Did you know-Tax liability for Canceled mortgage debt on a principle residence that is NOT waived?

Many of us get in the habit of saying "you're exempt from the tax liability for canceled debt on your principle residence.". Do you know in a lot of cases, this is not true?
Did you realize that mortgage debt, NOT used for the Purchas or Improvement of the property, is NOT covered by the Tax Relief Act?
Example: owner buys house for 200k with 190k mortgage.
Refinances later for $300k, without using the money to improve that house.
Short sells house for 200k, Net to lender of 180k, with deficiency waiver.
Canceled/forgiven debt of 120k, 1099C issued 120k
Result: the first 110k of debt forgiveness(300k minus 190) is not exempt and IS TAXABLE.
The 10k of original purchase money mortgage(190k minus180k) is exempt.
Remember when talking to homeowners "you must seek advice of accountant and attorney concerning the implications of your sort sale".
The targets are on our chests for all the homeowners who will be getting sued for the non deficiency waived debts, tax consequences they "didn't realize because my agent didn't tell me", etc.

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I never say your 1st statement. I do encourage them to ask a CPA about IRS section 108.

 

In this specific case, I've had clients use insolvency / IRS form 982 and not have to pay taxes. Of course, it will depend on the assets / liabilities of the borrower.

 

From the IRS website:

Is Cancellation of Debt income always taxable?
Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:

  • Qualified principal residence indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.
  • Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
  • Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets.
  • Certain farm debts: If you incurred the debt directly in operation of a farm, more than half your income from the prior three years was from farming, and the loan was owed to a person or agency regularly engaged in lending, your cancelled debt is generally not considered taxable income.
  • Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. However, it may result in other tax consequences.

http://www.irs.gov/Individuals/The-Mortgage-Forgiveness-Debt-Relief...

You're right, insolvency issues come into play.
But, the language in my post, regarding mortgages not used for the purchase/improvement of the property, comes directly from the Mortgage Debt Relief Act on the IRS.GOV website.
Just a reminder about what we tell homeowners.

Ok -- got it. We do need to be careful on the tax / deficency issue.

Have you ever had a situation where a homeowner didn't qualify for either exemption?

I "almost" did. =)

Yep, they refinanced/pulled money out of the house, did a short sale, but weren't insolvent. How much exactly they were liable for, I don't know.

First, it is principal, not principle.  And yes, we should have all known that or we should not be doing short sales.

I don't even venture into whether or not they will owe taxes.  My standard line is, "We encourage EVERY SELLER to take their approval letter to their accountant to make sure there are no tax ramifications on the sale of their property."  I'm not a CPA and have no idea what will happen post closing, so I don't even try to explain that.

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