Foreclosures, Repossessions, and Cancelled Debt

Transcription

1 CPE/CE 4 Credit Hours Foreclosures, Repossessions, and Cancelled Debt Help Clients Get Back on Their Feet Interactive Self-Study CPE/CE Course

2 Foreclosures, Repossessions, and Cancelled Debt Self-Study CPE/CE Course Overview Program Content: Publication Date: September Expiration Date: Field of Study: Program Level: Recommended Participants: Prerequisites: Advance Preparation: Type of Delivery Method: CPE/CE Credit Hours: Passing Grade: Record Retention: This course provides continuing professional education for tax professionals to enhance knowledge of tax treatment of issues commonly associated with clients who have property foreclosed or repossessed. Subject matter includes tax reporting income from cancellation of debt, exceptions to taxation of income from the cancellation of debt, 1099-series forms, and effect on tax attributes of debt cancellation. The Final Exam must be completed online within one year from your date of purchase or shipment. See the Final Examination Instructions on the next page for information regarding final exam completion. Taxes. Overview. This course provides a general overview of the subject area from a broad perspective. It is appropriate for tax professionals at all organization levels. Tax professionals who prepare individual income tax returns are encouraged to participate in this course. Individuals who have prepared Form 1040 tax returns. No advanced preparation is needed to complete this course. Interactive self-study. 4 Credit Hours. One 50-minute period equals one CPE/CE Credit Hour. Participants who answer a minimum of 70% correct on the final exam will receive a Certificate of Completion. See the Final Examination Instructions on the next page for further information regarding passing requirements and acquiring the Certificate of Completion. As an IRS-approved provider of continuing education, Tax Materials, Inc. will report successful completion of this course to the IRS. According to the IRS, at some point in the future, you will be able to view your completed continuing education credits through your online PTIN account. Complaint Resolution Policy: Please contact our customer service department toll-free at Refund Policy: 30-day money-back guarantee. For information about our refund, complaint, and/or program cancellation policies, visit our website at Tax Materials, Inc. is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be submitted to the National Registry of CPE Sponsors through its website: National Registry of CPE Sponsors ID Number In accordance with the standards set forth in Circular 230, section 10.6, CPE/CE credits have been granted based on a 50-minute hour. IRS Program Number is 7VT8K-T S Tax Materials, Inc. has been approved by the California Tax Education Council to offer the Foreclosures, Repossessions, and Cancelled Debt Self-Study CPE/CE Course 6193-CE-0024, which provides 4 hours of federal credit and 0 hours of state credit towards the annual continuing education requirement imposed by the State of California. A listing of additional requirements to register as a tax preparer may be obtained by contacting CTEC at P.O. Box 2890, Sacramento, CA, , toll-free by phone at , or on the internet at CTEC Course ID Number 6193-CE-0024 Copyright 2015 Tax Materials, Inc. All Rights Reserved TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Overview i

3 Foreclosures, Repossessions, and Cancelled Debt Self-Study CPE/CE Course Completion Instructions Helpful Hint: Attempt to relate your tax preparation experience with the information you are studying. By doing so, you will increase retention and maximize your results. Also, utilize the Notes sections to jot down reminders and information that will be helpful to you in your tax practice. Follow the instructions below: 1) Start each chapter by reading the Learning Objectives. 2) Read the course materials in the chapter. Pay close attention to: a) Key Facts: Information that is particularly pertinent to the Learning Objective. b) Examples: Review the examples to associate the information to real-world application. c) Notes: Many of the main points of the chapter are highlighted. Review the notes and try to relate the content with your experience. 3) Complete the Self-Quiz at the end of the chapter. The questions are broken out by Learning Objective. Review the Learning Objectives before completing each set of questions. Determine your progress by comparing your answers to the correct ones on the pages that follow. 4) After all chapters have been studied, and each Self-Quiz has been taken, complete the Final Exam located at the back of this instruction booklet. Final Examination Instructions Expiration Date Reminder: The Final Exam must be completed online within one year from your date of purchase or shipment. CPE/CE credits are not available more than one year after your date of purchase or shipment. All Final Exams are administered online at It is recommended that you review the Final Exam at the end of the course before taking it online. Final Exams mailed in will not be graded. Follow the instructions below: 1) Go to 2) Click on Login to Education Center, where you will find a location to log in to the Final Exam. 3) Enter your User Name in the self-study CPE/CE login location. The address associated with your account at Tax Materials, Inc. is your User Name. If you do not have an address, or have not provided one, please call our toll-free number at to be assigned a User Name. 4) Enter your Password. The zip code associated with your account is your password. If you are having difficulty logging onto the Final Exam, please call our toll-free number at ) Select the Foreclosures, Repossessions, and Cancelled Debt Exam and click the Take Exam button. 6) You will be taken to the Final Exam. First confirm your First Name and Last Name are correct. This is how your name will appear on your Certificate of Completion should you achieve a score of 70% or higher. Take the Final Exam. Read the questions carefully and answer them to the best of your ability. At the bottom of the exam, click on Submit Answers when finished. You will instantly know if you have passed the test. If you failed, you are able to retake the test. If you passed, the Certificate of Completion will be available for you to print. Complete Evaluation Form Please provide suggestions and feedback regarding this CPE/CE course. The last page contains an Evaluation Form. After completion, please mail to: Tax Materials, Inc Minnetonka Ind. Rd., Ste. 221 Minnetonka, MN Thank you for helping us improve our CPE/CE course offerings! ii Overview TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

4 Learning Objectives / Table of Contents Chapter 1 Cancelled Debt A Differentiate between recourse and nonrecourse debt. 1-B Identify characteristics of Forms 1099-A and 1099-C issued in respect to abandoned property or cancelled debt. 1-C Determine how to properly report income from cancelled debt on the tax return. 2 Cancelled Debt as Income A Identify the tax effects of discounts and loan modifications. 2-B Apply exceptions to cancelled debt as income. 2-C Identify taxpayers who qualify to exclude cancelled debt from income using Form Foreclosures and Repossessions A Recognize tax effects of the Mortgage Forgiveness Debt Relief Act. 3-B Identify the tax effect on the borrower when property that is collateral for a loan is abandoned, foreclosed, or repossessed. 3-C Identify the tax effect on the seller or lender when property that is collateral for a loan is abandoned, foreclosed, or repossessed. 4 Form A Identify required tax attribute reductions resulting from exclusions of debt cancellation income. 4-B Determine the extent to which a taxpayer is insolvent. 4-C Properly report exclusion of debt cancellation income and reduction of tax attributes on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustments). Final Exam Index Course Evaluation TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Table of Contents iii

5 iv Table of Contents TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

6 1 Cancelled Debt Learning Objectives Successful completion of this course will enable the participant to: 1-A Differentiate between recourse and nonrecourse debt. 1-B Identify characteristics of Forms 1099-A and 1099-C issued in respect to abandoned property or cancelled debt. 1-C Determine how to properly report income from cancelled debt on the tax return. CPE/CE Glossary Terms Abandonment. Abandonment is the intentional and permanent action of a borrower to discard property from use and relinquish ownership. Foreclosure. A lender forecloses on property that secures a loan when the borrower no longer has the right to redeem the property by making payments to the lender. Foreclosure proceedings may be judicial (involving court action) or nonjudicial (no court involved). Nonrecourse debt. A debt that the borrower is not personally liable to repay is a nonrecourse debt. Recourse debt. A debt that the borrower is personally liable to repay is a recourse debt. Repossession. A lender repossesses property that secures a loan when the lender reacquires or takes possession of the property in full or partial satisfaction of the loan. Learning Objective 1-A Differentiate between recourse and nonrecourse debt. Cancellation of Debt Basics A debt includes any indebtedness for which a taxpayer is liable or which attaches to the taxpayer s property. Cancellation of indebtedness can involve auto loans, credit card debt, medical care, professional services, installment purchases of furniture or other personal property, mortgages, and home equity loans. Generally, if a debt for which a taxpayer is personally liable is cancelled or forgiven, the taxpayer must include the cancelled amount in income. There is no income from cancelled debt if the cancellation or forgiveness of debt is a gift or bequest. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 1

7 NOTES Acquisition debt tends to be nonrecourse debt, since the property being purchased is usually collateral for the loan. Recourse vs. Nonrecourse Debt Debt for which a borrower is personally liable is referred to as recourse debt. All other debt is nonrecourse debt. State law may specify which loans can be recourse loans. Whether a debt is recourse or nonrecourse may vary from state to state, depending on state law. Recourse debt. Refinances, second mortgages, and equity loans tend to create recourse debt. The borrower is personally liable to repay any amount of debt not satisfied by the surrender of the property securing the debt. The lender can repossess the loan collateral, but the borrower remains responsible for any deficiency if the property does not fully repay the loan. Lenders have the right to garnish wages or levy accounts in order to collect what is owed. Nonrecourse debt. Acquisition debt tends to be nonrecourse debt, since the property being purchased is usually collateral for the loan. Nonrecourse debt is satisfied by the surrender of the property securing the loan, regardless of the FMV of the property at the time of the surrender. The borrower is not personally liable for the debt after the surrender of the property. The creditor or lender has no recourse for collecting any part of the debt after the property securing the loan has been surrendered. EXAMPLE Andrew buys a new car, financed by a $25,000 loan from the car dealership. Andrew s loan documents state that if Andrew defaults on the car loan, he is responsible to pay the difference between the FMV of the car and the remaining balance on the car loan. The car loan is recourse debt. EXAMPLE Tina starts a new business and the business borrows $50,000 to buy equipment from an equipment reseller. The loan documents state that the equipment is collateral for the loan and that surrender of the equipment will satisfy the debt. Tina s equipment loan is nonrecourse debt. State laws dictate whether a loan is recourse or nonrecourse. EXAMPLE Denise borrows $150,000 to buy her home. The loan is secured by the home. Denise lives in a state in which home acquisition indebtedness is considered nonrecourse debt. After a few years, Denise s home value has increased enough that she is able obtain a home equity loan for $20,000. In Denise s state, home equity loans are specifically classified as recourse debt. Denise is personally liable to repay the $20,000. State Laws The following steps can be taken to determine whether a debt is recourse or nonrecourse: Check the state s lending statutes. State laws dictate whether a loan is recourse or nonrecourse. 2 Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

8 Check the state s laws on deficiency judgments. These laws determine whether a lender has the right to seek recourse. Review all loan documents. The documents may state whether the loan is recourse or nonrecourse. Note that state law overrides what the loan documents may say. Get legal advice, or in the case of a potential foreclosure, consult a HUDapproved foreclosure prevention counselor. The legal expert or counselor can review the loan documents and interpret the language regarding recourse and nonrecourse loans. Recourse mortgage state. States that are not nonrecourse mortgage states are recourse mortgage states. In a recourse state, the lender may be able take collection action against the borrower for loan deficiencies even if the lender acquires the home through foreclosure or repossession. Nonrecourse mortgage state. If state law does not hold a borrower personally liable for more than the home s value at the time the loan is repaid, the state is referred to as a nonrecourse mortgage state. That is, the lender may foreclose on a home in satisfaction of the loan, but may not pursue the borrower for the amount by which the loan exceeds the home s value. Anti-deficiency laws vary from state to state. Some states have determined that only purchase money, or money used in the initial acquisition of the home, qualifies as nonrecourse debt. NOTES Lender Reporting A lender may be required to file Form 1099-C, Cancellation of Debt, or Form 1099-A, Acquisition or Abandonment of Secured Property, or both. Each form includes Box 5 with the same wording: Check here if the debtor was personally liable for repayment of the debt. When the box is checked, this indicates that the debt in question was recourse debt. When the box is not checked, this indicates the debt is nonrecourse debt. Note: Forms 1099-C and 1099-A are often incorrect. If box 5 has been checked, care should be taken to determine whether the debt was in fact a recourse debt. If box 5 has been erroneously checked, ask the lender to issue a corrected form. See Learning Objective 1-B, page 4, for more information about Forms 1099-C and 1099-A. Potential Tax Consequences KEY FACT Even though a lender may not be able to pursue collection of the unpaid balance of a nonrecourse debt, the debt cancellation amount may be considered income by the IRS. If property securing a debt is repossessed, foreclosed on, or abandoned, the taxpayer may need to report the disposition as a sale. The date of the sale depends on whether the debt secured by the property was nonrecourse debt or recourse debt. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 3

9 NOTES Nonrecourse debt. If the taxpayer abandons property that secures a debt for which the taxpayer is not personally liable, the abandonment is treated as a sale or exchange that occurs on the date of abandonment. Recourse debt. Generally, if the taxpayer abandons property that secures a debt for which the taxpayer is personally liable, the taxpayer does not have a gain or loss until the later foreclosure is completed. See Chapter 3, Foreclosures and Repossessions, page 37. See Learning Objective 1-C, page 11, for more information about reporting income from cancelled debt. Learning Objective 1-A Self-Quiz For answer, see Chapter 1 Self-Quiz Answers, page 17. Test your knowledge and comprehension of information presented in Learning Objective 1-A. 1) Paul lives in a recourse state. He used a home equity loan of $10,000 from SmallBank to finance expansion of his guppy farm. When a virus wiped out the entire guppy population, Paul defaulted on the loan. Which of the following is true? a) Since the loan was a home equity loan, federal rules say that Paul is personally liable to repay it. b) SmallBank can take collection action against Paul for the unpaid balance of the loan. c) Paul s fish tanks and other equipment are collateral for his loan and can be surrendered to satisfy the loan. d) The $10,000 is a nonrecourse loan since it was a home equity loan. Learning Objective 1-B Identify characteristics of Forms 1099-A and 1099-C issued in respect to abandoned property or cancelled debt. If the creditor is a commercial lender and that obligation is subsequently cancelled, the creditor will issue Form 1099-C, Cancellation of Debt, to report the cancellation to the IRS. Form 1099-A and Form 1099-C A taxpayer may receive either Form 1099-A or Form 1099-C or both in connection with the same debt. Form 1099-A, Acquisition or Abandonment of Secured Property. When someone borrows money from a lender to buy property, the lender may require the loan to be secured by the purchased property. Property includes real estate, personal property, and intangible property. If the borrower transfers an interest in the secured property to the lender (such as in a foreclosure) or abandons the property, the lender reports the acquisition or abandonment to the IRS by filing Form 1099-A, Acquisition or Abandonment of Secured Property. Form 1099-C, Cancellation of Debt. When someone borrows money from a lender, the loan proceeds are not includable in income because the borrower has an obligation to repay the lender later. If the creditor is a commercial 4 Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

10 lender and that obligation is subsequently cancelled, the creditor will issue Form 1099 C, Cancellation of Debt, to report the cancellation to the IRS. NOTES KEY FACT Form 1099-A is used to report information about foreclosed, repossessed, or abandoned property and debt associated with the property. Form 1099-C is used to report information about cancelled debt. Comparison of Form 1099-A and Form 1099-C Form 1099-A, Acquisition or Abandonment of Secured Property What is the purpose of the form? Reports information about property that secures a loan. Alerts the IRS that the lender may issue Form 1099-C at some point in the future. Who must file the form? A taxpayer that lends money in the course of a trade or business, even if the taxpayer is not in the business of lending money. When is the form issued? A lender repossesses or forecloses on property that was security for a loan, or A lender acquires property that the borrower abandoned. What is reported? Names, addresses, and identification numbers of lender and borrower, as well as lender s phone number. Box 1: Date of foreclosure, repossession, or abandonment. Box 2: Balance of debt principle outstanding. Box 4: Fair market value of the foreclosed, repossessed, or abandoned property. Box 5: Whether the borrower was personally liable for the debt. Box 6: Description of foreclosed, repossessed, or abandoned property. Form 1099-C, Cancellation of Debt Reports debt that has not been repaid by the borrower. Notifies the IRS that the borrower has income from debt cancellation. A financial institution, credit union, certain Federal corporations and agencies, or any organization in the trade or business of lending money. A lender cancels or forgives a debt of $600 or more, or An identifiable event occurs for which the IRS requires the debt to be treated as cancelled. Names, addresses, and identification numbers of creditor and debtor, as well as creditor s phone number. Box 1: Date of debt cancellation or identifiable event. Boxes 2 and 3: Amount of debt discharged and any included interest. Box 4: Description of debt. Box 5: Whether the borrower was personally liable for the debt. Box 6: Identifiable event code. Box 7: Fair market value, if foreclosure or abandonment of property has occurred. Identity Theft and Debt Cancellation Form 1099-C should not be issued when fraudulent debt is cancelled due to identity theft. A taxpayer who receives Form 1099-C in this instance should ask the lender to file a corrected form, since the cancelled debt was not actually the taxpayer s liability. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 5

11 NOTES EXAMPLE Laurie s business equipment is collateral for a $35,000 business loan. Laurie defaults on the business loan and surrenders the equipment to the lender. The lender will file Form 1099-A to report its acquisition of the equipment. EXAMPLE In 2009, Tom borrowed $200,000 to purchase a home. In 2015, Tom s business fails and he is unable to continue making house payments. Because the loan balance is now $180,000 but the home has lost value and is worth only $150,000, Tom decides to abandon his home and permanently moves out on July 1, His lender will file Form 1099-A to report the abandonment. EXAMPLE Joel borrowed $1,200 from Missy. He was unable to repay the debt, so Missy agreed to accept $500 in satisfaction of the entire debt. Joel has cancelled debt of $700. Missy is not in the trade or business of lending money, so she is not required to file Form 1099-C. Suppose that instead of settling his debt to Missy for $500, Joel agreed to paint Missy s house in full satisfaction of the debt. Joel would have income from services, not cancellation of debt income. EXAMPLE In 2014, someone used Jamie s identity to obtain credit cards and ran up large debts in his name. When the identity theft was discovered in 2015, the credit card company removed Jamie s name as the debtor. Jamie does not have debt cancellation and should not receive Form 1099-C. Box 6 on Form 1099-C reports the reason a creditor is filing Form 1099-C. Form 1099-C Identifiable Event Codes Box 6 codes. Box 6 on Form 1099-C reports the reason a creditor is filing Form 1099-C. The identifiable event codes refer to specific events that led to the debt cancellation and triggered the requirement to file Form 1099-C. Code A. Bankruptcy. Code A is used to identify cancelled debt as a result of a Title 11 bankruptcy case. Code B. Other judicial debt relief. Code B is used to identify cancellation of debt as a result of receivership, foreclosure, or similar federal or state court proceedings other than bankruptcy. Code C. Statute of limitations or expiration of deficiency period. Code C is used to identify cancellation of debt when the statute of limitations for collecting the debt expires, or when the statutory period for filing a claim or beginning a deficiency judgment proceeding expires. Note: An identifiable event in the case of expiration of a statute of limitations occurs only if and when the borrower s affirmative defense of the statute of limitations is upheld in a final judgment or decision in a judicial proceeding, and the period for appealing the judgment or decision has expired. 6 Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

