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FEDERAL TAX LAW - IRS
CALIFORNIA TAX LAW - CA FTB

Relief from 'phantom income' on mortgage defaults for primary residences ...
Summary Click to read HR 3648
Extended to DEC 31, 2012 : UPDATED: January 2009
Clearly an indication of how bad the situation is for distressed homeowners.

The tax consequences arising from your situation are severe. Please contact your CPA or other tax reporting professional to clarify the foregoing and attached spreadsheet. I am not a licensed Certiified Public Accountant. You must speak with the individual who actually prepares your tax reporting forms / returns that are submitted to the IRS to determine for your particular purposes the likelihood and extent of taxation.

http://www.irs.gov/newsroom/article/0,,id=174034,00.html

FEDERAL TAX LAW

What is the Mortgage Forgiveness Debt Relief Act of 2007 and how does it affect me?
It amends the Internal Revenue Code to exclude from gross income amounts attributable to a discharge of indebtedness incurred to acquire a principal residence. It limits to $2 million the excludable amount of such indebtedness and reduces the basis of a principal residence by the amount of discharged indebtedness excluded from gross income.

WINDOW PERIOD: The tax break applies, if at all, to debts discharged from:
January 1, 2007 to December 31, 2012

INTENDED IMPACT:
Help certain borrowers avoid some of the negative consequences arising from mortgage defaults.

CONGRESS PROVIDED AN 'EXPLANATION' OF THE NEW (TEMPORARY) LAW

Read / Print Summary Here

WHAT DOES CONGRESS SEEM TO MEAN?
Two key terms seem to drive interpretation.

Principal residence is defined in this link to Section 121
Acquisition indebtedness means any indebtedness which - (1) is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and (2) is secured by such residence.

So, over-simplifying the interpretation, the MFDRA appears to apply to a homeowner's primary residence - NOT INVESTMENT PROPERTIES or SECOND HOMES - and a portion of debt - DEBT ACQUIRED TO PURCHASE THE PRIMARY RESIDENCE or MAKE CAPITAL IMPROVEMENTS - is excluded from the determation of taxation as follows:

* COD = Cancellation of Debt

1 COD* income may not be reportable for some disposing of principal residences
i. Q: did the homeowner itemize / deduct interest paid on the discharged loan?
ii. A guiding factor is reference to a homeowner's IRS Form 1040 SCH A

2 COD* income relating to investment properties is still reportable / taxable

3 Negative credit consequences exist whenever there is a default

4 Calculating COD income is done by subtracting amount due on debt from qualified 'acquisition indebtedness'

5 Short sales are taxed under the same rules as foreclosures

6 There well may be different treatment of COD from purchase money versus 'cash out' and second loans such as HELOCs + LOCs

7 Homeowners who took advantage of the run up in real estate prices to do "cash-out" refinancing, in which the funds were not put back into the home but, instead, were used to pay off credit card debt, tuition, medical expenses, or other expenditures, are not covered by the new law exclusion for the cash-out amount. That indebtedness income is fully taxable income unless other exceptions such as insolvency or bankruptcy can be met.

8
Stated differently: The tax relief applies to the original purchase price, plus improvements, of the taxpayer's principal residence. It doesn't apply to discharges of second mortgages or home equity loans, unless the loan proceeds were used to acquire, construct, or substantially improve the taxpayer's principal residence. Refinanced indebtedness qualifies to the extent it doesn't exceed the amount of indebtedness being refinanced. (Cash out from refinancing doesn't qualify for the exclusion.)

Debt forgiven on second homes, rental property, business property, credit cards or car loans does not qualify for the new tax-relief provision. In some cases, however, other kinds of tax relief, based on insolvency, for example, may be available. See Form 982 for details.

NOTE: whether or not the MRDRA applies to a homeowner's situation, there may be capital gain or loss concerns that must be addressed by a Certified Public Accountant. Factors in determining these tax consequences include such concerns as date of purchase PLUS any adjustment to the cost basis from things like 'capital improvements'.

Note too that whether or not there is COD income, there can be a capital gains issue depending on when the property was purchased. Taxpayers must consult their CPAs to learn whether any gain must be reported or whether it might be exempt.

