Cancellation of Debt and §121

No.

But if I understand short sale correctly, is there really any gain to exclude?

There could be, if the owner did a cash-out refi when home values went up, and then values went down again.

For example: Bob buys a $200,000 home with a typical mortgage. During a boom, the house value jumps up, and Bob does a refi for $400,000. Sometime later, the house is worth $300,000 and Bob wants out.

Bob finds someone to buy the house for $300,000 and the bank agrees to the sale. He now has $100,000 gain on the house, and he has $100,000 of loan forgiveness.

Thanks. The guy told me his accountant said that the section 121 exclusion would apply to cancellation of debt income on the short sale of a personal residence.

I went back to look at §108, and it says that, until 2013, cancellation of acquisition debt on a personal residence will not result in cancellation of debt income. The fact that Congress thought it necessary to say that indicates that the §121 exemption won't normally apply. I suspect either the client misunderstood, or the accountant got it wrong.

[previously snipped, pasted back in] On 2010/11/16 05:44, Bill Brown wrote: > On the other hand, under current law, COD income is excludible when > associated with acquisition indebtedness on a primary residence that > meets the Sec 121 rules.

The amount of COD excluded from income under this temporary law is used to reduce the basis in the property. The gain (if any) due to this reduced basis typically will fall under the normal Sec. 121 exclusion rule.

One way to think of it, is that it has the effect of making short sale or foreclosure of a house with recourse debt behave as if it were non-recourse debt for tax purposes. (Or maybe I should say, the end result is the same).

Stu, the qualified COD income, under the Mortgage Debt Forgiveness Relief Act, does get "converted", indirectly via basis reduction, into primary home sale gain, which can then be excluded under §121. So I agree in principal with what the accountant said.

I don't quite understand your second paragraph.

Remember that California does not fully conform to the federal mortgage debt forgiveness relief law, so there may well still be ordinary income on the CA return due to COD.

-Mark Bole

It's all explained quite clearly and with examples in IRS Pub 4681.

I guess I'm not understanding.

This matter involves two loans from the same lender, and there was a refi, though I don't remember at the moment whether the home owner borrowed additional money when he refinanced.

Let's say basis of $300,000, outstanding loans of $400,000 and current value/short sale at $200,000.

Under §108 whether a home is someone's principal residence is tested under §121, but otherwise there is no reference in §108 to §

121. It just simply says that cancellation of debt on acquisition debt is not included in taxable income.

In the example I can see how $100,000 might come under §121, but the other $100,000 wouldn't qualify either for that or as acquisition debt under §108.

I didn't see anything there that specifically addressed my question. But the examples make it clear that, to the extent cancelled debt exceeds basis (and a short sale is for a price less than the seller's basis), §121 wouldn't apply to avoid any taxable income from cancellation of debt.

Well then, I think that implies a *minimum* of $100K of equity debt (assuming his original loan was 100% of the purchase cost and interest-only, so that no principal was ever paid down).

Let's use $110K for equity debt, to keep the numbers interesting.

But it *is* used to reduce the basis of the property.

Based on the example above, there is $200K of COD [$400K - $200K]. Since $110K of that is equity debt, it will show up as $110K of ordinary income on Form 1040 line 21. The remaining $90K [$200K - $110K] of COD is excluded from income under the temporary law because it is acquisition debt.

However, the basis is reduced to $210K [$300K - $90K], for a non-deductible personal loss on the short sale of $10K [$200K - $210K]. If it has been a gain instead, it could be excluded under §121 if requirements are met.

Without the temporary law, he would have had $200K of COD income instead, and a $100K non-deductible loss, assuming all loans are recourse.

If the original acquisition debit of $290K [$400K - $110K] had been a non-recourse loan, there would be no COD for that loan, and the sale price would be considered to be $290K. Then he would have had $110K [$400K - $290K] of ordinary COD income, and a non-deductible personal loss on sale of $10K [$290K - $300K], just as with the temporary law.

-Mark Bole

Thanks. I think I've got it now.

Purchase money home loans in CA are non recourse by law, so except in the case of a refi there's no problem in any case. I'd forgotten that. Thanks.

Careful: To have home equity indebtedness, one must have home equity. If the loan is upside-down, there is no equity (if there were, there'd be no CoD income).

People can have zero (or even negative) equity in their homes.

Are you asserting that if Taxpayer bought a house for $500,000 with a $450,000 mortgage, and took out a $50,000 home equity loan, and the value of the house has since dropped to $400,000, then the interest on the home equity loan ceases to be deductible? (Does the IRS really want to get into the business of determining the market value of the house each month, while it was dropping from $500,000 to $450,000, to determine how much of the loan interest is deductible for that month?)

Seth

I omitted an important point in this thread from last month.

To recap (the thread is too long to include full quotes), it had to do with the interaction between COD income which is excluded under the Mortgage Debt Forgiveness Relief Act, and §121 exclusion on the sale of the residence.

The reduction in basis under the Mortgage Debt Forgiveness Relief Act only applies if the taxpayer continues to own the property when the debt is forgiven. In a foreclosure or short sale, the taxpayer no longer owns the property at the time the debt is forgiven, so no reduction in basis is required.

The last paragraph in my example is not realistic, as there would probably be no basis reduction for a short sale where the taxpayer no longer owned the property.

-Mark Bole