TAX TALK: IRS, Home Loan Modification and Tax Debt

Well, it’s tax time. Some of you have been early birds who have filed and already accounted for your refund. Others are just coming to the “do or die” April 15th tax deadline. We’ll provide some information you should consider whether you are filing for 2012 or making some financial decisions now that could impact your taxes for 2013.

Each day, I will give you some examples offered up by the IRS to help consumers like us figure out the difference between a schedule C, a 1099 and the hole in the wall. Here’s today’s example one:

Home Loan Modification, Debt Forgiveness and Taxable “Income”
SPOILER ALERT: If you have taken money out of the house in a refi and used for non home items and renovations, like paying off credit cards, when the loan is modified, you are responsible tax-wise as though you had received that money in income. See a real world example below. (Complete with link to tax form)

These examples use actual forms to help you prepare your income tax return. However, the information shown on the filled-in forms is not from any actual person or scenario.

Example 1—Mortgage loan modification. In 2006, Nancy Oak bought a main home for $435,000. Nancy took out a $420,000 mortgage loan to buy the home and made a down payment of $15,000. The loan was secured by the home. The mortgage loan was a recourse debt, meaning that Nancy was personally liable for the debt. In 2007, Nancy took out a second mortgage loan (also a recourse debt) in the amount of $30,000         that was used to substantially improve her kitchen. In 2010, when the outstanding principal of the first and second mortgage loans was $440,000, Nancy refinanced the two recourse loans into one recourse loan in the amount of $475,000. The FMV of Nancy’s home at the time of the refinancing was $500,000. Nancy used the additional $35,000 debt ($475,000 new mortgage loan minus $440,000 outstanding principal of Nancy’s first and second mortgage loans immediately before the refinancing) to pay off personal credit cards and to pay college tuition for her son. After the refinancing, Nancy has qualified principal residence indebtedness in the amount of $440,000 because the refinanced debt is qualified principal residence indebtedness only to the extent the amount of debt is not more than the old mortgage principal just before the refinancing.

In 2012, Nancy was unable to make her mortgage loan payments. On August 31, 2012, when the outstanding balance of her refinanced mortgage loan was still $475,000 and the FMV of the property was $425,000, Nancy’s bank agreed to a loan modification         (a “workout”) that resulted in a $40,000 reduction in the principal balance of her loan. Nancy was neither insolvent nor in bankruptcy at the time of the loan modification.

Nancy received a 2012 Form 1099-C from her bank in January 2013 showing discharged debt of $40,000 in box 2. Identifiable event code “F” appears  in box 6.  This box shows the reason the creditor has filed Form 1099-C.  To determine if she must include the canceled debt in her income, Nancy must determine whether she meets any of the exceptions or exclusions that apply  to canceled debts. Nancy determines that the only exception or exclusion that applies to her is the qualified principal residence indebtedness exclusion.

Next, Nancy determines the amount, if any, of the $40,000 of canceled debt that was qualified principal residence  indebtedness. Although Nancy has $440,000 of qualified principal residence indebtedness, part of her loan ($35,000) was no qualified principal residence indebtedness because it was used to pay off personal credit cards and college tuition for her son. Applying the ordering rule, the qualified principal residence indebtedness exclusion applies only to the extent the amount canceled is more than the amount of the debt (immediately before the cancellation) that is not qualified principal residence indebtedness. Thus, Nancy can exclude only $5,000 of the canceled debt as qualified principal residence indebtedness ($40,000 amount canceled minus $35,000 nonqualified debt).

Because Nancy does not meet any other exception or exclusion, she checks only the box on line 1e of Form 982 and enters $5,000 on line 2. Nancy must also enter $5,000 on line 10b and reduce the basis of her main home by the $5,000 she excluded from income, bringing the adjusted basis in her home to $460,000 ($435,000 purchase price plus $30,000 substantial improvement minus $5,000). Nancy must also include the $35,000 nonqualified debt portion in income on Form 1040, line 21.

 Nancy’s 2012 Form 1099-C, Cancellation of Debt             

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