Californians who received mortgage modifications or participated in a short sale or foreclosure could be getting the short end of the stick again in the form of a huge tax bill.

That’s because legislation preventing their canceled debt from being treated as taxable income is caught up in a budget squabble between the Governator and the California state legislature.

According to an AP story out of Sacramento:

Schwarzenegger, a Republican, said this week that he would veto a tax bill passed by majority Democrats. Among other things, the legislation would have mirrored federal tax relief given to those who had mortgage debt forgiven in 2009. In previous years, the state conformed with federal law.

Business groups have objected to an unrelated provision in the bill dealing with penalties for tax fraud, and that prompted Schwarzenegger’s veto threat.

The governor has asked the Legislature to pass a separate bill dealing solely with the mortgage issue so he can sign it before April 15. Democrats, the majority in both houses of the Legislature, appear to be in no hurry…

Depending on the type of loan, the government can consider the forgiven debt as income and tax it. In California, most first mortgages to buy a home aren’t affected, but homeowners can face big tax bills if they default on some types of refinance loans and second mortgages that let them cash out equity.

Congress responded to the growing problem by passing the Mortgage Forgiveness Debt Relief Act of 2007, which prevented homeowners from being liable for their canceled debt. The act prohibits such federal taxes through 2012.

California matched its state tax laws to the federal act in 2007 and 2008. It has not passed an extension for 2009, which has left many short sellers in limbo.

Conforming California to the federal standard would help an estimated 16,000 people who have mortgage debt forgiven between 2009 and 2012, according to the California Franchise Tax Board.”

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