California Short Sale Taxes vs. Personal Liability

A reader from my homebuying website on About.com asked me this morning if he could stop paying on a promissory note after his short sale closed. His short sale agent negotiated, he said, two purchase-money loans in 2010, in which he ended up paying the second lender $5,000, plus he handed over an additional $10,000 promissory note to a credit union. I suspect that the credit union loan was not a purchase-money mortgage because credit unions were not in the business of financing 80 / 20 combo loans. I’m betting that second loan was a hard-money loan. But that’s neither here nor there. The main problem for this guy seems to be that he negotiated a discounted payoff and promised to repay part of it, which he hopes to undo.

This is a pretty good example of short sale confusion. Not only do some people hope that once a law changes or goes into effect that it’s retroactive and can reach back into the past to change agreements or somehow alter things that were legal to do into being against the law — which ain’t gonna happen — but personal liability is often confused with taxation issues. Whether in California a seller has personal liability for a loan after a short sale is a separate issue from whether a seller is liable to pay taxes on that forgiven debt. Mortgage debt relief and whether banks can legally pursue a seller for a deficiency are not the same thing. They are two different things.

But wait, you might say, does this mean a bank might try to collect the balance due on a short sale at the same time the government goes after a seller for taxes on that balance due? Yes, that’s exactly what I am saying. It’s a double whammy.

Fortunately, SB 458, passed in California in July of 2011, added Section E to the California Civil Code 580. It basically says that short of mortgage fraud, in which case it can still pursue, if a seller does a short sale on 1 to 4 units, the bank can’t pursue; can’t go after the seller. But that’s for short sales that closed after July of 2011. It doesn’t matter if the loan was hard money or purchase money, whether the property was owner occupied or a rental, whether the loan was in first, second or third position. Can’t go after the seller. This is a good reason to avoid foreclosure and try to do a short sale. Especially if a seller has a hard-money loan because, legal experts say, foreclosure proceedings do not offer any protection for the seller against a hard-money loan.

But can the seller be taxed on a short sale? On the federal side, for 2013, the mortgage debt relief law has been extended to January 1, 2014. The California law regarding short sale taxes for 2012 has expired. State legislators are working on an extension. This is the part where the law after extension the last time was made retroactive. It took California lawmakers almost a year to pass the extension last go around. We were sweating. But then they made it retroactive. Will they do it again this year? We sure hope so. But this is a classic example of why a seller in Sacramento should get legal and tax advice before doing a short sale. Don’t rely on your Sacramento short sale agent to dispense legal and tax advice because we are not allowed to do it.