As my readers are aware, we’ve been grappling for many months over whether “Personal Residence” means 1) where you live at the time the property is sold or foreclosed; or 2) where you lived for 2 of the past 5 years. Obviously we’d all like the 2nd definition to apply since that would give debt forgiveness tax relief to the many property owners who have rented out their homes or moved. 

I have argued that the 1st definition controls based upon the following statements in the IRS Publication 4681 concerning Cancellation of Debt. In that document, the IRS defines Qualified Personal Residence Indebtedness as: “any mortgage you took out to buy, build, or substantially improve your main home. It also must be secured by your main home. Qualified principal residence indebtedness also includes any debt secured by your main home that you used to refinance a mortgage you took out to buy, build, or substantially improve your main home, but only up to the amount of the old mortgage principal just before the refinancing.”  The IRS then goes on to define “Main Home” as: “the home where you ordinarily live most of the time. You can have only one main home at any one time.”   Given this definition, I do not see how one could identify their Main Home as being anything other than where they live now.  This supports the argument that you must live there to get the debt forgiveness tax relief.    But, that may not be as clear as it sounds.

In a 2007 Publication on the tax impacts of foreclosure, the California Franchise Tax Board defines the taxpayer’s principal residence as “where they have lived for at least two of the past five years”. However, at that point, the FTB was talking about the possible capital gains liability from a foreclosure and for that purpose, the 2 of 5 year Rule does apply.

All of the commentarors on this issue look to U.S. Code Section 121 - Exclusion of Gain from Sale of Principal Residence - which provides: “Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more”.  So, does this only concern Capital Gains Tax or does it include Debt Forgiveness Tax? 

We get some clarity from the language of the actual law: “The Mortgage Forgiveness Debt Relief Act of 2007″ which states at Section 2.5: “principal residence’ has the same meaning as when used in section 121″. ie: the capital gains definition does apply. This was reaffirmed in 2008 when Congress passed the “Emergency Economic Stabilization Act of 2008″ which created the TARP bailout program for banks and extended the operative term of the Debt Relief Act to December 31, 2012. The joint committee report for the EESA states that the meaning of personal residence for purposes of the QPRI exclusion is the same as in Section 121.

So, what should we conclude from all this?  It does appear that the intent of Congress in passing these laws is that a foreclosure is considered to be a “sale” and the definition of “Principal Residence” shall be the 2 of 5 year Rule set forth in U.S. Code Sec. 121, not the Main Home definition that the IRS appears to be using.  It also means that there may remain an ambiguity in the law that has yet to be defined conclusively. Arguably, the IRS could disallow an exclusion from Debt Forgiveness Tax when the debtor was not living in the home at the time of sale.  Will they do so?  We don’t know yet.  What we do know is that if you need the 2 of 5 year definition to apply to you, be sure to get competent advice from an accountant or CPA that you trust and who knows these issues.

If you have specific questions about your liability, short sales, foreclosure, or any legal issues, feel free to contact me at sjbeede@bpelaw.com.  We offer a $200 flat fee consultation to evaluate your liabilities and strategize a resolution. This can be done in person or by phone. If interested, please call us at 916-966-2260. Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: /http://www.stevebeede.com/copingwithanupsidedownmortgage

As many already know, the California legislature passed SB 401 on April 9th. While Gov. Schwarzenegger originally said he would not sign the Bill due to tax riders, but he signed the Bill yesterday  and it is now law.  California law will now be aligned with the Federal Mortgage Debt Forgiveness Relief Act and will give CA owner-occupant property owners debt forgiveness tax protection through 2012 and retroactively running from 2009 (2007-2008 already protected). To learn more, read today’s article by Jim Wasserman in the Sacramento Bee: http://www.sacbee.com/2010/04/13/2674065/california-wont-tax-forgiven-home.html.

There is some confusion in the Blogging world concerning debt forgiveness relief.  Some believe that the forgiveness automatically exists if the loan or loans were acquisition loans (1 to 4 unit, owner-occupied). This would be correct if the owner never refinanced and stayed owner occupant throughout. But it would not be correct if the owner later moves and rents the propertyout.  If you are in this situation, be sure to check with your accountant to determine how this will apply yo your situation.

If you have any questions concerning your rights and obligations concerning real property, foreclosure, or any related issues, please feel free to contact me at sjbeede@bpelaw.com or contact my office at 916 966-2260 for a confidential appointment by phone or in person.

As borrowers continue to grapple with upside-down loans and short sales and foreclosures continue to climb, the risk of debt forgiveness tax becomes more important, especially for investors who do not have the personal residence exclusion from Federal taxes on forgiven debt.  “Debt Forgiveness” occurs when the lender doesn’t get paid all that they are owed and they are not going to pursue you for any unpaid balance.  Although the risk of a judgment on the unpaid balance goes away, you can be taxed on the amount of forgiven debt as if it were income you had earned,. This is often called “Phantom Income” because you never really saw it but you are still affected by it.  As I discussed in prior Blogs, the Federal government has relief from this tax on personal residences through 2012. California has no relief.  Luckily, both have an “insolvency Exclusion” that may apply and which can enable a debtor to otherwise avoid being driven into Bankruptcy. Since Bankruptcy has far greater potential negative consequences than a short sale or even a foreclosure, the possibility of avoiding these taxes without filing Bankruptcy is important. Here’s how the Insolvency exclusion works.

As set forth in full on IRS Publication 4681 “Cancelled Debts, Foreclosures, Repossessions, and Abandonments” http://www.irs.gov/pub/irs-pdf/p4681.pdf, Insolvency is determined by first listing the fair market value of all of your liabilities immediately before the debt forgiveness event (short sale or foreclosure). Next you list the fair market value of all of your assets at the same point in time.  Next, you subtract your assets from your liabilities. If the result is zero or less, ie: your liabilities exceed your assets, then you are insolvent.  Page 6 of Publication 4681 has the actual worksheet you can use to make this calculation.  Once the insolvency is determined, you report this on your tax return through the use of IRS Form 982 http://www.irs.gov/pub/irs-pdf/f982.pdf. 

California appears to draw it’s insolvency determination from the IRS Form 982. California’s taxing agency is the Franchise Tax Board (”FTB”). As stated in the FTB Tax News dated February, 2010 http://www.ftb.ca.gov/professionals/taxnews/2010/February/Article_8.shtml “if the loan is recourse indebtedness and the debtor incurs cancellation of indebtedness income (CODI), IRC Section 108 provides certain exceptions in recognition of that income. One of the exceptions applies where the taxpayer was insolvent (total liabilities exceed total assets) when the CODI was realized. The exclusion only applies up to the amount of insolvency, i.e., to the extent the liabilities exceed the FMV of the assets”. However, California law does not conform to all of the provisions currently available in IRC Section 108.

The key is this:  If you are an upside-down borrower facing a debt forgiveness tax as a result of a short sale or foreclosure, you may be liable for debt forgiveness tax and may queslify for the insolvency exclusion. Be certain to get tax advice from a qualified professional who can look at your specific situation and advise you on how these rules apply to you.  This Article is solely intended to give you an introduction to what might be available for you but you should not rely on it to apply to your financial circumstances.

If you have specific questions about your liability, foreclosure, or any legal issue, feel free to contact me at sjbeede@bpelaw.com.  Need help Coping with an Upside Down Loan? Checkout Steve’s audio-seminar and e-book at: http://www.stevebeede.com/copingwithanupsidedownmortgage/.