INCOME TAX ISSUES
CAPITAL GAINS ON SALE OF RESIDENCE: The Federal capital gains rate for long-term (property held for more than 1 year) capital gains for the sale of real estate for most tax payers is 15% ( See Capital Gains Rates for a discussion of Federal capital gains tax rates on investment propertu, particularly the 25% rate for depreciation recapture ). Capital gains in California are taxed at ordinary income tax rates (up to 9.3%). For the sale of a personal residence, if it meets certain requirements (see the links below), up to $500,000 of the gain ($250,000 if filing as a single) may be excluded from the gain on sale calculation for both Federal and California tax purposes. .For a few good links to an explanation of the Federal tax laws explained in plain english relating to the sale of a personal residence, and the exclusions from gain available see the following links:
For a link to the IRS regulations regarding the sale of a residence, see the following link:
Note that in this link, there is a discussion regarding exceptions to the general rule that you can only exclude all or some of the gain for a home sold every two years. There are exceptions if the home is sold due to: a change in place of employment, Health, or unforeseen circumstances (as defined ). Note that this results in a "pro-rated exclusion" depending on how many months the property was sold compared to the 2 year allowable period.
INCOME TAX BENEFITS OF HOME OWNERSHIP: The following link is a good summary of the tax benefits of home ownership, including a discussion of the tax deductibility of mortgage interest, property taxes, and other issues: https://www.mortgagecalculator.org/helpful-advice/home-ownership-tax-benefits.php
To estimate the tax benefits of your proposed home purchase compared to renting, click here.You should use the "marginal" tax rate, which is the tax rate that your last dollar earned during the year is taxed at. Use the IRS tax table to estimate your marginal rate (look at the table and use the rate for your total taxable income you expect for the year) based on whether you are single, married or head of household. This will give you an estimate of the tax savings you will enjoy compared to if you were to take the standard deduction for federal purposes (the calculator includes points paid to the lender in the first year--your tax benefits in future years will be less). The program asks you to input the state tax rate. These tables reflect the 2018 changes to the tax law.You should, of course, consult with your own tax professional in evaluating the tax ramifications of your home purchase and should not rely on these calculations in making your home purchase decision.
Federal 1031 Tax Free Exchange:
1031 Tax Free Exchange is available for property held as Investment Property and not as a Personal Residence
"Federal Tax regulations allow for the deferral of gains on the sale of real property, if the property is exchanged for a similar property meeting certain "like-kind" requirements. The exchange property must be identified within 45 days after you complete the escrow and transfer of title to the Relinquished (sold) Property, and the exchange must be completed within the earlier of a)180 days after the transfer of the Relinquished Property or b) the due date (including extensions) for your tax return for the taxable year in which the transfer of the Relinquished Property occurs. You may identify more than one property as Replacement Property subject to three rules: the 3-property rule, the 200% rule, and the 95 percent rule. You only have to satisfy one of these rules-not all of them. "
"The maximum number of replacement properties you may identify is three properties without regard to fair market values of the properties. You may identify any number of properties as long as their total fair market value does not exceed 200 percent of the total fair market value of all Relinquished Properties. You figure fair market value of Replacement Property as of the end of the identification period. You figure fair market value of Relinquished Properties as of the date you transfer them. You may identify any number of Replacement Properties if the fair market value of the properties actually received by the end of the exchange period is at least 95% of the aggregate FMV of all the potential replacement properties identified. The Replacement Property you wish to acquire needs to have a value equal to, or greater than, the adjusted sales price of the Relinquished Property. All proceeds from the Relinquished Property sale need to be invested in the Replacement Property. Replacement Property is identified only if it is designated as Replacement Property in a written document signed by you. This document must be hand delivered, mailed, telecopied or otherwise sent before the end of the identification period to a person (other than yourself or a related party) involved in the exchange."
"Section 1031 requires an actual exchange of properties. If you simply sell your property and reinvest the money in another property, you will not qualify for exchange treatment, even though it is a simultaneous close. The secret of a successful deferred exchange is avoiding receipt of money or other property during the transaction. If you receive the cash proceeds from the exchange of your property, you will not qualify for 1031 treatment. The deferred exchange Regulation provides a "safe harbor" that permits you to sell your Relinquished Property and acquire Replacement Property and avoid constructive receipt. This safe harbor is your written contractual agreement with a Qualified Intermediary."
