Mortgage Debt Relief Act - Is it applicable in California?

If you're unable to afford the current mortgage payments, and it isn't possible to refinance with FHA Secure, then you may consider going for a short sale, if you're staying in a declining market where the home sale price will not be enough to cover balances on both the loans. So, you need to pay off the remaining balance on the combined loan amount.

If your lender accepts a short sale, and if it's a purchase loan, he may not ask for the deficiency (difference between unpaid loan balance and price at which lender sells off your property) on the primary mortgage, provided the property is your primary residence. But, the anti-deficiency laws are not applicable in case of second mortgages. Therefore, you can avoid paying deficiency on the first but not on the second.

Now, if it is a refinance loan, the lender will ask for the deficiency if the short sale doesn't yield much to cover the combined debt. In case you fail to pay the deficiency on then the unpaid amount is considered as income and the IRS requires you to pay federal income tax on the unpaid debt. However, this rule is applicable only in California where the Mortgage Debt Forgiveness Tax Relief Act, 2007 is yet to be implemented unlike other states where it has already come into effect. In all other states, if the lender forgives your unpaid debt or deficiency, you need not pay tax on it. However, the Mortgage Debt Forgiveness Tax Relief Act can help you with tax relief only under certain conditions.

Moreover, the Mortgage Debt Relief Act applies even if your property is foreclosed and there's a deficiency amount left to be paid. However, if you opt for a deed-in-lieu, the lender may not ask for a deficiency in most cases, as is the general rule.