Archive for the ‘qualified principal residence indebtedness’ Tag

Relief if You Paid Tax on a Short-Sale 2011-2013

Originally published in the Cedar Street Times

February 21, 2014

Hopefully we are nearing the end of the short-sale and foreclosure saga that has continued since 2008.  My litmus test based on tax return filings is indicating that things are much closer to being back on track.  Prior to 2008, it was all about 1031 exchanges.  Those turned off like a faucet when the markets crashed, and then short-sales and foreclosures took center stage.  I have seen those tapering off over the last couple years, and I am starting to see 1031 exchanges again.  The cycles continue!

But before we leave short-sales and foreclosures in the dust, there is a possible silver-lining handed down by the IRS and FTB in the last few months.  Taxpayers that generated income tax as a result of a short-sale in California on their principal residence, retroactive to January 1, 2011, may be entitled to a refund.

California Code of Civil Procedure Section 580b has been dubbed California’s “anti-deficiency laws” for years.  It had a positive effect on homeowners because it basically said if you had never refinanced your home and you lost it in a short-sale or foreclosure that you could not be pursued for the balance you still owed (the deficiency), and the remaining debt would not be taxable income to you because the debt was considered nonrecourse debt.

This, however, left many people out in the cold that had refinanced.  Suddenly, it was a different ball game if you had done a refinance (and who didn’t during the run of good years up through 2007!?), and the debts were then allowed by lenders to be treated as recourse debts and they could pursue your personal assets.  Alternatively they could cancel the debt if it was not worth pursuing, leaving you with taxable income for the amount cancelled.

Congress stepped in (and California generally conformed) during the housing crisis and enacted favorable legislation which said you could exclude cancellation of debt income generated by your personal residence.  The catch, however, was that the debt had to be “qualified debt.”  In short, if you lived off the equity in your house by refinancing to pull cash out and did anything with it other than improve the property, then you were not eligible for the exclusion on that portion and would still have to pay tax.

Then, a few years ago, California passed Senate bills 931 and 458 which were codified into law as California Code of Civil Procedure Section 580e as of January 1, 2011.  This resulted because some unscrupulous lenders were entering into short-sale agreements to allow sellers to go through with the sale of their property for less than the amount owed to the bank, but then still pursuing the seller for the remaining debt after the fact (often a big surprise to the seller).  California’s enactment of this law was good news for homeowners because it basically said, even if you had refinanced, but had entered into a short-sale agreement with a lender, then you could not be pursued for the remaining balance owed and that lenders would basically have to cancel the debt.  Of course, cancelling the debt could mean tax was owed, but that was still better than being pursued for the remaining balance!

Finally, in November 2013 a letter from the Office of the Chief Counsel at the IRS written to Senator Barbara Boxer, due to an inquiry from her, stated that the IRS would treat any debt pursuant to California’s 580e as nonrecourse debt!  The Chief Counsel’s office at California’s Franchise Tax Board followed up with their own letter a month later saying they will conform to the IRS interpretation.

This means that anyone who filed a tax return in 2011 or 2012, or even this year, and reported cancellation of debt income related to the short sale of a principal residence, should consider filing an amendment for a possible refund.  It is still possible to have income tax, primarily if you did not live in the house for two of the last five years prior to your short-sale.  The reason is that when a home is disposed of with nonrecourse debt, the total amount of debt outstanding at the time of the short-sale becomes the sales price of the home.  You then subtract your cost basis, and the difference is your gain on sale.  However, if you lived in the home for two of the last five years, then you get a $250,000 gain exclusion for filing as a single status, and $500,000 gain exclusion if married filing jointly, pursuant to IRC Section 121.

You need to act on this during the next year if your short sale was in 2011 as the statute of limitations expires three years after filing.

Prior articles are republished on my website at www.tlongcpa.com/blog.

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, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Losing Your Home? Favorable Tax Provisions Expire 12/31/12.

