(Disclaimer – The following post is for informational purposes only. I am not a tax lawyer or CPA. In all cases of debt cancellation, readers are strongly encouraged to seek competent advice from a tax professional familiar with their specific situation. The material below is a summary only. For specifics consult your tax advisor.)
One of the basic rules of tax law is that cancellation of debt is a taxable event. For the lay person, cancellation of debt is the same as forgiveness of debt. It makes no difference how the cancellation occurred. It could be voluntary – through a short sale or deed in lieu of foreclosure, or certain loan modifications – or involuntary – through a foreclosure. In the tax lawyer’s lexicon, “cancellation of debt” is referred to as “COD” – like the fish – just harder to swallow.
However, with the housing and credit crisis forcing many people into foreclosure and pre-foreclosure events that resulted in significant debt cancellation, the Mortgage Debt Relief Act of 2007 was enacted. Subject to certain exceptions, this law permits taxpayers to exclude taxable income arising from the discharge of debt on their principal residence. It also applies to certain loan modification events where the debt is either forgiven, or restructured in a significant manner, such that it triggers a taxable event. For many taxpayers, this new federal law was a “codsend,” if you will.
Here are some of its main features:
- It applies to debt forgiven in calendar years 2007 through 2013. [We don’t know whether Congress will extend through 2014. It is likely, but first they have to stop acting like children, and start attending to the Peoples’ Business.]
- Up to $2 million of forgiven debt is eligible ($1 million if married filing separately).
- The debt must be secured by the taxpayer’s primary residence. It does not appear to make any difference whether the debt is secured by a first trust deed or subordinate trust deed.
- However, the debt must be used to buy, build or substantially improve the primary residence and it must be so used for two of the last five years. This is known as “qualified principal residence indebtedness.”
- A home equity line of credit secured by a primary residence would qualify, but only to the extent that the funds were used to build, buy, or substantially improve the primary residence.
- You can only have one principal residence at a time. The IRS uses the same analysis under this law as that for a “primary residence” under IRC 121 (the $250,000/$500,000 gain exclusion law).
- Refinanced debt is eligible to the extent that it replaces only the existing qualified principal residence indebtedness. Any portion of the refinancing used for other purposes would be treated as taxable COD income.
- Lenders or creditors cancelling debt will issue IRS Form 1099-C to the taxpayer identifying the amount reported to the IRS for the year of the cancellation.
- IRS Form 982 is used to claim the exemption.
Here are some of the main exclusions from COD taxes:
- Debts discharged through bankruptcy.
- Insolvency at the time of the cancellation of debt. However, some of the cancellation may remain taxable, as it is proportioned against the insolvency. Insolvency is defined as total debt exceeding the fair market value of one’s total assets. (The insolvency exclusion applies to residential or nonresidential COD.)
- If the debt is “non-recourse,” meaning that the creditor’s collection remedy is limited to the property itself – not the taxpayer – COD does not generally apply (although other tax events may be triggered)
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