CCP 580e Short Sales: Cancellation of Debt Becomes Non-Recourse Per IRS

Refer Reply to: CONEX-137691-13The Honorable Barbara BoxerUnited States SenateWashington, DC 20510Dear Senator Boxer:

I am responding to your letter dated August 28, 2013, to Acting Commissioner Daniel Werfel. You asked whether a homeowner would have taxable cancellation of indebtedness income on a lender approved short sale that qualifies under section 580e of the California Code of Civil Procedure (CCP).

A short sale involves a sale of property for less than the outstanding mortgage loan balance. When an owner of property enters into a short sale, the lender may hold the owner personally liable for the difference between the loan balance and the sales price. This is the nature of a recourse obligation. If the lender forgives the personal liability, the owner generally must include the forgiven amount of the loan in income unless an exception applies (Section 61(a)(12) of the Internal Revenue Code (the Code)). Congress has provided an exception that allows homeowners who have cancellation of indebtedness income on the sale of their principal residence to exclude the cancelled debt from income if it is qualified principal residence indebtedness. However, this exception will expire at the end of 2013 (Sections 108(a)(1)(E) and 108(h) of the Code).

On the other hand, if a property owner cannot be held personally liable for the difference between the loan balance and the sales price, we would consider the obligation a nonrecourse obligation. In this situation, the owner would not treat the cancelled debt as income. Instead, the owner must report the entire amount of the nonrecourse debt as an amount realized on the sale of the property. If the owner realizes a gain on the sale of the property, the owner generally must include the gain in gross income (Section 61(a)(3) of the Code). However, if the property was the owner’s principal residence, the owner may qualify to exclude all or part of the gain from income (Section 121 of the Code).

In 2011, California enacted an anti-deficiency provision under section 580e of the CCP, which generally prohibits a lender who holds a deed of trust on a homeowner’s principal residence from either claiming a deficiency or obtaining a deficiency judgment from the homeowner after agreeing to a short sale. The statute effectively limits the homeowner’s liability to the amount the lender received on the sale of the principal residence, and the homeowner is not personally liable for the deficiency balance (the difference between the loan balance and the sales price).

We believe that a homeowner’s obligation under the anti-deficiency provision of section 580e of the CCP would be a nonrecourse obligation to the extent that, for federal income tax purposes, the homeowner will not have cancellation of indebtedness income. Instead, the homeowner must include the full amount of the nonrecourse indebtedness in amount realized. (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.)

Section 580e has certain exceptions to its anti-deficiency provisions. Also, federal law may override California’s anti-deficiency provisions 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 of section 61(a)(12) of the Code.

Other states have enacted anti-deficiency statutes. However, this information letter is limited to the consequences under section 580e of the CCP.

I hope this information is helpful. If you have any additional questions, please call me or * * * at * * *.

Sincerely,

Michael J. Montemurro

Chief, Branch 4,

Office of Associate Chief Counsel,

What this Letter Means: The 580e Strategy

The most important part of the letter is here:”… if a property owner cannot be held personally liable for the difference between the loan balance and the sales price, we would consider the obligation a nonrecourse obligation. In this situation, the owner would not treat the cancelled debt as income. Instead, the owner must report the entire amount of the nonrecourse debt as an amount realized on the sale of the property. If the owner realizes a gain on the sale of the property, the owner generally must include the gain in gross income (Section 61(a)(3) of the Code). However, if the property was the owner’s principal residence, the owner may qualify to exclude all or part of the gain from income (Section 121 of the Code).

In other words 580e can transform a cancellation of debt of a recourse loan into non-recourse debt. Meaning if your sale is executed properly you may not have to pay income taxes on the income reported on the 1099-C the lender will send you. However, make sure you address the issue of Capital gains.

1. Warning about Approval Letters

Do not assume that the mere existence of CCP 580e will force your lender to approved your short sale or that they will issue a proper short sale approval. While the statute is designed to prevent deficiencies, lenders often use ambiguous language in their approval letters.

The Risk of a Future Zombie Loan: Letters that say “Short Sale Approved” but remain silent on the balance of the debt may become problematic in the future. Consider request the lender provide a full release in writing.
The Solution: If you have an attorney on your team form the beginning experience shows you are more likely to get your short sale approved and more likely to get your short sale on terms you find satisfactory.

2. The 2026 Tax Reality

As of January 2026, the Mortgage Forgiveness Debt Relief Act has expired. This shift means that some debts canceled by a lender may be treated as taxable income by the IRS and the California Franchise Tax Board (FTB). Avoiding foreclosure on a recourse debt now becomes a very high priority. Please make sure you have a back up plan if your short sale is not approved or your buyer walks away.

Cancellation of Debt (COD) Income: You may receive a 1099-C for the forgiven amount. Having a lawyer on your team may help you “recharacterize” the debt to its proper category.
Capital Gains Analysis: You must calculate your Adjusted Basis (original purchase price + improvements) against the sale price. Even in a short sale, you could technically trigger a capital gain if your basis is low.

3. The UpsideDownRealEstate.com Analysis™

Before committing to a loan workout, we run every file through a three-point check:

Lender Liability: Is the loan truly extinguished under 580e or 580d?
Tax Exposure: What is the specific dollar-amount liability to the IRS and FTB?
Credit Mitigation: What is the fastest path to recovery after the deed is recorded?

Author Schema & Disclosure

John McConnin | john@listingattorney.com | San Diego, CA Broker- Attorney | DRE # 01445675 | State Bar # 154852

Important Notice: The website UpsideDownRealEstate.com is owned and operated by a California-licensed real estate broker and attorney. Statutes, court decisions, and tax regulations are subject to change without notice. The content provided is for informational purposes only and does not constitute legal, tax, or financial advice. Homeowners facing default are strongly urged to consult licensed counsel and an accountant before taking action.