12 Code D. Foreclosure election. Code D is used to identify cancellation of debt when the creditor elects foreclosure remedies that statutorily end or bar the creditor s right to pursue collection of the debt. This event applies to a mortgage lender or holder who is barred from pursuing debt collection after a power of sale in the mortgage or deed of trust is exercised. Code E. Debt relief from probate or similar proceedings. Code E is used to identify cancellation of debt resulting from probate court or similar proceedings. Code F. By agreement. Code F is used to identify cancellation of debt as a result of an agreement between the creditor and the debtor to cancel the debt at less than full consideration. Code G. Decision or policy to discontinue collection. Code G is used to identify cancellation of debt because of a decision or defined policy of the creditor to discontinue collection activity and cancel the debt. A defined policy includes both a written policy and the creditor s established business practices. Code H. Expiration of nonpayment testing period. Code H is used to indicate that the creditor has not received a payment on the debt during a testing period ending on the December 31. The testing period is a 36-month period increased by the number of months the creditor was prevented from engaging in collection activity by a stay in bankruptcy or similar bar under state or local law. This identifiable event applies only for a creditor that is a financial institution, credit union (and certain of their subsidiaries), or one of certain other Federal corporations and executive agencies. Expiration of the nonpayment testing period does not necessarily result from an actual discharge of indebtedness. Code I. Other actual discharge before identifiable event. Code I is used to identify an actual cancellation of debt that occurs before any of the identifiable events described in codes A through H. KEY FACT Form 1099-C codes A through G and I identify specific occurrences resulting from actual discharge of indebtedness. These events determine the date of debt cancellation that is listed in box 1 of Form 1099-C. Code H does not necessarily identify an actual discharge of indebtedness. Coordination of Form 1099-A and Form 1099-C. A taxpayer may receive both Form 1099-A and Form 1099-C in connection with the same indebtedness. For example, the lender may foreclose on property that secures a debt, and then later cancel all or part of the outstanding loan. If the lender sells the property or cancels debt after the foreclosure or abandonment, the taxpayer may receive both Forms 1099-A and 1099-C. If the debt cancellation or sale occurs in the same calendar year as foreclosure or abandonment of the property, the taxpayer may receive only Form 1099-C. Completion of boxes 4, 5, and 7 on Form 1099-C satisfies the lender s filing requirement for Form 1099-A. The taxpayer may receive Form 1099-A in the year of the foreclosure or abandonment, but may receive Form 1099-C in a later year when the property has been sold or cancellation of debt has occurred. In this case, boxes 4, 5, and 7 NOTES A taxpayer may receive both Form 1099-A and Form 1099 C in connection with the same indebtedness. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 7

13 NOTES should be left blank on Form 1099-C since the information in those boxes has already been reported on Form 1099-A. If the FMV of the foreclosed or abandoned property exceeds the outstanding loan secured by the property, no debt cancellation occurs. The taxpayer may receive Form 1099-A to report the foreclosure or abandonment, but Form 1099-C should not be issued in connection with the indebtedness. Form 1099-C issued to more than one person. If two taxpayers are jointly and severally liable for a debt that was cancelled, both taxpayers may receive Form 1099-C showing the entire amount of the cancelled debt. The amount that is reportable on each taxpayer s tax return depends on the following: State law. The amount of loan proceeds each taxpayer received. How much of any interest deduction from the debt has been claimed by each taxpayer. How much of the basis of any co-owned property purchased with the loan proceeds was allocated to each co-owner. Whether the cancelled debt qualifies from any of the exceptions or exclusions discussed in Chapter 2, Cancelled Debt as Income, page 19. EXAMPLE #1 In 2007, Pam bought her main home for $235,000. She made a $15,000 down payment and took out a mortgage secured by the home for $220,000. Eventually, Pam was unable to make the mortgage payments. On March 1, 2014, when the outstanding balance of the loan was $215,000 and the home was worth $190,000, the lender foreclosed on the home. On January 15, 2015, the lender sold the home for $190,000 and cancelled the remaining mortgage debt. Pam received a 2014 Form 1099-A showing the following information: Box 1: March 1, 2014 (date of foreclosure). Box 2: $215,000 (balance of principle outstanding). Box 4: $190,000 (fair market value of property). Box 5: Checked, if the loan was a recourse loan. Box 6: Property address CORRECTED (if checked) LENDER S name, street address, city or town, state or province, country, ZIP or foreign postal code, and telephone no. Mortgage Lender OMB No Acquisition or Abandonment of Secured Property Form 1099-A 1 Date of lender's acquisition or 2 Balance of principal Copy B knowledge of abandonment LENDER S federal identification number BORROWER S identification number outstanding For Borrower 3/1/2014 $ 215,000 This is important tax information and is being BORROWER S name 3 4 Fair market value of property furnished to the Internal Revenue Service. If you Pam are required to file a $ 190,000 return, a negligence Street address (including apt. no.) 5 If checked, the borrower was personally liable for repayment penalty or other of the debt sanction may be X imposed on you if City or town, state or province, country, and ZIP or foreign postal code 6 Description of property taxable income results from this transaction (address of home) and the IRS determines Account number (see instructions) that it has not been reported. Form 1099-A (keep for your records) Department of the Treasury - Internal Revenue Service continued on next page 8 Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

14 Example #1 continued The next year, Pam also received a 2015 Form 1099-C showing the following: Box 1: January 15, 2015 (date of identifiable event). Box 2: $25,000 (amount of debt discharged). Box 3: Blank, because the lender did not include interest in the box 2 amount. Box 4: Blank, because Form 1099-A was previously filed for this debt. Box 5: Blank, because Form 1099-A was previously filed for this debt. Box 6: Code D, since the lender has decided to foreclose on the home rather than pursue collection of the loan Pam defaulted on. Box 7: Blank, because Form 1099-A was previously filed for this debt. NOTES CORRECTED (if checked) CREDITOR'S name, street address, city or town, state or province, country, 1 Date of identifiable event OMB No ZIP or foreign postal code, and telephone no. 1/15/2015 Mortgage Lender 2 Amount of debt discharged Cancellation $ 25, of Debt 3 Interest if included in box 2 $ Form 1099-C CREDITOR'S federal identification number DEBTOR'S identification number 4 Debt description Copy B DEBTOR'S name Pam Street address (including apt. no.) 5 If checked, the debtor was personally liable for For Debtor This is important tax information and is being furnished to the Internal Revenue Service. If you are required to file a return, a negligence repayment of the debt penalty or other sanction may be City or town, state or province, country, and ZIP or foreign postal code imposed on you if taxable income results from this transaction Account number (see instructions) 6 Identifiable event code 7 Fair market value of property and the IRS determines that it has not been D $ reported. Form 1099-C (keep for your records) Department of the Treasury - Internal Revenue Service EXAMPLE #2 Assume the same facts as Example #1, but the foreclosure and debt cancellation occur simultaneously on January 15, Pam does not receive Form 1099-A. Instead she receives only a 2015 Form 1099-C showing the following: Box 1: January 15, 2015 (date of identifiable event). Box 2: $25,000 (amount of debt discharged). Box 3: Blank, because the lender did not include interest in the box 2 amount. Box 4: Home mortgage loan. Box 5: Checked, if the loan was a recourse loan. Box 6: Code D, since the lender has decided to foreclose on the home rather than pursue collection of the loan Pam defaulted on. Box 7: $190,000 (fair market value of property). CORRECTED (if checked) CREDITOR'S name, street address, city or town, state or province, country, 1 Date of identifiable event OMB No ZIP or foreign postal code, and telephone no. 1/15/2015 Mortgage Lender 2 Amount of debt discharged Cancellation $ 25, of Debt 3 Interest if included in box 2 $ Form 1099-C CREDITOR'S federal identification number DEBTOR'S identification number 4 Debt description Copy B For Debtor DEBTOR'S name This is important tax Home mortgage loan information and is being Pam furnished to the Internal Revenue Service. If you are required to file a Street address (including apt. no.) 5 If checked, the debtor was personally liable for return, a negligence repayment of the debt X penalty or other sanction may be City or town, state or province, country, and ZIP or foreign postal code imposed on you if taxable income results from this transaction Account number (see instructions) 6 Identifiable event code 7 Fair market value of property and the IRS determines that it has not been D $ 190,000 reported. Form 1099-C (keep for your records) Department of the Treasury - Internal Revenue Service TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 9

15 NOTES EXAMPLE #3 Assume the same facts as Example #1, but the house is worth $215,500 on the date of foreclosure. The fair market value of the house exceeds the outstanding loan amount so there is no debt cancellation and no Form 1099-C. Pam receives only a 2014 Form 1099-A showing the following information: Box 1: March 1, 2014 (date of foreclosure). Box 2: $215,000 (balance of principle outstanding). Box 4: $215,500 (fair market value of property). Box 5: Checked, if the loan was a recourse loan. Box 6: Property address. If the house loses value before the lender can sell it, there is no debt cancellation. CORRECTED (if checked) LENDER S name, street address, city or town, state or province, country, ZIP or foreign postal code, and telephone no. Mortgage Lender OMB No Acquisition or Abandonment of Secured Property Form 1099-A 1 Date of lender's acquisition or 2 Balance of principal Copy B knowledge of abandonment LENDER S federal identification number BORROWER S identification number outstanding For Borrower 3/1/2014 $ 215,000 This is important tax information and is being BORROWER S name 3 4 Fair market value of property furnished to the Internal Revenue Service. If you Pam are required to file a $ 215,500 return, a negligence Street address (including apt. no.) 5 If checked, the borrower was personally liable for repayment penalty or other of the debt sanction may be X imposed on you if City or town, state or province, country, and ZIP or foreign postal code 6 Description of property taxable income results from this transaction (address of home) and the IRS determines Account number (see instructions) that it has not been reported. Form 1099-A (keep for your records) Department of the Treasury - Internal Revenue Service In the first two examples, Pam has cancellation of debt in the amount of $25,000. The taxable amount, if any, depends on Pam s circumstances. Principal residence rules for tax consequences of the foreclosure and debt cancellation are discussed in Chapter 3, Foreclosures and Repossessions. Note: The fair market value amount provided by the lender in box 4, Form 1099 A, may not necessarily be correct. The taxpayer may benefit from obtaining a formal appraisal of the property as of the date of foreclosure or abandonment. Learning Objective 1-B Self-Quiz For answer, see Chapter 1 Self-Quiz Answers, page 17. Test your knowledge and comprehension of information presented in Learning Objective 1-B. 2) Which of the following items of information is reported on Form 1099-A? a) Date of debt cancellation. b) Amount of debt discharged. c) Description of debt. d) Description of foreclosed property. 10 Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

16 Learning Objective 1-C Determine how to properly report income from cancelled debt on the tax return. NOTES Generally, if a taxpayer owes a debt to someone else and the debt is cancelled or forgiven for less than the full amount owed, the amount cancelled or forgiven is treated as income. The taxpayer may be required to include cancelled debt in gross income and pay tax on all or part of the cancelled debt. Exceptions and exclusions may apply. See Chapter 2, Cancelled Debt as Income, page 19, for more information on determining the amount of cancelled debt that must be included in gross income. If the debt being forgiven is part of a loan secured by property, the taxpayer may also have to recognize gain or loss. KEY FACT Once the amount of cancelled debt that is includable in gross income has been determined, the nature of the debt dictates how the income will be reported on the tax return. The taxable amount must be reported whether or not the taxpayer receives Form 1099-C, Cancellation of Debt. Generally, if a taxpayer owes a debt to someone else and the debt is cancelled or forgiven for less than the full amount owed, the amount cancelled or forgiven is treated as income. Nonbusiness Debt If the cancelled debt is a nonbusiness debt, report the taxable amount as ordinary income on line 21, Form Recourse nonbusiness debt. The borrower is personally liable to repay recourse debt. Examples of recourse nonbusiness debt include nonbusiness credit card debt, consumer loans, and personal loans. Unless an exception or exclusion applies, the full amount cancelled or forgiven is reported on line 21, Form Nonrecourse nonbusiness debt. The borrower is not personally liable to repay nonrecourse debt. Generally, nonrecourse debt is secured by collateral that can be returned to the lender in full satisfaction of the loan. For example, a mortgage or a car loan could be a nonrecourse nonbusiness loan. When nonrecourse debt is forgiven, the borrower does not have ordinary income from the cancellation of the debt unless the borrower retains the collateral and one of the following is true. The lender offers a discount for the early payment of the debt, or The lender agrees to a loan modification that results in the reduction of the principal balance of the loan. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 11

17 NOTES EXAMPLE Jana owes $15,000 on her personal credit card and makes no attempt to pay the amount owed. After unsuccessfully attempting to collect, the credit card company cancels the debt and in 2015 issues Form 1099-C, Cancellation of Debt, in the amount of $15,000. Box 6 of Form 1099-C is marked with Code G, Decision or policy to discontinue collection. Jana determines that she does not qualify for any of the exceptions or exclusions (discussed in Chapter 2, Cancelled Debt as Income, page 19). She must report $15,000 of ordinary income on line 21 of her 2015 Form EXAMPLE In 2013, Simon bought a motorcycle for his personal use from a dealer, who loaned him the full purchase price of $20,000. Simon is not personally liable for the debt, since his loan documents stipulate that the debt is fully secured by the motorcycle. The dealer needs quick cash and in 2015, offers Simon a $5,000 discount for paying off his motorcycle loan early. Simon agrees to the offer, pays off the loan on July 4, 2015, and keeps the motorcycle. He receives Form 1099-C, Cancellation of Debt, in the amount of $5,000. Box 6 of Form 1099-C is marked with Code F, By agreement. Unless Simon qualifies for one of the exceptions or exclusions discussed in Chapter 2, he must report $5,000 as ordinary income on line 21 of his 2015 Form Note: If Simon returns the motorcycle to the dealer rather than continue making payments, there is no cancellation of debt income because the loan was a nonrecourse loan. The amount of cancelled debt remains as part of Simon s basis in the motorcycle. Business Debt When debt incurred as part of a trade or business activity is cancelled, any taxable amount is reported on the form used by the business to report business income. Schedule C. If the cancelled debt is related to a nonfarm sole proprietorship, report the taxable amount as other income on line 6, Schedule C. Schedule E. If the cancelled debt is related to the nonfarm rental of real property, report the taxable amount with other rental income on line 3, Schedule E. Schedule F. If the cancelled debt is farm debt and the taxpayer is a farmer, report the taxable amount as other income on line 8, Schedule F. Form If the cancelled debt is related to a farm rental activity for which the taxpayer uses Form 4835, Farm Rental Income and Expenses, to report farm rental income based on crops or livestock produced by a tenant, report the taxable amount as other income on line 6, Form Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

18 Shareholder Debt Schedule B. When a corporation cancels or forgives debt owed to the corporation by a shareholder, the cancelled debt is a constructive dividend. The corporation cannot deduct the cancelled debt and the shareholder must report any taxable portion of the dividend on Schedule B, Interest and Ordinary Dividends. NOTES EXAMPLE Jim operates his chiropractic business as a sole proprietorship. He purchased some equipment in 2013 for his business. In 2015, the remaining balance of the loan was cancelled. Unless he qualifies for one of the exceptions or exclusions discussed in Chapter 2, Cancelled Debt as Income, Jim must include the full amount of cancelled debt in his 2015 Schedule C income. His basis in the equipment for depreciation remains unchanged. EXAMPLE Rick owns an airplane hangar, which he rents to the owner of a small plane. In 2012 he borrows $15,000 so that he can replace the concrete around the hangar. In 2015, his lender agrees to a loan modification and reduces the remaining principal by $5,000. Rick must increase his 2015 rental income by $5,000. EXAMPLE Mary owns land which she leases to a tenant farmer in return for 35% of his crop proceeds. After the tenant s 2013 crop failures, Mary receives no income in 2014 and 2015 and is unable to make the payments on the farm. The lender forecloses on the land and cancels Mary s mortgage. After applying the exceptions and exclusions discussed in Chapter 2, Mary determines that she has $10,000 of taxable debt cancellation income. She must report $10,000 as other income on her 2015 Form Because Mary no longer owns her land, she must report the disposition as a taxable event, discussed next. EXAMPLE Cathy is a shareholder in a C corporation. During 2012 and 2013 she borrowed money from the corporation. In 2015, the corporation wrote off the loans and cancelled Cathy s debt. Cathy determines that in her case, the entire amount is taxable, and reports the cancelled debt as dividend income on her 2015 Schedule B. Debt Cancellation and Sales or Other Dispositions of Property Securing the Debt KEY FACT Cancellation of debt often occurs in connection with a foreclosure, repossession, abandonment, sale, or other disposition of the property that secures the debt. The lender s repossession or foreclosure of the property is treated as a sale of the property by the taxpayer. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 13

19 NOTES When property subject to a debt is abandoned, the lender must foreclose on the property in order to acquire it. Foreclosure or repossession of property subject to recourse debt. If a lender repossesses or forecloses on property subject to a recourse debt and the remaining amount of the debt exceeds the FMV of the property at the time of the repossession or foreclosure, then: The gain or loss on the disposition of the property is measured by the difference between the FMV of the property at the time of the disposition and the adjusted basis (usually cost) in the property. The character of the gain or loss (ordinary income or capital gain income) is determined by the character of the property. If the lender forgives or cancels all or part of the amount of debt in excess of the FMV, the cancellation of the excess debt results in ordinary income for the borrower. The borrower reports any taxable portion of the debt cancellation income on line 21, Form 1040, or on Schedule C, E, or F, or on Form 4835 as explained above. See Chapter 2, Cancelled Debt as Income, page 19, for information about exceptions and exclusions that may apply. A gain or loss may be realized by the borrower. Gain or loss on the disposition of the property is the difference between the FMV at the time of the disposition and the borrower s adjusted basis in the property. Foreclosure or repossession of property subject to a nonrecourse debt. If a lender repossesses or forecloses on property subject to a nonrecourse debt and the remaining amount of the debt exceeds the FMV of the property at the time of the repossession or foreclosure, then: The foreclosure does not result in ordinary income from debt cancellation, even if the lender forgives all or part of the excess debt. The entire amount of the nonrecourse debt is treated as the amount realized on the disposition of the property. The gain or loss realized by the borrower is the difference between the total amount realized (entire amount of nonrecourse debt plus the amount of cash and the FMV of any property received) minus the borrower s adjusted basis in the property. The character of the gain or loss (ordinary or capital) is determined by the character of the property. See Chapter 3, Foreclosures and Repossessions, page 37, for more information on computing this gain or loss. Abandonment of property subject to a debt. When property subject to a debt is abandoned, the lender must foreclose on the property in order to acquire it. Then the above rules for foreclosure or repossession of property apply. If the debt is recourse debt and the amount in excess of the property s FMV is cancelled by the lender, the cancellation of the debt is ordinary income for the borrower. If the cancelled or forgiven debt is nonrecourse debt, there is no debt cancellation income. The borrower does not have gain or loss until the foreclosure is completed. If the debt was recourse debt, gain or loss is the FMV of the property minus the borrower s adjusted basis in the property. If the debt was nonrecourse debt, then the gain or loss is the entire amount of the outstanding debt minus the borrower s adjusted basis. KEY FACT The character of the gain or loss (ordinary or capital) upon disposition of property securing a debt is determined by the character of the property. 14 Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

20 Personal-use property and investment property. Disposition of personaluse property or investment property securing a debt is reported on Form 8949, Sales and Other Dispositions of Capital Assets, and on Schedule D, Capital Gains and Losses. Gain or loss is determined using the rules explained above, depending on whether the property was subject to a recourse debt or a nonrecourse debt. The amount of capital loss may be limited. No loss is allowed from the abandonment, repossession, or foreclosure of personal-use property. See Chapter 3, Foreclosures and Repossessions, page 37, for more information on computing this gain or loss. NOTES Property used in a trade or business. If the foreclosed or abandoned property is business-use property, the taxpayer may be required to report the disposition as a sale on Form 4797, Sales of Business Property. Gain or loss is determined using the rules explained on page 14, depending on whether the property was subject to a recourse debt or a nonrecourse debt. Depreciation allowed or allowable and depreciation recapture must be considered. As with the sale of any property used in a trade or business, the resulting gain or loss may be ordinary income, capital gain, or a combination of the two. EXAMPLE In 2012, Reid and Nick each buy real estate for $200,000. Reid s loan is a recourse loan, and Nick s loan is a nonrecourse loan. After two years, the FMV of each property has dropped to $110,000. Reid and Nick each owe $150,000 on their properties, and both are behind on payments. The banks foreclose on Reid and Nick, and their debts are cancelled in Reid and Nick make the following calculations. Step 1: Determine cancellation of debt income. Reid (Recourse loan) Nick (Nonrecourse loan) Debt owed... $ 150,000 Less FMV...($ 110,000) Ordinary income from cancellation of debt...$ 40,000 There is no debt cancellation income, since Nick s mortgage debt is nonrecourse. Reid must report $40,000 in 2015 debt cancellation income on: Line 21, Form 1040, if the property was personal-use or investment property, or Schedule C, E, or F, or Form 4835, if the property was used in a trade or business. If Reid qualifies for one of the exclusions or exceptions discussed in Chapter 2, Cancelled Debt as Income, page 19, his basis for gain/loss on the foreclosure is reduced by the amount of nonrecognized debt cancellation. continued on next page TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 15

