Cancellation of Debt Income (1099-C)
It has taken a long time, but the FTB and IRS now officially state that “if a property owner cannot be held personally responsible for the difference between the loan balance and the sale price, ... the obligation (is) a non-recourse obligation.” The long string of court cases dates back to at least 1934 where a negotiated settlement of a debt was held to be a price reduction, not a cancellation of debt.

It took a letter by Sen. Barbara Boxer to the IRS requesting clarification of the IRS position on a 2011 California law (CCP 580(e)) followed by a response from the IRS legal office to get them to acknowledge that CODI does not, in general, apply to loans secured by real estate.

The result of some two years of tossing this hot potato around, CCP 580(e) and subsequent clarifications and court cases (Crane and Tufts vs FTB) established that debt secured by real property that was disposed of by foreclosure, repossession or short sale at an amount less than the secured debt should be treated as settlement of a non-recourse loan. Settlement of a non-recourse loan does not result in CODI but may result in capital gains.

Now try telling that to lenders who continue to issue 1099-C forms. A survey by FTB reported that 70% of 1099-C forms incorrectly report the tax consequences. If you received a 1099C notice that is not correct, a properly worded challenge to the IRS and FTB will result in the burden of proof transferred to the tax authorities. They must then request a correction with proof from the lender.

Note that current law only applies to debt secured by real property. Non-payment of a credit card, automobile loan or personal loan still results in taxable income if the notice is correct.