"The Qualified Intermediary does not provide legal or specific tax advice to the exchanger, but will usually perform the following services:
- Coordinate with the exchangers and their advisors, to structure a successful exchange.
- Prepare the documentation for the Relinquished Property and the Replacement Property.
- Furnish escrow with instructions to effect the exchange.
- Secure the funds in an insured bank account until the exchange is completed.
- Provide documents to transfer Replacement Property to the exchanger, and disburse exchange proceeds to escrow.
A reverse exchange is a transaction in which the Replacement Property is acquired before the Relinquished Property is sold. This powerful tax planning procedure permits you to acquire the Replacement Property currently under favorable circumstances before you are able to sell the Relinquished Property. " There are two methods of completing a reverse exchange. In either case, the Qualified Intermediary is required to hold title to one of the assets involved in the exchange (either the Replacement Property or the Relinquished Property) during the exchange period for the exchange to fall within the IRS safe-harbor guidelines."Exchange First" is where the Qualified Intermediary buys the Replacement Property on behalf of the taxpayer and then simultaneously exchanges the Replacement Property for the Relinquished Property, therefor the Qualified Intermediary temporarily takes title to the Relinquished Property, until the Relinquished Property is sold to an independent third party, while the taxpayer takes title to the Replacement Property. "Exchange Last" is where the Qualified Intermediary takes title to the Replacement Property until the Relinquished Property is sold, at which time the exchange is made. The type of Reverse Exchange that an Exchangor uses typically depends on the way in which the Replacement Property is being purchased. If the Exchangor is using cash or private financing, either type of Reverse Exchange can be used. If the Exchangor is using conventional financing, an Exchange First is the preferred option because lenders seldom agree to have a third party, in this case the Qualified Intermediary, "on title" to the property securing the loan. The "like-kind" property requirements and the 180-day deadline of delayed exchanges also apply to Reverse Exchanges.
For an additional source of information on 1031 exchanges, use the following link:
Withdrawing funds from a 401(k) or an IRA for a down payment on a home: To avoid penalties and taxes, you may borrow funds from your company's 401(k) for a down payment on a home, if the plan allows it. You may not borrow money from an individual IRA, and any withdrawals to use funds from an IRA would be subject to early withdrawal penalties as well as income taxes.
Debt Forgiveness - Federal and California Tax Issues
For most states, other than California as explained below, if you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is normally reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.The amount of debt forgiven must be reported on Form 982 and this form must be attached to your tax return
The Mortgage Debt Relief Act of 2007, however, generally allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. This provision applies to debt forgiven in calendar years 2007 through 2017, but has not yet been extended past 2017. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion does not apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home's value or the taxpayer's financial condition. For California purposes, this exposes some taxpayers to debt forgiveness income for foreclosure properties and loan modifications, but in most instances will not result in debt forgiveness income for residential short sales as explained below.
The Act applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes. In addition, the debt must be secured by the home. This is known as qualified principal residence. If you refinanced, the debt is eligible but only up to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. If you take out additional equity, that debt does not qualify for this exclusion.For instance, home equity lines of credit must have been used to make improvements to the home, and if used to buy a car would not qualify.
If the debt forgiven is not for your personal residence, the forgiven debt may qualify under the insolvency exclusion. Normally, you are not required to include forgiven debts in income to the extent that you are insolvent. You are insolvent when your total liabilities exceed your total assets. The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness. If you believe you qualify for any of these exceptions, see the instructions for Form 982. Publication 4681 discusses each of these exceptions and includes examples.
California law generally conformed with federal law, the Mortgage Forgiveness Debt Relief Act of 2007, with the following exceptions:
(1) The maximum amount of acquisition indebtedness is reduced to $800,000 for couples filing jointly and $400,000 for individual filers;
(2) The maximum amount of debt relief income that can be forgiven is $500,000 for couples filing jointly and $250,000 for individual filers; and
(3) California's debt relief statute applies to property sold on or after January 1, 2007 and before January 1, 2013. It was not extended when Congress extended the Federal tax act to 12/31/2013. This therefore exposes some California taxpayers to debt forgiveness income for foreclosures, but California taxpayers are generally not exposed to debt forgiveness income for short sales as noted below.