21 NOTES Example continued Step 2: Determine gain/loss on foreclosure. Reid (Recourse loan) Nick (Nonrecourse loan) Sale proceeds (cancelled debt up to FMV of foreclosed property).$110,000 Basis*...($200,000) Loss on foreclosure...($90,000) Sale proceeds (full amount of cancelled debt)... $150,000 Basis*...($200,000) Loss on foreclosure... ($50,000) * Depreciation allowed or allowable is disregarded for this example. Both Reid and Nick realize a loss on the foreclosure. Depending on the use of the property, the loss may be: A nondeductible personal loss, or A capital loss on an investment reportable on From 8949 and Schedule D, or A loss on property used in a trade or business reportable on Form Note: When debt cancellation income is combined with gain/loss on the foreclosure, the net amount is the same whether the debt is recourse or nonrecourse. Recourse and nonrecourse debt considerations merely serve to allocate that net amount to different places on the tax return. Learning Objective 1-C Self-Quiz For answer, see Chapter 1 Self-Quiz Answers, page 17. Test your knowledge and comprehension of information presented in Learning Objective 1-C. 3) Judy bought a new car for $20,000 for her personal use. She paid $5,000 down and borrowed the remaining $15,000 from the car dealer and pledged the car as security for the loan. In 2015, Judy stopped making payments and the dealer repossessed the car and cancelled the loan. On the date of the repossession, the remaining loan balance was $12,000 and the FMV of the car was $10,000. Which of the following statements is true? a) If Judy s car loan is a nonrecourse loan, she realizes $10,000 on the repossession. b) If Judy s car loan is a recourse loan and the dealer forgives the unpaid balance, she has $10,000 in debt cancellation income. c) Since the car is personal use, Judy does not have debt cancellation income. d) If Judy s car had been a business-use vehicle, she might have been able to recognize a loss on her tax return. 16 Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

22 Chapter 1 Self-Quiz Answers NOTES 1) Paul lives in a recourse state. He used a home equity loan of $10,000 from SmallBank to finance expansion of his guppy farm. When a virus wiped out the entire guppy population, Paul defaulted on the loan. Which of the following is true? a) Since the loan was a home equity loan, federal rules say that Paul is personally liable to repay it. Incorrect. State laws, not federal rules, determine whether a loan is recourse or nonrecourse. b) SmallBank can take collection action against Paul for the unpaid balance of the loan. Correct. Since Paul lives in a recourse state, his home equity loan is a recourse loan. Paul is personally liable for repayment of the $10,000. c) Paul s fish tanks and other equipment are collateral for his loan and can be surrendered to satisfy the loan. Incorrect. The home equity loan was not secured by the fish tanks. d) The $10,000 is a nonrecourse loan since it was a home equity loan. Incorrect. A home equity loan is not an acquisition loan and therefore is unlikely to be a nonrecourse loan. 2) Which of the following items of information is reported on Form 1099-A? a) Date of debt cancellation. Incorrect. The date of debt cancellation is reported on Form 1099-C. Form 1099-A reports the date of foreclosure, repossession, or abandonment of a property. b) Amount of debt discharged. Incorrect. The amount of debt discharged is reported on Form 1099-C. Form 1099-A reports the balance of debt principle outstanding which may or may not be discharged at a future date. c) Description of debt. Incorrect. Form 1099-C reports a description of the debt that has not been repaid by the borrower. Form 1099-A reports a description of the property that has been foreclosed, repossessed, or abandoned. d) Description of foreclosed property. Correct. Form 1099-A reports information about property that has been foreclosed, repossessed, or abandoned. Form 1099-C reports that a debt has not been repaid by the borrower. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 1 17

23 NOTES 3) Judy bought a new car for $20,000 for her personal use. She paid $5,000 down and borrowed the remaining $15,000 from the car dealer and pledged the car as security for the loan. In 2015, Judy stopped making payments and the dealer repossessed the car and cancelled the loan. On the date of the repossession, the remaining loan balance was $12,000 and the FMV of the car was $10,000. Which of the following statements is true? a) If Judy s car loan is a nonrecourse loan, she realizes $10,000 on the repossession. Incorrect. When a nonrecourse loan is cancelled, the amount realized by the borrower is the full amount of the cancelled debt. Judy realizes $12,000 on the repossession. b) If Judy s car loan is a recourse loan and the dealer forgives the unpaid balance, she has $10,000 in debt cancellation income. Incorrect. When a recourse loan is cancelled, the borrower has debt cancellation income equal to the cancelled debt minus the FMV of the property securing the debt. In Judy s case, this is $12,000 $10,000 = $2,000. c) Since the car is personal use, Judy does not have debt cancellation income. Incorrect. The determining factor for debt cancellation income is whether the loan is recourse or nonrecourse, not whether the property is used personally or for business. d) If Judy s car had been a business-use vehicle, she might have been able to recognize a loss on her tax return. Correct. The repossession of the car is treated as a sale of property. Judy would have reported the sale on Form 4797 and recognized any gain or loss calculated. 18 Chapter 1 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

24 2 Cancelled Debt as Income Learning Objectives Successful completion of this course will enable the participant to: 2-A Identify the tax effects of discounts and loan modifications. 2-B Apply exceptions to cancelled debt as income. 2-C Identify taxpayers who qualify to exclude cancelled debt from income using Form 982. CPE/CE Glossary Terms Debt cancellation. A debt is cancelled when the debt is settled for less than the full amount owed, whether voluntarily by a lender or through bankruptcy or other legal proceedings. The terms debt cancellation and discharge of indebtedness are often used interchangeably. Exception. An exception is one of five specific situations in which cancelled debt is not included in the taxpayer s income, and for which tax attribute reduction is not required. Exclusion. An exclusion is one of five specific situations in which cancelled debt is not included in the taxpayer s income, and for which tax attribute reduction is required. Insolvent. A taxpayer is insolvent at a particular moment in time if the sum of the taxpayer s debts exceeds the FMV of all of the taxpayer s assets at that moment. The extent of insolvency is the amount by which liabilities exceed FMV of assets. Loan modification. A loan modification or workout is a permanent change in one or more of the terms of a borrower s loan, such as interest rate, term, or reduction in principal balance. Making Home Affordable Program. The Making Home Affordable (MHA) Program is a collection of federal initiatives intended to provide homeowners with options that lower monthly mortgage payments or avoid foreclosure. Learning Objective 2-A Identify the tax effects of discounts and loan modifications. Discounts and Loan Modifications When a discount or loan modification results in the reduction of the principal amount of the loan, the amount of the reduction is cancelled debt. The lender may offer to reduce or discount the loan principal in exchange for early pay-off by the borrower. Loan terms that may be permanently changed as part of a loan modification or work-out include interest rate, term, and principal balance. Only reductions to principal amount result in debt cancellation. When a discount or loan modification results in the reduction of the principal amount of the loan, the amount of the reduction is cancelled debt. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 2 19

25 NOTES The amount of principal reduction is cancelled debt whether the loan is recourse or nonrecourse. Cancelled debt may or may not be includable in income, depending on whether the debt is recourse or nonrecourse and whether any of the exceptions or exclusions applies. See Learning Objectives 2-B, page 24, and Learning Objectives 2-C, page 28, for more information about the exceptions and exclusions. KEY FACT When recourse debt is forgiven or satisfied for less than the full amount of the debt, the debt is considered cancelled in whatever amount remains unpaid. The amount cancelled debt must be included in the taxpayer s gross income unless one of the exceptions or exclusions applies. EXAMPLE Darren owes $25,000 on his personal credit card. He lost his job and found new work at a much lower salary. He cancelled his credit card and negotiated an arrangement with the credit card company to pay off a total of $15,000 in satisfaction of his debt. The $10,000 discount is debt cancellation. Darren is personally responsible for paying his credit card debt. That is, the debt was recourse debt, so Darren must report the cancelled debt amount as income unless one of the exceptions or exclusions applies. EXAMPLE Samantha owes $200,000 on her home mortgage. Her lender offers her a loan modification that reduces her interest rate and lengthens the term of her loan, resulting in lower monthly payments. Samantha does not have debt cancellation income because there was no reduction to the loan principal. KEY FACT When nonrecourse debt is forgiven or satisfied for less than the full amount of the debt, the borrower does not have ordinary income from the cancellation of the debt unless the borrower retains the collateral and one of the following is true. The lender offers a discount for the early payment of the debt, or The lender agrees to a loan modification that results in the reduction of the principal balance of the loan. EXAMPLE #1 Brian is underwater on his home mortgage. He owes $300,000 but his home is worth only $180,000. He is considering defaulting on the loan and letting the house go into foreclosure. In the meantime, Brian s mortgage loan is sold to investors for $150,000. The new loan holders offer to refinance Brian s mortgage and reduce his principal to $180,000. If Brian accepts the deal, he has debt cancellation of $120,000, the investors have $30,000 profit, and Brian will keep his home. 20 Chapter 2 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

26 EXAMPLE #2 Assume the same facts as Example #1. Assume Brian s mortgage loan was nonrecourse debt and that Brian accepts the loan modification and keeps his home. He must report the $120,000 as ordinary income unless one of the exceptions or exclusions applies. NOTES Summary. Does the borrower have ordinary income from debt cancellation when a debt is discounted by the lender? If the debt being discounted is Recourse Debt Nonrecourse Debt and borrower kept the collateral... Yes*...Yes* and borrower surrendered the collateral... Yes*...No * The debt cancellation amount must be included in gross income unless one of the exceptions or exclusions applies. Making Home Affordable Program The Making Home Affordable (MHA) Program is a collection of federal incentives to lenders that would allow homeowners to: Refinance mortgages to take advantage of lower interest rates. Reduce monthly mortgage payments. Obtain mortgage relief while searching for re-employment. Obtain assistance when the mortgage principal exceeds the home value. Avoid foreclosure when home ownership is no longer affordable or desirable. Debt cancellation from MHA programs. Borrowers whose mortgage principal is reduced under one of the MHA programs have debt cancellation and can expect to receive Form 1099-C, Cancellation of Debt. The taxpayer may be eligible to use the qualified principal residence indebtedness exclusion (discussed in Learning Objective 2-C, page 28). One of the exceptions or other exclusions may also apply, allowing the taxpayer to avoid being taxed on the cancelled debt. Eligibility for MHA assistance. Each of the MHA alternatives has its own set of eligibility requirements. Most require that the borrower not have been convicted in the prior 10 years of felony larceny, theft, fraud or forgery, money laundering, or tax evasion, in connection with a mortgage or real estate transaction. Several commonly-used MHA programs are summarized below. Programs also exist for mortgages owned by the FHA, VA, and USDA. Borrowers should contact the corresponding agency directly for details. HAMP (Home Affordable Modification Program) The most widely-used of the MHA initiatives is the Home Affordable Modification Program, or HAMP, which reduces monthly mortgage payments for struggling borrowers and makes the payments more sustainable for the longterm. In some cases, participating borrowers may receive Pay-for-Performance compensation. Any such payments that reduce the mortgage principle are not taxable. HAMP requirements include: Mortgage obtained on or before January 1, Mortgage amounts up to $729,750 on primary residence or single unit rental property, with higher limits for multi-unit rental properties. The most widely-used of the MHA initiatives is the Home Affordable Modification Program, or HAMP, which reduces monthly mortgage payments for struggling borrowers and makes the payments more sustainable for the long-term. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 2 21

27 NOTES The property has not been condemned. Borrower has a financial hardship and is either delinquent or in danger of falling behind on mortgage payments. Currently employed and sufficient documented income to support a modified payment. Four additional programs are included with HAMP. 1) PRA (Principal Reduction Alternative). The PRA is designed to encourage mortgage servicers and investors to reduce the amount owed when the amount owed significantly exceeds the home value. PRA requirements include: Mortgage not owned or guaranteed by Fannie Mae or Freddie Mac. Borrower owes more than the home is worth. Occupied as a primary residence. Mortgage payment is more than 31% of borrower s pre-tax monthly income. Mortgage amount up to $729,750 on first mortgage. Borrower has a financial hardship and is either delinquent or in danger of falling behind on mortgage payments. Sufficient documented income to support a modified payment. 2) HAFA (Home Affordable Foreclosure Alternative). As part of HAMP, borrowers who cannot afford the mortgage payment can complete a HAFAshort sale or deed-in-lieu of foreclosure. HAFA requirements include: Documented financial hardship. No new home purchase within the last 12 months. First mortgage amount less than $729,750. Mortgage obtained on or before January 1, The borrower may receive up to $3,000 in relocation assistance upon HAFA completion. Also see Chapter 3, Foreclosures and Repossessions, page 37. 3) FHA Short Refinance (FHA Refinance for Borrowers with Negative Equity). Under HAMP, borrowers who owe more that the home is worth may be eligible for FHA Short Refinance. Requirements include: Borrower is current on mortgage payments. Mortgage is not owned by Fannie Mae, Freddie Mac, FHA, VA, or USDA. Borrower owes more than the home is worth. The home is occupied as the borrower s primary residence. Borrower is eligible for a new loan under FHA underwriting requirements. Total debt does not exceed 55% of monthly gross income. Participating lenders must reduce the amount owed on the first mortgage to no more than 97.75% of the home s current value. 4) UP (Home Affordable Unemployment Program). Under HAMP, unemployed borrowers may qualify for reduced or suspended mortgage payments for 12 months or more. UP requirements include: Borrower is unemployed and eligible for unemployment benefits. Borrower occupies the home as a primary residence. Borrower has not previously received a HAMP modification. Mortgage obtained on or before January 1, Total of all mortgages up to $729, Chapter 2 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

28 EXAMPLE Bruce can t afford his house payments but hasn t yet fallen behind. He researches the Making Home Affordable Program and finds out that his lender participates in HAMP. Bruce and the lender determine that the current loan principal is less than the home value, so Bruce is not eligible for the PRA or the FHA Short Refinance options. Bruce wants to keep his home and agrees with his lender to a loan modification under HAMP that involves only an interest rate reduction. Other than a smaller mortgage interest deduction, Bruce has no tax consequences. NOTES EXAMPLE Dan lives in a recourse state, which means he is personally responsible to pay his home mortgage even though it is secured by the house. He can t afford his house payments but hasn t yet fallen behind. He s employed, but he owes $100,000 more on his original mortgage than his house is worth. Dan s lender also participates in HAMP and agrees to work with him on a loan modification. Dan and the lender determine that Dan is eligible for the Principal Reduction Alternative. Dan receives a 2015 Form 1099-C that shows the amount by which his mortgage principal has been reduced as a result of PRA. Learning Objective 2-A Self-Quiz For answer, see Chapter 2 Self-Quiz Answers, page 34. Test your knowledge and comprehension of information presented in Learning Objective 2-A. 1) Which of the following is a true statement about home loan modifications? a) A mortgage of up to $729,750 obtained after January 1, 2009, qualifies for the HAMP program as long as it is an acquisition loans on the taxpayer s principal residence. b) A borrower need not be in financial distress to qualify for a loan modification under HAMP. c) All federal Making Home Affordable programs require that the taxpayer retain ownership of the property on which the loan is modified. d) A taxpayer who participates in HAMP will not receive a Form 1099-C, Cancellation of Debt, in connection with the home loan modification. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 2 23

29 NOTES Learning Objective 2-B Apply exceptions to cancelled debt as income. In general, cancelled debt is includable in income. There are five exceptions to this general rule, as well as five exclusions. Exclusions are discussed in Learning Objective 2-C, page 28. KEY FACT The exceptions must be applied before the exclusions when determining the amount of cancelled debt that must be included in income. Exceptions do not require the reduction of tax attributes. Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance. Exception #1: Gifts, Bequests, Devises, and Inheritances The Internal Revenue Code states that Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance. [IRC 102(a)] A gift is the transfer of property by one individual to another while receiving nothing, or less than full value, in return. A bequest is the act of giving or leaving property to another through the last will and testament. Strictly speaking, bequest refers to personal property, though the term is often used in connection with real property. A devise is the act of giving or leaving real property to another through the last will and testament. An inheritance generally refers to anything received from the estate of a person who has died, whether by laws of descent or as the beneficiary of a will or trust. When cancellation of debt is intended by the lender as a gift, bequest, devise, or inheritance, the recipient does not have income from debt cancellation. EXAMPLE Marjorie loaned $25,000 to her grandson Eric. Eric made principal and interest payments until Marjorie died. The terms of Marjorie s will forgave the balance of the loan. Eric does not have to report the cancelled amount as income. Exception #2: Qualified Student Loans In some circumstances, student loan cancellation and student loan repayment assistance do not have to be included in gross income. Qualifying student loans. To meet this exception, the student loan must have been made by a qualified lender to assist the borrower in attending an eligible education institution. The loan must contain a provision that all or part of the debt will be cancelled if the borrower works: For a certain period of time, and In certain professions, and For any of a broad class of employers. 24 Chapter 2 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

30 KEY FACT The cancellation of a student loan will not qualify for the exception if: 1) The loan was made by an educational institution, and 2) The loan was cancelled because of services performed by the borrower for the educational institution or other organization that provided the loan funds. Qualified lenders. Qualified lenders must be one of the following. 1) The federal government, a state or local government, or an instrumentality, agency, or subdivision thereof. 2) A tax-exempt public benefit corporation that has assumed control of a state, county, or municipal hospital, and whose employees are considered public employees under state law. 3) An educational institution, and if the loan was made a) As part of an agreement with an entity described in (1) or (2) above under which the funds to make the loan were provided to the educational institution, or b) As part of a program of the institution designed to encourage students to serve in occupations or areas with unmet needs, and under which the services provided are for or under the direction of a governmental unit or a tax-exempt section 501(c)(3) organization. Occupations with unmet needs include medicine, nursing, teaching, and law. Refinanced loans. A loan that refinances a qualified student loan will also qualify if it was made by an educational institution or tax-exempt section 501(c) (3) organization as described above. Eligible educational institution. An eligible institution is one that maintains a regular faculty and curriculum and normally has a regularly enrolled body of students in attendance at the place where it carries on its educational activities. Educational loan repayment assistance. A borrower may receive education loan repayment assistance. These payments are not debt cancellation, and are tax-free if received for any of the following: The National Health Service Corps (NHSC) Loan Repayment Program. A state education loan repayment program eligible for funds under the Public Health Service Act. Any other state loan repayment or loan forgiveness program that is intended to provide for the increase availability of health services in underserved or health professional shortage areas, as determined by the state. EXAMPLE Robyn borrowed $100,000 from a qualified lender to finance her nursing degree at an accredited university. The loan included two options for cancellation: 1) The loan will be cancelled if Robyn works at least half-time as a registered nurse for a new hospital in a rural area of the state for five years. 2) The loan will be cancelled if Robyn works 20 hours a week as a research assistant in the university s infectious disease lab during her years as a nursing student. If Robyn chooses the first option, the cancelled debt meets the exception. continued on next page NOTES A loan that refinances a qualified student loan will also qualify if it was made by an educational institution or tax-exempt section 501(c)(3) organization. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 2 25

