DEBT CANCELLATION AND FORECLOSURE ISSUES Code Sec 108 Income for Discharge of Indebtedness and Code Sec 1017 Discharge of Indebtedness

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1 Debt Cancellation & Foreclosure DEBT CANCELLATION AND FORECLOSURE ISSUES Code Sec 108 Income for Discharge of Indebtedness and Code Sec 1017 Discharge of Indebtedness NOTE - Bankruptcy This material only deals with issues that must be reported on a taxpayer s 1040 and does not include Bankruptcy issues. Any debt which is forgiven under a Title 11 bankruptcy is excludable from income. Title 11 of the Federal Code contains all chapters of the bankruptcy codes, including Chapters 7, 11, and 13. The taxpayer who uses this exclusion must reduce tax attributes to the extent of the exclusion. In the case of bankruptcy, the taxpayer is usually the bankruptcy estate. A debtor is rarely affected by debt relief in a bankruptcy proceeding. Debt Relief Income - Whenever a debt of a taxpayer is forgiven, whether it is credit card debt, home mortgage debt or other debt, the forgiven debt (debt relief) is generally taxable income to the taxpayer unless: (1) the debt was discharged in a bankruptcy proceeding or (2) the taxpayer qualifies for one of the exclusions for relief from cancellation of debt (COD) income. Exception Overview Tax code provides for a number of exceptions to the recognition of debt cancellation income in cases of: Insolvency see details page Principal Residence Acquisition Mortgage Debt Relief see details page Qualified Real Property Business Debt see details page Qualified Farm Debt see details page Student Loans see details page Forgiveness of Tax-Deductible Items see details page Gifts see details page Purchase Price Reductions see details page Tax Attributes Reduced If debt relief is not taxed because exclusion applies, tax attributes (for example, carryover losses or credits and basis) must be reduced, to the extent of the debt relief. Related IRS Publications and Forms o Form 1099-A Acquisition or Abandonment of Secured Property o Form 1099-C Cancellation of Debt o Instructions Form 1099-A and 1099-C o Pub Bankruptcy Tax Guide o Pub 4681 Canceled Debts, Foreclosures, Repossessions and Abandonment o Insolvency Worksheet Page 6 of Publications 4681 o Form Reduction of Tax Attributes Due to Discharge of Indebtedness Step-by-step Approach Although the issues related to debt relief and foreclosure can seem overwhelming, it can be greatly simplified by approaching it in a step by manner: Step #1 Determine if there is COD income and if so the amount and applicable year. Step #2 Determine if the taxpayer qualifies for one or more the exclusions. Step #3 Determine if there is also an asset sale that must be dealt with. Step #4 Complete Form and Reduce Tax Attributes if Required STEP #1 DETERMINE IF THERE IS COD INCOME AND IF SO THE AMOUNT. Determining the amount of the COD income and the year in which it is taxable is not always readily apparent for the following reasons: 1. Personal Liability There is no COD income where the debtor is not personally liable for the debt. That is where the lender s only recourse is against the property secured by the debt. 2. Date of Debt Discharge Debt discharge generally does not occur until the lender no longer has any legal opportunity for collection from the debtor, which is defined by IRS Regulations as an identifiable event. See list of identifiable events on the next page. Determining if a Loan is Recourse or Non-Recourse Determining whether a loan is recourse or nonrecourse has a huge bearing on how the COD is treated on the borrower s tax return. If a loan is non-recourse then the borrower is not personally liable for a deficiency and the lender s only recourse is against the secured

2 Debt Cancellation & Foreclosure property. Where the borrower is not personally liable there is no COD income. Therefore it is extremely important to determine if the borrower is personally liable. Generally it is necessary to read the actual loan documents to determine whether a loan is recourse or nonrecourse. Both the 1099-A and 1099-C include an entry (Box 5) for the lender to indicate whether the taxpayer is personally liable or not, but the box is frequently left blank or in some cases answered incorrectly. Several states have statutes that prohibit lenders from seeking deficiencies from borrowers and are referred to as non-recourse states. Each non-recourse state has its own anti-deficiency statutes that prohibit lenders from seeking judgments. Not all non-recourse statutes are the same so it is important to understand the law as it applies to your state. For example in California the statutes only apply to purchase money loans (acquisition debt) and then only if the loan is for 4 residential units or less and at least one unit is owner occupied. Almost all home equity line of credit loans abbreviated HELOCs and home equity loans are considered recourse loans and lenders for these loans may sue borrowers to recoup loss although most do not go to that expense. The following is a list of supposedly anti-deficiency/non-recourse states. The list is from on-line commercial legal sites and not independently verified, so use at your own risk. Alaska Florida North Dakota Arizona Idaho Texas California Minnesota Utah Connecticut North Carolina Washington Date of Debt Discharge The debt discharge generally does not occur until the lender no longer has any legal opportunity for collection from the debtor. IRS regulations ( P-1(a)(1)) set forth identifiable events that trigger cancellation of debt income whether or not an actual discharge of indebtedness has occurred on or before the date on which the identifiable event has occurred. Although the list is long the following are the more commonly encountered identifiable events: Discharge of indebtedness under title 11 of the United States Code (bankruptcy); Cancellation or extinguishment of an indebtedness that renders a debt unenforceable in a receivership, foreclosure, or similar proceeding in a federal or State court; A cancellation or extinguishment of an indebtedness upon the expiration of the statute of limitations for collection of an indebtedness; A cancellation or extinguishment of an indebtedness pursuant to an election of foreclosure remedies by a creditor that statutorily extinguishes or bars the creditor's right to pursue collection of the indebtedness; A cancellation or extinguishment of an indebtedness that renders a debt unenforceable pursuant to a probate or similar proceeding; A discharge of indebtedness pursuant to an agreement between an applicable entity and a debtor to discharge indebtedness at less than full consideration; A discharge of indebtedness pursuant to a decision by the creditor, or the application of a defined policy of the creditor, to discontinue collection activity and discharge debt; or When a nonpayment testing period expires. This applies to financial institutions such as banks and savings and loans, credit unions and certain government agencies such as the Federal Deposit Insurance Corporation, military departments and the US Postal Service who have not received a payment on the debt during a testing period, which is a 36-month period ending on December 31 plus any time collection was prevented due to a stay in bankruptcy or similar legal bars. No 1099-C or a 1099-C Issued in a Subsequent Year Because of the identifiable event rules the 1099-C may show up in a year other than the year when a 1099-A is issued. The IRS provides no special guidance in situations such as this even though the regulations acknowledge that the debt relief may have occurred prior to the issuance of the 1099-C. To deal with this problem, a practitioner needs to carefully review the facts and circumstances to determine when the debt relief actually took place, which is not necessarily in the year when the 1099-C was issued. Where there is no 1099-C issued the practitioner will also need to determine the amount of debt relieved, generally 1099-A box 2 minus Box 4. Practitioners may wish to utilize the Form 8275-Disclosure Statement to provide an explanation of why the COD income was reported in a year when a 1099-C was not issued or why the COD income is not included in the year the 1099-C was issued