What is COD income, and how is it calculated?
Loan proceeds are not included in income when received because there is an offsetting obligation to repay. However, if the debt is cancelled in part or full in a short sale, deed in lieu, or foreclosure proceeding, a homeowner might be compelled to recognize COD income equaling the difference between the unpaid amount of the debt and the 'acquisition indebtedness' of the property.

EXAMPLE: Thus, assume that a principal residence is secured by an indebtedness of $1 million, of which $800,000 is qualified principal residence indebtedness. If the residence is sold for $700,000 and $300,000 debt is discharged, then only $100,000 of the amount discharged may be excluded from gross income under this provision:

$        700,000.00 FMV - Sales Price per lender approved SHORT SALE

$     1,000,000.00 Total Debt at Close of Escrow ( whether PMTD or REFI / Cash Out )

$        800,000.00 'Acquisition Indebtedness' - Qualified Principal Indebtedness

$        200,000.00 COD INCOME derived from cancellation of debt - 1099 issued

Lender may isuse 1099c unless dischargeable via homeowner declaration of bankruptcy or insolvent per IRC Section 108

NOTE: MFDRA may eliminate portion of COD Income - consult CPA

Senior lienholder may not allow junior lienholder to get any payoff

Junior lienholder may refuse to reconvey if not paid anything

Junior lienholder will typically release lien IF paid consideration

25%
ESTIMATED TAX BRACKET > Consult your CPA

$          50,000.00 ESTIMATED TAX ON COD INCOME

NOTE: If you borrow money from a friend or relative and he or she cancels all or part of the debt, the cancellation often is treated as a gift from the lender to you. Gifts, including gifts of cancelled debts, are excludible from income. However, the cancellation of debt by a commercial lender is not a gift.

It appears that 'CASH OUT' for any purpose other than the replacement of the acquisition indebtedness or capital improvement of the property is subject to taxation.

How do I compute gain or loss on a disposition by short sale, deed in lieu of foreclosure, or actual foreclosure?
Gain or loss is the difference between your amount realized and your 'adjusted cost basis' in the property. In general, the amount realized by the homeowner is:

Step # 1 - Compute Adjusted Cost Basis

$        565,000.00 Original acquisition costs / Purchase Price

$                     -   + PLUS Capitalized buyer closing costs

$                     -   + PLUS Capital Improvements

$                     -   - LESS Depreciation if used as home office

$        565,000.00 ADJUSTED COST BASIS on date of sale

Step # 2 - Compute Gain or Loss on Sale of Home

$        479,000.00 Amount realized on sale (sales price)

$         (23,950.00) - LESS Seller Costs (i.e., commission, escrow, title, misc)

$       (565,000.00) - LESS Adjusted Cost Basis (above)

$       (109,950.00) EQUALS GAIN ( LOSS ) FROM SALE

Can COD income ever be excluded from my gross income?
You may be able to exclude all or part of the cancelled debt income if all or part of the debt was discharged in bankruptcy, if you were insolvent immediately before the transfer, or if the debt is a qualified farm debt or qualified real property indebtedness. Refer to Publication 908 ( PDF), Bankruptcy Tax Guide.

ACCESS INTERNAL REVENUE CODE
IRC § 108
Income from Discharge of Indebtedness

Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—
(A) the discharge occurs in a title 11 case,
(B) the discharge occurs when the taxpayer is insolvent

(3) Insolvent
For purposes of this section, the term “insolvent” means the excess of liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge.

How do I report COD income on my return? Income Reported on 1099-C
COD income is ordinary income and is reported on FORM 982 - http://www.irs.gov/pub/irs-pdf/f982.pdf.

Can GAIN on the foreclosure of my house be excluded from my gross income?
If the house is your principal residence, you may be able to exclude part of all of the gain under I.R.C. 121. See Publication 523, Selling Your Home.

How do I report a foreclosure gain or loss on my return?
Gain or loss on the foreclosure of your house usually is capital gain or loss. However, a loss on the foreclosure of your residence is not deductible. Capital gains are reported on Form 1040, Schedule D (PDF). If, however, the gain on the foreclosure of your residence is excluded under I.R.C. 121, you are not required to report the gain on your return.