31 NOTES Example continued If she chooses the second option, the exception is not met and Robyn must include the cancelled debt in her gross income in the year of cancellation. A cash method taxpayer does not report income from the cancellation of debt if the payment of the debt would have been a deductible expense. Exception #3: Deductible Debt Taxpayers who use the cash method of accounting deduct expenses as they are paid and report income as it is received. A cash method taxpayer does not report income from the cancellation of debt if the payment of the debt would have been a deductible expense. The deductible debt exception must be applied before the exception for price reduction after purchase, discussed next. EXAMPLE Henry repairs a piece of equipment for Karen s business. Karen is unable to pay for Henry s services, and Henry eventually forgives the debt. If Karen is a cash method taxpayer, she doesn t deduct the cost of Henry s services because she hasn t paid for them. The forgiven debt meets the exception and Karen does not include the cancelled amount in her gross income. If Karen is an accrual method taxpayer, she deducts the cost of Henry s services as soon as she is billed, even if she hasn t made any payments. Unless another exception or one of the exclusions applies, Karen must include the cancelled amount in her gross income in the year Henry forgives the debt. Exception #4: Price Reduced After Purchase If a buyer owes a seller for the purchase of property and the debt is reduced by the seller, the buyer is not require to report the cancelled debt amount as income if all of the following conditions are met: The price reduction does not occur at a time when the buyer is insolvent, and The reduction does not occur in a Title 11 bankruptcy case, and The buyer reduces the basis of the property being purchased by the amount of debt reduction. EXAMPLE Sharon buys $10,000 worth of materials from her supplier, to be used 80% in her business and 20% by Sharon s family. After the purchase, Sharon s business has cash flow problems and the supplier agrees to reduce the price by 15%, although Sharon is not insolvent and not in bankruptcy. Sharon is a cash method taxpayer. She applies the deductible debt exception first, as follows: Debt cancellation due to deductible debt... $ 8,000 15% = $ 1,200 Debt cancellation due to price reduction... $ 2,000 15% = $ 300 Total debt cancellation...$ 10,000 15% = $ 1,500 Sharon can deduct only $6,800 for her business materials. Note that the deductible debt exception doesn t apply to personal expenses. She must reduce her basis in the personal use materials to $1, Chapter 2 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

32 Exception #5: Home Affordable Modification Program Borrowers who have received a loan modification under HAMP (discussed in Learning Objective 2-A, page 19) may be eligible to receive incentive payments as part of the program. Taxpayers who benefit from these payments do not report the principal reductions as income. (Rev. Rul ) Homeowners who make timely payments on their modified loans are eligible to have incentive payments made on their behalf to the mortgage lender. Each month that a homeowner makes a mortgage payment on time, the homeowner accrues an amount toward a Pay-for-Performance Success Payment. A payment of the accrued amounts is made annually to reduce the principal balance on the homeowner s mortgage loan. The maximum principal reduction is $1,000 a year for up to five years. NOTES EXAMPLE Sophie is making timely payments on her mortgage loan, which she was able to have modified under HAMP. Since the loan was modified in 2010, her loan has been reduced by a total of $3,500, thanks to the Pay-for-Performance Success Payments. None of the $3,500 is included in Sophie s income. Learning Objective 2-B Self-Quiz For answer, see Chapter 2 Self-Quiz Answers, page 34. Test your knowledge and comprehension of information presented in Learning Objective 2-B. 2) Which of the following cancelled debts qualifies for an exception to inclusion in gross income? a) Business property is appraised at less than the purchase price so the lender reduces the amount that the buyer may borrow. b) A university funds student loans but forgives them for students who work in the university s student health center for a certain number of years. c) A taxpayer makes a loan of $40,000 to her brother, who uses the money to buy business equipment for his company. As a Christmas gift, she forgives the loan in exchange for 10% ownership share in her brother s company. d) A homeowner s mortgage lender reduces the principal balance of a HAMP loan by $800 after the homeowner makes timely payments for an entire calendar year. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 2 27

33 NOTES Learning Objective 2-C Identify taxpayers who qualify to exclude cancelled debt from income using Form 982. In general, cancelled debt is includable in income. In general, cancelled debt is includable in income. There are five exclusions to this general rule, as well as five exceptions. Exceptions are discussed in Learning Objective 2-B, page 24. The exclusions may be considered only after any applicable exceptions have been applied when determining the amount of cancelled debt that must be included in income. Use of exclusions requires the reduction of tax attributes. See Learning Objective 4-C, page 70, for a discussion of tax attributes. KEY FACT Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), must be filed when a taxpayer applies one of the exclusions to cancelled debt. Each exclusion corresponds to a box on line 1 of Form 982, and the total amount being excluded must be entered in box 2. See Learning Objective 4-C, page 70, for more information about completing this form. Exclusion #1: Bankruptcy (Form 982, box 1a) Title 11 of the United States Code relates to bankruptcy. A Title 11 bankruptcy case is a case under Title 11 of the Code (including Chapters 7, 11, and 13 of Title 11). Debt cancelled in a Title 11 case is not included in the debtor s gross income if both of the following conditions are met: The debtor must be under the jurisdiction of the court, and The cancellation of the debt is granted by the court or occurs as a result of a plan approved by the court. EXAMPLE Scott was sued for $300,000, and the court found for the plaintiff. Scott later filed for bankruptcy and the court cancelled the $300,000 debt, along with Scott s other debts. Scott does not have to pay tax on the cancelled debt. He files Form 982 with his tax return in the year of discharge. Debt cancelled when the taxpayer is insolvent is excluded from gross income to the extent the taxpayer is insolvent immediately before the cancellation. Exclusion #2: Insolvency (Form 982, box 1b) Debt cancelled when the taxpayer is insolvent is excluded from gross income to the extent the taxpayer is insolvent immediately before the cancellation. The amount excluded is limited to the extent of insolvency. The insolvency exclusion does not apply to: Cancellation of debt that occurs in a Title 11 bankruptcy case. Debt that is qualified principal residence indebtedness, unless the taxpayer elects to have the insolvency exclusion apply instead of the qualified principal indebtedness exclusion (discussed on page 29). 28 Chapter 2 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

34 Determining insolvency. The taxpayer is insolvent immediately before the cancellation to the extent that the sum of all of the taxpayer s liabilities exceeds the FMV of all of the taxpayer s assets immediately before the cancellation. For purposes of determining insolvency: NOTES Liabilities Include Entire amount of recourse debts. Amount of nonrecourse debt in excess of the FMV of property securing the debt. Amount of nonrecourse debt in excess of property subject to the debt to the extent nonrecourse debt in excess of the FMV of the property is forgiven. Assets Include FMV of everything the taxpayer owns. FMV of assets that serve as collateral for the debt being cancelled. FMV of exempt assets that are beyond the reach of creditors, such as interest in a pension plan and the value of a retirement account. KEY FACT The extent of insolvency must be determined separately for each date that debt is cancelled. A taxpayer may be insolvent on one date and not insolvent just a few days before or after that date. See Learning Objective 4-B, page 65, for more information about determining insolvency. EXAMPLE In 2015, Tim was released from his obligation to pay his personal credit card in the amount of $5,000. He received a 2015 Form 1099-C from the credit card company showing the entire $5,000 as cancelled debt in box 2. None of the exceptions to the general rule that cancelled debt is included in income apply, and Tim is not involved in a bankruptcy case. He determines that his total liabilities immediately before the cancellation were $10,000 and the FMV of his assets were $7,000. Tim is insolvent to the extent of $3,000 ($10,000 $3,000). He can exclude $3,000 of the cancelled credit card debt from income under the insolvency exclusion. He checks box 1b of Form 982 and enters $3,000 in box 2. He completes Part II of Form 982. Unless another exclusion applies, Tim must include $2,000 of cancelled debt income on line 21 of his 2015 Form Exclusion #3: Qualified Farm Indebtedness (Form 982, box 1c) A taxpayer can exclude all or part of the cancelled debt from qualified farm indebtedness if the discharge was made by a qualified person. The qualified farm indebtedness exclusion does not apply to discharge that occurs in a Title 11 bankruptcy case or to the extent the taxpayer was insolvent immediately before the discharge. Qualified farm indebtedness. Farm indebtedness qualifies for the exclusion if: The debt was incurred directly in connection with the taxpayer s operation of the trade of business of farming, and 50% or more of the taxpayer s aggregate gross receipts for the three tax years preceding the debt cancellation year must be from the trade or business of farming. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 2 29

35 NOTES Qualified person. A qualified person is an individual or organization, including a federal or state government agency, that: Is actively and regularly engaged in the business of lending money, and Is not related to the taxpayer, and Is not the person (or related to the person) from whom the taxpayer acquired the property, and Is not a person (or related to a person) who receives a fee due to the taxpayer s investment in the property. Limit on qualified farm indebtedness exclusion. The amount of cancelled farm debt that a taxpayer can exclude from income under this exclusion cannot exceed the sum of: The taxpayer s adjusted tax attributes, and The total adjusted basis at the beginning of the year of property used or held for use in a trade or business or for the production of income. Any cancelled farm debt that is more than this limit must be included in income. KEY FACT If the taxpayer also excluded cancelled debt under the insolvency exclusion in the same year as using the qualified farm indebtedness exclusion, the adjusted basis of any qualified property and adjusted tax attributes are determined after any reduction of tax attributes required under the insolvency exclusion. EXAMPLE Martin has been a farmer for 20 years and earns his entire living from the operation of his farm. Recently, he bought a new farm tractor. He borrowed the $10,000 down payment from his father-in-law and financed the rest through his bank. Both parts of the tractor loan are qualified farm indebtedness, but only the bank is a qualified lender. If both the bank and Martin s father-in-law cancel the tractor loans, the qualified farm indebtedness exclusion applies only to the bank loan. It is possible that one of the other exclusions or an exception could apply to the $10,000 loan. EXAMPLE #1 On August 7, 2015, Vern was released from his obligation to pay a $12,000 business credit card debt to a qualified lender. The credit card was used exclusively in connection with Vern s farming business. For the years 2012, 2013, and 2014, at least 50% of Vern s gross receipts were from the trade or business of farming. Vern receives a 2015 Form 1099-C from the lender showing cancelled debt of $12,000 in box 2. The FMV of Vern s total assets on August 7, 2015 (immediately before the cancellation of the credit card debt) was $9,000, and his total liabilities at the time were $13,000. Vern is insolvent to the extent of $4,000 immediately prior to the debt cancellation. He qualifies to exclude $4,000 of the cancelled credit card debt under the insolvency exclusion. He must reduce his tax attributes due to the insolvency exclusion before determining how much of the remaining $8,000 ($12,000 total less $4,000 insolvency exclusion) cancelled farm debt he can exclude. 30 Chapter 2 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

36 EXAMPLE #2 In Example #1, page 30, suppose Vern has $3,000 adjusted tax attributes (after reducing them for the insolvency exclusion) and $3,500 in total adjusted basis in qualified property at the beginning of His qualified farm indebtedness exclusion is limited to $6,500 ($3,000 + $3,500). He reports his cancelled debt as follows. Form 982, Part I: Tim checks boxes 1b and 1c and includes $10,500 ($4,000 insolvency exclusion + $3,500 limited qualified farm indebtedness exclusion) in box 2. Form 982, Part II: Tim reports the reduction of tax attributes as described in Learning Objective 4-A, page 59. Schedule F: Tim reports the remaining $1,500 ($12,000 cancelled $10,500 excluded) cancelled debt as other income on line 8. NOTES Exclusion #4: Qualified Real Property Business Indebtedness (Form 982, box 1d) A taxpayer can elect to exclude all or part of the cancelled debt from qualified real property business indebtedness from income. The qualified real property business indebtedness exclusion does not apply to discharge that occurs in a Title 11 bankruptcy case or to the extent the taxpayer was insolvent immediately before the discharge. The bankruptcy and insolvency exclusions must be applied before the qualified real property business indebtedness exclusion is considered. Qualified real property business indebtedness. Qualified real property business indebtedness is debt that is not qualified farm debt and that meets all of the following conditions: 1) It was incurred or assumed in connection with real property held or used in a trade or business or for the production of income (including rental property). 2) It is secured by that real property. 3) It was incurred or assumed Before 1993, or After 1992, if the debt is either qualified acquisition indebtedness or is debt incurred to refinance qualified acquisition indebtedness acquired before 1993 (but only to the extent the amount of such debt does not exceed the amount of debt being refinanced). 4) It is debt to which the taxpayer elects to apply these rules. Qualified acquisition indebtedness. Qualified acquisition indebtedness is: Debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property that is used in a trade or business and that secures the debt, or Debt resulting from the refinancing of qualified acquisition indebtedness, to the extent the amount of the debt does not exceed the amount of debt being refinanced. The bankruptcy and insolvency exclusions must be applied before the qualified real property business indebtedness exclusion is considered. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 2 31

37 NOTES Limit on qualified real property business indebtedness exclusion. The amount of cancelled qualified real business indebtedness that a taxpayer can exclude from income under this exclusion is subject to two limits. The first limitation is: The outstanding principal amount of the qualified real property business debt (immediately before the cancellation), minus The FMV (immediately before the cancellation) of the business real property securing the debt, reduced by the outstanding principal amount of any other qualified real property business debt secured by this property immediately before the cancellation. The second overall limitation is the total adjusted basis of depreciable real property held by the taxpayer immediately before the debt cancellation, but not including the basis of any depreciable real property acquired in contemplation of the cancellation. When calculating these bases, reductions required by the exclusion of debt cancelled under the bankruptcy, insolvency, or farm debt provisions must first be taken. Making the election and reporting the qualified real property business indebtedness exclusion. Exclusion of debt cancellation from gross income under the qualified real property business indebtedness exclusion is an election, and can be revoked only with IRS consent. To make the election, the taxpayer must attach Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to a timely-filed (including extensions) tax return in the year the qualified real property business indebtedness exclusion is used. Amended returns. An omitted election can still be made by filing an amended return within six months of the due date (excluding extensions). Write Filed pursuant to section on page 1 of the amended return. EXAMPLE Roger owns a commercial building with an adjusted basis of $250,000 and FMV of $275,000. He owes $200,000 on the first mortgage and has a second mortgage of $100,000. Both loans are qualified real property business indebtedness. In 2014, Roger lost two major tenants and has been unable to make his mortgage payments. In 2015, he reached an agreement with the lender to reduce the second mortgage to $60,000, which results in $40,000 debt cancellation income. Note that Roger must first apply the bankruptcy and insolvency exclusions, if applicable, to the $40,000 cancelled debt. If Roger then elects to use the qualified real property business indebtedness exclusion, he will be limited to excluding $25,000 under that provision: $ 100,000 Amount of second mortgage debt before discharge. ($ 75,000) FMV of property before discharge, less first mortgage balance. $ 25,000 Qualified real property business indebtedness exclusion limit. 32 Chapter 2 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

38 Exclusion #5: Qualified Principal Residence Indebtedness (Form 982, box 1e) Discharge of qualified principal residence indebtedness refers to cancelled debt excluded under the Mortgage Forgiveness Debt Relief Act of 2007 and its extensions. Taxpayers may exclude income from cancellation of qualified principal residence indebtedness for discharges of debts occurring after 2006 and before If the discharge occurred in a Title 11 bankruptcy case, the bankruptcy exclusion must be used. An insolvent homeowner who is not in a Title 11 bankruptcy case can elect to apply the insolvency exclusion instead of the qualified principal residence indebtedness exclusion. The Mortgage Forgiveness Debt Relief Act of 2007 and qualified principal residence indebtedness are discussed in more detail in Learning Objective 3-A, page 37. Limits on qualified principal residence indebtedness exclusion. The qualified principal residence exclusion is limited to $2 million ($1 million if married filing separately). The following additional conditions apply: No exclusion is allowed if the borrower performed services for the lender or on account of any other factor not directly related to a decline in the home s value or the borrower s financial condition. The exclusion does not apply to any portion of the discharged loan that is not qualified principal residence indebtedness. The remaining part of the loan may qualify for another exclusion. If the taxpayer continues to own the home, the basis of the home must be reduced (but not below zero) by the amount of cancelled qualified principal residence indebtedness excluded from income. Report the reduction on Form 982, line 10b. See Learning Objective 4-A, page 59. NOTES Learning Objective 2-C Self-Quiz For answer, see Chapter 2 Self-Quiz Answers, page 34. Test your knowledge and comprehension of information presented in Learning Objective 2-C. 3) Which of the following is a true statement about exclusion of cancelled debt from income? a) The exclusions can be used in the order that is most beneficial to the taxpayer. b) The election to use the qualified real property business indebtedness exclusion can be made on an amended return filed within three years of the original due date of the return, excluding extensions. c) Qualified farm indebtedness includes seller-financed debt. d) Cancelled debt may be allocated to more than one exclusion. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 2 33

39 NOTES Chapter 2 Self-Quiz Answers 1) Which of the following is a true statement about home loan modifications? a) A mortgage of up to $729,750 obtained after January 1, 2009, qualifies for the HAMP program as long as it is an acquisition loans on the taxpayer s principal residence. Incorrect. The HAMP program applies to mortgages obtained on or before January 1, b) A borrower need not be in financial distress to qualify for a loan modification under HAMP. Correct. The FHA Short Refinance for borrowers with negative equity has no financial distress requirement. c) All federal Making Home Affordable programs require that the taxpayer retain ownership of the property on which the loan is modified. Incorrect. The Home Affordable Foreclosure Alternative is intended to assist borrowers to avoid foreclosure when home ownership is no longer desirable or affordable. d) A taxpayer who participates in HAMP will not receive a Form 1099-C, Cancellation of Debt, in connection with the home loan modification. Incorrect. A lender may issue Form 1099-C in connection with the modification of a recourse home loan whether or not the modification is done under HAMP. 2) Which of the following cancelled debts qualifies for an exception to inclusion in gross income? a) Business property is appraised at less than the purchase price so the lender reduces the amount that the buyer may borrow. Incorrect. The price reduced after purchase exception applies when the seller makes the reduction, not when a lender limits borrowing. b) A university funds student loans but forgives them for students who work in the university s student health center for a certain number of years. Incorrect. Student loans that are made by an educational institution and later forgiven in exchange for services provided to the institution do not meet the qualified student loan exception. c) A taxpayer makes a loan of $40,000 to her brother, who uses the money to buy business equipment for his company. As a Christmas gift, she forgives the loan in exchange for 10% ownership share in her brother s company. Incorrect. Although the lender may have regarded the loan forgiveness as a gift, she has actually purchased her share of the company for $40,000. The $40,000 is no longer a debt owed by the brother to the sister, but an investment in the company by the sister. There is no actual debt forgiveness, so none of the exceptions matters. 34 Chapter 2 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

40 d) A homeowner s mortgage lender reduces the principal balance of a HAMP loan by $800 after the homeowner makes timely payments for an entire calendar year. Correct. Up to $1,000 of Pay-for-Performance Success Payments that reduce the loan principal under HAMP can meet an exception to inclusion of cancelled debt in gross income.. NOTES 3) Which of the following is a true statement about exclusion of cancelled debt from income? a) The exclusions can be used in the order that is most beneficial to the taxpayer. Incorrect. The bankruptcy and insolvency exclusions, if applicable, must be used before the qualified farm indebtedness and qualified real property business indebtedness exclusions. The bankruptcy exclusion must also be used before the qualified principal residence indebtedness exclusion. b) The election to use the qualified real property business indebtedness exclusion can be made on an amended return filed within three years of the original due date of the return, excluding extensions. Incorrect. An omitted election can be made by filing an amended return within six months of the due date of the original return (including extensions). c) Qualified farm indebtedness includes seller-financed debt. Incorrect. Debt discharged by the person from whom the farmer acquired the farm property does not qualify for the qualified farm indebtedness exclusion. d) Cancelled debt may be allocated to more than one exclusion. Correct. The cancelled debt must first be allocated to the bankruptcy and insolvency exclusions, if applicable. Any remaining cancelled debt may then qualify to be excluded under the provisions for qualified farm indebtedness, qualified real property business indebtedness, or qualified principal residence indebtedness. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 2 35

