short sale or rental house

[oceanlovin'ea]

Here are 2 scenarios dealing with a home with a mortgage that was 3/4 used for another purpose.
Here is the scenario:
Taxpayer owed about $50,000 on home. They refinanced and got an additional $150,00 and bought another house in another state. This is second home and they are in the process of moving there in the next year or 2. Present house was once valued at $230,000 and now around $120,000.

Scenario 1 - If they did a short sale on the house and only got $130,000 for the house, but they owe $200,000 on the house. They would get a 1099C for approximately $70,000. Would $50,000 of that be excludable as personal residence and then $20,000 be taxable?

2) Since they can't sell it for what it is worth right now, they decide to convert it to rental property and rent the house for a while to see if market rebounds. The basis for the rental property would be the lower of adjusted basis and FMV. Is that correct? Then when they sell it they would have gain or loss depending on sales price versus basis. Is FMV determined by the amount on the tax statements. That has gone down consistently every year.

Are my assumptions about the options for this scenario correct? If not, show me the light please.

Linda, EA

[taxmom34]

I was always told that the IRS doesn't care how much you owe on your house or how much you had to pay the bank when you sold your house, they are only interested in your basis and the selling price.

[MilTaxEA]

taxmom34, if you have canceled debt income, they certainly care. Also, if you exclude any cancled debt under Section 108, then it decreases your basis in the home.

Scenario 1: "Qualified principal residence indebtedness is any mortgage you took out to buy, build, or substantially improve your main home. It also must be secured by your main home." (From Pub 4681). I would consider the first $150k of canceled debt as fully taxable under Section 108(1)(E) since it is non-qualified debt (wasn't used to buy/build/improve main home).

Scenario 2: Yes, the depreciable basis is the lesser of FMV or their adjusted basis. Don't just use the county tax statements to determine FMV, use comps or an appraiser. The county tax statements do not typically get held up in court.

[oceanlovin'ea]

So you would not take the portion that was used for the personal residence first. Why not?

I would think it would qualify for the exclusion first and then the rest taxable.

Linda, EA

[MilTaxEA]

From Pub 4681:

Ordering rule. If only a part of a loan is qualified principal residence indebtedness, the exclusion applies only to the extent the amount canceled is more than the amount of the loan (immediately before the cancellation) that is not qualified principal residence indebtedness. The remaining part of the loan may qualify for another exclusion.

Example. Ken incurred recourse debt of $800,000 when he bought his main home for $880,000. When the FMV of the property was $1,000,000, Ken refinanced the debt for $850,000. At the time of the refinancing, the principal balance of the original mortgage loan was $740,000. Ken used the $110,000 he obtained from the refinancing ($850,000 minus $740,000) to pay off his credit cards and to buy a new car.

About 2 years after the refinancing, Ken lost his job and was unable to get another job paying a comparable salary. Ken's home had declined in value to between $700,000 and $750,000. Based on Ken's circumstances, the lender agreed to allow a short sale of the property for $735,000 and to cancel the remaining $115,000 of the $850,000 debt. Under the ordering rule, Ken can exclude only $5,000 of the canceled debt from his income under the exclusion for canceled qualified principal residence indebtedness ($115,000 canceled debt minus the $110,000 amount of the debt that was not qualified principal residence indebtedness). Ken must include the remaining $110,000 of canceled debt in income on line 21 of his Form 1040 (unless another exception or exclusion applies).

[MilTaxEA]

Here is the link to Pub 4681 or Section 108(h), although that just reiterates what is written in the publication (almost verbatim but without the examples).

Someone else jump in if they think my logic is flawed.

[oceanlovin'ea]

That is what I need to show them. That might help in the decision they need to make.

Thanks a bunch.

Linda, EA

[MilTaxEA]

You're welcome. I had some similar issues with a couple short sales earlier this year and had some help from another expert in this area. It was the least I could do.

It's frustrating sometimes the way people structure their debt. I hate being the person who breaks the bad news that their short sale COD is fully taxed. However, the law clearly states the debt can only be excluded if it was taken out to buy/build/improve their principal residence, not a second/vacation home. Of course, if they fall under another exception in Section 108 (e.g., insolvency) they may be able to exclude some more of the COD income.

Of course, everything here depends upon the fact that the loan was recourse, which it sounds like it is based on the facts you gave.