Cancellation of debt as taxable income for short sale on priorresidence turned into rental?


M

Matt S.

When is debt forgiveness from short-sale of a property included as
taxable income?

Specifics... before we got married, my wife was living in her first
house for about 19 months. She moved into a 2nd larger house and kept
the 1st one as a rental.

Last year she sold the 2nd house in a short sale and the debt
cancellation of $110,000 was not included as part of our 2010 income
because it was her primary residence previous to the short sale (and
our moving in together in a different home).

We are in the process of selling the 1st house in a short sale...
expected to close in the next few months (in 2011). She lived in that
house between 2005 and 2006 for about 19 months. The debt cancellation
is expected to be about $80,000 to $100,000. Will that be counted as
income on our 2011 taxes or will it also be ignored because she
previously lived in that house and it was orginally purchased as a
residence?

Would really appreciate links to IRS docs that explain the details.

Thanks!!
-Matt
 
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R

removeps-groups

When is debt forgiveness from short-sale of a property included as
taxable income?
See http://www.irs.gov/newsroom/article/0,,id=174034,00.html
Specifics... before we got married, my wife was living in her first
house for about 19 months. She moved into a 2nd larger house and kept
the 1st one as a rental.
It looks like the mortgage forgiveness act only applies to your
primary home. If you've moved back into the smaller home after
selling the larger one, then it is now your primary residence. The
law probably addresses rental homes turned into primary residence
homes (ie. maybe the mortgage forgiveness does not apply), but I don't
know the details.
Last year she sold the 2nd house in a short sale and the debt
cancellation of $110,000 was not included  as part of our 2010 income
because it was her primary residence previous to the short sale (and
our moving in together in a different home).

We are in the process of selling the 1st house in a short sale...
expected to close in the next few months (in 2011). She lived in that
house between 2005 and 2006 for about 19 months. The debt cancellation
is expected to be about $80,000 to $100,000. Will that be counted as
income on our 2011 taxes or will it also be ignored because she
previously lived in that house and it was orginally purchased as a
residence?
If the debt is non-recourse it is not included in 1099-C. If you're
in bankruptcy, the debt is not included. If you're in insolvency then
part of the debt is not included. See section 2 in the link I sent
you.

<Quote>

2. Is Cancellation of Debt income always taxable?

Not always. There are some exceptions. The most common situations when
cancellation of debt income is not taxable involve:

* Bankruptcy: Debts discharged through bankruptcy are not
considered taxable income.
* Insolvency: If you are insolvent when the debt is cancelled,
some or all of the cancelled debt may not be taxable to you.You are
insolvent when your total debts are more than the fair market value of
your total assets.Insolvency can be fairly complex to determine and
the assistance of a tax professional is recommended if you believe you
qualify for this exception.
* Certain farm debts:If you incurred the debt directly in
operation of a farm, more than half your income from the prior three
years was from farming, and the loan was owed to a person or agency
regularly engaged in lending, your cancelled debt is generally not
considered taxable income.The rules applicable to farmers are complex
and the assistance of a tax professional is recommended if you believe
you qualify for this exception.
* Non-recourse loans:A non-recourse loan is a loan for which the
lender’s only remedy in case of default is to repossess the property
being financed or used as collateral.That is, the lender cannot pursue
you personally in case of default.Forgiveness of a non-recourse loan
resulting from a foreclosure does not result in cancellation of debt
income.However, it may result in other tax consequences, as discussed
in Question 3 below.

</Quote>
 
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A

Alan

When is debt forgiveness from short-sale of a property included as
taxable income?

Specifics... before we got married, my wife was living in her first
house for about 19 months. She moved into a 2nd larger house and kept
the 1st one as a rental.

Last year she sold the 2nd house in a short sale and the debt
cancellation of $110,000 was not included as part of our 2010 income
because it was her primary residence previous to the short sale (and
our moving in together in a different home).

We are in the process of selling the 1st house in a short sale...
expected to close in the next few months (in 2011). She lived in that
house between 2005 and 2006 for about 19 months. The debt cancellation
is expected to be about $80,000 to $100,000. Will that be counted as
income on our 2011 taxes or will it also be ignored because she
previously lived in that house and it was orginally purchased as a
residence?
There is no cancellation of debt income unless the debt is a recourse
loan. If it is a recourse loan, there is no exclusion available for the
cancellation of qualified residential mortgage debt because it is not
the disposition of her main home. It is the disposition of residential
rental property. She may elect to exclude this type of debt under the
rules for cancellation of “qualified real property business
indebtedness”. See IRC Section 108(a)(1)(D) and 108(c). The maximum
amount to be excluded is limited to the adjusted basis of depreciable
real property before the discharge. The definition of qualified debt is
the same as it is for principal residence debt (amount borrowed to
build, acquire or make capital improvements). Note that if the rental
was used by the taxpayer for more than 14 days in the year, it is
disqualified from this provision. See CCA 200919035, February 20, 2009.
The disposition of business property is accounted for on Form 4797.

Also see pages 7 & 10 in IRS Pub 4681: Qualified Real Property Business
Indebtedness for more information. I also recommend you seek
professional help for this disposition, as accounting for the
disposition of rental property and debt cancellation can get quite
complicated.
 

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