41 36 Chapter 2 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

42 3 Foreclosures and Repossessions Learning Objectives Successful completion of this course will enable the participant to: 3-A Recognize tax effects of the Mortgage Forgiveness Debt Relief Act. 3-B Identify the tax effect on the borrower when property that is collateral for a loan is abandoned, foreclosed, or repossessed. 3-C Identify the tax effect on the seller or lender when property that is collateral for a loan is abandoned, foreclosed, or repossessed. Glossary Terms Deed in lieu of foreclosure. A borrower voluntarily surrenders the deed to a property that secures a loan to the lender in order to avoid foreclosure. Foreclosure. A lender forecloses on property that secures a loan when the borrower no longer has the right to redeem the property by making payments to the lender. Foreclosure proceedings may be judicial (involving court action) or nonjudicial (no court involved). Principal residence. A principal residence is the taxpayer s main home where he or she lives most of the time. A taxpayer can have only one principal residence at any one time. Repossession. A lender repossesses property that secures a loan when the lender reacquires or takes possession of the property in full or partial satisfaction of the loan. Short sale. A short sale is the sale of property for less than the outstanding mortgage amount and closing costs. Learning Objective 3-A Recognize tax effects of the Mortgage Forgiveness Debt Relief Act. CPE/CE A short sale is the sale of property for less than the outstanding mortgage amount and closing costs. Mortgage Forgiveness Debt Relief Act of 2007 Under the Mortgage Forgiveness Debt Relief Act, taxpayers may exclude from income certain debt forgiven or cancelled on their principal residence, instead of being bound by the general rule that cancelled debt must be included in income. If the cancelled debt qualifies for exclusion from gross income, the debtor may be required to reduce tax attributes (certain credits, losses, and basis of assets) by the amount excluded. The mortgage forgiveness debt exclusion expired for tax years beginning after However, the provision has expired and been extended several times in the past few years. See TheTaxBook Update Service at for late-breaking news about extension of this provision. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 3 37

43 NOTES The amount of cancelled debt is determined at the time the debt is cancelled or forgiven. Qualified Principal Residence Indebtedness The exclusion granted by the Act is applicable only to the discharge of qualified principal residence indebtedness. Qualified principal residence indebtedness is debt that is: Secured by the taxpayer s main home, and Used to buy, build, or substantially improve the home. Refinanced debt. Qualified principal residence indebtedness also includes a mortgage used to refinance such a debt and secured by the home, but only to the amount of the old principal just before refinancing. EXAMPLE Kimberly purchased her home in 2002 for $125,000. She put $25,000 down and financed the remaining $100,000 with a mortgage secured by the home. By 2007, her property had risen in value to $150,000, and she owed $95,000 on her mortgage. She refinanced her home and obtained a new mortgage for $130,000. She used $15,000 to remodel her kitchen, and used the remaining $20,000 to pay off some of her credit cards. At the time of the refinance, Kimberly s qualified principal residence indebtedness was $110,000 (= $95,000 + $15,000). Debt reduced through mortgage restructuring. The Act also applies to debt reduced through restructuring of the mortgage, such as a mortgage loan modification under HAMP. This kind of reduction in debt qualifies for an exception as discussed in Learning Objective 2-B, page 24, which is not the same as the exclusion discussed in this chapter. Limitations. The maximum amount of cancelled debt that can be treated as qualified principal residence indebtedness is: $1,000,000 for married taxpayers filing separately. $2,000,000 for all others. The amount of cancelled debt is determined at the time the debt is cancelled or forgiven. Amounts in excess of the limitation may qualify for another exclusion. EXAMPLE Donald s mortgage balance was $1,500,000 at the time he defaulted on his loan. The loan was used to buy his main home and was secured by that home. Donald bought the home before he was married and is the only person on the mortgage. If Donald files a joint tax return with his wife, he can treat the entire mortgage balance as qualified principal residence indebtedness. If he files separately, only $1,000,000 could be qualified principal residence indebtedness. KEY FACT Under the Act, cancelled qualified principal residence indebtedness cannot be excluded from income if the cancellation was granted: In exchange for services performed for the lender, or On account of any factor not directly related to a decline in the value of the residence or the taxpayer s financial condition. 38 Chapter 3 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

44 EXAMPLE Ronald owns a main home and a vacation home. Both are worth more than he had paid for them, but only the main home has a mortgage. He decides to stop making mortgage payments on his main home, even though he could easily afford them. His plans to let the home go into foreclosure and then move into his vacation home debt-free. If he follows through with this plan and his lender cancels the mortgage on Ronald s main home, Ronald will not be able to exclude the cancelled debt from income under the Act. The cancellation would not be directly related to a decline in value of the home or to Ronald s financial condition. NOTES Ordering Rules for Bankrupt or Insolvent Taxpayers Bankruptcy. If qualified principal residence indebtedness is cancelled in a Title 11 bankruptcy case, the taxpayer must first apply the bankruptcy exclusion rather than the qualified principal residence indebtedness exclusion. Insolvency. If the taxpayer was insolvent immediately before the cancellation, the taxpayer can elect to apply the insolvency exclusion instead of the qualified principal residence indebtedness exclusion. See Learning Objective 2-C, page 28, for more information about the bankruptcy and insolvency exclusions. Homeowners and Forms 1099-C and 1099-A If a taxpayer does not make payments owed on a loan secured by a home, the lender may foreclose on the loan or repossess the home. A taxpayer may also decide to stop making payments and abandon the home. KEY FACT Two transactions. When a taxpayer s principal residence is abandoned, foreclosed, or repossessed, the taxpayer must generally report two transactions on the tax return: Cancellation of debt income. Gain or loss from the sale of property. The lender issues two information forms that are needed by the taxpayer to report these two transactions. Form 1099-C. When a mortgage lender cancels or forgives all or part of the mortgage debt, the taxpayer should receive Form 1099-C, Cancellation of Debt. If foreclosure (or abandonment) and debt cancellation occur in the same calendar year, the lender may issue only Form 1099-C, including the information otherwise reported on Form 1099-A. Form 1099-A. If a property was taken by the lender (foreclosure and repossession) or given up by the borrower (abandonment), the lender usually sends the taxpayer Form 1099-A, Acquisition or Abandonment of Secured Property. See Learning Objective 1-B, page 4, for more detailed information about Forms 1099-C and 1099-A. When a mortgage lender cancels or forgives all or part of the mortgage debt, the taxpayer should receive Form 1099-C, Cancellation of Debt. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 3 39

45 NOTES The abandonment, foreclosure, or repossession of the taxpayer s home is treated as a sale from which the taxpayer may realize gain or loss. Reporting Cancellation of Qualified Principal Residence Indebtedness A taxpayer who receives Form 1099-C, Cancellation of Debt, in connection with cancellation or forgiveness of all or part of qualified principal residence indebtedness should not ignore the form. Form 1099-C does not report whether the cancelled debt was qualified principal residence indebtedness. It is the taxpayer s responsibility to maintain records to prove how much of the cancelled debt qualifies for relief under the Act. Recourse mortgage debt. If the taxpayer is personally liable for the debt, the Act allows the exclusion from income of the portion of the cancelled debt that is qualified principal residence indebtedness. The taxpayer must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment). The following steps should be taken to properly exclude the cancelled debt. 1) Determine whether the bankruptcy exclusion applies to the cancelled debt. 2) If the bankruptcy exclusion does not apply, determine whether the taxpayer was insolvent just before the debt cancellation, and if so, the extent of the insolvency. Then determine whether the election to use the insolvency exclusion will be made, and how much cancelled debt, if any, exceeds the extent of insolvency. 3) After considering the bankruptcy and insolvency exclusions, determine how much of the remaining cancelled debt is qualified principal residence indebtedness. 4) If the qualified principal mortgage indebtedness exclusion will be applied to all or part of the cancelled debt, check box 1e, Form 982 to indicate that the exclusion will be used. 5) Include the amount being excluded in the total on line 2, Form ) If the taxpayer continues to own the home after the debt cancellation, line 10b of Form 982 must also be completed. Enter on line 10b the smaller of: The portion of line 2 attributable to exclusion of qualified principal residence indebtedness, or The taxpayer s basis in the home. See Chapter 4, Form 982, page 60, for examples and additional information about Form 982. Nonrecourse mortgage debt. Cancelled nonrecourse debt generally does not result in ordinary income from debt cancellation. See Learning Objective 1-A, page 1, for more information about recourse and nonrecourse debt. See Learning Objective 3-B, page 42, for an exception involving short sales. Reporting Capital Gain or Loss on a Principal Residence A taxpayer who receives Form 1099-A, Acquisition or Abandonment of Secured Property, in connection with a former principal residence should not ignore the form. The abandonment, foreclosure, or repossession of the taxpayer s home is treated as a sale from which the taxpayer may realize gain or loss. This is true whether or not the mortgage was a recourse loan, and even if either of the following is true: Cancelled qualified principal mortgage indebtedness qualifies for exclusion from income. The taxpayer voluntarily returns the property to the lender. 40 Chapter 3 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

46 KEY FACT The Act does not relieve the taxpayer of the requirement to report gain or loss realized from the abandonment, foreclosure, or repossession of a taxpayer s main home. NOTES Sale of residence. Form 1099-A provides information needed to report the deemed sale of the home. Note: If foreclosure (or abandonment) and debt cancellation occur in the same calendar year, the lender may issue only Form 1099 C, including the information otherwise reported on Form 1099-A. Any gain the taxpayer realizes is taxable unless the home qualifies for a full or partial exclusion under the provisions of IRC section 121. The IRC section 121 limitation for exclusion of gain on the sale of a principal residence ($250,000 gain per individual) is separate from the limitation under the Act for exclusion of cancelled qualified principal residence indebtedness. See Learning Objective 3-B, page 42, for information on how the homeowner must report the abandonment, foreclosure, or repossession of a principal residence. Learning Objective 3-C, page 48, discusses the tax consequences for the seller or mortgage lender. Learning Objective 3-A Self-Quiz For answer, see Chapter 3 Self-Quiz Answers, page 55. Test your knowledge and comprehension of information presented in Learning Objective 3-A. 1) Liz and Larry bought a mansion for $3,000,000 that they used as their principal residence. Eventually, they could no longer afford the mortgage payments and decided to let the house go into foreclosure. When the foreclosure was completed, they still owed $2,500,000 on the original mortgage. They receive Form 1099-C, Cancellation of Debt, with $250,000 in box 2 (amount of debt cancelled). All of the following statements are true except: a) If the mortgage loan is nonrecourse, Liz and Larry may exclude up to $2,000,000 of the cancelled debt from income. b) Liz and Larry can exclude no more $2,000,000 of cancelled recourse mortgage debt from the income. c) If Liz and Larry s mortgage is cancelled in a Title 11 bankruptcy case, they may not use the qualified principal residence indebtedness exclusion to exclude any of the $2,500,000 from their income. d) Even though Liz and Larry s original mortgage was used solely to buy their home, only part of the amount outstanding at the time of the foreclosure is qualified principal residence indebtedness. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 3 41

47 NOTES Learning Objective 3-B Identify the tax effect on the borrower when property that is collateral for a loan is abandoned, foreclosed, or repossessed. If the borrower abandons the property, is behind on loan payments, or otherwise fails to live up to the terms of the loan agreement, the lender may foreclose on the property. Borrower s Loss of Property Ownership A borrower may lose or forfeit ownership of property that is collateral for a loan by one of the following processes: Abandonment. The borrower intentionally and permanently discards the property and relinquishes ownership. Abandonment is indicated by objective facts and circumstances, and is generally followed by foreclosure. Foreclosure. If the borrower abandons the property, is behind on loan payments, or otherwise fails to live up to the terms of the loan agreement, the lender may foreclose on the property. Foreclosure takes away the right of the borrower to redeem the property by making payments to the lender. Foreclosure proceedings may be judicial (involving court action) or nonjudicial (no court involved). The lender may take title to the property (repossession) or force the sale of the property to satisfy all or part of the debt (foreclosure sale). Repossession. The lender reacquires or takes possession of the property in full or partial satisfaction of the loan. KEY FACT Abandonment is an action taken by the borrower. Foreclosure and repossession are actions taken by the lender. Foreclosure and/or repossession by the lender generally follow the borrower s abandonment of property that is collateral for a loan. Foreclosure or Repossession is Treated as a Sale A lender s foreclosure or repossession of property that secures a loan is treated as a sale of the property by the borrower, even if the borrower voluntarily returns the property to the lender. The transfer of the property to the lender may satisfy all or part of the debt. The borrower may realize gain or loss on the deemed sale. The amount realized on the deemed sale depends on whether the loan was recourse debt or nonrecourse debt. Debt cancellation. When property that secures a loan is foreclosed or repossessed, the borrower may also have ordinary income from cancellation of debt if all of the following are true: The loan balance is more than the fair market value of the foreclosed or repossessed property, and The lender cancels all or part of the remaining loan balance secured by the foreclosed or repossessed property, and The loan is a recourse loan. If the loan is a nonrecourse loan, there is no income from cancellation of debt. See Chapter 2, Cancelled Debt as Income, for an in-depth discussion of income from cancelled debt. An exception to this general rule applies for property disposed of in a short sale. See Short Sale vs. Foreclosure, page Chapter 3 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

48 Calculating Gain or Loss on Foreclosed or Repossessed Property Gain or loss from a foreclosure or repossession is calculated and reported in the same way as gain or loss from a sale of property. That is, the borrower must subtract the adjusted basis from the amount realized on the transfer of the property. The amount realized includes net foreclosure sale proceeds received by the borrower, if any. NOTES Gain or loss from a foreclosure or repossession is calculated and reported in the same way as gain or loss from a sale of property. Gain or loss realized by the borrower. Calculate gain or loss using the method for recourse debt or nonrecourse debt, as applicable. Note that the FMV of the property is disregarded in the case of nonrecourse debt. Property Secured By Recourse Debt The lesser of: The outstanding debt immediately before the transfer minus the recourse debt remaining immediately after the transfer, or FMV of the transferred property. plus Any net foreclosure sale proceeds received by the borrower. minus The borrower s adjusted basis. Property Secured By Nonrecourse Debt The outstanding debt immediately before the transfer. plus Any net foreclosure sale proceeds received by the borrower. minus The borrower s adjusted basis. Ordinary income in the case of recourse debt. The borrower s ordinary income from cancellation of recourse debt equals the outstanding debt immediately before the transfer minus the recourse debt remaining immediately after the transfer, minus the FMV of the transferred property. If the FMV of the property exceeds the debt balance, there is no cancellation of debt income. The basis of the property must be reduced by any exclusion of debt cancellation income. Thus in the case of recourse debt, the amount of debt cancellation excluded from income must be calculated before the realized gain or loss can be calculated. EXAMPLE #1 Tim bought his personal residence for $210,000. By 2015, the value of Tim s home dropped to $120,000, although he still owed $160,000 on his recourse mortgage loan. Tim was behind on his payments, so the lender foreclosed on the home and cancelled the debt on May 15, Tim s cancelled debt is qualified principal residence indebtedness and qualifies for exclusion from income under the Mortgage Forgiveness Debt Relief Act of Tim received Form 1099-C, shown on page 44, from his bank. Code D in box 6 of Form 1099-C indicates that the identifiable event that created the debt cancellation is a foreclosure election made by the lender. (The lender elects to cancel the debt rather than pursue collection.) Since the foreclosure occurred in the same year as the debt cancellation, the lender indicated the FMV of the property on Form 1099-C. Tim must determine whether he has debt cancellation income and calculate gain or loss realized on the foreclosure. continued on next page TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 3 43

49 NOTES Example #1 continued CORRECTED (if checked) CREDITOR'S name, street address, city or town, state or province, country, 1 Date of identifiable event OMB No ZIP or foreign postal code, and telephone no. May 15, 2015 Mortgage Lender 2 Amount of debt discharged Cancellation $ 40, of Debt 3 Interest if included in box 2 $ Form 1099-C CREDITOR'S federal identification number DEBTOR'S identification number 4 Debt description Copy B For Debtor DEBTOR'S name This is important tax Home mortgage loan information and is being Tim furnished to the Internal Revenue Service. If you are required to file a Street address (including apt. no.) 5 If checked, the debtor was personally liable for return, a negligence repayment of the debt X penalty or other sanction may be City or town, state or province, country, and ZIP or foreign postal code imposed on you if taxable income results from this transaction Account number (see instructions) 6 Identifiable event code 7 Fair market value of property and the IRS determines that it has not been D $ 120,000 reported. Form 1099-C (keep for your records) Department of the Treasury - Internal Revenue Service Cancellation of debt income: Debt owed (recourse)...$ 160,000 Recourse debt remaining after foreclosure... ($ 0) FMV of transferred property... ($ 120,000) Ordinary income from cancellation of debt (excluded)...$ 40,000 Gain or loss on foreclosure: Amount realized (cancelled debt up to the amount of FMV)...$ 120,000 Basis ($210,000 $40,000 cancellation of debt excluded)... ($ 170,000) Capital loss on foreclosure...($ 50,000) Tim realizes a nondeductible personal loss of $50,000. In order to exclude the $40,000 cancelled debt from income, he must complete Form 982 as explained in Learning Objective 3-A, page 37. EXAMPLE #2 Assume the same fact as Example #1, except that Tim s mortgage loan was nonrecourse. He received the same Form 1099-C from his bank as shown in Example #1, except that Box 5 is not checked. Since the loan is nonrecourse and the bank repossessed the home, Tim has no income from cancellation of debt. He calculates his realized gain or loss on the foreclosure as follows: Gain or loss on foreclosure: Amount realized (full debt cancelled)...$ 160,000 Basis... ($ 210,000) Capital loss on foreclosure...($ 50,000) In this case, Tim realized a nondeductible personal loss of $50,000. EXAMPLE #3 Assume the same fact as Example #1, except that Tim s cancellation of debt does not qualify for the exclusion of principal residence indebtedness. Tim received the same Form 1099-C from his bank as shown in Example #1. His calculations are as follows: continued on next page 44 Chapter 3 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

50 Example #3 continued Cancellation of debt income: Debt owed (recourse)...$ 160,000 Recourse debt remaining after foreclosure... ($ 0) FMV of transferred property... ($ 120,000) Ordinary income from cancellation of debt...$ 40,000 Gain or loss on foreclosure: Amount realized (cancelled debt up to the amount of FMV)... $120,000 Basis... ($ 210,000) Capital loss on foreclosure...($ 90,000) Unless another exclusion applies, Tim must report $40,000 income from cancellation of debt on line 21, Form He realizes a nondeductible personal loss of $90,000. NOTES Abandonment of Property That Secures a Debt Since the lender usually forecloses on abandoned property that secures a loan and repossesses it, the tax implications of abandonment are similar to those for foreclosure and repossession. The borrower may have cancellation of debt income from abandonment of the property securing the debt. The borrower generally does not have gain or loss on the abandonment of property securing a debt until the foreclosure is completed, which can happen in a tax year later than the abandonment year. Real Estate Short Sale and Deed in Lieu of Foreclosure A borrower who is in default on a mortgage may be able to avoid foreclosure proceedings by taking action before the foreclosure can happen. Avoiding foreclosure often saves time and expense for both the lender and the borrower. Short sale. A short sale of real estate occurs when the mortgage lender permits a borrower to sell his or her property for less that the outstanding mortgage and closing costs. The lender can forgive the unpaid loan amount or the lender can pursue a deficiency judgment to satisfy the full amount of the loan. Short sale agreements do not necessarily release the borrower from the obligation to pay any deficiencies. Short sales involve special tax considerations. See Short Sale vs. Foreclosure, page 46. Deed in lieu of foreclosure. A deed in lieu of foreclosure is a deed instrument given by a borrower to voluntarily convey property to a lender before foreclosure can be accomplished. Lenders are not obligated to accept deeds in lieu and may instead prefer to pursue foreclosure action. A deed in lieu of foreclosure not an abandonment but is treated as the exchange of property to satisfy all or part of a debt, receiving the same tax treatment as a foreclosure. Avoiding foreclosure often saves time and expense for both the lender and the borrower. Lenders are not obligated to accept deeds in lieu and may instead prefer to pursue foreclosure action. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 3 45

