Monthly Tax Tips
Homeowner cancellation of debt income requires expert assistance
The last several years have been particularly difficult for homeowners, many of whom may have experienced an unfortunate event with regard to their homes, such as a foreclosure or a short sale.
If the homeowner's loan was recourse to the homeowner, the homeowner may have cancellation of debt income if the proceeds from the sale of the home were less than the loan amount (in the case of a short sale) or in the case of a foreclosure, if the fair market value of the home was less than the loan. Of course, when a homeowner has cancellation of debt income in addition to losing a property, either in a short sale or a foreclosure, insult is added to injury. Thankfully, Congress has provided relief from the income recognition requirements for homeowners.
The Mortgage Forgiveness Debt Relief Act of 2007 and the Emergency Economic Stabilization Act of 2008 provide for an exclusion from income for discharge of mortgage debt in the years 2007 through 2012 in certain circumstances.
The mortgage debt that is discharged must be recourse to the homeowner, which means that the lender may pursue other assets of the homeowner in addition to the home itself for satisfaction of the debt. The debt must be qualified acquisition indebtedness, i.e., it must be secured by the property, and the proceeds must be used to acquire, construct or improve a residence. The exclusion also applies only if it is principal residence debt. Cancellation of debt income from second homes or vacation homes does not qualify for this exclusion. The exclusion is limited to $2,000,000.
This exclusion will not apply if the homeowner is in Title 11 Bankruptcy, as the bankruptcy exclusion available under IRC Sec. 108(a)(1)(A) will take precedence. The homeowner may also choose to use the insolvency exception instead of the mortgage relief provisions, if applicable.
It is possible that a homeowner may have several loans on a property and that one of those loans may not qualify for exclusion. In that case, the cancellation of debt income available for exclusion is reduced by the amount of discharged non-qualifying debt. Any debt not qualifying for exclusion must be included in taxable income.
If the homeowner takes advantage of this exclusion, the basis of the home is reduced by the amount of the excluded debt; however, the basis may not be reduced below zero.
Reporting Issues
Cancellation of debt income is reported to the borrower by the lender on Form 1099-C. The recipient of a Form 1099-C should report that income on the current year tax return, as the amounts on the 1099-C are ordinary income.
If the cancellation of debt income may be excluded, the exclusion must be reported on Form 982. Line 1(e) in Part 1 must be checked to indicate that the excluded income is from qualified principal residence debt. Part II, line 10(b), which shows the basis reduction, must also be filled out.
As you can see, the rules for excluding cancellation of debt income are complex. If you have specific question on this topic, please consult your tax professional.
This tax tip contributed by:
Joyce Jukubiak
AKT LLP
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