Consider these links to explore tax impacts:
http://www.irs.gov/publications/p523/index.html
"Income" / Debt Relief Reported on 1099-C
http://www.irs.gov/individuals/article/0,,id=179414,00.html Report on FORM 982

Sales and Other Dispos of Assets
http://www.irs.gov/pub/irs-pdf/p544.pdf

Article: Some homeowners get relief from COD income (IRS 02.28.2008)
http://www.realestateinvestingtax.com/shortsale.shtml
http://www.toolkit.com/news/newsDetail.aspx?nid=07-004mortgage
http://www.thetaxdiva.com/2008/01/forgiven-mortgage-debt-relief-in.html

Also consider
Basis of Assets
http://www.irs.gov/publications/p551/ar02.html#d0e301
http://www.irs.gov/pub/irs-pdf/p551.pdf
Canceled Debts, Foreclosures etc & Solvency
http://www.irs.gov/pub/irs-pdf/p4681.pdf
Capital Gain/Loss
http://www.irs.gov/individuals/article/0,,id=138991,00.html
http://www.irs.gov/newsroom/article/0,,id=170634,00.html
http://www.irs.gov/pub/irs-pdf/i1040sd.pdf

CALIFORNIA TAX LAW

So what about California? Am I subject to taxation from debt relief?
Mortgage Debt Forgiveness May Be Taxable in California.

The California mortgage forgiveness debt relief law is effective immediately. It is similar to federal law, but with important differences.

The California law covers qualified debt forgiven in 2007 and 2008, and it:

Limits the amount of qualified principal residence indebtedness to $800,000 for taxpayers who file as married/registered domestic partners (RDP) filing jointly, single, head of household, or widow/widower, and to $400,000 for taxpayers who file as married/RDP filing separately.
Limits debt relief to $250,000 for taxpayers who file as married/RDP filing jointly, single, head of household, or widow/widower, and to $125,000 for taxpayers who file as married/RDP filing separately.

The federal law covers qualified debt forgiven from 2007 through 2012 (1-BELOW) and it:

Limits the amount of qualified principal residence indebtedness to $2,000,000 for taxpayers who file as married filing jointly, single, head of household, or widow/widower, and to $1,000,000 for taxpayers who file as married filing separately.
Does not limit the debt relief amount: it only limits the indebtedness amount used to calculate the debt relief amount.

Claiming mortgage forgiveness debt relief for a previously filed 2007 tax return

If you already filed your 2007 tax return, file a Form 540X, Amended Individual Income Tax Return, in order to claim debt relief.
If the amount of debt relief for federal purposes is more than the California limit, include the amount in excess of the California limit on Schedule CA (540/540NR) line 21f, column (C).
If the amount of debt relief for federal purposes is the same as the California limit, no adjustment is necessary on Schedule CA (540/540NR). On Form 540X, simply enter on line 2e, column (B), the amount originally entered on Schedule CA (540/540NR) line 21f, column (C).

Claiming mortgage forgiveness debt relief on an original 2007 or 2008 tax return

You can file for debt relief on your original 2007 or 2008 Form 540, California Resident Income Tax Return, or Form 540NR, California Nonresident or Part-Year Resident Income Tax Return.
If the amount of debt relief for federal purposes is more than the California limit, include the amount in excess of the California limit on Schedule CA (540/540NR) line 21f, column (C).
If the amount of debt relief for federal purposes is the same as the California limit, then no adjustment is necessary on Schedule CA (540/540NR).
You must include a copy of your federal return, including Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) with your original California tax return.

Get more information - Federal Mortgage Forgiveness Debt Relief Act of 2007

1- The federal law previously covered debt forgiven from 2007 through 2009. On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (H.R. 1424) extended the federal period through 2012.

How will I know which is the best option for me?
This is a tremendously complicated question. The answer will depend upon your assets, liabilities, income, expenses and the underlying reason why the house is in foreclosure. The best solution will also depend upon the type of mortgage you have and where in the foreclosure process you are when you make the decision to save the house.

Contact me to assess your particular situation.
CONTACT YOUR CPA for specific TAX QUESTIONS based on your reporting.
It is not in your best interest to wait.
Time is working against you.
Act NOW.

The tax consequences arising from your situation are severe. Please contact your CPA or other tax reporting professional to clarify the foregoing and attached spreadsheet. I am not a licensed Certiified Public Accountant. You must speak with the individual who actually prepares your tax reporting forms / returns that are submitted to the IRS to determine for your particular purposes the likelihood and extent of taxation.

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