Senate Bill 1055: Damned if You Do, Damned if You Don’t

by Mike Wiegert, broker Chico Homes Real Estate

A bill that is now pending before the California full Senate would make it possible for California taxpayers to avoid paying taxes on forgiven mortgage debt through a short sale, short sale payoff or other loan modifications.

Senate Bill (SB) 1055, authored by Sen. Michael J. Machado, passed the Senate Revenue and Taxation Committee on an 8-0 vote. The measure would help California taxpayers whose lenders have forgiven a portion of their mortgage debt, by allowing them to exclude the forgiven debt from their incomes for state income tax purposes. Under existing state tax law, forgiven debt on mortgages is taxable to the borrower as ordinary income for the year in which the debt is forgiven. OUCH!

Think about it. You’re already in financial straits, otherwise you wouldn’t be in foreclosure. You list your home with your friendly Chico Realtor hoping to stem off the foreclosure and hopefully not have your credit significantly damaged. Next thing you know you’re getting a tax bill from the state. I regrettably report to you that a huge number of home sellers were unaware or didn’t understand the tax implications of the short sale/foreclosure process in Chico CA. Broken record time: Don’t make any major moves in buying or selling Chico real estate without adequate counseling from a trusted and knowledgeable real estate professional, attorney or tax specialist.

“SB 1055 an example of something the Legislature can do to help mitigate the pain that the mortgage crisis is causing,” said Machado. “The last thing we want to do to a borrower who has just lost his or her home is hit them with a higher tax bill.”

Currently, when a bank or other lender forgives debt on a house sold for less than what its value was when the mortgage was funded (a so-called short sale), the owner must pay taxes on the difference. So if a home originally valued at $350,000 sells for $300,000, and the bank forgives the difference, the owner must pay state taxes on the $50,000 difference. A law recently passed by Congress eliminates those taxes at the federal level for the next three years.

At the national level, Treasury Secretary Henry Paulson recently said a correction in the housing market was “inevitable and necessary.” Paulson, speaking last month at a foreclosure forum in Stockton went on to say that 1.8 million subprime mortgages are scheduled to reset to sharply higher rates over the next two years. Reasoning that this mortgage crisis might result in market failure prompted the administration to broker a deal with the mortgage industry to freeze certain subprime mortgage rates for five years, thereby allowing the housing market to recover. The overall effect is yet to be seen but this is definitely a step in the right direction.

In other recent real estate news, an upcoming trend we’re starting to see is actually a reenactment of the long ago use of custom crafted seller “takeback” or carry back financing. This type of financing has been popularly used in past times of stringent mortgage lending practices or higher interest rates.

Takeback financing means property sellers offer mortgages on their own to buyers on mutually beneficial terms. Interest rates, payback terms, and down payments are all negotiable. There is no bank involvement and the seller can spread out receipt of the full price for the property over a period of years. In the meantime, the seller collects interest and principal payments and often gets a balloon payment at the end of a specified number of years.

Senate Bill 1055 is really a temporary alternative solution to the current mortgage conditions and presumes that the property in question has little or no existing loan against it, but in many instances can make the difference to a buyer having trouble qualifying to buy and a seller experiencing difficulty selling.

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Sandi Bauman (Chico Homes): Real Estate Agent in Chico, Butte County, California
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