Discussion:Cancelled Debt (deed in lieu)

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Discussion Forum Index --> Basic Tax Questions --> Cancelled Debt (deed in lieu)


Discussion Forum Index --> Tax Questions --> Cancelled Debt (deed in lieu)

FloridaTaxes (talk|edits) said:

21 January 2010
I have a client who just received a 1099 for cancelled debt. She gave the house back to the bank via a deed in lieu. They reported the entire amount of the loan balance even though they sold the house for about half of it. Do I have to include the entire loan balance as cancelled debt? The reported FMV was equal to the loan balance which was also equal to the purchase price.

This is taxpayer's second house that was lived in for 2 years and then she moved back to the other house. Do the rules about excluding cancelled debt from income apply? It was her principle home for 2 years but she kept most of the mail going to the old house, where a relative was living.

DaveFogel (talk|edits) said:

21 January 2010
Assuming that the debt was a recourse debt (this is different depending upon the facts and the law of your particular state), the cancellation of debt (COD) income is the difference between the principal balance of the debt and the FMV of the property on the date that the debt was canceled. See Frazier v. Commissioner, 111 T.C. 243 (1998); Reg. 1.1001-2(a)(2); Example (8) at Reg. 1.1001-2(c); Rev. Rul. 90-16, 1990-1 C.B. 12. Then, the taxpayer has gain or loss (probably loss) equal to the difference between the FMV of the property and her adjusted basis. If the property was a personal residence, then the loss is nondeductible. See Reg. 1.165-9.

If there is COD income, and the property was not the taxpayer's principal residence at the time that the debt was canceled, then the taxpayer may not use the principal residence exclusion in Sec. 108(h) to exclude the COD income.

If the debt was a nonrecourse loan, then there is no COD income, and instead, the principal balance of the loan is treated as the "amount realized" in the sale. See 2925 Briarpark Ltd. v. Comm., 163 F.3d 313 (5th Cir. 1990); Commissioner v. Tufts, 461 U.S. 300 (1983); Reg. 1.1001-2(a)(1); L&C Springs Associates et al. v. Commissioner, 188 F.3d 866 (7th Cir. 1999).

FloridaTaxes (talk|edits) said:

21 January 2010
It was recourse debt and the FMW on the 1099 is the same as the amount of cancelled debt.

My issue is with the principal residence. Taxpayer says she moved into the house a month after she bought it and gave a relative the other house to live in while she continued to make mortgage payments. There were only a few mortgage payments made on the new house. If she moved back into the other house while the repo was taking place does that count? Obviously she couldn't move out exactly on the date of cancellation. But I know she mentioned a six month process for the deed in lieu to be finalized so I'm not sure at which point she moved back into the other house.

FloridaTaxes (talk|edits) said:

21 January 2010
Do I, as a preparer, need proof from her that she lived in this second house? She says all mail kept going to the old one, so it sounds a bit fishy to me.

DaveFogel (talk|edits) said:

21 January 2010
If the principal amount of the debt was equal to the FMV, then there is no COD income. As to whether the residence was the taxpayer's principal residence, see Reg. 1.121-1(b)(2), which discusses how to determine which of two residences used by the taxpayer is the principal residence.

FloridaTaxes (talk|edits) said:

21 January 2010
If there is no COD income, does it matter if it was her principal residence or not? She swears she lived there but has no proof because she never changed her address. The daughter was living in the old house and just brought her the mail once or twice a week.

DaveFogel (talk|edits) said:

21 January 2010
It matters if there is gain that you want to exclude under Sec. 121. Your posts don't indicate whether the principal amount of the debt exceeds the taxpayer's adjusted basis.

FloridaTaxes (talk|edits) said:

21 January 2010
Basis = 1099 reported FMW = Cancelled debt. The mortgage was interest only.

FloridaTaxes (talk|edits) said:

21 January 2010
Interest only for several years.

R2 (talk|edits) said:

21 January 2010
How fortuitous that the fmv equals the basis! No gain to report. Sec. 121 does not apply.

FloridaTaxes (talk|edits) said:

21 January 2010
Well, the FMW was not really equal to the basis and loan amount. But the lender reported it as such, which is ridiculous. The housing market went way down in Florida from 2006 to 2009.

FloridaTaxes (talk|edits) said:

21 January 2010
So if I understand correctly- COD income is excluded and no gain on sale of residence? This was my original thought but since the others I have done were short sales I needed to make sure.

DaveFogel (talk|edits) said:

21 January 2010
You appear to be raising a new issue here by saying that the Fair Market Value (FMV) was not really equal to the basis and loan amount, it's just that the lender reported it this way on the Form 1099-C.

In preparing the return, you must use the correct FMV at the time that the debt was canceled, even if it differs from the FMV shown on the 1099-C. So, there MIGHT be COD income.

FloridaTaxes (talk|edits) said:

21 January 2010
FMW was probably about $75k less than cancelled debt and basis.

R2 (talk|edits) said:

22 January 2010
Then you have $75,000 in COD income unless the debtor was insolvent or the debt on the property was principal residence home acquisition indebtedness.

