The first part of this two-article series discussed the basic rules for exclusions from income for homeowners who’ve had mortgage debts forgiven or canceled in foreclosures or short sales and deconstructed QPRI, short for qualified principal residence indebtedness.
Code Section 108 permits exclusions only for acquisition indebtedness, IRS-speak for mortgages taken out by owners when they buy, build, or substantially improve their principal residences or main homes. Part three will explain more aspects of the exclusions.
Exclusion amounts and Code Section 108’s ordering rule. As noted in part one, the exclusions aren’t unlimited. They top out at $750,000 for married couples filing jointly, dropping to $375,000 for single persons and married couples filing separately.
Section 108 includes a precise explanation of just how much owners are able to exclude when only part of a loan is QPRI. It allows an exclusion for QPRI to the extent the amount cancelled exceeds the amount of the loan (immediately before the cancellation) that isn’t QPRI. The rest of the loan may still qualify under the exclusions for insolvency or bankruptcy.
The following example is based on an example from IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments, just one of many agency booklets that are available at irs.gov. Pub. 4681 also has other examples.
Evalina bought her condo for $880,000, with a down payment of $80,000 and a mortgage loan for $800,000 from Last National Bank (LN). When the condo’s fair market value was $l million and the principal balance of the original loan was $740,000, Evalina refinanced the debt for $850,000. She used the $110,000 from refinancing ($850,000 minus $740,000) to pay off credit card debts, medical and other health costs and to buy furniture and clothing.
About two years after the refinancing, Evalina lost her job and was unable to find another position paying a comparable salary. LN refused to allow a loan modification after concluding that she couldn’t meet her future payments. Adding to her travails, the tanking market caused the condo’s value to decline to between $675,000 and $725,000.
To avoid foreclosure, LN okayed Evalina’s short sale for a discounted price of $700,000––$150,000 less than the amount due of $850,000. LN cancelled her remaining debt of $150,000 in exchange for the sales proceeds of $700,000. The ordering rule lets her exclude $40,000 as income from QPRI ($150,000 canceled debt minus $110,000 of debt that’s not QPRI).
Form 1040 paperwork. By IRS standards, it’s a piece of cake. Evalina claims the exclusion of $40,000 on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment). She only needs to fill out a few lines on the form, specifically, lines 1e, 2 and 10(b).
The 982 accompanies her 1040. On 2021’s 1040, the remaining $110,000 goes on line 8c (cancellation of debt) of Schedule 1 (Additional Income and Adjustments to Income), unless Evalina can avail herself of exceptions like insolvency (discussed in part four) or bankruptcy.
How Evalina figures her loss on the condo sale. The short sale causes her to incur a loss of $180,000 (adjusted basis of $880,000 minus net sales price of $700,000). The $880,000 figure assumes no basis adjustments upwards for certain settlement or closing costs connected with the purchase, such as legal fees or title searches, as well as for subsequent improvements.
Nor are there any adjustments downward to reflect depreciation write-offs (without taking land into account, as land isn’t depreciable) because the property was rented out or partly used for business purposes. In any case, the LN loan has no bearing on the loss calculation.
Different rules apply if Evalina had used the $110,000 from refinancing for home improvements, as opposed to purchases of furniture and clothing. QPRI after refinancing becomes $910,000 ($880,000 original cost plus $110,000; adjusted basis becomes $990,000 ($880,000 plus $110,000); and Section 108 allows her to exclude the entire remaining debt of $150,000. Her nondeductible loss on the sale of a person residence becomes $290,000 ($990,000 adjusted basis minus net sales price of $700,000).
They’re as high as $750,000 for married couples filing jointly and $375,000 for single individuals and couples filing separately. In IRS lingo, an exclusion is a QPRI, short for Qualified Principal Residence Indebtedness Exclusion. To end the series, part four will focus on the highlights of the rules that apply to owners who are insolvent.
As noted in part one, Code Section 61(a)(12) generally requires debtors to report all forgiven debts on their 1040 forms. Section 108 specifies several carefully hedged exceptions, including bankruptcies (Chapter 11 cases) and insolvency.
There’s tax relief when your debt is cancelled while you’re insolvent. The amount cancelled isn’t reportable income to the extent of the insolvency.
Under Section 108, when are you considered to be insolvent? The seemingly straightforward answer: When your liabilities exceed the fair market value of your total assets immediately before the cancellation of the debt.
To arrive at an answer, the IRS considers many assets. The possibilities, says the agency, includes “interest in retirement accounts (IRA accounts, 401(k) accounts, and other retirement accounts).” While these accounts are typically exempt from creditors, they count for exclusion purposes.
What about hefty penalties that could kick in when you remove funds from them? Too bad, says the IRS. It doesn’t require you to file for bankruptcy in order to qualify under the exclusion for insolvency.
Paperwork. In the following year, you should receive IRS Form 1099-C, Cancellation of Debt, from a bank or other lender that cancels or forgives a debt you owe of $600 or more. The lender also sends a copy of the form to the IRS. Box 2 of Form 1099-C shows the amount of cancelled debt.
IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments. Pub. 4681, an agency booklet that’s available at irs.gov., includes an “insolvency worksheet” for use in determining whether you were insolvent immediately before the cancellation and the amount of the insolvency.
Just how reader friendly are Pub. 4681 and other offerings available at the site? The IRS’s standard answer is that its publications provide nearly all the answers to questions and problems that come up when you’re doing returns or complying with other requirements of the tax laws.
While most of them do supply satisfactory answers in plain, uncomplicated language, Pub. 468 doesn’t. Section 108’s complexity thwarted the agency’s efforts to clarify its Byzantine regulations for cancelled debts. I’m able to say with complete confidence that there can be no two opinions about whether it’s appropriate to characterize Pub. 4681 as tough reading even for tax professionals
