A recent IRS letter to Senator Barbara Boxer concerning the income tax implications of short sales by California homeowners seems to be provoking unqualified celebration. This headline – IRS Will Not Penalize Cali Families Losing Homes To Short Sales -is fairly typical. There was a lot of concern about this because at the end of 2013 the generous exclusion from debt discharge income when qualified principal residence mortgages are involved is set to expire. People losing their homes in a short sale is upsetting enough. The idea that they will end up with a tax bill if the bank does not pursue a deficiency judgement is really upsetting. Hence the celebration since the import of the letter is that there will be no debt discharge income when California homeowners end up doing short sales.
I hate to spoil a nice celebration, but I am going to risk it. The position that the IRS outlined in the ruling is probably good news for most people affected by it. It may not be good news for everybody, though. In order to understand why you have to understand the IRS reasoning. Here is the deal. When debt is secured by property, it is either recourse or non-recourse. Recourse means that even if the property is taken in satisfaction of the debt the creditor can still pursue the debtor. If the debt is non-recourse, the debtor can just hand the creditor the keys and walk away.
Copy of the Letter Below