Ddoshan (talk|edits) said:

22 January 2010
I don't quite understand why or how you can estimate .. FMV was probably 75K. Who the heck knows what it was. As a tax preparer I sure as heck am not going to try and figure it out for someone. Did the bank sell the home?

FloridaTaxes (talk|edits) said:

22 January 2010
The bank sold the home for $100k less than the mortgage amount. The property appraiser appraised it around $60k less than the mortgage amount.

Debt was for her principal residence according to client. The problem is she can't prove it. She still had the other house the whole time and never changed her address anywhere.

FloridaTaxes (talk|edits) said:

22 January 2010
Why can't we use the amount the bank provided? Like Doshan said- I am not in a position to appraise the value of a house and neither is the client. The house sold for a lot less but that was 6 months after the deed in lieu.

DaveFogel (talk|edits) said:

22 January 2010
You can't use the FMV amount that the bank provided because you said it was "ridiculous." You don't have to be an appraiser; there are several real estate websites that will allow you to obtain comparable sales data within a few seconds.

FloridaTaxes (talk|edits) said:

22 January 2010
Okay, I found one of those websites. It says the FMW was about $40k less than reported.

Question- what about the money the bank got when they sold the house? In a short sale that would have been reduced from the cancelled debt on the 1099. In the case if a deed in lieu, does the taxpayer get "credit" for that anywhere?

EA rob (talk|edits) said:

22 January 2010
the 1099c should show whole mortgage when the 1099a comes it will give credit for the short sale. the latter can come either this year or next depending on closing date

DaveFogel (talk|edits) said:

23 January 2010
Why are you concerned about the money that the bank got when they sold the house? It doesn't affect your client.

In a short sale, the selling expenses reduce the amount of gain or increase the loss on the sale, but don't affect the COD income. Example:

Principal amount of debt - $200,000
FMV of house - $160,000
Selling expenses of short sale - $10,000
Taxpayer's adjusted basis of house - $200,000

COD income: $200,000 (debt) minus $160,000 (FMV) = $40,000
Assume no IRC §108(h) exclusion
Gain on sale: $160,000 (FMV) minus $10,000 (exp's) minus $200,000 (basis) = <$50,000> (loss)
Loss is not deductible for a personal residence.

RoyDaleOne (talk|edits) said:

23 January 2010
(a) IN GENERAL. If any portion of an underpayment, as defined in section

6664(a) and Section 1.6664-2, of any income tax imposed under chapter 1 of subtitle A of the Code that is required to be shown on a return is attributable to a substantial valuation misstatement under chapter 1 ("substantial valuation misstatement"), there is added to the tax an amount equal to 20 percent of such portion. Section 6662(h) increases the penalty to 40 percent in the case of a gross valuation misstatement under chapter 1 ("gross valuation misstatement").

I would be careful.

RoyDaleOne (talk|edits) said:

23 January 2010
The bank has a fiduciary responsibility to the owner of repossessed property such that if the bank sells the property the bank must obtain a fair price for property. Therefore, it is generally inferred that the price for which the banks sells the property is its fair market value. Clear evidence to the contrary is required to over come such presumption.

If the foregoing is incorrect please correct me.

FloridaTaxes (talk|edits) said:

23 January 2010
Dave- Doesn't she have to pay tax on the COD income even if there was a loss on the sale? The forgiven debt minus the price the bank sold it for is less than the FMV of the house. However, the forgiven debt reported without taking into account the money the bank got for the house is more than the FMV of the house. I have another one of these that was a short sale and the bank reported only the amount of the loan that was not covered by the sales price of the house as amount of debt cancelled.

RoyDaleOne- the problem is the house sold 6.5 months after the deed in lieu, so it would not be fair to assume that the FMV when the deed in lieu occured is the same as the sales price of the house when it was finally sold. In those 6.5 months my home's value decreased 15% in Florida.

DaveFogel (talk|edits) said:

23 January 2010
Do you have any authority that you can cite for your statements? I think you're incorrect. If the bank acquires the property at a foreclosure sale, the fair market value of the property is the bid price in the absence of clear and convincing evidence. See Treas. Reg. §1.166-6(b)(2). But the situation described here is not a foreclosure sale, it's a deed in lieu of foreclosure. As FloridaTaxes stated, the bank sold the property 6 months after the deed in lieu of foreclosure transaction, so the selling price at that time was not the fair market value 6 months earlier, and in addition, we don't know the circumstances of the sale. It might have been a forced sale by the bank as opposed to a situation involving a willing seller and a willing buyer.

FloridaTaxes (talk|edits) said:

23 January 2010
In this situation, the seller agreed to the deed in lieu because an attorney told her that was the best option. She had the house on the market for 6 months as a short sale and since it didn't sell the bank was going to take the house back.

RoyDaleOne (talk|edits) said:

23 January 2010
Thank you for your comments.

Tnash01 (talk|edits) said:

10 October 2013
Above, DaveFogel writes:

"If there is COD income, and the property was not the taxpayer's principal residence at the time that the debt was canceled, then the taxpayer may not use the principal residence exclusion in Sec. 108(h) to exclude the COD income."

