Archive for August, 2011|Monthly archive page
Foreclosures and Short-Sales – Part V – Insolvency
Filed under: Foreclosures and Short-Sales | Tags: basis reduction, cancelled debt, carryovers, Foreclosure, foreign tax credits, general business credits, insolvency, net operating losses, nonrecourse, passive activity losses, recourse, Short-Sale, tax attributes
Leave a comment Originally published in the Pacific Grove Hometown Bulletin
August 17, 2011
The last four issues I went over the basic concepts of foreclosures and short-sales, an overview of ways to exclude the resulting taxable income, the effects of recourse/nonrecourse debt, and the principal residence exclusion. If you missed these articles they are re-published on my website at www.tlongcpa.com/blog. This issue I will specifically discuss the exclusion available when you are insolvent.
Insolvency means your liabilities are greater than the fair market value of your assets – essentially you have a negative net worth. In such cases, the IRS may allow you to exclude cancellation of debt income, created as a result of losing a home or rental property, to the extent that you are insolvent. This insolvency calculation is performed based on your assets and liabilities the moment before your debts are discharged.
Let us assume you are losing a second home with recourse loans so the principal residence exclusion does not apply to you. You have a house worth $300,000 and the value of everything else you own – cars, savings, retirement plans, household items, etc. is $100,000 for a total of $400,000 in assets. Then assume your home loan was $550,000 and you have you have $50,000 in credit card debt and car loans for a total of $600,000 in liabilities. You are insolvent by $200,000. If your home was foreclosed, you would have cancellation of debt income of about $250,000. You can exclude $200,000 of the $250,000, from income, leaving you with only $50,000 of taxable income.
When calculating your insolvency, do not forget to include the fair market value of pension plans, annuities, etc. If you have a plan such as CalPers, for instance, that pays you a monthly retirement benefit, you need to call your plan administrator and ask for an actuarial calculation of the value of your plan. Some people are surprised to learn that that pension can easily be worth $500,000 or $1,000,000, and would drastically change your insolvency calculation!
After determining how much debt can be excluded, you then have to reduce any tax attributes you may have. In exchange for excluding the $200,000 of income as in the above example, you then have to reduce or eliminate tax benefits that may have been useful to you in the future, or defer tax to a later date through basis reductions in items you may sell later. There is a specific order, method, and timing for doing this, but items such as carryovers of net operating losses, general business credits, minimum tax credits, and capital losses; basis in depreciable and nondepreciable property; passive activity loss carryovers and foreign tax credit carryovers are all on the chopping block. If after all these rules are applied and you still haven’t traded enough to equal your exclusion, then you are off the hook!
Oh, and you still have to calculate the gain or loss on the disposition of the property. We will not discuss that in this issue.
It is possible for the insolvency exclusion to be used in conjunction with other exclusions, and there are ordering rules to the exclusions themselves. This is just a summary of some of the key provisions. There are many other circumstances and specific rules that could affect you, and you need to consult with a qualified professional to review your situation. Consult as soon as you can foresee the possibility of losing a home in order to plan the most tax efficient way to lose it.
If this exclusion does not help you completely, and you are losing a rental property, you may be eligible for the qualified real property business indebtedness exclusion – next issue’s topic!
IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.
Travis H. Long, CPA is located at 706-B Forest Avenue, Pacific Grove, CA, 93950. He can be reached at 831-333-1041.
Foreclosures and Short-Sales – Part IV – Primary Residence
Filed under: Foreclosures and Short-Sales | Tags: Foreclosure, Mortgage Foregiveness Debt Relief Act, nondeductible personal loss, primary residence, qualified principal residence indebtedness, section 108, section 121, Short-Sale
Leave a comment Originally published in the Pacific Grove Hometown Bulletin
August 3, 2011
The last three issues I went over the basic concepts of foreclosures and short-sales, an overview of ways to exclude the resulting taxable income, and the effects of recourse/nonrecourse debt. If you missed these articles they are re-published on my website at www.tlongcpa.com/blog. This issue I will specifically discuss the exclusion available to people losing a principal residence.
Due to the tsunami of defaults anticipated when the markets began to fall in late 2007, Congress enacted the Mortgage Forgiveness Debt Relief Act on December 20, 2007 which resulted in an additional exclusion in IRS Code Section 108 trying to help people going through short-sales, foreclosures, or mortgage reductions on a principal residence. There is a lot of incomplete and incorrect tax advice that floats around regarding this exclusion – not only from water-cooler talk and media blurbs, but from ill-trained tax preparers as well.
As discussed in my previous articles, cancelled debt on recourse loans is taxable income to you. The Qualified Principal Residence Indebtedness exclusion allows you to exclude the resulting income if the home was your principal residence (you can only have one and it is determined by facts and circumstances) subject to limitations. One of the common oversights is not understanding that only “qualified” debt is eligible for the exclusion. Generally speaking, this is the original debt to purchase or construct the property as well as debt subsequently obtained to improve the property (such as additions or remodels). If you refinanced your home to get cash out, and used the money for a new car, vacations, for a down payment on another home or rental property, education, to pay down other debts, or to pay your living expenses or even the mortgage on your home, or anything else – none of this is qualified for the exclusion. Yikes! In addition there are different Federal and California limits for how much qualified debt you can exclude. Any amount you cannot exclude will be taxable as ordinary income to you unless you can qualify for another exclusion.
Any amount you can exclude reduces your cost basis in the home. When the home is sold or the bank forecloses, you also have to calculate your gain or loss on the disposition. If you bought the home shortly before prices fell significantly, chances are that even with the basis reduction, the sales price will be less than your cost basis resulting in a nondeductible personal loss. (In a foreclosure the “sales price” is the fair market value of the home when foreclosed.) In cases where the calculation results in a gain, you may be able to exclude the gain, or part of the gain per Section 121, if you lived in the home for two out of the last five years.
If your loan was nonrecourse, you do not have cancellation of debt income, but you still have to calculate the gain/loss on disposition. Unfortunately, the “sales price” in these cases is the amount of debt outstanding when the home was disposed – and not the low, actual sales price (or fair market value if foreclosed). This can create taxable gains, but Section 121 may help you here as well.
This is just a summary. There are many other circumstances and specific rules that could affect you, and you need to consult with a qualified professional to review your situation. Consult as soon as you can foresee the possibility of losing a home in order to plan the most tax efficient way to lose it.
If this exclusion does not help you completely, you may be eligible for the insolvency exclusion – next issue’s topic!
IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.
Travis H. Long, CPA is located at 706-B Forest Avenue, Pacific Grove, CA, 93950. He can be reached at 831-333-1041.
Travis H. Long, CPA, Inc. Blog 