California Short Sales: Section 580e of the California Code of Civil Procedure also addresses mortgages. This section was added in 2010 and it prohibits a deficiency judgment on specific agreed to "short sales" (allowing the defaulter to sell the house at below cost, and the lender accepting the proceeds as payment in full). In 2011, section 580e was amended to expand its provisions in order to mitigate the impact of the ongoing foreclosure crisis and to encourage the approval of short sales as an alternative to foreclosure. This relates only to principal residences.
According to an IRS Information Letter dated September 19, 2013, the IRS has determined under the 2011 changes to the California Code of Civil Procedure Section 580e, that California taxpayers who sell their principal residences in a short sale for less than what is owed on the home are relieved of incurring cancellation of indebtedness income, if the lender agrees to the short sale as full consideration of the mortgage debt, and there will be no cancellation of indebtedness income.
The IRS’s letter answered the question regarding whether a homeowner would have taxable cancellation of indebtedness (COD) income when the lender approved a short sale considering California’s Code of Civil Procedure (CCP) section 580e. The letter finds California’s anti-deficiency provision under section 580e of the CCP which generally prohibits a lender who holds a deed of trust from either claiming a deficiency or obtaining a deficiency judgment from the homeowner after agreeing to a short sale, treats the homeowner’s obligation as a nonrecourse obligation for tax purposes.
This means in California, upon a lender’s acceptance of the short sale any CCP 580e qualifying cancellation of indebtedness income is nontaxable nonrecourse debt. CCP 580e does not apply to all short sales. In addition to other restrictions this law states it does not apply if the trustor or mortgagor is a corporation, limited liability company, limited partnership, or political subdivision of the state.
California conforms to the relevant portions of the federal tax law governing the forgiveness of nonrecourse and recourse debt, so if the lender agrees to the short sale as full consideration of the mortgage debt, for tax purposes, the loan will be nonrecourse thus, there is no cancellation of indebtedness income for California tax purposes.
In California, for foreclosure purposes, purchase money home loans used to initially acquire a home are considered nonrecourse because lenders are prohibited from seeking a deficiency judgment against the borrower after a foreclosure sale of real property that secures a purchase money loan. CCP §580. A subsequent refinancing of the loan would result in its not being a purchase money mortgage and would be a recourse debt. A loan is nonrecourse if the lender's only remedy in case of default is to repossess the secured property (because the lender cannot reach the borrower's other assets to satisfy any shortfall). Under these circumstances, the unpaid principal balance of the mortgage is not seen as being "forgiven" or "cancelled" and does not cause the borrower to have cancellation of indebtedness income. Treas Reg §1.1001-2(a)(4)(i) and (c), Examples 7-8; IRS Letter Ruling 9302001. Thus, there would be no debt foregiveness in California for those who had used purchase money indebtedness to acquire or substantially improve a principal residence. Such homeowners would not have cancellation of indebtedness income to exclude because their loans were considered nonrecourse in the first place.
For foreclosures, The following comes from the California Franchise Tax Board website :
"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."
"Although forgiveness of a non-recourse loan resulting from either a foreclosure or a short sale does not result in COD ( Cancelation of Debt ) income, it may result in other tax consequences, like a reportable gain from the disposition."
"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. "
"If the loan is a recourse loan, then depending on the facts, you may have COD income, and potentially a reportable gain".
The above rules generally apply to reductions in loan balances for loan modifications as well. Effective January 1, 2013,however, a refinancing for a California dwelling for not more than four families occupied entirely or in part by the purchaser will still be nonrecourse for the portion of the loan principal refinanced that was a purchase money mortgage.It is not clear, however, if this would be effective for subsequent refinancings.
In California, therefore, there are significant tax advantages to complete a short sale versus losing a property through foreclosure. Make sure and consult with your own tax accountant or attorney when making this decision.
A seller of a short sale property or a foreclosure sale could be "insolvent" for tax purposes, i.e., overall debts exceed assets at the time the cancellation of debt income is realized. When a taxpayer is "insolvent," under both state and federal law, the tax liability for the cancellation of debt could be limited or eliminated.
For further information on other tax issues relating to foreclosures and short sales including both calculation of gain or loss as well as debt forgiveness issues , see the excellent article Tax Consequences of a "Short Sale" of Real Estate vs. Foreclosure
**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**