Does anyone have a citation stating that in fact the property has to be the taxpayer's principal residence at the time the debt was canceled?

Everything that I can find states that it has to be qualified debt but I can't find anything that specifically states that the property has to be the principal residence when the debt is cancelled.

Ckenefick (talk|edits) said:

10 October 2013
http://www.taxalmanac.org/index.php/Discussion:Discharge_of_qualified_principal_residence_indebtedness

Read the above link. Dave Fogel has a point. But many of us, including R2, disagreed with his strict constructionist viewpoint on the matter.

Tnash01 (talk|edits) said:

10 October 2013
Thank you Ckenefick. Great link. I wish I was better at searching the site.

Here is an interesting link to IRS training material on the subject. You might have to try it a couple of times to get it to load. http://apps.irs.gov/app/vita/content/36/36_03_095.jsp?level=advanced&t=1&ans=C

The materials tend to point out that moving out in July of a year and having the debt forgiven in November of the same year is okay for excluding the cancelled debt from income using Form 982.

Now if I could just find something that stated just how long was okay.

Ckenefick (talk|edits) said:

10 October 2013
You will not find what you are looking for. We have cited other IRS materials where the IRS has punted on this issue, making the time difference just a few weeks (or a few days) if I recall correctly (might be Pub 4681). Congress didn't put a provision in the law so that no one would qualify for it. And, again, the point has been made in numerous posts that just a single day could violate the literality (is that a word?) of this provision. After all, if a guy moves out with no intent to return, it is no longer his primary residence. Period. I simply don't believe we should construe this provision so strictly. Now, a judge might. There are plenty of instances where Congress intended one thing, but the statutory language didn't adequately convey this intention, and the courts went by the strict language in the statute. But we're not in court (yet). And this is a battle I would fight, if given the opportunity. Of course, I don't know the facts of your case. If this was my client, I would apply the 2 out of 5 year rule.

Tnash01 (talk|edits) said:

10 October 2013
You mention the 2 out of 5 year rule. I know where this comes from in that it is used in the code section that was referenced in the mortgage forgiveness act.

But I have been of the opinion that it was only referenced to have a common place for the definition of "principal residence" rather than there being any applicability of the 2 of 5 year rule to the mortgage debt cancelation issue.

These issues have been well hashed out here and I don't mean to stir them all back up as we can scroll up...

Ckenefick (talk|edits) said:

10 October 2013
I'm just giving you my opinion. Here's your options (1) $0 exclusion. Statute is clear. Congress passed a statute that is completely meaningless because if a guy is foreclosed upon, there is no way possible for the property to be the guy's primary residence at the time the debt is forgiven...which could actually be many months or years after the guy gets kicked out, especially in light of delays resulting from the Robo-signing of foreclosure documents. And especially in light of the massive wave of foreclosures that plagued the country for several years. I don't think this is what Congress intended. (2) Use a reasonable time frame? Okay, then, what is it? You obviously have no idea. IRS has no idea or they would have told us. IRS' scenarios are very, very short term. Why is that? We don't know, they haven't told us. But it does seem that IRS disagrees with #1, just as I do. So, whatever you pick here is just a guess. (3) Go by the 2 out of 5 year rule since this is the closest we're gonna get to any kind of time frame associated with income stemming from a primary residence transaction. Yes, COD isn't the same as gain on sale, but it's all income and potentially taxable income. And, it is a given time frame that has some history to it. And, the purpose of Sec 121 is similar to the purpose of 108. Note that they are both 3 digits and being with a "1."

I simply vote for #3. And, I suspect that this might be what Congress intended.

But this is your client, so do you want, including letting the client make the call.

Tnash01 (talk|edits) said:

10 October 2013
Thanks again.

I just briefed the client and am waiting for a response. Just wish we had more then a few days left. The 1099-C is marked as recourse but we believe that it is non-recourse which will make a big differnece in the outcome.

Ckenefick (talk|edits) said:

10 October 2013
...let me also say this: If the guy had formally converted this property to a rental prior to the foreclosure, I do think you have an issue, even if the 2 out of 5 year rule is met. So, I vote for a "modified" 2 out of 5 year rule.

Ckenefick (talk|edits) said:

10 October 2013
If prop is in CA, Dave Fogel has written extensively on this R/NR issue...

Tnash01 (talk|edits) said:

10 October 2013
Hawaii

Tnash01 (talk|edits) said:

10 October 2013
Taxpayer just got off the phone with the bank (B of A of course) and they said they made a mistake and it is really non-recourse.

Wish I would have had that answer a few days ago... Now to just calculate the gain...

RexT2013 (talk|edits) said:

10 October 2013
Suggest you get the bank to put it in writing, because I prepared a return for a client earlier this year who had a short sale on a Maui rental condo, and a real estate attorney in Hawaii sent me an email saying that all loans on real estate in Hawaii are RECOURSE unless the loan documents say otherwise.

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