong in the past, what makes you think the outcome will be different this time.

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