In a letter to Senator Boxer dated September 19, 2013, IRS Chief Counsel Michael J Montemurro gave a statement on the treatment of debt forgiveness and short sales in the state of California.  In his statement Chief Counsel set forth (with respect to California short sales) the difference between the loan balance and the sales price (which might ordinarily be considered cancelation of debt)  be treated as nonrecourse indebtedness for federal income tax purposes.  The homeowner must include the full amount of the nonrecourse debt in the amount realized on the sale of the property.  If there is a gain on the sale it must generally be included in gross income; however, if the property was the owner’s principle residence a Section 121 exclusion may apply.

The reason Chief Counsel gave for treating short sale debt forgiveness as nonrecourse debt is the effect of Sec. 580e of the California Code of Civil Procedures on the sale.  California’s “anti-deficiency provision” under Sec. 580e effectively limits the homeowner’s liability to the amount the lender receives on the sale of the property, making the homeowner “not personally liable for the deficiency balance.”  Generally, loans for which an individual is “not personally liable” are considered nonrecourse loans.

Chief Counsel included the following statement, “We do not express an opinion on whether an indebtedness described in section 580e of the CCP is treated as nonrecourse debt for other federal income tax purposes.” and “Also, federal law may override California’s anti-deficiency provision in certain circumstances.  If any state or federal law would have the effect of nullifying an obligation’s nonrecourse status, we would generally consider the obligation a recourse obligation subject to the application of the cancellation of indebtedness provisions…”  So while this letter is indeed great news for Californians, care must be taken the taxpayer’s situation meets the requirements of nonrecourse indebtedness before excluding it from the cancelation of debt rules.

For the full text of  this letter by Chief Counsel, visit