Taxes Related to Cancellation of Debt
Posted 11-30-2010 | By Joan Morrow | Download Article
The downturn in the economy and the housing market crash has led to a record number of foreclosures, short sales, and loan modifications. The Emergency Economic Stabilization Act of 2008 provides an exclusion from gross income, through December 31, 2012, for the discharge of qualified principal residence indebtedness of up to $2 million. In other words, a homeowner does not have to pay tax on the income created when a bank forgives a portion of the mortgage debt. However, there are limitations to the definition of "qualified principal residence indebtedness".
Qualified principal residence indebtedness is debt incurred in acquiring, constructing, or substantially improving a principal residence. For example, if you took out a mortgage to purchase your residence, and later the bank forgives some of that debt through foreclosure, short sale, or loan modification, there will be no tax liability associated with the transaction. This also is true if you refinance the mortgage and use the cash from the refinance to substantially improve the home. Things get a little tricky if you use cash from a refinance to pay for other things such as education expenses, debt consolidation, etc., or if the loan was used to purchase property other than a principal residence. IRS rules for calculating the amount of debt forgiveness allowable for income exclusion are not favorable to taxpayers when a portion of the loan does not qualify as principal residence indebtedness. The rules require that any debt cancelled be treated as non-qualified if used for purposes other than purchase, construction, or substantial improvement of the residence.
For example, let's say an individual purchases a $300,000 house using $60,000 cash and a $240,000 loan. A few years later, the house is worth $350,000 and the homeowner decides to cash in on some of the equity by refinancing the $240,000 original loan with a new $275,000 loan. The homeowner uses the additional $35,000 to pay off credit cards and other personal expenses. Unfortunately, a few years down the road, the house is worth $225,000 and the homeowner is no longer able to make payments. As a result, the bank forecloses on the property, sells it for $225,000, and forgives the remaining $50,000 balance on the mortgage. In this situation, the homeowner can only exclude $15,000 of cancellation of debt income from their tax return. The first $35,000 of debt cancelled does not qualify for the exclusion because it was not qualified principal residence indebtedness.
If a loan is used to purchase an investment property, whether a rental or a house the taxpayer intended to flip, any debt cancelled by the bank through foreclosure, short sale, or loan modification is not excluded from income under the Emergency Economic Stabilization Act of 2008. In many situations, any cancellation of debt income reported on the tax return will be offset, at least partially, by the loss sustained on the sale or abandonment of the property. This is true only for property held for investment. If the loan is associated with personal property (i.e. a cabin or other vacation home), the debt cancellation income is taxable and there is no corresponding deduction for the loss sustained; however there are some exceptions to this rule (i.e. if the taxpayer was insolvent immediately before the cancellation of debt transaction).
The rules (and exceptions to the rules) involving the taxation of cancellation of debt income from a foreclosure, short sale, or loan modification are complicated, and the calculations to determine the amount of income to report, potential gains and losses, and the necessary basis adjustments to the underlying property are complex. If you are facing foreclosure, or trying to work out a short sale or loan modification with your lender, please discuss your situation with an accountant to help you prepare for the potential tax implications. Please contact Joan Morrow, CPA, for more information or questions at jmorrow@hlbtr.com.