Short Sale

[Harvey Lucas]

My client bought his house in 2001, primary residence, he paid $475,000.

Over the years he did major improvments to the tune of $350,000.

So his basis is $825,000.

He financed his improvments 100% by refinacing the home so that his "aqcuisition debt" is $825,000,

He currently owes the lender $900,000, full recourse.

For easy figuring lets say that the $900,000 is made up of $825,000 "aqcuisition debt" and $75,000 in deferred interest from a negative amortization loan, and also becuase he has made no payments for about one year.

All refi proceeds went towards improvments.

The house is scheduled to close in a short sale within the next 30 days for $600,000.

The lender has agreed to forgive the $300,000 short amount.

I am hoping the entire amount qualifies under the "principal residence Indebtedness" provisions and that the none of this COD income will be taxable.

I'm a little concerned about the $75,000 portion of the debt?

Assuming the entire amount qualifies as not taxable, I am also wondering if the same tax free treatment would apply if the lender forclosed on him instead of agreeing to the short sale.

Thank you in advance,

Harvey Lucas

[JG EA]

The $75,000 does not count on that exclusion. So, if the TP is not insolvent it is taxable.

Qualified principal residence indebtedness. This
indebtedness is a mortgage you took out to buy, build, or
substantially improve your principal residence. It also must be
secured by your principal residence. If the amount of your
original mortgage is more than the cost of your principal
residence plus the cost of any substantial improvements, only
the debt that is not more than the cost of your principal
residence plus improvements is qualified principal residence
indebtedness. Any debt secured by your principal residence
that you use to refinance qualified principal residence
indebtedness is treated as qualified principal residence
indebtedness, but only up to the amount of the old mortgage
principal just before the refinancing. Any additional debt you
incurred to substantially improve your principal residence is
also treated as qualified principal residence indebtedness.

[solomon]

§108(e)(2)

No income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction.

[Harvey Lucas]

TTB Example ????

Similar to my situation posted above, the example in TTB on page 14-10 is perplexing me.

To recap the example, Tom bought a home for $200,000 and owned it for over 2 years.

The FMV of the home dropped to $110,000.

Tom owed $150,000 to the bank, recourse loan.
.
Tom stopped making payments and the bank forclosed, took the home, and forgave Tom's debt.

The conclusion in the example is that Tom must report $40,000 on 1040 line 21 other income because of cancellation of debt, ie, the diference between the FMV of the home and the debt cancelled..

This thouroughly confuses me because on the very next page it indicates that if cancelled debt is "qualified principal residence indebtedness" then it is nontaxable.

?????

Harvey Lucas

[Maribeth]

Similar to my situation posted above, the example in TTB on page 14-10 is perplexing me.

To recap the example, Tom bought a home for $200,000 and owned it for over 2 years.

The FMV of the home dropped to $110,000.

Tom owed $150,000 to the bank, recourse loan.
.
Tom stopped making payments and the bank forclosed, took the home, and forgave Tom's debt.

The conclusion in the example is that Tom must report $40,000 on 1040 line 21 other income because of cancellation of debt, ie, the diference between the FMV of the home and the debt cancelled..

This thouroughly confuses me because on the very next page it indicates that if cancelled debt is "qualified principal residence indebtedness" then it is nontaxable.

?????

Harvey Lucas

You have TWO issues going on at the same time. You have to separate those two issues and look at each individually.

Your example: Basis 200, FMV 110, loan balance 150. Property is foreclosed upon.

Issue #1: sale of principal residence. Selling price 150, basis 200, loss of 50 is not recognized.

Issue #2 COD. Bank received 110 in satisfaction for 150 loan. Difference of 40 is COD income, not subject to principal residence exclusion.

Maribeth

[appelman]

Why not, Maribeth?

In the example, why do you think the COD income shouldn't be excludible as principal residence indebtedness? I think the intention of the example was simply to calculate the COD, leaving the discussion of exclusion until later. You have to determine the COD before you can exclude it!

And, BTW, for a recourse loan, the non-deductible loss is actually 90K (as given in the example), not 40K. See worksheet on p. 5 of Pub. 544.