3 Debt Cancellation & Foreclosure 1099-C: A financial institution, credit union, federal government agency or others in the business of lending money must issue a 1099-C if the debt relief is $600 or more. Individual lenders such as the seller of the property are not required for file the 1009-C. This form will generally provide the information needed to determine the amount of debt relief. The 1099-C can be issued for a variety of circumstances related to debt forgiveness including credit card debt, vehicle repossessions, home foreclosures, etc. Box 2 Shows the amount of the debt cancelled (will also include the amount in Box 3) Box 3 Shows the amount of the interest that may or may not be included in debt relief income (see forgiveness of tax-deductible items page 2,09.17) Box 5 Indicates whether a taxpayer is personally liable for the debt (whether it is recourse) Box 7 FMV of abandoned or foreclosed property or the taxpayer may receive a separate 1099-A Forms 1099-A: A lender who acquires an interest in a property in a foreclosure or repossession should issue Form 1099-A showing the information needed to figure the taxpayer s gain or loss. However, if the lender also cancels part of the debt and must file Form 1099-C, the lender can include the information about the foreclosure or repossession on that form instead of on Form 1099-A. The 1099-A includes the amount of the debt relieved and the FMV of the property which should be the auction price. Box 2 Shows the amount of the principal outstanding Box 4 FMV of abandoned or foreclosed property. Generally, the gross foreclosure bid price is considered to be the FMV. Box 5 Indicates whether a taxpayer is personally liable for the debt (whether it is recourse). If it is checked No then a 1099-C should not be issued. FMV (Box 4) Greater than Balance of Mortgage (Box 2) It is not uncommon for a 1099-A to have the amount shown in Box 4 Fair market value of property to be equal to or greater than the Balance of principal outstanding shown in Box 2. If the FMV of the property is greater than the debt then there is no cancellation of debt income and only the disposition of the property need be dealt with. Generally, the gross foreclosure bid price is considered to be the FMV

4 Debt Cancellation & Foreclosure Pass-through entities - If a partnership s liability is discharged, the partnership allocates the income from discharge of debt to the partners as a separately stated item. The debt relief is thus reported on Form 1040 by the partners. Any available exclusion is also applied at the partner level. STEP #2 DETERMINE IF THE TAXPAYER QUALIFIES FOR ONE OR MORE THE EXCLUSIONS. Choosing an Exclusion Method Generally the insolvency exclusion takes precedence over the other available exclusions except in the case of the principal residence and student loan exceptions. Not all incidences of debt relief qualify for the possible exceptions. The table below matches type of debt with possible exceptions: Type of Debt Primary Residence Second Home Vacant Land Credit Card Rental Commercial Real Estate Student Loans Farm Debt Possible COD Exceptions Home Mortgage Debt Relief Income (Applied 1 st unless taxpayer elects otherwise (Sec 108(2)(C)) limited to acquisition debt. Insolvency Insolvency Insolvency (Must be applied 1 st to extent insolvent (Sec 108(2)(B))) Qualified Real Property Indebtedness generally limited to acquisition debt. Insolvency Student Loan Exception Insolvency (Must be applied 1 st to extent insolvent (Sec 108(2)(B))) Qualified Farm Indebtedness - indebtedness is attributable to the trade or business of farming. Insolvency Exception If the indebtedness is discharged when the debtor is insolvent (but not in a bankruptcy case), the discharge is excluded from the debtor's gross income up to the amount of the insolvency (Sec 108(a)(1)(B)). Note: If the debt relief is related to the taxpayer s primary residence, the principal residence exclusion takes precedence over the insolvency exclusion unless elected otherwise. Definition of Insolvent - The term insolvent means the excess of liabilities over the fair market value (FMV) of assets determined with respect to the taxpayer's assets and liabilities immediately before the discharge. This means that the discharged debt counts as a liability and the property FMV as an asset (unless the discharge is in a subsequent year and the taxpayer no longer owns the property) for purposes of determining the taxpayer's insolvency. The taxpayer's financial status immediately after the discharge is irrelevant. (Code Sec. 108(d)(3)) Assets ($) Liabilities ($) Insolvency Thus, to the extent of the insolvency, the taxpayer can exclude debt relief income. When is Insolvency Determined? Immediately before the debt is discharged. (Code Sec. 108(d)(3)) Reduction of Tax Attributes If the debtor has tax attributes they must be reduced to the extent of the insolvency exclusion. If the attributes are less than the exclusion they are simply reduced to zero and the debtor is still able to exclude the debt to the extent of insolvency. (Code Sec. 108(b)(3)) If, after going through the attribute reductions sequence shown below, and the taxpayer surrenders attributes with a total value of LESS than the excludable debt relief, the balance of the debt relief is still forgiven and there is never a tax impact

5 Debt Cancellation & Foreclosure Sequence of Attribute Reduction - Attributes include loss and credit carryovers and basis in assets. Credit carryovers are reduced 33-1/3 per dollar of debt discharge amount while the others are reduced dollar for dollar. For insolvency, attributes are reduced in this strict order (but see a special election to first reduce the basis of depreciable assets this page). (1) Any NOL for: the taxable year of the discharge, and any NOL carryover to such taxable year, dollar for dollar. (Sec 108(b)(2)(A)) (2) General business credit carryovers to or from the taxable year of discharge are reduced, $1 for each $3 of debt relief. (Sec 108(b)(2)(B)) (3) Minimum tax credits - The carryover amount to the year immediately following the taxable year of the discharge is reduced $1 for each $3 of debt relief. (Sec 108(b)(2)(C)) (4) Any Net Capital Loss for the taxable year of the discharge, including any Capital Loss Carryover (CLCO) to such taxable year. (Sec 108(b)(2)(D)) (5) Basis of assets - is reduced at the beginning of the year following the year of debt cancellation, based on the assets owned at that time. Here again, there is a strict ordering for which property bases get reduced first: (a) Trade or business property purchased with the proceeds of the debt which was forgiven; (b) Trade or business property securing the loan; (c) All other trade or business assets; (d) Inventory and notes and accounts receivable; (e) Property held for investment; (f) Other assets. The limit for basis reduction under the insolvency rule is the extent to which basis of assets after debt relief exceeds liabilities after the debt relief. This limit will not apply if the taxpayer elects to reduce basis first (see special election (1) below). (6) Suspended passive losses - Reduce the suspended passive activity losses from the year of discharge $1 for each $1 of excluded debt relief; reduce suspended passive loss credits from the year of discharge by $1 for each $3 of excluded debt relief (Sec 108(b)(2)(F)). (7) Foreign tax credit carryovers - Reduce the foreign tax credit carryovers from the year of discharge $1 of credit for each $3 of debt relief (Sec 108(b)(2)(G)). When Are the Attributes Reduced? - The reductions are generally made after the tax is computed for the tax year of the discharge (but see NOL and Capital Loss details above). That means a calendar year taxpayer will adjust the attributes at the beginning of the year subsequent to the debt relief year. Thus, the debtor can utilize many of the attributes in the year of the relief. (Code Sec. 108(b)(4)(A)). Determine Insolvency Immediately before the event Cancellation of Debt Event Year End/Begin Adjust Attributes Year 1 Year 2 Election To First Reduce The Basis of Depreciable Assets - Rather than reduce the loss and credit carryovers first, a taxpayer can elect (on Form ) to apply any or all of the excluded amount first to reduce his basis in depreciable assets (or real property held as inventory) before any other tax attributes are reduced under the normal ordering rules. (Code Sec. 108(b)(5)(A)) This special rule may be attractive to taxpayers who have net operating losses or other attributes that can be carried over and used in subsequent years and where the concern for basis reduction is a secondary issue. However, it should be noted that if the basis reduction is insufficient to offset the COD income, then the other tax attributes must be reduced beginning in the normal manner