51 NOTES EXAMPLE #1 Steve owes $225,000 on his main home, which is only worth $175,000. His mortgage lender agrees to a short sale rather than enter into a lengthy foreclosure process. Steve sells his home for $175,000 and moves out. The lender forgives the $50,000 loan balance and sends Steve Form 1099-C in the amount of $50,000. EXAMPLE #2 Assume the same facts as Example #1, but Steve wants to transfer the deed to his home to the lender instead of going through foreclosure or selling the home himself. The lender determines that even though the home is worth less than the mortgage balance, Steve should be able to make the payments. The lender refuses the deed in lieu of foreclosure. Steve must either continue to make his mortgage payments or pursue some other option for ending his ownership. Deficiency. Some states have anti-deficiency laws that prohibit lenders from pursuing a deficiency judgment against the borrower after the lender has foreclosed on a principal residence or accepted a short sale or deed in lieu of foreclosure. Anti-deficiency laws generally do not apply to second mortgages or home equity loans. If an anti-deficiency law applies or if the lender cancels the unpaid mortgage amount instead of pursuing a deficiency judgment, the borrower can expect to receive Form 1099-C, Cancellation of Debt, indicating the unpaid amount of the mortgage. Short Sale vs. Foreclosure In a short sale, the borrower is the seller. If a property is sold in a foreclosure sale, the lender is the seller. In each case, the borrower may have income from cancellation of debt if the full amount of the mortgage is not satisfied in the short sale or foreclosure. In each case, the borrower must calculate realized gain or loss. KEY FACT Cancellation of debt income may result from a short sale even if a nonrecourse loan is involved. Recourse mortgage debt and short sales. When the mortgage deficiency involves recourse debt, the borrower has income from cancellation of debt whether the cancellation occurred in a short sale or in a foreclosure. Nonrecourse mortgage debt and short sales. In general, cancellation of nonrecourse debt does not result in debt cancellation income. However, if the lender agrees to cancel the amount of mortgage that will be unpaid as a result of the short sale, then the loan has been discounted while the borrower still owns the property. The borrower has income from cancellation of debt even if the loan was nonrecourse. See Discounts and Loan Modifications, Learning Objective 2-A, page Chapter 3 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

52 EXAMPLE #1 Martin owes $400,000 on his main home, which has a FMV of $350,000. His basis in the home is $200,000. His lender agrees to a short sale, leaving $50,000 of the mortgage unpaid. After the short sale is complete, the lender cancels the $50,000 mortgage deficiency and sends Martin Form 1099-C to report the debt cancellation. The tax effect on Martin is the same whether the loan was recourse or nonrecourse. In either case, the realized gain is not taxable if Martin meets the requirements for excluding gain on the sale of a principal residence. However, in each case Martin must include the cancellation of debt in his income unless an exclusion applies. Case 1. Martin s loan is a recourse loan. He computes cancellation of debt income and realized gain or loss as follows: Mortgage balance (recourse)... $ 400,000 FMV...($ 350,000) Cancellation of debt income...$ 50,000 Lesser of ($ 400,000 $ 50,000) and FMV... $ 350,000 Basis of home...($ 200,000) Realized gain... $ 150,000 Case 2. Martin s loan is a nonrecourse loan. He computes cancellation of debt income and realized gain or loss as follows: Mortgage balance (nonrecourse)... $ 400,000 Mortgage payoff using sale proceeds...($ 350,000) Cancellation of debt income...$ 50,000 Sales proceeds... $ 350,000 Basis of home...($ 200,000) Realized gain... $ 150,000 Since Martin was the seller, he retained the loan collateral (his home) at the time the lender agreed to accept the short sale proceeds in satisfaction of the full mortgage amount, prior to the actual short sale closing. That means that cancellation of the nonrecourse debt results in ordinary income for Martin. NOTES EXAMPLE #2 Assume the same facts as Example #1, except that Martin lets the home go into foreclosure instead of disposing of it in a short sale. Case 1. Martin s loan is a recourse loan. The tax consequences are the same as those for a recourse loan in Example #1. Case 2. Martin s loan is a nonrecourse loan. Martin does not have income from cancellation of debt as a result of the foreclosure. He computes his realized gain or loss as follows: Mortgage balance (nonrecourse)... $ 400,000 Basis of home...($ 200,000) Realized gain... $ 200,000 The realized gain is not taxable if Martin meets the requirements for excluding gain on the sale of a principal residence. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 3 47

53 NOTES Learning Objective 3-B Self-Quiz For answer, see Chapter 3 Self-Quiz Answers, page 55. Test your knowledge and comprehension of information presented in Learning Objective 3-B. 2) The outstanding mortgage balance on Danielle s principal residence was $250,000 when she refinanced for $300,000. She used the extra $50,000 to buy a car and pay off credit card debt. Her basis in the home is $260,000 and the new mortgage was a recourse loan. She stopped making payments when she still owed $295,000. The lender foreclosed, sold the house for $235,000, and sent Danielle Form 1099-C showing cancelled debt of $60,000. All of the following statements are true except: a) Since $50,000 of Danielle s debt was not used to buy her home, only $10,000 of her cancelled debt qualifies for exclusion as qualified principal residence indebtedness. b) Danielle realized a loss of $25,000 on the foreclosure. c) Since Danielle has refinanced her original mortgage, none of her loan is qualified principal residence indebtedness under the terms of the Mortgage Forgiveness Debt Relief Act of d) If Danielle s refinanced loan had been a nonrecourse loan, her realized gain would have been $35,000. Learning Objective 3-C Identify the tax effect on the seller or lender when property that is collateral for a loan is abandoned, foreclosed, or repossessed. Information Return Filing Requirements Form 1099-A filing requirements. A taxpayer who lends money in connection with a trade or business must file Form 1099-A, Acquisition or Abandonment of Secured Property, when: The taxpayer acquires in interest in property in full or partial satisfaction of the debt secured by the property, or The taxpayer has reason to know that the property has been abandoned, based on all the facts and circumstances concerning the status of the property. A copy of Form 1099-A or an equivalent statement must be provided to the borrower. Property. For purposes of the Form 1099-A filing requirement, property means any real property, any intangible property, and any tangible personal property except: No reporting is required for tangible personal property held by the borrower only for personal use. No reporting is required if the property securing the loan is located outside the United States and the borrower is an exempt foreign person. 48 Chapter 3 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

54 KEY FACT The taxpayer need not be in the business of lending money to be subject to the 1099-A filing requirement. NOTES EXAMPLE #1 Jerry operates a landscaping business. He sold one of his tractors to Tom for use in Tom s lawn care business. Tom couldn t pay for the tractor in full so Jerry accepted an installment agreement. Tom stopped making payments so Jerry repossessed the tractor. Jerry must file Form 1099-A to report the repossession. EXAMPLE #2 Assume the same facts as Example #1, except that Tom uses the tractor solely for maintaining the land around his vacation home. Jerry is not required to file Form 1099-A when he repossesses the tractor. Form 1099-C filing requirements. Financial institutions, credit unions, certain Federal corporations and agencies, or any organization in the trade or business of lending money must file Form 1099-A, Cancellation of Debt, when: The lender cancels or forgives a debt of $600 or more, or An identifiable event occurs for which the IRS requires the debt to be treated as cancelled. See Learning Objective 1-B, page 4, for more information about identifiable events that trigger the 1099-C filing requirement. Debt. Debt is any amount owed to the lender, including stated principal, stated interest, fees, penalties, administrative costs, and fines. The amount of debt cancelled may be all or only part of the total amount owed. The amount required to be reported on Form 1099-C generally includes only the principal. Exceptions to Form 1099-C filing requirements. Filing of Form 1099-C is not always required. Some examples include: Certain bankruptcies. Do not file Form 1099-C for debt discharged in a bankruptcy unless the lender knows that the debt was incurred for business or investment purposes (but not for providing services as an employee). Otherwise, file Form 1099-C in the year the amount discharged can first be determined, or in the year the debt was discharged in bankruptcy, whichever is later. Release of a debtor. Do not file Form 1099-C if one debtor is released from a debt but other debtors are liable for the full unpaid amount. Guarantor or surety. Do not file Form 1099-C for a guarantor or surety. Guarantor or surety refers to a person or entity that agrees to be responsible for the debt of another. A guarantor is not a debtor for purposes of filing Form 1099-C, even if demand for payment is made to the guarantor. Seller financing. Organizations whose principal trade or business is the sale of nonfinancial goods or services often extend credit to customers in connection with those nonfinancial goods or services. Such organizations are not considered to be in the trade or business of lending money with respect to the credit extended, and need not file Form 1099-C to report discharge of client indebtedness. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 3 49

55 NOTES EXAMPLE #3 Assume the same facts as Example #1, page 49. Although Jerry must File Form 1099-A to report the repossession of the tractor, he is not required to file Form 1099 C in connection with the cancellation of Tom s debt. Jerry meets the seller financing exception to the Form 1099-C filing requirement. KEY FACT When debt is cancelled in the same year as foreclosure or abandonment of the property that secures the debt and the lender or creditor would otherwise be required to file both Forms 1099-A and 1099-C, then all of the necessary information can be included on Form 1099-C. See Learning Objective 1-B, page 4, for more information on information that must be included on Form 1099-C to meet the 1099-A filing requirement. Repossession Repossession of property that was collateral for a loan occurs when the seller reacquires or takes possession of the property in full or partial satisfaction of the loan. Repossession is accomplished through foreclosure or by voluntary surrender of the property by the seller. Repurchase by the seller of the property from the buyer is not repossession. The seller s tax consequences depend on the type of property repossessed. The repossession rules apply even if the buyer never took title to the property. KEY FACT A seller who repossesses property that secured a loan must calculate: Gain or loss realized as a result of the repossession. The character of that gain or loss (ordinary or capital). The basis in the repossessed property. Gain or loss from a repossession is reported on the same form (Schedule D or Form 4797) used by the seller to report the original sale. Character of seller s gain or loss on a repossession. The character of the gain or loss realized by the seller depends on whether the installment method was used to report the original sale. Installment method used. The gain or loss has the same character (ordinary or capital) as the gain or loss on the original sale. Installment method not used. Since the full amount of the gain was reported in the year of sale, any gain on the repossession is ordinary gain and any loss is a bad debt. Reporting of the bad debt by the seller depends on whether the repossessed property was the seller s business or nonbusiness property at the time of the original sale. Seller s total basis in the installment obligation. The seller s total basis in the installment obligation depends on whether the installment method was used by the seller to report the original sale of the personal property. 50 Chapter 3 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

56 Installment method used. Multiply the unpaid balance by the gross profit percentage from the original sale and subtract that amount from the unpaid balance. The result is the seller s total basis in the installment obligation. Installment method not used. The basis in the installment obligation is the unpaid principal balance of the debt. NOTES Repossession of Personal Property Effect on the Seller Seller s gain or loss. The seller s realized gain or loss on the repossession of personal property equals: FMV of the repossessed property, minus Total basis in the installment obligation, minus Repossession costs, plus FMV of anything received from the buyer in addition to the repossessed property. Seller s basis in repossessed personal property. If a seller repossesses personal property that secures a loan made by the seller, then the seller s basis in the repossessed property is the FMV of the property at the time of repossession. EXAMPLE Hans sold equipment to Lars for $10,000 on an installment agreement with the equipment as collateral. Hans gross profit percentage was 20% and his gain is ordinary (reported on Form 4797). Lars stopped making payments when the principal balance was $6,000, so Hans repossessed the equipment. At the time of the repossession, the equipment was worth only $5,000, so Lars also gave Hans a trailer worth $500 in partial satisfaction of the amount he still owed. Case 1: Hans reported the original sale using the installment method. He calculates his realized gain as follows: $ 5,000 FMV of equipment at repossession ($ 4,800) Basis in installment obligation [$6,000 (20% $6,000)] $ 500 Value of trailer $ 300 Gain on repossession Hans realizes an ordinary gain of $300 on the repossession. Hans reports the repossession on Form 4797, Sale of Business Property. Case 2: Hans did not use the installment method but instead reported his entire profit of $2,000 at the time of the original sale. He calculates his realized loss as follows: $ 5,000 FMV of equipment at repossession ($ 6,000) Basis in installment obligation (unpaid debt) $ 500 Value of trailer ($ 500) Loss on repossession Hans realizes a bad debt of $500 on the repossession. He reports the bad debt as a business bad debt or nonbusiness bad debt, depending on his use of the property at the time he sold it to Lars. Note that the $800 difference between the two cases is the gross profit percentage applied to the total principal payments before the repossession, or 20% $4,000. Hans basis in the repossessed equipment and the trailer is the FMV of each. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 3 51

57 NOTES The seller s basis in the property is determined as of the date of repossession. Repossession of Real Property Effect on the Seller The rules concerning basis and calculation of gain or loss on repossessed real property apply whether or not the installment method was used to report the sale. The rules are mandatory if all three of the following conditions are met: 1) The real property is repossessed in order to protect the seller s rights to the property, and 2) The installment obligation (if any) satisfied by the repossession must have been received in the original sale of the real property, and 3) No additional consideration (such as money, property, or debt assumption) can be paid to the borrower in order to repossess the real property unless one of the following conditions applies: The additional consideration was part of the original sales contract, or The buyer has defaulted on the loan, or default is imminent. If any of the above conditions are not met, then the rules for repossession of personal property must be used instead of the rules for repossession of real property. Seller s gain or loss. The FMV of repossessed real property is not a consideration in figuring the seller s gain or loss on the repossession. The seller s gain or loss on the repossession of real property equals: Total payments or consideration received on the sale, minus Total gain already reported as income. Taxable gain is limited to gross profit on the original sale, less repossession costs and any previously reported gain. This has the effect of treating all payments received as income, but limits total taxable gain to the gross profit expected on the original sale. Seller s basis in repossessed real property. The seller s basis in the property is determined as of the date of repossession and equals: Seller s adjusted basis in the installment obligation, plus Seller s repossession costs, plus Seller s taxable gain on the repossession. EXAMPLE In 2013, Dick sold a parcel of land to Bruce for $25,000. Bruce paid $5,000 down and agreed to pay $4,000 annually plus interest, beginning on January 1, Dick s adjusted basis in the property was $20,000, and he used the installment method to report the sale on his 2013 tax return. Dick s gross profit is $5,000. Assuming the contract price equals the selling price, Dick s gross profit percentage is 20% (= $5,000 $25,000). Dick reported the following gains on his tax returns: 2013 $ 1,000 (= 20% $ 5,000 down payment) 2014 $ 800 (= 20% $ 4,000 annual principal payment) $ 1,800 Total taxable gain reported In 2015, Bruce defaulted and Dick repossessed the property, after paying $500 in legal fees to get the property back. continued on next page 52 Chapter 3 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

58 Example continued Dick calculates his gain on the repossession as follows: $ 9,000 Total payments received before repossession ($ 1,800) Total gain already reported as income $ 7,200 Gain on repossession before limitation However, Dick s taxable gain is limited as follows: $ 5,000 Gross profit on original sale ($ 500) Repossession costs ($ 1,800) Previously reported gain $ 2,700 Limit on taxable gain. Dick s taxable gain is $2,700. Dick reports this gain on his 2015 tax return as the same type of gain he reported for the 2013 sale of the property. The remaining part of the realized gain becomes part of his basis in the repossessed land as follows: $ 16,000 Unpaid balance of the installment obligation 20% Gross profit percentage for the installment sale $ 3,200 Unrealized profit on installment sale $ 12,800 Basis in installment obligation (= $ 16,000 $ 3,200) $ 2,700 Taxable gain on the repossession $ 500 Repossession costs $ 16,000 Basis in the repossessed real property. Note that Dick s basis is reduced by $4,000, which is the difference between the realized gain and the taxable gain on the repossession of the property, plus the repossession costs. Seller s holding period. The seller s holding period for repossessed real property includes the period the seller owned the property prior to the original sale, plus the period after repossession, but not the period when the buyer held the property. The seller s holding period for any improvements made by the buyer begins on the day after the date of repossession. NOTES The seller s holding period for any improvements made by the buyer begins on the day after the date of repossession. Reacquisition of a Former Principal Residence The seller follows the usual rules explained above for repossession of real property if either of the following is true: The resale takes place more than one year after the repossession. The seller was ineligible to exclude any gain on the original sale under IRC section 121 for sale of principal a residence. One-year rule. If seller was eligible to exclude gain under the rules for sale of principal residence and the repossessed property is resold within one year of the date of repossession, the resale is treated as part of the original sale and as having occurred on the date of the original residence sale. Redetermination of gain required. Details of this calculation are given in Regulation section Essentially, the basis of the principal residence must be adjusted to account for any changes in basis resulting from the repossession, and the gain realized must be adjusted for any gain or loss realized on the repossession. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 3 53

59 NOTES Learning Objective 3-C Self-Quiz For answer, see Chapter 3 Self-Quiz Answers, page 55. Test your knowledge and comprehension of information presented in Learning Objective 3-C. 3) James bought a commercial van for use in his business from Sheila. The contract price was $24,000. James gave Sheila $6,000 as a down payment and agreed to pay off the balance according to a fixed amortization schedule, including interest, with the van as collateral for the loan. Sheila s adjusted basis in the van at the time of the sale was $20,000. When the loan balance was $16,000, James stopped making payments and Sheila repossessed the van. The van had been damaged and was worth only $8,000 at the time of repossession. What are Sheila s tax consequences from the repossession? a) Sheila s loss on the repossession is $4,800 and her basis in the van after repossession remains at $20,000. b) Sheila s loss on the repossession is $8,000 and her basis in the repossessed van is $16,000. c) Sheila s loss on the repossession is limited to the amount of principal payments she received and her basis in the repossessed van is $8,000. d) It is not possible to determine Sheila s tax consequences without knowing how she reported the sale of the van on her tax return. 54 Chapter 3 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

60 Chapter 3 Self-Quiz Answers NOTES 1) Liz and Larry bought a mansion for $3,000,000 that they used as their principal residence. Eventually, they could no longer afford the mortgage payments and decided to let the house go into foreclosure. When the foreclosure was completed, they still owed $2,500,000 on the original mortgage. They receive Form 1099-C, Cancellation of Debt, with $250,000 in box 2 (amount of debt cancelled). All of the following statements are true except: a) If the mortgage loan is nonrecourse, Liz and Larry may exclude up to $2,000,000 of the cancelled debt from income. Correct. Forgiveness of nonrecourse debt does not result in income from cancellation of debt. Since there is no income, there is no exclusion. b) Liz and Larry can exclude no more $2,000,000 of cancelled recourse mortgage debt from the income. Incorrect. The Mortgage Forgiveness Debt Relief Act of 2007 allows for an exclusion from income of up to $2,000,000 ($1,000,000 for married filing separately) of qualified principal residence indebtedness. c) If Liz and Larry s mortgage is cancelled in a Title 11 bankruptcy case, they may not use the qualified principal residence indebtedness exclusion to exclude any of the $2,500,000 from their income. Incorrect. If qualified principal residence indebtedness is cancelled in a Title 11 bankruptcy case, taxpayers must first apply the bankruptcy exclusion rather than the qualified principal residence indebtedness exclusion. d) Even though Liz and Larry s original mortgage was used solely to buy their home, only part of the amount outstanding at the time of the foreclosure is qualified principal residence indebtedness. Incorrect. The amount of qualified principal residence indebtedness is limited to $1,000,000 for married individuals filing separately, and to $2,000,000 for all others. Liz and Larry owed $2,500,000. 2) The outstanding mortgage balance on Danielle s principal residence was $250,000 when she refinanced for $300,000. She used the extra $50,000 to buy a car and pay off credit card debt. Her basis in the home is $260,000 and the new mortgage was a recourse loan. She stopped making payments when she still owed $295,000. The lender foreclosed, sold the house for $235,000, and sent Danielle Form 1099-C showing cancelled debt of $60,000. All of the following statements are true except: a) Since $50,000 of Danielle s debt was not used to buy her home, only $10,000 of her cancelled debt qualifies for exclusion as qualified principal residence indebtedness. Incorrect. To determine how much of Danielle s cancelled debt is excludable under the qualified principal residence indebtedness exclusion, subtract the amount of nonqualified debt from the total cancelled debt: $60,000 $50,000 = $10,000. This is the amount eligible to be treated as qualified principal residence indebtedness. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 3 55

