Both the Internal Revenue Service and the California Franchise Tax Board have issued clarifying statements to reassure taxpayers in California that debt written off after a short sale of a home will not be considered income for tax purposes. This is a major issue for many California homeowners who bought when prices were inflated and who now owe more on their mortgages than their homes are worth (called "underwater" homes).
When cancelled debt is counted as income it can create huge tax liability for families who are already struggling financially. In the case of cancelled debt on mortgages this can reach into the tens of thousands or even hundreds of thousands of dollars, pushing them into a much higher marginal tax rate and creating a difficult situation when they attempt to pay off a tax bill the following year.
The clarification on this issue came after California Senator Barbara Boxer made a formal request to ensure that taxpayers knew where they stood as the year ended. Uncertainty about tax liability makes it difficult to plan for the year ahead and to properly allocated financial resources to various commitments.
Income tax liability on cancelled debt had previously been an issue most commonly seen during bankruptcy proceedings when individuals have large quantities of consumer and other types of debt discharged. However, after the housing market crashed there as an influx of underwater homes, ballooning mortgages payments, and an overall increase in families losing homes to foreclosure or short sales. As a result, Congress passed the Mortgage Forgiveness Debt Relief Act to make special provisions for those who had been impacted by the complex banking issues that led to the housing bubble bursting.
Source: San Jose Mercury News, "Distressed sellers not subject to taxes," Rose Meily, Dec. 16, 2013.