6 Debt Cancellation & Foreclosure Reason for Making the Basis Reduction Election This election is generally made by a debtor who wants to preserve the Net Operating Loss deduction, General Business Credit, Alternative Minimum Tax Credit, and Capital Loss Carryovers. If the taxpayer does not have sufficient depreciable property basis to cover the excluded debt income he may acquire additional up to end of the year of discharge. However, the reduced basis will recapture as ordinary income when and if the property whose basis was reduced is sold. So the decision is whether or not to utilize the tax benefit currently and suffer the consequences in the future. Basis Reduction limitations - A debtor making the election to first reduce basis may not reduce the aggregate adjusted bases of his depreciable property below zero, and can't elect to have excluded debt discharge income applied to first reduce depreciable property basis in an amount greater than the aggregate adjusted bases of depreciable property held by the debtor as of the beginning of the tax year following the tax year in which the discharge occurs. (Code Sec. 108(b)(5)(B)) Special Election Dealers in Real Property - Dealers in real property may elect to treat real property held for sale in the ordinary course of business as depreciable. This election must be made on the original return for the year of debt forgiveness and can only be revoked or elected on a later return with reasonable cause and IRS consent. (Sec. 1017(b)(3)(E)) Calculating Insolvency The IRS provides an insolvency worksheet in Publication 4681 page 6. Another possibility would be to use Form 433-A (for individuals) or 433-B (for businesses) that IRS Collections uses as a financial statement. The computation includes all assets and all liabilities with no exclusions. Principal Residence Acquisition Debt Forgiveness Exclusion This provision allows taxpayers to exclude home debt forgiveness income from their income. The following is an overview of the provision: Effective: For tax years 2007 through 2012 Exclusion: Up to $2 Million ($1 Million MS) Home: Principal Residence Only (same definition as for Sec 121 gain exclusion rules) Debt: Acquisition Debt Only Basis of Home: Reduced by the amount of the exclusion if retained after relief Application - This exclusion applies where a taxpayer: Restructures the acquisition debt on a principal residence, Loses a principal residence in a foreclosure, or Sells a principal residence in a short sale. Limitations: The exclusion does not apply to a taxpayer s designated 2 nd (vacation) residence. The exclusion doesn't apply to the discharge of a loan if the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the taxpayer's financial condition. The exclusion only applies to the discharge of qualified principal residence acquisition debt. Thus equity debt is not included as part of the exclusion. Acquisition indebtedness of a principal residence is indebtedness incurred in the acquisition, construction, or substantial improvement of an individual's principal residence that is secured by the residence. It includes refinancing of debt to the extent the amount of the refinancing doesn't exceed the amount of the refinanced indebtedness. (Joint Committee on Taxation, JCX-86-07)

7 Debt Cancellation & Foreclosure o Debt used to refinance qualified principal residence indebtedness is eligible for the exclusion up to the amount of the old mortgage principal just before the refinancing. (H Rept No (PL ) p. 5) o If the amount of the taxpayer's original mortgage is more than the cost of the principal residence plus the cost of any substantial improvements, only the debt that doesn't exceed the cost of the principal residence plus improvements is qualified principal residence indebtedness. (Form Instructions, (3/2009), p. 4) Original Mortgage Cost plus Improvements This portion not excludable Forgiveness ordering rule -If only a part of a loan is qualified principal residence indebtedness, the exclusion applies only to the extent the amount discharged exceeds the amount of the loan (immediately before the discharge) that is not qualified principal residence indebtedness. Example - assume a principal residence is secured by a debt of $1 million, of which $850,000 is qualified principal residence indebtedness. If the residence is sold for $800,000 and $200,000 of debt is discharged, only $50,000 of the debt discharged can be excluded (the $200,000 that was discharged minus the $150,000 of nonqualified debt). The remaining $150,000 of nonqualified debt may qualify in whole or in part for one of the other exclusions, such as the insolvency exclusion. Debt Relieved Equity Debt Acq. Debt Equity debt is considered first when determining whether acquisition debt or equity debt is being relieved. Definitions: Qualified principal residence indebtedness - Qualified principal residence indebtedness means acquisition indebtedness on the taxpayer's principal residence, up to a $2 million limit ($1 million for married individuals filing separately). Acquisition indebtedness - Acquisition indebtedness is defined as in Code Sec. 163(h)(3)(B) for purposes of the interest deduction rules. (Code Sec. 108(h)(2)) Ordering rule - The principal residence exclusion takes precedence over the insolvency exclusion unless elected otherwise (Code Sec 108(a)(2)(C)). If only a part of a loan is qualified principal residence indebtedness, the exclusion from income for canceled qualified principal residence indebtedness applies only to the extent the amount canceled exceeds the amount of the loan (immediately before the cancellation) that is not qualified principal residence indebtedness. The remaining part of the loan may qualify for another Sec 108 exclusion. Basis Adjustment - If the taxpayer excludes canceled qualified principal residence indebtedness from income and continues to own the residence after the cancellation, the taxpayer must reduce the basis of the residence (but not below zero) by the amount of the canceled qualified principal residence indebtedness excluded from income. Enter the amount of the basis reduction on line 10b of Form. Thus basis adjustment would be required in a loan modification where the taxpayer retains the home. However, no basis adjustment is required in a foreclosure, short sale or abandonment because the taxpayer no longer owns the residence. This may or may not create a problem in the future since any gain will be subject to the Sec 121 home sale gain exclusion. Electing Out of Mortgage Relief Exclusion An insolvent taxpayer (other than one in a Title 11 bankruptcy) can elect to have the mortgage forgiveness exclusion not apply and can instead rely on the Code Sec. 108(a)(1)(B) exclusion for insolvent taxpayers. (Code Sec. 108(a)(2), as amended by Act 2(c)) Thus, where a taxpayer has significantly tapped the equity in the home, and has a significant amount of debt discharge that does not qualify for the exclusion, it may be to their advantage to forgo the mortgage relief exclusion and instead use the insolvent taxpayer exclusion