61 NOTES b) Danielle realized a loss of $25,000 on the foreclosure. Incorrect. The foreclosure sales price was less than the amount Danielle owed on her recourse loan. Danielle s loss on the foreclosure is computed as follows: $235,000 (foreclosure price) $260,000 (basis) = $25,000. c) Since Danielle has refinanced her original mortgage, none of her loan is qualified principal residence indebtedness under the terms of the Mortgage Forgiveness Debt Relief Act of Correct. Under the terms of the Act, qualified principal residence indebtedness also includes a mortgage used to refinance such a debt and secured by the home, but only to the amount of the old principal just before refinancing. d) If Danielle s refinanced loan had been a nonrecourse loan, her realized gain would have been $35,000. Incorrect. The gain on foreclosure of a nonrecourse loan is computed as follows: $295,000 (outstanding amount of loan) $260,000 (basis) = $35,000. 3) James bought a commercial van for use in his business from Sheila. The contract price was $24,000. James gave Sheila $6,000 as a down payment and agreed to pay off the balance according to a fixed amortization schedule, including interest, with the van as collateral for the loan. Sheila s adjusted basis in the van at the time of the sale was $20,000. When the loan balance was $16,000, James stopped making payments and Sheila repossessed the van. The van had been damaged and was worth only $8,000 at the time of repossession. What are Sheila s tax consequences from the repossession? a) Sheila s loss on the repossession is $4,800 and her basis in the van after repossession remains at $20,000. Incorrect. If Sheila had used the installment method to report her original sale, then her gross profit percentage would have been 20%. Her basis in the installment obligation would be $12,800 = $16,000 (20% $16,000). Then she would realize a loss of $4,800 = $8,000 (FMV at repossession) minus $12,800 (basis in the installment obligation). Her basis in the repossessed van is its FMV at the time of repossession, or $8,000. b) Sheila s loss on the repossession is $8,000 and her basis in the repossessed van is $16,000. Incorrect. If Sheila had not used the installment method to report her original sale, then her basis in the installment obligation is $16,000. She would realize a loss of $8,888 = $8,000 (FMV at repossession) minus $16,000 (basis in the installment obligation). Her basis in the repossessed van is its FMV at the time of repossession, or $8, Chapter 3 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

62 c) Sheila s loss on the repossession is limited to the amount of principal payments she received and her basis in the repossessed van is $8,000. Incorrect. Sheila s loss is determined by subtracting her basis in the installment obligation from the FMV value at the time of the repossession. Her basis in the repossessed van is its FMV at the time of repossession, or $8,000. NOTES d) It is not possible to determine Sheila s tax consequences without knowing how she reported the sale of the van on her tax return. Correct. The calculation of Sheila s gain or loss on the repossession depends on whether she reported the sale of the van using the installment method. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 3 57

63 58 Chapter 3 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

64 4 Form 982 Learning Objectives Successful completion of this course will enable the participant to: 4-A Identify required tax attribute reductions resulting from exclusions of debt cancellation income. 4-B Determine the extent to which a taxpayer is insolvent. 4-C Properly report exclusion of debt cancellation income and reduction of tax attributes on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustments). Glossary Terms Discharge of indebtedness. The term discharge of indebtedness conveys forgiveness of, or the release from, an obligation to pay. Discharge of indebtedness is synonymous with cancellation of debt or debt cancellation. Insolvent. A taxpayer is insolvent at a particular moment in time if the sum of the taxpayer s debts exceeds the FMV of all of the taxpayer s assets at that moment. The extent of insolvency is the amount by which liabilities exceed FMV of assets. Tax attribute. A tax attribute is any of seven specified credits, losses, and basis items that must be reduced when cancelled debt is excluded from gross income. Title 11 case. Title 11 of the United States Code relates to bankruptcy. A Title 11 bankruptcy case is a case under Title 11 of the United States Code (including chapters 7, 11, and 13 of Title 11), but only if the taxpayer is under the court s jurisdiction in the case and the discharge of indebtedness is granted by the court or is under a plan approved by the court. CPE/CE Discharge of indebtedness is synonymous with cancellation of debt or debt cancellation. Learning Objective 4-A Identify required tax attribute reductions resulting from exclusions of debt cancellation income. KEY FACT A taxpayer who excludes cancelled debt from income must reduce certain tax attributes (but not below zero) by the amount excluded. Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustments), is used to report both the exclusion and the corresponding tax attribute reductions. Completion of Form 982 is discussed in Learning Objective 4-C, page 70. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 4 59

65 NOTES Form 982 (Rev. July 2013) Department of the Treasury Internal Revenue Service Name shown on return Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) OMB No Attach this form to your income tax return. Attachment Information about Form 982 and its instructions is at Sequence No. 94 Identifying number Part I General Information (see instructions) 1 Amount excluded is due to (check applicable box(es)): a Discharge of indebtedness in a title 11 case b Discharge of indebtedness to the extent insolvent (not in a title 11 case) c Discharge of qualified farm indebtedness d Discharge of qualified real property business indebtedness e Discharge of qualified principal residence indebtedness Total amount of discharged indebtedness excluded from gross income Do you elect to treat all real property described in section 1221(a)(1), relating to property held for sale to customers in the ordinary course of a trade or business, as if it were depreciable property? Yes No Part II Reduction of Tax Attributes. You must attach a description of any transactions resulting in the reduction in basis under section See Regulations section for basis reduction ordering rules, and, if applicable, required partnership consent statements. (For additional information, see the instructions for Part II.) Enter amount excluded from gross income: 4 For a discharge of qualified real property business indebtedness applied to reduce the basis of depreciable real property That you elect under section 108(b)(5) to apply first to reduce the basis (under section 1017) of depreciable property Applied to reduce any net operating loss that occurred in the tax year of the discharge or carried over to the tax year of the discharge Applied to reduce any general business credit carryover to or from the tax year of the discharge. 7 8 Applied to reduce any minimum tax credit as of the beginning of the tax year immediately after the tax year of the discharge Applied to reduce any net capital loss for the tax year of the discharge, including any capital loss carryovers to the tax year of the discharge a Applied to reduce the basis of nondepreciable and depreciable property if not reduced on line 5. DO NOT use in the case of discharge of qualified farm indebtedness a b Applied to reduce the basis of your principal residence. Enter amount here ONLY if line 1e is checked b 11 For a discharge of qualified farm indebtedness applied to reduce the basis of: a Depreciable property used or held for use in a trade or business or for the production of income if not reduced on line a b Land used or held for use in a trade or business of farming b c Other property used or held for use in a trade or business or for the production of income... 11c 12 Applied to reduce any passive activity loss and credit carryovers from the tax year of the discharge Applied to reduce any foreign tax credit carryover to or from the tax year of the discharge Part III Consent of Corporation to Adjustment of Basis of Its Property Under Section 1082(a)(2) Under section 1081(b), the corporation named above has excluded $ from its gross income for the tax year beginning and ending. Under that section, the corporation consents to have the basis of its property adjusted in accordance with the regulations prescribed under section 1082(a)(2) in effect at the time of filing its income tax return for that year. The corporation is organized under the laws of. (State of incorporation) Note. You must attach a description of the transactions resulting in the nonrecognition of gain under section For Paperwork Reduction Act Notice, see page 5 of this form. Cat. No E Form 982 (Rev ) Reduction of tax attributes has the effect of postponing the tax liability on cancellation of debt income by decreasing dollar-for-dollar the items that would otherwise be available to offset future income. Tax Attributes Reduction of tax attributes has the effect of postponing the tax liability on cancellation of debt income by decreasing dollar-for-dollar the items that would otherwise be available to offset future income. Reductions of credit carryovers that would otherwise offset future taxes are 33.3 per dollar of excluded debt. Ordering rules. IRC section 108 specifies seven tax attributes, subject to specific ordering rules. Tax attributes are reduced after the tax for the taxable year of debt discharge has been determined. 60 Chapter 4 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

66 When cancelled business debt or certain personal debt is excluded, reductions are applied in the following order unless an election is made to apply the basis reduction first. 1) Net operating loss (NOL). The dollar-for-dollar reduction applies to any net operating loss for the taxable year of the discharge, and to any net operating loss carryover to the taxable year of discharge. The reduction is made after the carryover NOLs are considered in determining the tax liability and NOL in the discharge year. Any remaining reduction amount is applied to the carryover years in the order the NOL amounts arose. EXAMPLE In 2014, Aaron is eligible to exclude $30,000 of cancelled debt from his income. Without considering the cancelled debt, Aaron had a 2014 NOL of $100,000. His taxable income was $25,000 for both 2012 and If Aaron does not make the election to first reduce basis, then the amount of NOL available for carryforward to 2015 is calculated as follows: $100, NOL ($25,000) Carried back to 2012 ($25,000) Carried back to 2013 $50,000 Remaining NOL available after carryback ($30,000) Tax attribute reduction $20,000 NOL carryforward to 2015 Aaron must attach Form 982 to his 2014 tax return, as well as a statement detailing his NOL carryover calculations. He has accounted for all of his excluded income from debt cancellation. 2) General business credit. Form 3800, General Business Credit, is used to aggregate the various business credits and determine amounts available for current and carryover years. Any carryover of a general business credit to or from the taxable year of a discharge must be reduced 33.3 per dollar of excluded debt. The reduction is made after any credit being carried to the current year has been considered, and then in the order in which the credits apply to the current year. NOTES Form 3800, General Business Credit, is used to aggregate the various business credits and determine amounts available for current and carryover years. EXAMPLE In 2015, Briana is eligible to exclude $9,000 of cancelled debt from her income. She has a $5,000 general business credit carryforward from a prior year and a current year general business credit of $2,000. She has no other tax attributes. Taking into account the order in which the credits were generated, Briana determines that she is able to utilize the full carryforward amount. She calculates the general business credit available for 2015 as follows: $5,000 General business credit carried to 2015 $2,000 New general business credit generated in 2015 ($3,000) Tax attribute reduction (33.3 per dollar of excluded debt) $4,000 Net general business credit available for 2015 continued on next page TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 4 61

67 NOTES Under the alternative minimum tax rules, the potential exists for income from deferral items to be taxed twice: first under AMT, and then in a later year under regular tax. Example continued Briana must attach Forms 982 and 3800 to her 2015 tax return, as well as a statement detailing his general business credit calculations. Since credits are used in a first-in, first-out basis, and in the order listed on Form 3800, Briana should keep a separate record for each credit to ensure proper accounting of the credits. She has accounted for all of her excluded income from debt cancellation. 3) Minimum tax credits. Under the alternative minimum tax rules, the potential exists for income from deferral items to be taxed twice: first under AMT, and then in a later year under regular tax. A credit against regular tax for prior year AMT addresses this problem. Form 8801, Credit for Prior Year Minimum Tax Individuals, Estates, and Trusts, is used to determine the amount of current year credit and the amount to be carried forward, if any. Any carryforward of credit for prior year AMT to the taxable year of debt discharge must be reduced 33.3 per dollar of excluded debt. 4) Capital loss carryovers. The dollar-for-dollar reduction applies to any capital loss for the taxable year of the discharge, and to any capital loss carryover to the taxable year of discharge. The reduction is made after using any carryover loss from prior years to determine the net capital loss carryover in the discharge year. If any capital loss remains that would become a carryover to the following year, then that amount must be reduced. EXAMPLE In 2014, Debra is eligible to exclude $21,000 of cancelled debt from her income. Her current year net capital losses are $14,000, and she has a capital loss carryforward of $15,000. She has no other tax attributes. Debra calculates her capital loss carryforward to 2015 as follows: $14, capital loss $15,000 Capital loss carried forward from prior years. ($3,000) Report on 2014 Schedule D, line 13. $26,000 Tentative capital loss available to carry forward to ($21,000) Tax attribute reduction. $5,000 Net capital loss carried forward to Debra must attach Form 982 and Schedule D, Capital Gains and Losses, to her 2014 tax return. She should also include a statement detailing the reduction in her capital loss carryforward amount. 5) Basis of property. The adjusted basis of property is reduced dollar-for-dollar to the extent of cancelled debt income (but not below zero). The adjustment applies to property held on the first day of the tax year following the year of debt cancellation, and must be done in the following order: a) Real property used in a trade or business or held for investment (other than real property held as inventory), that secured the cancelled debt. Note: An election is available on line 3, Form 982, to treat real property held as inventory as if it were depreciable real property. 62 Chapter 4 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

68 b) Personal property used in a trade or business or held for investment (other than inventory, accounts receivable, and notes receivable), that secured the cancelled debt. c) Remaining property used in a trade or business or held for investment (other than real or personal property held as inventory, accounts receivable, and notes receivable). d) Inventory, accounts receivable, notes receivable, and real property held as inventory. e) Property not used in a trade or business or held for investment. Note: This category includes the personal-use portion of the taxpayer s principal residence. Any business-use portion of the principal residence is already included in category (a) on page 62. Proportional reduction. In addition to reducing basis in the order listed above, the reduction must be further allocated within each category in proportion to the adjusted basis of the separate assets in that category. Prior tax attribute reduction. The amount of excluded debt cancellation income applied to reduce basis does not include any debt cancellation income applied to reduce NOLs, general business credits, credit for prior year minimum tax, or capital loss carryovers in the same taxable year. However, an election is available to apply the tax attribute reduction rules to the basis of property before reducing other tax attributes. Insolvency limitation on basis reduction. If the election to reduce basis before other tax attributes is not made, then the amount by which basis is reduced cannot exceed the extent to which the taxpayer is insolvent. See Learning Objective 4-B, page 65, for information on determining insolvency. Multiple cancelled debts. If a taxpayer excludes cancelled debt income attributable to more than one discharged indebtedness in the same tax year, basis reduction must be applied in proportion to the amount of debt cancellation income attributable to each instance of cancellation. EXAMPLE Erik qualifies to exclude two cancelled debts from his income: $2,000 attributable to business property that secures the debt, and $8,000 attributable to unsecured indebtedness relating to personal-use property. His adjusted basis in the business property is $1,800 and his basis in the other property is $3,600. Erik does not make the election to reduce basis first. After applying the tax attribute reduction ordering rules and reducing his other tax attributes, Erik is left with $6,000 remaining to be applied to basis reductions. He must allocate the remaining $6,000 to secured and unsecured indebtedness as follows: Secured debt...$1,200 = $6,000 ($2,000 $10,000) Unsecured debt...$4,800 = $6,000 ($8,000 $10,000) Erik must reduce the adjusted basis of the property that secured the debt to $600 (= $1,800 $1,200). If more than one item of property is involved, Erik must further allocate the $600 total remaining basis in proportion to the adjusted basis in the properties before the reduction. His basis in the other property is reduced to zero. Erik must attach Form 982 to his tax return, along with a statement detailing how the basis reductions were calculated. NOTES TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 4 63

69 NOTES Attach Form 982 and a statement to the tax return explaining how the foreign tax credit and any carryovers were reduced. 6) Passive activity loss and credit carryovers. Passive activity loss and credit carryovers from the debt cancellation year are reduced to the extent of excluded cancelled debt as follows: Reduce passive activity loss carryovers dollar-for-dollar. Reduce passive activity credit carryovers 33.3 per dollar of excluded debt. Attach Form 982 and a statement to the tax return explaining how the loss carryovers and credit carryovers were reduced. 7) Foreign tax credit. Credits to or from the debt cancellation are reduced 33.3 per dollar of excluded debt as follows: First reduce foreign tax credits being carried to the debt cancellation year in the order in which they are taken into account for that year. Reduce any remaining carryforward of foreign tax. Attach Form 982 and a statement to the tax return explaining how the foreign tax credit and any carryovers were reduced. Election to Reduce Basis First The taxpayer can elect to reduce the basis of depreciable property before reducing other tax attributes, but only if cancelled debt being excluded from income includes: Discharge of indebtedness in a Title 11 case, or Discharge of indebtedness to the extent insolvent (not in a Title 11 case), or Discharge of qualified farm indebtedness. The election applies to depreciable property that is held on the first day of the tax year following the year of debt, and can be used to reduce the basis of this property by all or part of the cancelled debt. Ordering rule. When the election is made to reduce the basis of depreciable property before reducing other tax attributes, the reduction must be applied in the following order: 1) Depreciable real property that secured the cancelled debt and that is used in a trade or business or held for investment. 2) Depreciable personal property that secured the cancelled debt and that is used in a trade or business or held for investment. 3) Other depreciable property used in a trade or business or held for investment. 4) Real property held primarily for sale to customers (inventory), if the taxpayer elects on Form 982 to treat it as if it were depreciable real property. Limitation. Basis reduction is limited to the total adjusted bases of all the taxpayer s depreciable property. For purposes of this election, depreciable property means any property subject to depreciation or amortization, but only if the reduction will reduce depreciation or amortization allowed or allowable for the period immediately following the basis reduction. Cancelled debt in excess of basis. If the amount of cancelled debt excluded from income exceeds the total bases in depreciable property, then the excess must be used to reduce the other tax attributes in the prescribed order, including reduction of any remaining adjusted basis of property after the election to reduce basis first has been applied. Making the election. The election to reduce basis of depreciable property before reducing other tax attributes is made by completing line 5 of Form 982, 64 Chapter 4 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

70 Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment). The election can only be revoked with IRS consent. See Learning Object 4-C, page 70, for detailed information about completing Form 982. NOTES Learning Objective 4-A Self-Quiz For answer, see Self-Quiz Answers, page 75. Test your knowledge and comprehension of information presented in Learning Objective 4-A. 1) In 2014, Tom s lender agrees to cancel $13,000 of the amount he owes on an unsecured business line of credit used in his sole proprietorship. He qualifies to exclude the entire amount of cancelled debt from income. Tom has a $5,000 general business credit carryforward to He has a 2014 net operating loss of $10,000, and his adjusted basis in depreciable business property is $7,000. Immediately before the cancellation, he was insolvent to the extent of $3,000. How can Tom reduce his tax attributes? a) Tom can reduce the basis in his depreciable property to zero, and then reduce his NOL carryforward to $4,000. He is not required to reduce his general business credit carryforward. b) Tom decides not to make the election to reduce basis first. Tom first reduces his general business credit carryforward by $4,000. He uses the remaining $9,000 of excluded debt to reduce his NOL 33.3 on the dollar to $7,000. c) Tom makes the election to reduce part of the basis of his depreciable property first. He applies $1,000 to basis reduction and allocates the remaining $12,000 of debt cancellation proportionally to the NOL and general business credit. d) Tom decides not to make the election to reduce basis first. He first reduces his NOL to $0, and uses the remaining $3,000 to reduce his general business credit carryover to $2,000. Learning Objective 4-B Determine the extent to which a taxpayer is insolvent. Insolvency and Cancelled Debt Cancelled debt can be excluded from income to the extent the taxpayer was insolvent immediately before the cancellation. The exclusion does not apply to: A cancellation of debt that occurs in a Title 11 bankruptcy case. Cancelled qualified principal residence indebtedness, unless the taxpayer elects to use the insolvency exclusion instead of the qualified principal residence exclusion. Cancelled debt can be excluded from income to the extent the taxpayer was insolvent immediately before the cancellation. KEY FACT A taxpayer is insolvent immediately before the cancellation of debt to the extent that the total of all of the taxpayer s liabilities exceeded the total FMV of all of the taxpayer s assets immediately before the cancellation. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 4 65

