In a recent letter to California Senator Boxer, the IRS clarified the tax rules for California homeowners to treat nonrecourse debt in a short sale, the same way we treat nonrecourse debt in a foreclosure.
The new letter states, in part:
Section 580b(a)(3) of the California’s Code of Civil Procedure (CCP) provides that:
A deficiency judgment will not apply in any event after a sale of real property under a mortgage that secures a purchase-money loan.
A purchase money loan is a loan that was used to pay all or part of the purchase price of an owner-occupied dwelling for no more than four families, and that is secured by the property.
Therefore, the IRS states their understanding is for loans that qualify under section 580b(a)(3), a lender has no recourse against a mortgagor for a deficiency under any circumstance. The cancellation of a nonrecourse loan upon disposition of property does not result in cancellation of indebtedness (COD) income. In addition, under section 580b(a)(3), a “purchase-money loan” includes a loan used to refinance a purchase-money loan, or subsequent refinances of a purchase-money loan, except to the extent that the lender lends new principal that is not applied to an obligation owed or to be owed under the purchase-money loan.
If you are considering filing amended returns for your clients based on this new IRS letter, you should also file corresponding California amended tax returns.
To read the 2014 IRS Information letter, see this link.