8 Debt Cancellation & Foreclosure Things to Consider The home mortgage debt forgiveness only applies to Acquisition Indebtedness while the insolvency rule applies to all debt. The home mortgage forgiveness rule allows up to $2 mil of debt relief while the insolvency exclusion only allows exclusion to the extent of insolvency. Some states do not conform to the home mortgage forgiveness rule and only allow the insolvent taxpayer exclusion. Discharge of Qualified Real Property Business Indebtedness The exclusion of income from the discharge of qualified real property business indebtedness applies only to taxpayers who are not C corporations and applies only where the insolvency exception does not apply (Code Sec. 108(a)(2)(B)). The exclusion is limited to the taxpayer s equity in depreciable properties and the basis cannot be reduced below zero. (Sec 108(c)(2)(A)(ii)) Limitations In addition to the basis in depreciable property there are two limitations on the amount that can be excluded. Mortgage over FMV ( equity ) limit - The amount eligible for the exclusion is limited to the excess (if any) of: (1) The outstanding principal amount of the qualified real property business indebtedness immediately before the discharge, over (2) The fair market value of the real property immediately before the discharge, less the outstanding principal amount of any other qualified real property business indebtedness secured by the property at that time. (Code Sec. 108(c)(2)(A)(ii)) Mortgage over Basis Limit - The exclusion cannot reduce the basis below zero, thus the depreciated basis of the property also becomes a limit. \ Example: Jack owns a rental with a FMV of $200,000 and a depreciated basis of $80,000 that is subject to a first mortgage of $160,000 and second mortgage of $90,000. Jack makes a deal with the second mortgagee to reduce the second mortgage to $30,000. This results in debt relief income of $60,000. Mortgage over FMV = 90K ( ) = $50,000 (FMV Limit) Depreciated Basis = $80,000 (Basis Limit) Exclusion is limited to lesser of the two or: $50,000 Thus in this example, of the $60,000 debt relief only $50,000 can be excluded and the $10,000 balance is added to gross income. Definition Of Qualified Real Property Business Indebtedness - Qualified Real Property Business Indebtedness is indebtedness (Code Sec 108(C)(3): that was incurred or assumed by the taxpayer in connection with real property used in a trade or business; that is secured by the real property, at the time the debt is incurred or assumed; that is qualified acquisition indebtedness (including refinanced acquisition debt); and which the taxpayer elects to treat as qualified real property business indebtedness

9 Debt Cancellation & Foreclosure Definition of Qualified Acquisition Indebtedness - qualified acquisition indebtedness means indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve such property. When Does the Basis Adjustment Take Place? If the taxpayer retains the Property, the basis adjustment takes effect on the first day of the tax year following the tax year in which the discharge takes place. (Code Sec. 1017(a)) If the taxpayer disposes of the real property before the beginning of the next tax year, the reduction in basis is made immediately before the disposition of the property. Code Sec. 1017(b)(3)(F)(iii). Cancellation of Debt Event Property Sale Year End/Begin Year 1 Year 2 If the business property subject to the debt relief is sold (or foreclosed upon) in year of debt relief, adjust the basis of the affected property to the extent allowable immediately before the disposition! Make all other appropriate business property basis adjustments (and corresponding depreciation adjustments) effective January 1 of the subsequent year. SPECIAL NOTE: Under special rules for Qualified Real Property Indebtedness (Code Sec. 1017(b)(3)(F)) this is the only situation in which the basis of the property subject to the debt relief must be reduced in the year of debt. This substantially mitigates the benefits of this exclusion method. Discharge of Qualified Farm Indebtedness The qualified farm indebtedness exclusion applies only to the discharge of qualified farm indebtedness by a qualified person. No amount is included in a debtor's gross income by reason of a discharge of qualified farm indebtedness. Indebtedness of a taxpayer is treated as qualified farm indebtedness (Code Sec. 108(g)(2)) if: (1) The indebtedness was incurred directly in connection with the operation by the taxpayer of the trade or business of farming, and (2) 50% or more of the aggregate gross receipts of the taxpayer for the three tax years before the tax year in which the discharge of the indebtedness occurs is attributable to the trade or business of farming. Limitations Definitions Only Applies to Amount if Solvent - This exclusion is applied after the insolvency exclusion. Thus, it doesn't apply to the extent the debtor is insolvent. (Code Sec. 108(a)(2)) Limited to Adjusted Tax Attributes & Basis of Qualified Property - The amount excluded from income can't exceed the sum of the adjusted tax attributes of the taxpayer and the aggregate adjusted bases of qualified property (defined below) held by the taxpayer as of the beginning of the taxable year following the taxable year in which the discharge occurs. (Code Sec. 108(g)(3)(A)) To the extent there is unabsorbed discharge of indebtedness income after the taxpayer has reduced tax attributes and basis, income is recognized. (H Rept No (PL ) p. 29) Qualified Property - Qualified property means any property used or held for use in a trade or business or for the production of income. (Code Sec. 108(g)(3)(C)) Qualified Person - A qualified person generally means a lender who is unrelated to the debtor or to the seller of the property. In addition, the term qualified person includes any federal, state or local government or agency or instrumentality of a government. (Code Sec. 108(g)(1)(B))

