California Continues to Tax Forgiven Recourse Debt

Originally posted at the Irvine Housing Blog.

Today we look at one family in San Diego hoping for debt forgiveness that isn’t going to happen.

Love is like oxygen
You get too much you get too high
Not enough and you’re gonna die
Love gets you high

Time on my side
I got it all
I’ve heard that pride
Always comes before a fall

Sweet — Love Is Like Oxygen

Appreciation is like oxygen, you get too much prices get too high, not enough and your gonna die — or at least be forced to pay down debts – a fate antithetical to a borrowing dependant lifestyle.

Recently, I wrote about The Coming Tax Nightmare Over Forgiven Mortgage Debt in California, and recently another story was written about the Hefty tax bill may hit those who lost home.

San Diegans who have lost their homes through foreclosure or short-sales thought they had emerged from the dark times and could start rebuilding their lives.

Then the state tax man came calling.

With less than six weeks before taxes are due, an estimated 16,000 former homeowners statewide will owe $15 million in extra income taxes this year and $29 million through 2012.

Today we look at one family lamenting the $20,000 tax bill they must pay for their failed speculation.

[March 2, 2010 | Photo by Charlie Neuman. Bonnie and Clyde are facing a California tax bill of up to $20,000 because, they have found, the state treats short-sales differently than the IRS.]

Phyllis Roth, 63, a tax preparer, said she did not realize until recently that the state would treat the short-sale differently than the Internal Revenue Service would. She estimates her state taxes at $15,000 to $20,000.

“I didn’t call anybody,” she said. “I was looking online and didn’t see anything. That’s what happens when you rely on yourself.”

Brilliant marketing for her tax preparation business, “Let me help you miss a $20,000 tax obligation. I did.”

For the Roths, who continue to own a previous home and have other assets, their nearly $200,000 in losses does not cancel out their other holdings. The couple said they normally operate conservatively and only bought the home, which they lived in while their son continued to live in their first house, so they could sell it at a profit and pad their retirement accounts.

“If we have to pay it, we’ll pay it,” Phyllis Roth said of the taxes. “It’s less money to retire on, but it’s not the end of the world.”

If we have to pay it? Sure, let’s take our broken State budget and carve out a tax break for HELOC abusers and everyone else who lost money speculating in the housing market. That should provide a great incentive for frugality and curb speculation. Not.

Congress exempted most homeowners from the extra federal tax through 2012, and the state followed suit for 2007 and 2008 but did not extend the provision last year. The state Assembly may vote tomorrow on a bill to repeal the tax, but Gov. Arnold Schwarzenegger vetoed such a bill last year over unrelated provisions.

“The state of California is seriously upside down financially, and I think the governor will probably veto it again,” Nemeth said.

H.D. Palmer, a spokesman for the Department of Finance, said Schwarzenegger remains opposed to the bill in its present form but has not announced whether he will veto it again. Other versions of the tax repeal are in the hopper and could be passed next month, legislators’ analysts said.

Failure to halt the tax could cost Jack and Phyllis Roth of Fletcher Hills as much as $20,000 in state income taxes this year — they paid $781 last year — because of the home they sold short in Flinn Springs in November. They bought it in 2004 for $545,000, invested $50,000 in improvements, and then saw its value fall by one-third before they sold it for $410,000. The result was about $190,000 in net loss that was forgiven by the Roths’ lender.

Notice the words the reporter selected, “They bought … invested.” They did neither of those things; they borrowed. These people put no money down, borrowed another $50,000, sold for a $190,000 loss, and they are complaining because they might lose $20,000 of their money in taxes. We are not saving an already injured party from further pain, we are removing the only real pain these people will feel.

[schadenfreude alert] The state Franchise Tax Board has received an increasing number of calls from former homeowners who are discovering the giant tax bills they face, said spokeswoman Denise Azimi. Azimi said the former homeowners can work out a payment schedule, though the state charges 4 percent interest on such stretched-out payments.

If the tax is repealed eventually, the taxpayers could seek a refund, but for now, they have to pay what is due by April 15 or face a penalty.

Sen. Lois Wolk, D-Davis … who chairs the Senate Revenue and Taxation Committee, said it was appropriate to group all tax conformance measures into one bill. But if her bill is vetoed again, she indicated she would act to get the cancellation of debt tax repealed.

“We’re certainly not going to allow homeowners to have to pay significantly more tax when they’ve had to relinquish their homes through short-sales (and foreclosures),” Wolk said.

Why not? People who have non-recourse purchase money mortgages are not getting a tax bill. It is only investors, speculators, multiple-property owners, HELOC abusers and others with recourse loans who are getting a break. They are not a group who needs subsidies.

Insolvency

Every borrower will try to establish insolvency as defined by the Internal Revenue Service:

Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities exceeded the FMV of all of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account). Liabilities include:

• The entire amount of recourse debts, and
• The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt.

As defined by the IRS, insolvency is a condition of negative net worth; in other words, if you have no assets for the IRS to take, they will leave you alone. True or not, the incentive to feign and declare insolvency is huge.

How many people are filling false tax returns claiming insolvency when in reality, they just don’t want to pay, and they hope they can cheat and get away with it?