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Health & Fitness

California Home Owners

Troubled homeowners who get a break from their mortgage lenders could face a hefty tax bill next year if a key provision expires at the end of the year, though state laws could determine which borrowers will have to write a check to Uncle Sam.

Homeowners who live in states where mortgages are non-recourse—that is, where they aren’t personally liable for the unpaid balance—may avoid the potential tax hit even if Congress doesn’t act,according to a letter sent by the Internal Revenue Service released by Sen. Barbara Boxer (D., Calif.) on Friday.

The tax provision currently allows some homeowners—mostly those facing foreclosure—to avoid paying taxes on certain relief that they receive on their mortgages. The IRS considers debt forgiveness to be a form of taxable income. That means homeowners who sell their homes for less than the amount they owe in a short sale could face a tax bill.

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In 2007, as the foreclosure crisis spread, Congress exempted some homeowners from counting certain kinds of forgiven mortgage debt as taxable income in order to encourage banks and borrowers to seek foreclosure alternatives. Congress retroactively extended the provision earlier this year, after it expired on Dec. 31, 2012. The provision is set to expire this coming Dec. 31 and there appears to be less urgency in Congress right now to pass an extension.

In the letter to Sen. Boxer, the IRS clarified that certain non-recourse debt forgiven by lenders wouldn’t typically be considered taxable income by the IRS. This means that for most California borrowers, the expiration of the tax provision may not have a meaningful effect.

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“California homeowners have struggled through years of economic hardships during the Great Recession,” said Ms. Boxer in a statement Friday. “I am relieved that these families will not face a burdensome tax penalty just as they are trying to rebuild their lives with a short sale.”

In the letter, the IRS wrote that “if a property owner cannot be held personally liable for the difference between the loan balance and the sales price, we would consider the obligation a non-recourse obligation.” As a result, the owner would not have to count that forgiven debt as income.

Other states with laws that prevent lenders from seeking so-called “deficiency judgments” to recoup defaulted debts from borrowers would likely be in the same camp as California, the letter said.

Short sales have fallen sharply as a share of overall sales over the past year as the housing market has rebounded and fewer homeowners have found themselves underwater. In California, short sales accounted for around 12.6% of homes that were resold last month, down from 26.7% one year earlier, according to research firmDataQuickMDA.T -0.43%.

Nationally, lenders have approved more than 200,000 short sales this year through August, according to Hope Now, an industry coalition to promote foreclosure alternatives.

The IRS has more information online about the tax implications of mortgage forgiveness. The National Consumer Law Center has a detailed report on anti-deficiency laws by state.

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