It appears that "Californians who lose their homes in a foreclosure, short-sale or deed in lieu of foreclosure this year could be hit with a state income tax on canceled or forgiven debt." The current CA state law that had "temporarily exempted many homeowners from this tax at the state level" expired at the end of last year. Unfortunately, there were many attempts to revive it, but these have not resulted in any success.

This state law was quite similar to a federal one that exempts some homeowners from federal tax on canceled mortgage debt. The federal law, however, has been extended through 2012. It appears that CA state tax may result in a substantial number of taxpayers who were experiencing mortgage related problems and received some kind of debt forgiveness from a lender, may be faced with a potential state income tax liability.

Also, if these homeowners are behind in their payments, they should consult thier tax advisors to determine their particular tax consequences as a result of any pending bank action that could result in any debt forgiveness.

According to the current tax law, when a banker or lender forgives debt, the forgiven amount is generally taxed as income. But there are exceptions and this depends on whether or not the debt is considered to be Non-Recourse or Recourse Debt.

What is a Non-Recourse Loan?
A mortgage that has been obtained to purchase a principal home is considered nonrecourse loan. According to the IRS tax code,generally speaking, any forgiveness of a nonrecourse mortgage will not result in any tax on the canceled debt income.

What is a Recourse Loan?
If a borrower refinances his or her home mortgage loan and takes cash out, or obtains a home equity loan, that debt is generally considered recourse debt. According to the IRS tax code, forgiveness of recourse debt is subject to income tax.

Of course, there are some exceptions to this tax liability if the borrower is bankrupt or insolvent then he or she may be exempt from this tax liability.

What are the Federal Debt Forgiveness Limits?
The maximum amount of debt that can be exempted under the federal law is $2m for married filers and single taxpayers (married people filing separately the amount is $1m). The law applied to debt forgiven in 2007 through 2012.

What are the California Debt Forgiveness Limits?
The legislators in California State partially conformed with the federal law for debt forgiven in 2007 and 2008, but with much lower limits. According to the current tax law, the maximum amount of debt forgiveness that could be excluded from CA state taxes for married and single filers was $250,000 ($125,000 for married filing separately.)

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