Originally published in the Pacific Grove Hometown Bulletin

May 16, 2012

If you think you may not be able or willing to hold on to your home for the long-term, you should seriously consider your options for short sale or foreclosure as soon as possible.  At the end of this year, Internal Revenue Code Section 108(a)(1)(E) is set to expire (California tax law conforms to the expiration also).  This is the provision that allows people to possibly exclude from income, cancelled debt when recourse loans on their primary residence are higher than the value of the home.  These transactions take three to 12 months to complete, so time is of the essence.

Between foreclosures and short sales, short sales are your best option in this regard.  This is where you find a buyer and the lender accepts the buyer’s offer, even though it is less than what you owe the lender.  Current law in California forces lenders to cancel the remaining debt as of the date of the short sale and prohibits them from pursuing your personal assets if they agree to the short sale.  A foreclosure does not guarantee the lender will not pursue you for the remaining debt.  Even if they do decide to cancel the debt, it may not be until after the end of this year.

Whether debt is cancelled by short sale or possibly by foreclosure, the cancelled debt is potentially taxable income to you.  If you did not take cash out during past refinances, or to the extent you put cash-out back into improving the property, you will likely be able to exclude the cancelled debt income from your taxable income due to code section 108(a)(1)(E)…until the end of this year.  After that, you will likely only be able to exclude the debt if, and only to the extent you are insolvent (more liabilities than assets).  Bankruptcy is another option, but it must be filed before you lose the property – in other words, plan early.

Imagine $200,000 of income on your tax returns from cancelled debt, generating an extra $75,000 or more of tax.  Many people will find these transactions to be the largest potentially taxable transactions in their life, so it is important to seek competent professional advice, plan appropriately, and avoid the tax if at all possible.

Prior articles relating to foreclosures and short sales are republished on my website at www.tlongcpa.com/blog.

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, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Foreclosures and Short-Sales – Part IV – Primary Residence

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.

Foreclosures and Short-Sales – Part II – Exclusions from Income

Originally published in the Pacific Grove Hometown Bulletin

July 6, 2011

 

In the last issue I went over the basic concepts of foreclosures and short-sales and explained that your debt forgiven in these transactions is considered taxable income.  It is difficult to face a tax bill in congruence with losing a property so Congress provided some options to possibly exclude the cancelled debt from your taxable income.

Section 108 of the Internal Revenue Code will likely be your hero.  This code section and its related code sections and regulations are not for the faint of heart as I have witnessed by the glazed eyes of a sea of tax professionals trying to grasp the nuances in the rules, as well as phone calls I have received from other CPAs and attorneys.

Based on my experience with over 80 of these transactions, if you distill the mess of complex code down to its core, you will find after the dust settles and the house is gone, if you truly have nothing left, you will typically get off the tax hook.  For everyone else, to the extent you have a positive net worth or future tax benefits, these code sections swallow your benefits or act as a deferral of tax to a later date – do not be misled, however, this is still a great stamp in your passport (summer cliché).  To receive these benefits, however, you have to apply the code and file the forms and additional statements correctly with an original, timely filed return.  If you foresee the future chance of losing a property, consult early to strategize how to best “lose the property” – it may save you a lot of money.

Section 108 covers all discharges of debt, but I will focus on it from the perspective of debts discharged due to the loss of a home or rental property.  The circumstances that may qualify you to exclude the debt or part of the debt from income are: bankruptcy, insolvency (you have more liabilities than assets), qualified farm indebtedness, qualified real property business indebtedness (typically rental property debt falls here), and qualified principal residence indebtedness (debt on your main home usually qualifies here).  You see the word qualified in a number of these exclusions because not all debt is eligible.  The escape hatch may get smaller, for instance, if you lived off the equity of your home and did not reinvest refinance proceeds back into improving it.

Once it is determined how much debt can be excluded from income (which can come from a combination of exclusions), we then apply tax attribute reduction rules – on the chopping block include items that could have saved you tax in the future: net operating losses, general business credits, minimum tax credits, capital loss carryovers, tax basis in your other assets (most people have at least some of this), passive activity loss and credit carryovers, and foreign tax credit carryovers.  The order, timing, and calculation of these rules are different depending on which of the previously mentioned exclusions you are using.  Next issue, I will focus on the principal residence exclusion.

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.