10 Debt Cancellation & Foreclosure Order of Basis Reduction (Code Sec. 1017(b)(4)(A)(ii)) Basis of the qualified property is reduced in the following order: (1) the basis of qualified property that is depreciable property, (2) the basis of qualified property that is land used or held for use in the trade or business of farming, (3) the basis of other qualified property. Student Loan Cancellation Forgiveness An individual does not include as income COD income if the discharge was made under a provision of the loan that all or part of the indebtedness would be discharged if the individual worked for a certain period of time in certain professions for any of a broad class of generally public employers. As example, a doctor for any public hospital in a rural area of the U.S. (Code Sec. 108(f)(1)) Example: Taxpayer student received $200,000 under a medical educational loan program. Under the terms of the program, one-fifth of the loan (or $40,000) is canceled each year he practices medicine in a qualifying state hospital. He doesn't include the forgiven amounts in income. As part of the Affordable Health Care Act, the law has been amended to include amounts received by an individual in tax years beginning after Dec. 31, 2008; the gross income exclusion for amounts received under the National Health Service Corps loan repayment program or certain State loan repayment programs is modified to include any amount received by an individual under any State loan repayment or loan forgiveness program that is intended to provide for the increased availability of health care services in underserved or health professional shortage areas as determined by the State. (Code Sec. 108(f)(4)) Amendment Opportunity? Individuals who qualify and who ve already filed their 2009 returns should file amended returns to exclude amounts that had previously been reported as income. Forgiveness of Tax-Deductible Items Discharge of a liability that would have given rise to a deduction by the debtor doesn't result in debt cancellation income. (Code Sec. 108(e)(2)) Typically this is encountered when the lender includes unpaid interest with the principal amount of debt cancelled on the 1099-C. The key here is to remember that to be excluded from COD income the interest would have had to be deductible had the taxpayer paid it. Example Credit Card Debt Cancellation Rob had credit card consumer debt cancelled. In Box 2 of the 1099-C was an amount of $10,000 and in Box 3 an amount of $1,000. The $1,000 represents unpaid consumer interest which is not deductible so the COD income is $10,000 which includes the $1,000 interest. However, assuming the card was used exclusively for Rob s Schedule C business the COD income would only be $9,000 ($10,000 - $1,000) since the interest would have been deductible as a business expense. Example Home Mortgage Debt Cancellation Mike lost his home to foreclosure. He had refinanced the home s original purchase money debt of $270,000 and at the time of the foreclosure the debt was $500,000. None of the extra debt was used for substantial home improvements nor can any excess debt be traced to other deductible purposes. Mike s original loan would have been $250,000 at the time of the foreclosure. The amount in Box 2 of the 1099-C is $200,000 and Box 3 includes an amount of $55,000. Thus the amount in Box 3 must be prorated between deductible and non-deductible interest. Mike can deduct the interest for acquisition debt and $100,000 of equity debt. Thus the amount of the interest that would have been deductible is $38,500 (((250, ,000)/$500,000) x $55,000). As a result Mike s COD income is reduced to $161,500 ($200,000 - $38,500) Example Business Debt - Suppose you are the accountant for a small cash basis business. The business falls on hard times and cannot meet all of its liabilities. You decide to forgive a portion of the amount the business owes you. The forgiven amount becomes debt relief income to the business but is excluded from that company s income because it would have been deductible if paid. Gift Exception If a debt cancelled by a private lender, such as a relative or friend, is intended as a gift, there is no income. Likewise, a debt cancelled by a private lender's Last Will and Testament triggers no income to the borrower. (Code Sec. 102) Reduction of Purchase Price If a debt from a solvent buyer of property to the seller which arose out of the purchase is reduced, the reduction is treated as an adjustment of the purchase price not as debt cancellation income. (Code Sec. 108(e)(5)(A)) Caution - this exclusion only applies where the seller is also the lender. If the lender is a third party the reduction is COD income

11 Debt Cancellation & Foreclosure Example Ken purchased property from Jeff for $125,000. Ken made a $25,000 down payment and Jeff carried back the $100,000 balance secured by the property. In year three, Jeff agreed to reduce the $100,000 debt by $20,000. Assuming Ken wasn't in bankruptcy and remained solvent, the $20,000 debt reduction was an adjustment to the purchase price rather than debt cancellation income. STEP #3 DETERMINE IF THERE IS ALSO AN ASSET SALE THAT MUST BE DEALT WITH. If the debt cancelled was secured by an asset, then the disposition of the asset must also be accounted for. Here are some possible scenarios: Short Sale In a short sale, by agreement with the lender, the property is sold for a value less than the mortgage balance. Even though the lender ends up with all the net proceeds from the sale, the borrower must report the transaction as a sale on the tax return in the normal manner. Determine the sales price from the table below. Foreclosure (or abandonment) In a foreclosure, the lender has taken possession of the property through legal channels. This usually generates a Form 1099-A. The property sale must be reported on the tax return in the normal manner. Determine the sales price from the table below. Repossession Generally a term associated with having a vehicle reclaimed by the lender of personal property. If that personal property was also business property (in whole or in part) the disposition of the business portion of the property must be reported as a sale. Report the sale in the normal manner for the asset using the table below. Note: Generally all debts on personal property are recourse thus the sales price would be lesser of the FMV or the loan balance. Caution: Remember that personal use property such as a principal residence, 2 nd home, personal use vehicles, etc., cannot result in recognizable loss. So when reporting the sale the loss must be zeroed out. Computing Sale Price SALE PRICE OF PROPERTY Type of Foreclosure Voluntary Reconveyance Loan (or abandonment) (also short sale ) Recourse Lesser: FMV or Loan Bal. Lesser: FMV or Loan Bal. Nonrecourse Greater of Loan Bal. or FMV Loan Balance IMPORTANT ISSUE HOME SALE If a property subject to the debt relief is the taxpayer s primary home then the Sec 121 (home sale gain) exclusion applies, or if needed, the unforeseen circumstances reduced-gain exclusion applies. If there is a loss the loss would not be deductible since it is personal use property. If the home was partially business mixed use property at the time of sale, no loss is allowed. Mixed use means it is used both for personal and business use. ( Reg (a) LOSSES NOT ALLOWED. A loss sustained on the sale of residential property purchased or constructed by the taxpayer for use as his personal residence and so used by him up to the time of the sale is not deductible under section 165(a). Thus this regulation presumably applies in a mixed use situation.) If the business use was in a separate structure then there would be two separate sales with no loss allowed on the personal use portion. The gain or loss would be recomputed for the business use portion taking into account the depreciation taken. If the result is a loss, the loss is allowed on the business part. If the result is a gain, the gain is taxable and does not qualify for the Sec 121 exclusion. Example 1 Car Repossession Sonja purchased a car for $15,000 which was not used for business. She paid $2,000 down and took out a $13,000 recourse loan from a credit company. Sonja stopped making her loan payments and the credit company repossessed the car. The balance on the loan at the time of repossession was $10,000 and the FMV of the car was $9,000. The credit company decided they would not be able to collect the $1,000 balance on the loan because Sonja had insufficient assets and forgave it. Following the worksheet provided in Publication 4681:

12 Debt Cancellation & Foreclosure PART I 1a Enter the amount of outstanding debt immediately before the transfer of property.. $10,000 1b Enter any amount of line 1a for which the taxpayer remains personally liable immediately after the transfer of property.. 0 1c Subtract 1b from 1a $10, Enter the fair market value of the transferred property. 9, Ordinary income from the cancellation of debt (Subtract line 2 from line 1c. If less than zero, enter zero)... $1,000 Note: Just because the worksheet results in ordinary income does not necessary mean it is taxable. It may be excludable under one of the provisions discussed in Step #2. PART II 4. If Part 1 was completed enter the smaller of line 1c or line 2. If Part 1 was not completed, enter the amount of outstanding debt immediately before the transfer of property.. $9, Enter any proceeds the taxpayer received from the foreclosure sale Add line 4 and line 5... $9, Enter the adjusted basis of the transferred property... $15, Gain or loss from foreclosure or repossession. Subtract line 7 from line 6... <$6,000> Joan s tax return: 1040 Line 21 If no exclusion applies enter $1,000 Since it was personal use property (no loss allowed) and no gross proceeds have been reported there is no need to report the non-deductible loss. Note: Since the car was personal use property the loss is not allowed. Had it been partially business use property, the business portion of the gain or loss after taking into account the depreciation recapture would be reportable on Form Example 2 Home Foreclosure - Joan paid $200,000 for her home. She paid $15,000 down and took a recourse loan of $185,000 from a bank. Joan was unable to continue making payments and the bank foreclosed. When the bank foreclosed on the loan, the balance due was $180,000, the FMV of the house was $170,000, and Joan s adjusted basis was $175,000 due to a casualty loss she had previously deducted. At the time of the foreclosure, the bank forgave the $10,000 debt in excess of the FMV ($180,000 minus $170,000). In this case, Joan has ordinary income from the cancellation of debt in the amount of $10,000. Following the worksheet provided in Publication 4681: PART I 1a Enter the amount of outstanding debt immediately before the transfer of property.. $180,000 1b Enter any amount of line 1a for which the taxpayer remains personally liable immediately after the transfer of property.. 0 1c Subtract 1b from 1a $180, Enter the fair market value of the transferred property. $170, Ordinary income from the cancellation of debt (Subtract line 2 from line 1c. If less than zero, enter zero).. $10,000 PART II 4. If Part 1 was completed enter the smaller of line 1c or line 2. If Part 1 was not completed, enter the amount of outstanding debt immediately before the transfer of property.. $170, Enter any proceeds taxpayer received from the foreclosure sale Add line 4 and line 5... $170, Enter the adjusted basis of the transferred property... $175, Gain or loss from foreclosure or repossession. Subtract line 7 from line 6... <$5,000> Note: Assuming the home is personal use property the loss is not allowed. But see important issue above. Note: Just because the worksheet results in ordinary income does not necessary mean it is taxable. It may be excludable under one of the provisions discussed in Step #2. Joan s tax return: 1040 Line 21 If no exclusion applies enter $10,000 Schedule D When a 1099-A is issued there is a presumption of a sale. When a home s sales price is less than the Sec 121 exclusion technically the home sale need not be reported. However, those, including the author, who like to ensure all gross proceeds are accounted for on the tax return can show the loss transaction on Schedule D and on the next Schedule D line zero out the loss as personal use property no loss allowed

13 Debt Cancellation & Foreclosure Example 3 Rental foreclosure - Gain Joe purchased a rental six years ago for $120,000. He had refinanced the original $100,000 acquisition debt and used the refinanced funds for uses other than substantial improvements on the rental. The debt is recourse and in the current year the bank foreclosed on the rental since Joe had stopped making payments. The outstanding debt at the time of the foreclosure was $225,000 and the FMV was $150,000. The accumulated depreciation to the date of foreclosure was $16,000. The 1099-C shows a FMV in Box 7 of $150,000 and the debt relieved in box 2 of $125,000 and $12,000 in Box 3. As a result of the foreclosure Joe has the sale of a rental and COD income. Sale Computation Sales price for a recourse loan in foreclosure is the lesser of FMV or loan balance. Thus reported on Form 4797: Sales Price (FMV) $150,000 Cost 120,000 Depreciation <16,000> Basis <104,000> Net Gain 46,000 Ordinary Gain (Depreciation) 16,000 Long Term Capital Gain 30,000 COD Income Determination This example assumes the lender correctly completed the 1099-C. Mortgage $225,000 FMV (Box 7) <150,000> Debt Relief 75,000 Unpaid Interest (Box 3) 12,000 Debt Cancelled (Box 2) 87,000 Unpaid Acquisition debt Interest < 5,400> COD Income (Line ) 81,600 Where the unpaid interest would have been deductible if paid, it can be excluded from COD income. However, in this case the loan is only partially acquisition debt. For the example, assume the refinanced loan is attributed 45% to the acquisition debt and the balance is untraceable to another deductible use. Excludable? Only with insolvency exclusion! Joe s tax return: 1040 Line 21 If no exclusion applies enter $81, Report the sale of a rental Result will be $16,000 on line 14 of the 1040 And $30,000 on Schedule D as a long-term capital gain Form Form is only required if a portion of the debt relief is excludable Example 4 Rental foreclosure Loss Assume the facts as in example #3 except the purchase price of the rental was $300,000 and the loan is the original recourse acquisition debt. In such situations the ordinary loss from the rental can offset some or all of the COD income. Sale Computation Sales price for a recourse loan in foreclosure is the lesser of FMV or loan balance. Thus: Sales Price (FMV) $150,000 Cost 300,000 Depreciation <16,000> Basis <284,000> Net Ordinary 4797 Loss <134,000> COD Income Determination This example assumes the lender correctly completed the 1099-C. Mortgage $225,000 FMV (Box 7) <150,000> Debt Relief 75,000 Unpaid Interest (Box 3) 12,000 Debt Cancelled (Box 2) 87,000 Unpaid Acquisition debt Interest < 12,000> COD Income 75,000 Exclusion & Basis In this example, if Joe is insolvent he can excluded the COD income to the extent he is insolvent and still benefit from the 4797 loss. However, if the loss generates an NOL, that NOL will be subject to the attribute reductions shown in Step #4. If, to the extent he is solvent, he attempts to use the qualified real property business indebtedness exclusion he would have to reduce the sale basis by the amount of the forgiven debt which would reduce the loss by the same amount of the COD income exclusion, simply offsetting each other and providing no benefit. Example 5 Rental Mortgage Modification Pete, who is not insolvent, owns a rental that cost $200,000 on which the mortgage has a current balance of $150,000. The FMV of the rental is $110,000. Pete negotiates a loan modification with the bank and they reduce the mortgage to $110,000 and issue Pete a 1099-C in the amount of $40,000. Pete can utilize the Qualified Real Property Business Indebtedness exclusion rules and defer this $40,000 of COD income by reducing the basis of his rental property by $40,000 on January 1 of the succeeding year. Pete s tax return: 1040 Line 21 No entry (or enter see Form )

