Bought a house in 2006 as my primary residence for 185k. In 2009 we receieved an appraisal of the property for 90k from the county. In the middle of 2009, I had to take another job which required a move across the US.
With no time to try to sell the house, I decided to rent it out to wait the market out on a price recovery. We rented the property for 3 years for a loss and then the renters moved out.
We couldnt find renters quick enough and the house went into forclosure in late 2011. The mortgage was a no recourse VA home loan. I just got a letter saying that the property was sold at ~100k and I owed the remaining 75k but since it was a VA home loan, the VA covered the max allowed of ~45k which left ~30k unpaid.
The mortgage company has subsequently been forced to “forgive” the remaining ~30k but advised that there may be tax implications. I believe the home was sold in 2012 but its possible it could have sold in 2013.
Do I have to claim 70k or 30k on my taxes as income or is this non-taxable under the Mortgage Forgiveness Debt Relief Act of 2007? If so, should I seek insolvency instead?
There has been much debate about whether a previous homeowner who has turned the property into a rental property, for a short term, would allow them to qualify for the exclusion from tax on cancellation of home mortgage debt. Only a home that is a qualified principal residence applies. Furthermore, only the qualified principal residence indebtedness (Qualified principal residence indebtedness is any mortgage you took out to buy, build, or substantially improve your main home) can be excluded, if you qualify.
There are two schools of thought on the principal residence that was temporarily rented and how to apply the qualified principal residence exclusion, but the IRS has not provided any assistance on which is correct.
Position #1: The rule for determining qualified principal residence is the same rule as the exclusion of gain on the sale of a primary residence. The exclusion for gain on sale rule states that if you live in the home 2 out the last 5 years, you qualify for the exclusion. By inference, many believe the 2 out of 5 years rule also applies in determining if a property is a qualified principal residence. In fact, I have seen several prominent tax research companies take this position.
Position #2: The date you move out ends the qualification of principal residence. If the property is not your personal residence at the time of the cancellation of debt than the qualified principal residence indebtedness exclusion does not apply. The 2 out of 5 year rule only applies to excluding the gain on a sale of residence (Internal Revenue Code section 121). In this camp, the 1099C recipient would have to use the qualified real property business indebtedness exclusion (section 108) to exclude the 1099C income or the insolvency exception.
There is no clear answer on which position is correct. The IRS states in its Publication 4681 that a main home is the one in which you live most of the time. The most conservative approach is to treat the property as a rental and look to the exclusions under insolvency and the qualified real estate business indebtedness.
I hope this helps. If the IRS answers my question on this area, I will post it for you.
Jim Buttonow is one of the resident debt experts here at GetOutOfDebt.org that helps people for free. Jim is a licensed CPA who spent 19 years with the IRS coordinating large compliance teams of IRS agents and specialized personnel. In the last 5 years, Jim has invented consumer and practitioner software and treatises on how to address many different tax issues. He has also represented many people before the IRS examination, collection, filing, and appeals functions. He currently assists taxpayers on an active pro bono tax practice aimed at serving people in need. He can be reached at IRSMind.com.
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