When a short-sale occurs, and a 1099-C is received, is it taxable?
This is a question we sometimes receive. Whether the 1099-C is taxable (or even correct), is a matter of fact and law. California tends to treat mortgages secured by "dwellings", as defined in CA law as nonrecourse debt.
Late 2013, the IRS sent a letter to CA indicating how they will treat cancelled debt resulting from short-sales in CA. Because of anti-deficiency statutes, the debt is nonrecourse meaning the sales price is equal to the debt outstanding, which §121 can apply rendering the occurrence non-taxable. You can see the letter below.
This leaves a few questions, is "bad money" taxable? Is second mortgage debt or refinanced debt taxable?
This depends on CA law on whether it meets the civil procedures to be nonrecourse which is based on real estate law.
This letter is not a formal ruling, however, it does give you indication on how the IRS will treat the sale of the home and the resulting canceled debt. When receiving Form 1099-C for a principal residence, further inquiries may be needed. Sometimes the lender changes and information is missed on the bank's side, which can impact the accuracy of the information on Form 1099-C.
There has been an updated letter from the IRS clarifying and narrowing the scope of how the civil procedures in CA works. The IRS, while not reversing their position, has distinguished between loans that meet the anti-deficiency statutes and those that do not.
They separate it into two categories, those that are nonrecourse from inception of the loan and those that are nonrecourse due to non-judicial proceedings. They stand by their interpretation that if the loan is nonrecourse from inception to purchase a residence, there is no cancelled debt.
However, they clarify that not all loans meet this criteria. Professional judgment is required in determining if your taxpayer has cancelled debt income.
IRS letter to Senator Boxer
Senator Boxer's letter to the IRS