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NEW YORK, Oct. 27, 2008, /PRNewswire/ -- In a July 8, 2008 speech on
the U.S. housing market, Treasury Secretary Henry M. Paulson, Jr.
reported that 1.5 million foreclosures were started in 2007, and some
economists estimate that about 2.5 million foreclosures will be
started in 2008. By comparison, there were only 800,000 foreclosures
in 2004. Those who happen to be among the unlucky ones, are living in
a world of hurt and don't need to be facing giant tax bills on top of
losing their homes.
"But, before 2007, that was what often happened because any part of
their mortgage forgiven after the foreclosure, (such as when the house
was sold and the bank forgave the mortgage exceeding the home's sales
price), was considered taxable income. Fortunately, a tax law change
in the 2007 Mortgage Relief Act saved the day--at least for many
foreclosures and debt cancellations during 2007 through 2012," says
Robin Christian, Senior Tax Analyst for the Tax & Accounting business
of Thomson Reuters.
The help comes in a special provision called the qualified principal
residence indebtedness exclusion, according to Christian. To qualify
for the qualified prinicipal residence indebtedness tax exclusion,:
(1) the cancellation of debt (COD) must occur in a calendar years
2007-2012 and (2) the debt that was canceled must have been incurred
to acquire, construct, or improve the individual's principal residence
and it must be secured by that residence. Finally, only up to $2
million of COD can be excluded under this provision.
According to Christian, the basis of the taxpayer's residence is
reduced (but not below zero) by the amount excluded under this
exception. "Thus, the excluded COD will decrease any loss (or increase
any gain) on the sale of the residence," she says. "But, this usually
doesn't matter as the loss isn't deductible and any gain up to
$250,000 ($500,000 in the case of married taxpayers) usually qualifies
for the home-gain exclusion, so it isn't taxable anyway." She provides
this example:
A couple of years ago, Lois and Clark paid $500,000 for their home.
Now, thanks to a down real estate market, their home is now worth
$350,000, their mortgage balance is $450,000, and, to top it off,
Clark has lost his job. With no way to make the monthly payments and
no hope of selling and being able to pay off the mortgage, Lois and
Clark hand the deed back to the bank and walk away from their home.
The bank sells the house for $350,000 and forgives the $100,000
remaining loan balance. As far as Lois and Clark are concerned,
they've done nothing but lose their home and all the money they put
into it.
For tax purposes, however, two things have happened--they've sold
their home for a $150,000 loss and realized COD income of
$100,000--and the two transactions do not offset each other. In fact,
the loss from the sale of the residence is never deductible, whereas
the COD income is fully taxable, unless an exception applies.
Fortunately, for Lois and Clark, they can exclude the $100,000 of COD
under the qualified principal residence indebtedness exclusion. "This
will decrease the basis in their home by $100,000, so their loss will
now be $50,000 instead of $150,000, but who cares--it's not deductible
anyway," says Christian.
Bottom line: The foreclosure has no impact on their income taxes.
Note, however, that the COD will need to be reported on a special form
attached to their 2008 Form 1040--Form 982 (Reduction of Tax
Attributes Due to Discharge of Indebtedness). Basically, you use this
form to report the COD, and then indicate that it is excluded under
the qualified principal residence indebtedness exclusion and that the
residence's basis is reduced by the amount excluded.
"Unfortunately, this special COD exclusion does not apply to all home
loans--it doesn't work for second mortgages or home equity loans that
were used for purposes other than to improve the taxpayer's principal
residence, nor does it work for vacation home mortgages," warns
Christian. "It will only help those who borrowed too much to acquire,
build, or improve a principal residence."
However, other exclusions may apply. For example, COD that occurs
during bankruptcy proceedings is excluded from income as is COD, to
the extent of the borrower's insolvency immediately before the debt
forgiveness event occurs. Also, there's no COD income if your mortgage
was nonrecourse (meaning, you are not liable to the extent the loan
balance exceeds your home's value) or seller financed (that is, the
home's prior owner loaned you the money to buy the home).
"The COD exclusion for principal residence indebtedness may well save
the day if your home was foreclosed on in 2008," says Christian. "Be
careful though--real life is never as simple as our examples. Often a
foreclosure is a drawn out painful process, occurring in several
stages over more than one year --and each case is unique. That's where
your tax professional can be instrumental in getting the best
results," advises Christian.
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