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TAX NEWS - June 2010

California Tax: New Tax Law Assists Californians With Cancelled Debts

The relief a debtor feels upon a creditor forgiving a portion of a debt often gives way to frustration when the tax man comes knocking. For tax purposes, forgiven debt generally constitutes income.
The relief a debtor feels upon a creditor forgiving or canceling a portion of a debt often gives way to frustration when the tax man comes knocking. For taxation purposes, forgiven debt constitutes income subject to taxation unless there is a statutory directive to the contrary.

Three years ago, Congress opted to give home owners who have become unable to pay their mortgages a break. Under the Mortgage Debt Relief Act of 2007, taxpayers who had their debt reduced through mortgage restructuring or debt forgiven in connection with foreclosure do not have to include the forgiven debt as income for federal tax purposes.

However, federal taxes are only one component of the overall tax burden; homeowners must also pay state taxes, which are governed by state laws. Recently home owners in California have not been granted similar relief under state tax laws.

California law aligned with federal law on this matter in 2007 and 2008, but the protections had lapsed. Accordingly, since 2009, California home owners have been required to treat any forgiven debts as income when calculating state taxes.

Fortunately, California lawmakers have now addressed this burden, once again. Under SB 401, signed into law in April, California law aligns with the federal Mortgage Forgiveness Debt Relief Act of 2007. The new law is effective for tax years 2009 to 2012, retroactively providing relief for those who become unable to pay their mortgages in 2009 and early 2010.

Under the new law, Californians with qualifying short sales of their homes will not be required to pay state income tax on the forgiven debt. The legislation also excludes from state taxation any loan forgiveness associated with home loan modifications or foreclosure.

Many of the home owners affected by the new law have already lost their homes due to the floundering economy. Requiring home owners to pay tax on a debt forgiven because they were without means to pay the original debt seems unnecessarily harsh.

Although a tax break is unlikely to compensate for the loss of a home, it does help to ensure that those facing financial difficulties will be able to return to solid financial ground more quickly.
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