Tax relief for those with lost homes

SACRAMENTO -- Tax relief is on the way for thousands of fearful California mortgage borrowers. Most no longer face the double whammy of losing their homes and then paying a big state tax bill on the forgiven debt.

State lawmakers Thursday passed Senate Bill 401 by Sen. Lois Wolk, D-Davis, to exempt borrowers who lost homes to foreclosure or short sales in 2009 from state taxes that can run into thousands of dollars. The same is true for certain types of loan modifications.

State tax officials say 100,000 people will be spared paying tax they otherwise would owe.

A spokesman for Gov. Schwarzenegger said he will sign the bill.

What it does: SB 401 aligns much of California's tax code with the Internal Revenue Service. The U.S. government has banned the IRS from taxing forgiven mortgage debt as extra household income from 2007 through the end of 2012. California did the same for the 2007 and 2008 tax years.

The bill extends the state ban through 2012. It also bans state taxes on federal stimulus grants for renewable energy projects.

Who is affected: Primarily, the bill will affect people who had debt forgiven as they lost homes through foreclosures, short sales and deeds in lieu of foreclosure.

Also affected are those who got loan modifications that cut what they owed the bank.

In short sales, a bank might accept a sales price of $250,000 when it is still owed $350,000 on the home. In deeds in lieu of foreclosure, the bank simply takes back the house and may forgive what's still owed. The difference is the forgiven debt.

Borrowers can avoid state taxes on up to $500,000 in forgiven debt.

The Franchise Tax Board says the tax forgiveness measure mostly applies to people who refinanced homes to get better interest rates or extract equity, then had a short sale or foreclosure in which debt was forgiven.

But the tax board warned that refinanced dollars taken as cash and spent on items other than home improvements may be taxable.

Who is not affected: Those who bought houses and never refinanced before doing a short sale, loan modification or foreclosure are unaffected. In most cases the banks just take back the houses. There is no forgiven debt and no tax bill, said the tax board.

Investors also are unaffected. They must pay state taxes on forgiven debt. The bill affects only people who lived in their home.

What people should do now when filing their taxes: The Franchise Tax Board says: "Once the governor signs this into law, California taxpayers will not have to do anything. If they qualify for federal relief on the mortgage debt forgiven, then they will also qualify for state income tax purposes. California Form 540 starts with federal adjusted gross income, so there will be no adjustment necessary."

What this will cost the state: The tax board estimates it will collect about $34 million less in taxes as a result of the bill in this and coming years. The bill will grant relief to about 100,000 taxpayers statewide from now through 2012, agency spokeswoman Brenda Voet said Thursday.