Aquisition debt defined and cancelation of debt

[Bay ArEA]

I think I have no way of helping this client but want to make sure, any feedback would be appreciated on this one.
It's a cash-out refi / HELOC problem. I have a client that just short sold her primary residence, she had put a large amount of cash into the home. She was not insolvent. Her basis was 720K and the sale price was 370K, the debt forgiven was 121k. Her basis easily exceeds both the sale price and leftover debt forgiven and this is because she made a huge down payment and made large improvements all with cash. The problem is later on, after making those improvements she refi'ed and pulled out 10K, then got a HELOC for 110k for her business. If she had only paid for the improvements with the heloc and paid for the business stuff cash then none of this debt would be taxable, but she did it in the other order.
Is it possible to somehow classify the this debt as acquisition debt so we can save her from paying taxes on it? Can we make some crazy argument like the funds would have been used for improvements if her cash hadn't been depleted on the improvements and money is fungible so it's the same as acquisition debt? That's probably going way out on a limb so I think she's in trouble.

[JG EA]

I think I have no way of helping this client but want to make sure, any feedback would be appreciated on this one.
It's a cash-out refi / HELOC problem. I have a client that just short sold her primary residence, she had put a large amount of cash into the home. She was not insolvent. Her basis was 720K and the sale price was 370K, the debt forgiven was 121k. Her basis easily exceeds both the sale price and leftover debt forgiven and this is because she made a huge down payment and made large improvements all with cash. The problem is later on, after making those improvements she refi'ed and pulled out 10K, then got a HELOC for 110k for her business. If she had only paid for the improvements with the heloc and paid for the business stuff cash then none of this debt would be taxable, but she did it in the other order.
Is it possible to somehow classify the this debt as acquisition debt so we can save her from paying taxes on it? Can we make some crazy argument like the funds would have been used for improvements if her cash hadn't been depleted on the improvements and money is fungible so it's the same as acquisition debt? That's probably going way out on a limb so I think she's in trouble.

Okay. I've had a hard day with no sleep, but is there any income here to exclude? Did I do this worksheet correctly?
Worksheet for Foreclosures and Repossessions
Part 1. Income from cancellation of debt. (Note: If nonrecourse debt,
there is no income from cancellation of debt. Skip Part 1 and go to
Part 2.)
1) Enter the amount of debt canceled by the transfer
of property.......................................... ......................... 1) 121k
2) Enter the FMV of the transferred property................. 2)370K
3) Income from cancellation of debt.* Subtract line 2
from line 1. If less than zero, enter zero..................... 3)0
Part 2. Gain or loss from foreclosure or repossession.
4) Enter the smaller of line 1 or line 2. Add any
proceeds received from the foreclosure sale. (If not
personally liable for the debt, enter the amount of
debt canceled by the transfer of property.)................ 4)121k

5) Enter the adjusted basis of the transferred property.... 5)720K
6) Gain or loss from foreclosure or repossession.
Subtract line 5 from line 4........................................... 6)0

[ddoshan]

JG EA .. haven't studied your scenario worksheet but at a glance it doesn't make sense to me. If I owe 150K on a mortgage and the bank forecloses and receives only 130K for my home leaving 20K as cancelled debt ... I sure have cancelled debt to deal with.

[Gary2]

1) Enter the amount of debt canceled by the transfer
of property.......................................... ......................... 1) 121k
2) Enter the FMV of the transferred property................. 2)370K
3) Income from cancellation of debt.* Subtract line 2
from line 1. If less than zero, enter zero..................... 3)0

The first number should be 491. The wording is confusing, but the idea is that if you have $500K in debt, you turn over $300k worth of property, and the lender writes off $400K of debt with the expectation of collecting the remaining $100K from the debtor in the future, then the total canceled debt is $400K, there's $100K of income resulting from the cancellation, and there is still a $100K debt.

In most cases, the lender will write off the full amount; I included the $100K of remaining debt to show how the worksheets are designed.

[Bay ArEA]

Yes, I'm pretty sure there is taxable forgiveness of debt here, what I am trying to do is see if I can qualify this debt qualified principal residence debt exclusion. On page 14-14 it says only acquisition debt counts for the exclusion, see page page 4-10 for a definition. There it says if the funds were used to improve the property then it counts.
Most the mortgage was satisfied by the sale of the home, but the home equity line was not, most of the home equity line was used for her business only after she depleted her cash (a nearly identical amount as the heloc) on home improvements the year before. What I am hoping is that we can someone say the because the cash was depleted on the improvements she had to take out the home equity line, so it's like the same thing as spending the home equity line in her house. But I think that that's pushing it too far and was wondering what you folks think.

[JG EA]

OK now, thanks to Gary, that I see I was looking at it wrong, I'd like to help. Let me bump this up to the top. I don't know, but I think there may be a problem with the improvements being made "the year before". But what you say sounds reasonable but I don't know if it will work. I know you don't have to use the same actual monies as long as equal money was spent on improvements, but does it have to be in the same year?

[WhiteOleander]

Actually, you may be jumping the gun. If all you have so far is the 1099A on the foreclosure, there is no cancelled debt yet. The lien holder has a certain amount of time (varies by state) to try to collect the debt. Then they can decide later to forgive and issue a 1099C several years later. So, which form do you have? 1099A or 1099C.

[Bay ArEA]

Actually, you may be jumping the gun. If all you have so far is the 1099A on the foreclosure, there is no cancelled debt yet. The lien holder has a certain amount of time (varies by state) to try to collect the debt. Then they can decide later to forgive and issue a 1099C several years later. So, which form do you have? 1099A or 1099C.

We got a 1099C so yeah, they cancelled it. I've done some more research about dollar tracing and I'm thinking this argument won't work. She has a office in the home so I was hoping I could maybe do business real estate exclusion, but that one seems to be on shaky ground too :/ Looks like she's going to owe big.