14 Debt Cancellation & Foreclosure Form - check Box 1d, enter $40,000 on line 2 and $40,000 on line 11a. Step #4 Complete Form and Reduce Tax Attributes if Required The final step is completing Form and reducing tax attributes as required for the particular exclusion method. Only One Form Potential for Confusion It is possible that a taxpayer can have multiple discharges of debt during the year or use multiple exclusion methods for a single discharge of debt. However, only one Form can be submitted. The instructions for the indicate to check the appropriate box(es) indicating the type of exclusion or exclusions used. This can create some confusion down the road if the exclusion of income or reduction of attributes is subsequently challenged. The author recommends that practitioners complete a separate Form (use it as a worksheet) for each separate event and each different exclusion method used for each event. Number them in sequence and combine the results for the single Form to be filed. This will provide an audit trail for the future. Supplemental Attachment Identify Property Subject to Basis Reduction The instructions for Form state that when basis is required to be reduced under Code Section 1017 a list of the property and the amount of basis reduction for each must be attached to the filed return. The following is a suggested format for such a statement. FORM Supplemental Worksheet Identifying Property Subject to Basis Reduction (Sec 1017) Transaction Creating Basis Reduction: Date of Event: Adjusted Basis Amount of Reduced Basis Property Subject to Reduction Before Reduction Reduction After Reduction CAUTION - Basis Reduction Recaptures As Ordinary Income! To ensure that ordinary income treatment eventually will be given to the full amount of basis reduction made to depreciable or non-depreciable assets when debt discharge amounts are excluded from a debtor's income, any gain upon a debtor's subsequent disposition of reduced-basis property is generally subject to recapture as ordinary income. For recapture purposes, any reduction of the basis of property due to debt discharge amounts is treated as a deduction allowed for depreciation. (Code Sec. 1017(d)(1)(B)) Exception With respect to Sec 1250 property, the amount of basis reduction that is recaptured as ordinary income is reduced whenever the taxpayer's depreciation deductions are reduced because of the basis reduction (H Rept No (PL ) p. 625.) Because each exclusion method has a different sequence of attribute reductions and specials rules pertaining to the exclusion method the following charts were developed to assist with this final task. See flow charts starting on the next page

15 Debt Cancellation & Foreclosure Form - Reduction of Attributes INSOLVENCY EXCLUSION Check Box Line 1b Enter excluded income on Line 2 NO Assets Must Be Reduced in the Following Strict Sequence. Any NOL for: The taxable year of the discharge, and Any NOL carryover to such taxable year. Sec 108(b)(2)(A) Any General Business Credit carryover: To or From the taxable year of a discharge. Sec 108(b)(2)(B) Minimum Tax Credit: The carryover amount to the year immediately following the taxable year of the discharge. Sec 108(b)(2)(C) Does taxpayer elect to reduce basis of Depreciable Assets first? Sec 108(b)(5) Line 6 Line 7 Line 8 YES Reduce Basis of Depreciable Assets Note 1: This election is generally made by a debtor who wants to preserve the NOL, GBC, AMTC, and CLCO. Note 2: If the taxpayer does not have sufficient depreciable property he may acquire additional up to end of the year of discharge. Note 3: The basis adjustment is made at the beginning of the taxable year following the taxable year in which the discharge occurs (Sec 1017(a)). CAUTION The basis reduction limitation that normally applies to insolvency does not apply when the election to reduce basis of depreciable assets is made first (Sec 1017(b)(2)). Line 5 Any Net Capital Loss for: The taxable year of the discharge, Including any Capital Loss Carryover to such taxable year. Sec 108(b)(2)(D) Basis of ANY Property held: By the taxpayer at the beginning of the taxable year following the taxable year in which the discharge occurs. Sec 108(b)(2)(D) and Sec 1017(a). Line 9 Line 10a Basis Reduction Limitation The basis reduction is limited to the taxpayer s insolvency immediately after the discharge (Sec 1017(b)(2)). FMV of Assets.. Liabilities.. < > Limit (Not < Zero).. Any Passive Loss & Credit Carryovers From the year of discharge (Sec 108(b)(2)(F)). Any Foreign Tax Credit Carryovers To or From the year of discharge (Sec 108(b)(2)(G)). Line 12 Line 13 RATE OF REDUCTION Loss Carryovers: Dollar for Dollar Credit Carryovers 33-1/3 cents of credit for each dollar excluded. Sec 108(b)(3)

16 Debt Cancellation & Foreclosure Form - Reduction of Attributes PRINCIPAL RESIDENCE ACQUISITION DEBT FORGIVENESS NO Check Box Line 1e Enter excluded income on Line 2 Does the taxpayer continue to own the property after the debt cancellation? YES NOTE The amount excludable on line 2 is limited to the $2Mil ($1Mil MS) overall limitation but may exceed the basis reduction on line 10b. Enter zero on line 10b Line 10b Finished - No other attributes are reduced. Line 10b Reduce basis of the principal residence but not less than zero Form - Reduction of Attributes QUALIFIED REAL PROPERTY BUSINESS INDEBTEDNESS Check Box Line 1d Enter excluded income on Line 2 Reduce Basis of Depreciable Assets Finished No other attributes are reduced. Line 4 CAUTION The amount excludable on line 2 is limited to and must match the amount of the basis adjustment on form - line 4. Any excess is taxable on 1040 Line 21. Basis Reduction Limitation The basis reduction is limited to the taxpayer s equity in depreciable properties and basis cannot be reduced below zero (Sec 108(c)(2)(A)(ii)) FMV of Asset... Qualified Business Indebtedness..< > Equity Limit

17 Debt Cancellation & Foreclosure Form - Reduction of Attributes QUALIFIED FARM INDEBTEDNESS Check Box Line 1c Enter excluded income on Line 2 RATE OF REDUCTION Loss Carryovers: Dollar for Dollar Credit Carryovers 33-1/3 cents of credit for each dollar excluded. Sec 108(b)(3) Does taxpayer elect to reduce basis of Depreciable Assets first? Sec 108(b)(5) YES NO Any NOL for: The taxable year of the discharge, and Any NOL carryover to such taxable year. Sec 108(b)(2)(A) Any General Business Credit carryover: To or From the taxable year of a discharge. Sec 108(b)(2)(B) Minimum Tax Credit: The carryover amount to the year immediately following the taxable year of the discharge. Sec 108(b)(2)(C) Any Net Capital Loss for: The taxable year of the discharge, Including any Capital Loss Carryover to such taxable year. Sec 108(b)(2)(D) Line 6 Line 7 Line 8 Line 9 Reduce Basis of Depreciable Assets Note 1: This election is generally made by a debtor who wants to preserve the NOL, GBC, AMTC, and CLCO. Note 2: If the taxpayer does not have sufficient depreciable property he may acquire additional up to end of the year of discharge. Note 3: The basis adjustment is made at the beginning of the taxable year following the taxable year in which the discharge occurs (Sec 1017(a)). NOTE If the election to first reduce depreciable attributes is used, the basis reduction for line 11a will have already been made on line 5. Line 5 Line 11a Line 11b Line 11c Basis of the qualified property is reduced in the following order: (1) the basis of qualified property* that is depreciable property, (2) the basis of qualified property that is land used or held for use in the trade or business of farming, (3) the basis of other qualified property*. *Used or held for use in a trade or business, or for production of income Any Passive Loss & Credit Carryovers From the year of discharge (Sec 108(b)(2)(F)). Line 12 Any Foreign Tax Credit Carryovers To and from the year of discharge (Sec 108(b)(2)(G)). Line

