May 3, 2013
by Matthew B. Theunick
Trott & Trott, P.C.
USFN Member (Michigan)
Pursuant to § 61(a) of the Internal Revenue Code (26 U.S.C.S. § 61(a)), for income tax purposes, “gross income” is defined as “all income from whatever source derived.” As noted in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments: “Generally, if you owe a debt to someone else and they cancel or forgive that debt, you are treated for income tax purposes as having income and may have to pay tax on this income.” Accordingly, gross income consists of canceled debt, unless an applicable exclusion applies.
In the wake of the real estate market readjustment of 2006 and 2007, the federal government enacted such an exclusion in the form of the Mortgage Forgiveness Debt Relief Act of 2007, 110 P.L. 142, the purpose of which was to amend the Internal Revenue Code to exclude discharges of indebtedness on principal residences from gross income, by providing relief to underwater homeowners on foreclosures, short sales, deeds-in-lieu of foreclosure, mortgage refinances, loan modifications, abandoned properties, et cetera.
This relief was provided by amending § 108(a)(1)(E) of the Internal Revenue Code to note that an exclusion from gross income would include “qualified principal residence indebtedness which is discharged before January 1, 2010.” This governmental action allowed distressed homeowners the ability to exclude up to $2 million of certain debt forgiven on a principal residence or $1 million for a married person filing a separate return.
As noted in IRS Publication 4705, Tax Benefits, Credits, and Other Information, qualified principal residence indebtedness is debt “… used to buy, build or substantially improve the taxpayer’s principal residence and must have been secured by that residence. Debt used to refinance qualifying debt is also eligible for the exclusion, but only up to the amount of the old mortgage principal, just before the refinancing.”
For the distressed homeowner, a key provision of the Debt Relief Act is that debt reduced through mortgage restructuring as well as debt forgiven in connection with a foreclosure may qualify. If the homeowner qualifies for this debt relief, the homeowner can claim the special exclusion by filling out Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and attach it to his or her tax return for the year in which the qualified debt was forgiven. Additionally, if debt is reduced or eliminated, the homeowner can expect to receive a year-end statement Form 1099-C, Cancellation of Debt, from the mortgage lender.
The Debt Relief Act of 2007 was amended in section 303 of the Emergency Economic Stabilization Act of 2008, P.L. 110-343, by striking “January 1, 2010” and inserting “January 1, 2013” in Subparagraph (E) of section 108(a)(1) of the Internal Revenue Code and was again amended in section 202 of the American Taxpayer Relief Act of 2012, 112 P.L. 240, enacted January 2, 2013, to extend the exclusion to “January 1, 2014.” Whether relief beyond 2013 will be provided will no doubt depend on the state of the economy in relation to the benefit gained, as opposed to the taxable revenue lost by providing this relief.
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