IRS Reneges On Prior CA Short Sale Guidance

Background: As you all should know Sec 580b of the California Code of Civil Procedure (CCP) provides that no deficiency shall be owed or collected, and no deficiency judgment shall be awarded, with regard to a purchase money trust deed on a dwelling for not more than four families given to a lender to secure repayment of a loan that was used to pay all or part of the purchase price of that dwelling, occupied entirely or in part by the purchaser. Thus in such cases there is no cancellation of debt (COD) income as a result of the foreclosure or short sale of such property. The COD income is not included on the return and no Form 982 is required.  Report only the disposition of the property as if the loan was non-recourse.  This applies for both federal and California.
Purchase money trust deed refers to an original loan or loans used to purchase the property and should not be confused with acquisition debt, which includes debt used to acquire or substantially improve the property, or refinanced acquisition debt.
Short Sale Legislation: Section 580e of the California Code of Civil Procedure was amended by SB 458 and was signed into law by Governor Brown on July 11, 2011.   Under this law, no deficiency shall be owed or collected, and no deficiency judgment shall be requested or rendered for any deficiency upon a note secured solely by a deed of trust or mortgage for a dwelling of not more than four units, in any case in which the trustor or mortgagor (borrower) sells the dwelling for a sale price less than the remaining amount of the indebtedness outstanding at the time of sale.  These rules only apply where:
  • No fraud or waste has been committed with respect to the real property secured by the debt.  If fraud or waste was committed, then the holder of the deed of trust or mortgage (lender) may seek damages and use existing rights and remedies against the trustor or mortgagor (borrower) or any third party for fraud or waste.
  • The short sale is in accordance with the written consent of the holder of the deed of trust or mortgage (lender).
  • Title has been voluntarily transferred to a buyer by grant deed or by other document of conveyance that has been recorded in the county where all or part of the real property is located.
  • The proceeds of the sale have been tendered to the mortgagee, beneficiary, or the agent of the mortgagee or beneficiary (lender), in accordance with the parties' agreement.
  • A holder of a note (lender) shall not require the trustor, mortgagor, or maker of the note (borrower) to pay any additional compensation, aside from the proceeds of the sale, in exchange for the written consent to the sale.
Section 580e applies the same treatment to any secondary or junior loans involved in the transaction.
The Big Question was how does this impact the COD calculation for federal purposes?  Does amended Section 580e make loans non-recourse for federal purposes when there is a short sale?
Original IRS Guidance - Back in August of 2013, Senator Barbara Boxer attempted to get some clarification on this issue by writing Acting Commissioner Daniel Werfel. The Acting Commissioner passed the letter on to the IRS Office of Chief Counsel who responded to Senator Boxer. In the letter - Number 2013-0036, the IRS stated that they believed that a homeowner's obligation under the anti-deficiency provision of section 580e of the CCP would be a nonrecourse obligation to the extent that, for federal income tax purposes, the homeowner will not have cancellation of indebtedness income. Instead, the homeowner must include the full amount of the nonrecourse indebtedness in the amount realized. The IRS also specifically noted that they did not express an opinion on whether an indebtedness described in section 580e of the CCP is treated as nonrecourse debt for other federal income tax purposes.
Here we are several months later, and the IRS Office of Chief Council has decided to change their position. In a letter to Senator Barbara Boxer dated April 29, 2014 the IRS now says that the short sale legislation passed by the California legislature in 2011 does not change the character of a recourse loan to non-recourse.
Senator Boxer has responded by requesting additional clarification and relief for taxpayers that relied upon the IRS's first stated position.
Unmentioned in the latest round of letters is section 580b(c) that extends that anti-deficiency protection to include any loan used to refinance the purchase money loan, plus any loan fees, costs, and related expenses for the refinance. The anti-deficiency protection, however, does not extend to any cash out in a refinance. This new law only applies to refinance loans or other credit transactions used to refinance a purchase money loan, or subsequent refinances of a purchase money loan, that are executed on or after January 1, 2013.
A lot of unanswered questions remain related to this issue, and the IRS letters indicate the Service's opinion and are not statutory.  The conservative position would be to treat a short sale with recourse debt as cancellation of debt. You and your client will need to discuss whether to amend prior filed returns now or wait for further clarification.
June 03, 2014 by Lee Reams II
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