Distressed homeowners no longer have to pay California state income tax on debt forgiven in a short sale, foreclosure, or loan modification.  Senate Bill 401, enacted April 12, 2010, generally aligns California's tax treatment of mortgage debt relief income with federal law.  Qualified principal residence borrowers will now be exempt from both federal and state income tax consequences.  The new California exemption is for indebtedness up to $800,000, rather than $2 million, and forgiven debt up to $500,000.

Qualified principal residence indebtedness is debt incurred in acquiring, constructing, or substantially improving a principal residence.  It includes both first and second trust deeds.  It also includes a refinance loan to the extet the funds were used to payoff a previous loan that would have qualified.

The tax breaks apply to debts discharged from 2009 through 2012.  Californians who have already filed their 2009 tax returns may claim the exemption by filing a Form 540X amendment.

However, taxpayers who do NOT qualify for the above exemptions may be exempt under other provisions.  Unfortunately, bankrupt and insolvent taxpayers are exempt from debt relief income tax.

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