18 Debt Cancellation & Foreclosure Form - Part I This part is completed to indicate which method(s) of discharge was used Check appropriate boxes. Enter the amount of COD excludable Form - Part II This part is used when the taxpayer has tax attributes that must be reduced by the amount of the excluded debt relief or when the special rule for qualified principal residence indebtedness applies. Enter attribute reductions in appropriate boxes TENANT RIGHTS IN FORECLOSURE The Protecting Tenants at Foreclosure Law (PL ) enacted in 2009 offers some protection to those who are renting a home that has been foreclosed upon and is based upon whether the new owner of the property intend to occupy the property or not. New Owner Plans to Occupy - The tenant must be given 90-day notice to vacate. New Owner Does Not Occupy The tenant must be given 90-day notice to vacate. If the tenant has a valid lease the new owner must honor the term of that lease. However, for the provisions of this law to apply, the tenant must be bona fide, the rental agreement must be for fair rental value and must the result of an arms-length transaction. There also must be documented evidence or rent paid. The previous owner s spouse, children and parents are specifically excluded from the term of this law

19 Debt Cancellation & Foreclosure California law generally conforms to the provisions of the IRC Sec 108. Thus it conforms to all the federal debt relief income exclusions with the exception of the home mortgage debt relief exclusion. Legislation passed in 2010 retroactively, with modifications, conforms California to the federal mortgage forgiveness debt relief related to principal residences for discharges that occurred in tax years 2007 through December 31, The amount of qualifying indebtedness is less than the federal amount and California imposes a state-only limitation on the total amount of relief excluded from gross income. Details of California s home mortgage debt relief exclusion provision: Taxable years 2009 through 2012 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 $500,000 for taxpayers who file as married/rdp filing jointly, single, head of household, or widow/widower, and to $250,000 for taxpayers who file as married/rdp filing separately. Taxable years 2007 and 2008 Limited the amount of qualified principal residence indebtedness to $800,000 for taxpayers who file as married/(rdp) filing jointly, single, head of household, or widow/widower, and to $400,000 for taxpayers who file as married/rdp filing separately. Limited 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 difference between the federal exclusion and the amount allowed for California is an income adjustment on Schedule CA. NOTE Practitioners should carefully analyze whether to utilize the mortgage forgiveness debt relief exclusion or the insolvent taxpayer exclusion for California purposes keeping in mind the federal and state treatments do not need to be the same. Example CA Computation for home mortgage debt relief income exclusion The home foreclosed upon had acquisition debt of $1,000,000 and equity debt of $200,000 and the FMV of the home was $500,000. When following the example computation below remember that where there is both acquisition debt and equity debt, the equity debt is forgiven first and the home mortgage debt relief income exclusion only applies to acquisition debt. A blank worksheet is included on the next page. Part I - Debt Relief Income 1. Home Acquisition Debt 1,000, Equity Debt 200, Total Recourse Debt (1) (Ln1 + Ln2) 1,200, Home s FMV 500, Debt Relief Income (2) (Ln3 Ln4) 700, ,000 Part II Excludable Amount Federal California 6. Total Recourse Debt (Ln3) 1,200,000 1,200, Maximum Qualified Debt (from table #1) 800, Non-Qualified Debt (Ln6 - Ln7 but not <0) 400, Qualified Debt Relief Income (Ln5 Ln8) 300, Acquisition Debt Limit (Ln5 Ln2) 500, , Excludable Debt Relief Amount before Limit (Fed: amt from Ln 10; CA: smaller of Ln9 or Ln10) 500, , Maximum Excludable Debt Relief Amount (from table #2) 2,000, , Excludable Amounts (smaller of Ln11 or Ln12) 500, , CA Sch CA Adjustment (Fed Ln 13 less CA Ln 13) 200,

20 Debt Cancellation & Foreclosure NOTE The above calculation is ONLY required where the underlying debt exceeds $800,000 ($400,000 for MFS). If the debt is less than that, simply exclude the debt using the Federal computation and no Schedule CA adjustment is required. Worksheet California Principal Residence Debt Relief Income Exclusion Note: This worksheet is only required when debt securing the property exceeds $800,000 ($400,000 for MFS) immediately before the debt relief. This worksheet does not apply if qualified principal residence debt exceeds $2 million. Part I - Debt Relief Income 1. Home Acquisition Debt 2. Equity Debt 3. Total Recourse Debt (1) (Ln1 + Ln2) 4. Home s FMV 5. Debt Relief Income (2) (Ln3 Ln4) Part II Excludable Amount Federal California 6. Total Recourse Debt (Ln3) 7. Maximum Qualified Debt (from table #1) 8. Non-Qualified Debt (Ln6 - Ln7 but not <0) 9. Qualified Debt Relief Income (Ln5 Ln8) 10. Acquisition Debt Limit (Ln5-Ln2) 11. Excludable Debt Relief Amount before Limit (Fed: amount from Ln 10; CA: smaller of Ln9 or Ln10) 12. Maximum Excludable Debt Relief Amount (from table #2) 13. Excludable Amounts (smaller of Ln11 or Ln12) 14. CA SchCA Adjustment (Fed Ln 13 less CA Ln 13) (1) Note that if the taxpayer is not personally liable for the debt (non-recourse) there would be no debt relief; thus the amount on line 3 is referred to as recourse debt. (2) This amount should be the same as the amount in box 2 of the 1099-C. If there is also an amount in box 3 of the 1099-C and that amount would have been deductible if paid, then the amount on Ln 5 should match the amount of the 1099-C box 2 minus box 3. (3) Includes Registered Domestic Partners (RDP) filing separately for CA purposes Table #1 Table #2 Qualified Principal Residence Debt Maximum Debt Relief MFS (3) All Others MFS (3) All Others Fed $1 Million $2Million $1 Million $2Million CA $400,000 $800,000 $250,000 $500,

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