Favorable Treatment of Main Home Debt Relief Expiring This Year

No question that times are tough in the real estate world these days, and IRS has bestowed a little sympathy toward homeowners – certain discharge of indebtedness won’t be taxed if it relates to your principal residence.  But time is running out on this kindliness……

Generally speaking, whenever a lender agrees to accept less than he’s due from a borrower, the borrower may have some form of taxable income as a result.  Present law, however, allows any discharge of “qualified principal residence indebtedness,” of up to $2 million to be excluded from gross income.  But unless Congress gets moving (which, any more, is somewhat of a contradiction in terms), this favor will expire next New Year’s Day – January 1, 2013.

The exclusion available under 2012 law applies in situations where a taxpayer restructures his acquisition debt on his personal residence, loses the principal residence in foreclosure, or even sells the principal residence in a “short sale.”  In transactions of this nature, the good news is that the income may be excludible; in return, IRS wants you to reduce the basis in your home by the amount of the exclusion.

Note that this rule does not apply to debt forgiven on second homes, business real estate, or rental property – only to a bloke’s principal residence.

Note also that in some foreclosure and short sale transactions, a taxpayer may derive gain  in addition to income from discharge of indebtedness – to the extent of any deemed gain on sale, the exclusion rule doesn’t apply.  This gets tricky, so let’s consider an example.

Assume your mortgage is recourse (common in many states), your lender forecloses, and your numbers are as follows:

  • Outstanding balance on the mortgage – $260,000
  • Fair market value of the residence – $200,000
  • Tax basis of the residence – $150,000

Two things happen:  you will be deemed to have “sold” your house at a $50,000 taxable

gain ($200,000 less $150,000), and you will have debt discharge income of $60,000 ($260,000 less $200,000) which will be covered by the exclusion described above.  Not all bad, though some tax may still be due.

And just to make things more convoluted, California imposes similar, but not identical rules to those mentioned above relative to the exclusion of the debt discharge income.  Identical to the Federal rule, however, California’s favored treatment of certain debt discharge income related to one’s principal residence will expire December 31, 2012 unless the state Revenooers extend the current provisions.

CONSULT YOUR TAX ADVISOR – This article contains general information about various tax matters.  You should consult your CPA regarding the implications to your own particular situation.

Jeff Quinn, the author of this article, is a shareholder in Ashley Quinn, CPAs and Consultants, Ltd., with offices in Incline Village and Reno.  He may be reached at 831-7288, welcomes comments at jquinn@ashleyquinncpas.com, and invites readers to consider his other commentary at http://blog.nolo.com/taxes.

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