71 NOTES Liabilities. For purposes of determining the insolvency exclusion, liabilities include: The entire amount of the taxpayer s recourse debts, and The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt, and The amount of nonrecourse debt in excess of the FMV of the property that secures the nonrecourse debt, to the extent that debt is forgiven. Assets. For purposes of determining the insolvency exclusion, assets include the fair market value of everything the taxpayer owns, including: Assets that are collateral for debt, and Exempt assets that are beyond the reach of creditors under the law, such as an interest in a pension plan and the value of a retirement account. EXAMPLE Teri s car is collateral for her nonrecourse car loan. The car s FMV is $8,000 but Teri still owes $11,000 on the loan. When she fails to make payments, the car is repossessed. The lender cancels only $10,000 of the total loan. Teri s liabilities include $2,000 of the car loan ($10,000 $8,000). The remaining $1,000 of the nonrecourse debt is not included in her liabilities for purposes of determining insolvency. KEY FACT The extent of insolvency must be calculated separately for each date of debt cancellation. Multiple debts cancelled on the same date can be combined on a single worksheet for this calculation. Insolvency Worksheet Complete a separate worksheet for each date of debt cancellation. Do not include the same liability or asset in more than one category. The worksheet does not need to be attached to the tax return, but should be kept with the taxpayer s records for the year. INSOLVENCY WORKSHEET Date Debt Was Cancelled (month, day, year) Part I. Total liabilities immediately before the cancellation Amount owed immediately Liabilities (debts) before the cancellation 1) Credit card debt, car and other vehicle loans, medical bills owed, and student loans owed... $ 2) All mortgages on real property, 1 including first and second loans and equity loans... $ 3) Accrued or past due mortgage interest, real estate taxes, utilities, and child care costs... $ 4) Prior year federal or state income taxes owed... $ 5) Judgments... $ continued on next page 66 Chapter 4 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

72 Insolvency Worksheet continued 6) Business debts, including those owed as a sole proprietor or partner... $ 7) Debt to purchase or secured by investments other than real property. Includes margin debt... $ 8) Other liabilities or debts not included above... $ 9) Total liability immediately before the cancellation. (Add lines 1 through 8.)... $ NOTES Part II. FMV of assets owned immediately before the cancellation Assets FMV immediately before the cancellation 10) Cash and bank account balances... $ 11) All real estate, 2 including land value... $ 12) Cars and other vehicles... $ 13) Computers, tools, books, household goods and furnishings, jewelry, clothing, etc... $ 14) Stocks, bonds, and investments in collectibles... $ 15) Hobby equipment including firearms, sports, photographs, etc... $ 16) Interest in IRAs, 401(k)s, pension plans, etc... $ 17) Interest in education accounts... $ 18) Cash value of life insurance... $ 19) Security deposits with landlords, utilities, etc... $ 20) Interest in partnerships, value of business investments, and other financial investments... $ 21) Other assets not included above... $ 22) FMV of total assets immediately before the cancellation. (Add lines 10 through 21)... $ Part III. Insolvency 23) Amount of insolvency. Subtract line 22 from line 9... $ Note: If zero or less, the taxpayer is not insolvent. 1 Do not include qualified principal residence indebtedness unless making the election to use the insolvency exclusion instead of the qualified principal residence indebtedness exclusion. 2 Do not include the principal residence unless making the election to use the insolvency exclusion instead of the qualified principal residence indebtedness exclusion. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 4 67

73 NOTES EXAMPLE On September 17, 2015, Wendy was released from her obligation to pay her personal credit card debt of $5,000. Her 2015 Form 1099-C, Cancellation of Debt, from the credit card company showed the entire $5,000 discharged debt in box 2. Box 5 was checked, indicating that the debt was a recourse debt. None of the five exceptions to the general rule that cancelled debt is income apply in Wendy s situation. Wendy completes the insolvency worksheet to determine that on September 17, 2015, immediately before the debt cancellation, she was insolvent to the extent of $3,000. She can exclude only $3,000 of the cancelled debt from her income. She attaches Form 982 to her tax return. She checks box 1b to indicate that she is using the insolvency exclusion and enters $3,000 on line 2 to report the amount she is excluding from income. She also completes Part II of Form 982 to reduce her tax attributes (see Learning Objective 4-A, page 59). Unless another exclusion applies, Wendy must report $2,000 as taxable cancellation of debt income on line 21 of her 2015 Form Married taxpayers. The cancelled debt being excluded from income may be a joint debt or it may be the separate debt of one of the spouses. It may be desirable to allocate joint debt between spouses if the loan proceeds can be separately tracked. If the debt is a joint debt, complete the insolvency worksheet using liabilities and assets of both spouses. If the debt belongs only to one spouse, complete the insolvency worksheet only for the spouse whose debt was cancelled, even if a joint return is filed. EXAMPLE In 2014, Dan and his wife Rita were released from a recourse debt of $10,000 for which they were jointly and severally liable. They each received a 2014 Form 1099-C showing the full $10,000 of the cancelled debt in box 2. None of the exceptions apply, so they want to determine if they can exclude the cancelled debt from income. The original debt was $12,000, incurred to buy Dan s laptop for $3,000 and Rita s motorcycle for $9,000. Dan and Rita agree that based on the use of the loan proceeds, the $10,000 cancelled debt should be allocated $2,500 (= $10,000 25%) to Dan and $7,500 (= $10,000 75%) to Rita. Dan and Rita each complete the insolvency worksheet. Dan determines that he is insolvent to the extent of $4,000 ($9,000 total liabilities minus $5,000 FMV of his total assets). Rita determines that she is insolvent to the extent of $5,000 ($15,000 minus $10,000 FMV of her total assets). Case 1. Dan and Rita file separate 2014 tax returns. The extent of Dan s insolvency exceeds his $2,500 share of the cancelled debt. He can exclude the entire $2,500 from his income. However, Rita s share of the cancelled debt exceeds the extent of her insolvency. She can exclude $5,000 from income but must report the remaining $2,500 on line 21 of her 2014 Form 1040 unless she qualifies for another exclusion. Dan and Rita each attach Form 982 to their tax returns, along with an explanation of how they allocated the cancelled debt between them. Each must reduce tax attributes separately. continued on next page 68 Chapter 4 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

74 Example continued Case 2. Dan and Rita file jointly for When they combine the information on their insolvency worksheets, they are jointly insolvent to the extent of $9,000 ($24,000 total liabilities minus $15,000 FMV of their total assets). Now they can exclude $9,000 of the $10,000 cancelled debt. Only $1,000 must be reported on line 21 of the 2014 Form 1040 (unless they qualify for another exclusion). They must attach only one Form 982 to their tax return in connection with this instance of debt cancellation. They complete Part II of Form 982 to reduce their tax attributes. NOTES Learning Objective 4-B Self-Quiz For answer, see Self-Quiz Answers, page 75. Test your knowledge and comprehension of information presented in Learning Objective 4-B. 2) Jim s credit card company cancelled $5,000 of his debt on May 1, The $4,000 balance on his boat loan was cancelled when the boat was repossessed on August 1, The FMV of his home has been $100,000 since he bought it early in He makes interest-only payments on his $90,000 mortgage and has various other debts. Just before the credit card debt was cancelled, Jim s total liabilities were $150,000 and the total FMV of his assets was $155,000. Just before his boat loan was cancelled, his total liabilities were $146,000 and the total FMV of his assets had dropped to $140,000. Jim received a 2014 Form 1099-C for each of the cancelled debts. He was not in a Title 11 case during 2014 would like to apply the insolvency exclusion so that he does not have to pay taxes on his cancelled debt income. How should he calculate the extent of his insolvency? a) Jim excludes his home from his insolvency calculations. He completes a separate insolvency worksheet for each date of debt cancellation and determines that he was insolvent to the extent of $5,000 on May 1, 2014, and $6,000 on August 1, He can exclude all of his cancelled debt from income. b) Jim completes an insolvency worksheet for each date and determines that his assets exceeded his liabilities by $5,000 on May 1, 2014, but that the extent of his insolvency on August 1, 2014 was $6,000. He can exclude $1,000 (= $6,000 $5,000) of the cancelled debt from his income. c) Jim completes an insolvency worksheet for each date and determines that his assets exceeded his liabilities by $5,000 on May 1, 2014, but that the extent of his insolvency on August 1, 2014 was $6,000. He can exclude $4,000 of the cancelled debt from his income. d) Jim completes an insolvency worksheet for each date and determines that his assets exceeded his liabilities by $5,000 on May 1, 2014, but that the extent of his insolvency on August 1, 2014 was $6,000. He can exclude $6,000 of the cancelled debt from his income. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 4 69

75 NOTES Learning Objective 4-C Properly report exclusion of debt cancellation income and reduction of tax attributes on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness and Section 1082 Basis Adjustments). KEY FACT Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness and Section 1082 Basis Adjustments), must be filed with the tax return whenever cancelled debt is excluded from income. Completing Form 982 Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness and Section 1082 Basis Adjustments), is used to determine the amount of discharged indebtedness that can be excluded from income. Form 982 has three parts. Part I, General Information. Part I is used to identify the amount of cancelled debt being excluded from income and which of the five exclusions applies. The exclusions must be applied in a specified order, and more than one exclusion may be used. See Learning Objective 2-C, page 28, for a detailed discussion of the five exclusions. The total amount excluded may not necessarily equal the total amount of tax attribute reduction in Part II. Part II, Reduction of Tax Attributes. The amount of cancelled debt being excluded from income is allocated among seven tax attributes in Part II. The reductions must be applied in a specified order. Tax attributes are reduced either dollar-for-dollar or 33.3 per dollar of excluded debt. See Learning Objective 4-A, page 59, for information about the seven tax attributes. Part III, Consent of Corporation to Adjustment of Basis of Its Property Under Section 1082(a)(2). Part III is used by corporations to certify consent to the general rules for adjusting basis of property as part of tax attribute reduction. If a corporation desires to have the basis of property adjusted in a different manner, a request must be attached, showing the precise method and allocation of amounts. Elections and Form 982. Several elections are available with Form 982. Part I, line 1b. If the taxpayer is insolvent and not in a Title 11 bankruptcy case, an election can be made to exclude qualified principal residence indebtedness under the insolvency rules. Part I, line 1d. The choice to exclude discharge of qualified real property business indebtedness is an election. See Exclusion #4: Qualified Real Property Business Indebtedness (Form 982, box 1d), page 31, in Learning Object 2-C. Part I, line 3. An election may be made to treat real property being held as inventory as if it were depreciable property. The election is made by checking yes on line 3. Failure to complete line 3 is the same as checking no. Note: The line 3 election does not apply to discharge of qualified real property indebtedness, which involves a separate election on line 1d. Part II, line 5. An election may be made to reduce the basis of depreciable property first, before reducing other tax attributes in the prescribed order. See Election to Reduce Basis First, page 64, in Learning Objective 4-A. 70 Chapter 4 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

76 These elections must be made on a timely-filed return and can only be revoked with IRS consent. An election omitted on a timely-filed return can still be made on an amended return filed within six months of the original (unextended) due date of the return. NOTES KEY FACT Although there is a prescribed order in which tax attributes must be reduced, the type of cancelled debt further affects the order of tax attribute reduction. Cancelled debt is grouped into three categories: Qualified principal residence indebtedness. Other nonbusiness debt. Any other debt. Form 982 is completed by considering each of these categories in turn. Qualified Principal Residence Indebtedness and Form 982 The Mortgage Debt Forgiveness Act of 2007 and its extensions permit exclusion of cancelled qualified principal residence indebtedness for tax years after 2006 and before The Act is discussed in Learning Objective 3-A, page 37. Form 982, Part I. Include the amount of qualified principal residence indebtedness being excluded from income in the total on line 2. 1) If the discharge occurs as part of a Title 11 case, check box 1a in Part I and follow the instructions, discussed on page 72, under Other Nonbusiness Debt and Form ) If the taxpayer was insolvent (not in a Title 11 case) immediately before the discharge, and elects to apply the insolvency rules, check box 1b in Part I. Follow the instructions, discussed on page 72, under Other Nonbusiness Debt and Form ) Otherwise, check box 1e to indicate discharge of qualified principal residence indebtedness. Form 982, Part II. If the taxpayer retained ownership of the home, the basis of the home is a tax attribute that must be reduced. The reduction is reported on line 10b and is the lesser of: The amount of qualified principal residence indebtedness included on line 2, or The taxpayer s basis in the home. Note: If the home was sold or otherwise disposed of, determine whether gain must be recognized. Learning Objective 3-B, page 42, discusses this calculation. EXAMPLE Ken s bank agreed to a home loan modification that resulted in a $40,000 reduction to the principal on Ken s mortgage. His basis in the home is $180,000. Ken received a 2014 Form 1099-C in the amount of $40,000. Ken determines that $15,000 of the cancelled amount is not qualified principal residence indebtedness, due to a previous refinance when he used loan proceeds to buy a car. He includes $25,000 in the total on line 2 of Form 982, and reports a $25,000 home basis reduction on line 10b. Unless Ken qualifies for another exclusion, he must report $15,000 as taxable income on line 21 of his 2014 Form TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 4 71

77 NOTES Other Nonbusiness Debt and Form 982. Nonbusiness debt treatment applies not only to nonbusiness recourse debts such as car loans and credit card debt, but also to qualified principal residence indebtedness discharged in a Title 11 case or for which the insolvency rules have been elected. Form 982, part I. Determine whether the taxpayer has any of the seven tax attributes (discussed in Learning Objective 4-A, page 59). 1) If the taxpayer any tax attributes other than basis in nondepreciable property, follow the instructions under Any Other Debt and Form 982, discussed on page 73. 2) Otherwise, check box 1a or 1b for discharge in a Title 11 case or discharge to the extent insolvent, as applicable. (Boxes 1c, 1d, and 1e do not apply to other nonbusiness debt.) 3) Include on line 2 the amount of discharged nonbusiness debt that is excluded from gross income. If the taxpayer was insolvent immediately before the discharge, do not include more than the extent of insolvency. Form 982, part II. Reduce the basis of the taxpayer s nondepreciable property by including on line 10a the lesser of: The basis of nondepreciable property, or The amount of nonbusiness debt included on line 2, or The total aggregate bases of the property plus the amount of money held by the taxpayer immediately after the discharge, minus total liabilities immediately after the discharge. EXAMPLE Pam received Form 1099-C showing $12,000 cancelled credit card debt in box 2. She completes the insolvency worksheet and determines that she was insolvent to the extent of $15,000 immediately before the debt cancellation. She is not in a Title 11 case and has no tax attributes other than her basis in nondepreciable assets. She checks box 1b on Form 982 to indicate that she is using the insolvency exclusion and enters $12,000 on line 2 to report the amount she is excluding. Pam s basis in her home is $90,000 and her basis in all of her other nondepreciable property is $9,500. Immediately after the discharge, she has $500 in her financial accounts and still owes $84,000 on her home and $6,000 on her car. She must enter on line 10a, Form 982, the lesser of: $99,500 = $90,000 + $9,500 $12,000 $10,000 = ($90,000 + $9,500 + $500) ($84,000 + $6,000) Pam s tax attribute reduction amount is $10,000, which she allocates proportionally to her home and her other nondepreciable property as follows: Home basis reduction... $9,045 = $10,000 ($90,000 $99,500) Other property basis reduction...$955 = $10,000 ($9,500 $99,500) Pam attaches a statement to her tax return detailing how the basis reductions were allocated. 72 Chapter 4 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

78 Any Other Debt and Form 982 This category includes business debts, as well as the nonbusiness debts of a taxpayer who has tax attributes other than basis in nondepreciable property. Form 982, Part I. 1) Determine which of the five exclusions applies to the debt being cancelled and check the appropriate box on line 1. More than one box may be checked. 2) Include the amount being excluded in the total on line 2. 3) If desired, the election can be made on line 3 to treat real property being held as inventory as if it were depreciable property. Form 982, Part II. Reduce the taxpayer s tax attributes as follows: Line 4. If box 1d was checked (indicating the election to exclude discharge of qualified real property business indebtedness), then the discharged debt reduces the basis of the real property that secured the debt. See Exclusion #4: Qualified Real Property Business Indebtedness (Form 982, box 1d), page 31, in Learning Objective 2-C for more information about this exclusion and its limitations. Line 5. If box 1a, 1b, or 1c was checked (indicating exclusion under the bankruptcy, insolvency, or qualified farm indebtedness rules), then an election may be made to apply all or part of the discharged debt to first reduce basis of depreciable property, including property elected on line 3. If the line 5 election is made, follow the rules described in Election to Reduce Basis First, page 64. If the line 5 election is not made, or if excluded cancelled debt remains available after lines 4 and 5 have been considered, then reduce the seven tax attributes as discussed in Learning Objective 4-A, page 59. Reduction is made in the following order: Line 6: Net operating losses for the discharge year and any NOL carryover to that year. Line 7: Any general business credit carryover to or from the discharge year. Line 8: Any minimum tax credit as of the beginning of the year immediately following the discharge year. Line 9: Any capital loss for the discharge year and any capital loss carryover to that year. Line 10a: Basis of property not reduced on line 5, or Line 11: Basis of property related to qualified farm indebtedness and not reduced on line 5. Line 12: Any passive activity credit and loss carryovers from the discharge year. Line 13: Any foreign tax credit to or from the discharge year. NOTES TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 4 73

79 NOTES Learning Objective 4-C Self-Quiz For answer, see Self-Quiz Answers, page 75. Test your knowledge and comprehension of information presented in Learning Objective 4-C. 3) Donna owes $125,000 for equipment used on her soybean farm and $250,000 her home, which is located on the farm. On March 5, 2014, she received a home modification resulting in the cancellation of $25,000 in qualified principal residence indebtedness, of which $5,000 is allocable to land. Her 2014 crops were damaged by a flood and she was unable to make some of the loan payments on her equipment due to her decreased income. Her lender cancelled $15,000 of the amount owing on her equipment. Donna does not qualify to use the bankruptcy or insolvency exclusions and she has no tax attributes other than the basis in the property she owns. How should she complete her 2014 Form 982? a) Donna checks boxes 1c (discharge of qualified farm indebtedness) and 1e (discharge of principal residency indebtedness). She enters $40,000 on line 2 and on line 10a. b) Donna checks box 1d (discharge of qualified farm indebtedness and enters $40,000 on line 2. She enters $15,000 on line 11a, $5,000 on line 11b, and $20,000 on line 11c. c) Donna checks boxes 1c (discharge of qualified farm indebtedness) and 1e (discharge of principal residency indebtedness). She enters $40,000 on line 2, $25,000 on line 10b, and $15,000 on line 11b. d) Donna checks boxes 1c (discharge of qualified farm indebtedness) and 1e (discharge of principal residency indebtedness). She enters $40,000 on line 2, $25,000 on line 10b, and $15,000 on line 11a. 74 Chapter 4 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

80 Chapter 4 Self-Quiz Answers NOTES 1) In 2014, Tom s lender agrees to cancel $13,000 of the amount he owes on an unsecured business line of credit used in his sole proprietorship. He qualifies to exclude the entire amount of cancelled debt from income. Tom has a $5,000 general business credit carryforward to He has a 2014 net operating loss of $10,000, and his adjusted basis in depreciable business property is $7,000. Immediately before the cancellation, he was insolvent to the extent of $3,000. How can Tom reduce his tax attributes? a) Tom can reduce the basis in his depreciable property to zero, and then reduce his NOL carryforward to $4,000. He is not required to reduce his general business credit carryforward. Correct. Tom can elect to reduce the basis of his depreciable property before reducing other tax attributes, leaving him $6,000 (= $13,000 $7,000) to apply to other tax attribute reductions in the prescribed order. The first item is his NOL, which is reduced dollarfor-dollar to $4,000. b) Tom decides not to make the election to reduce basis first. Tom first reduces his general business credit carryforward by $4,000. He uses the remaining $9,000 of excluded debt to reduce his NOL 33.3 on the dollar to $7,000. Incorrect. The reduction of the general business credit can only be considered after the NOL has been reduced. The NOL would be reduced to $0 (dollar-for-dollar), leaving $3,000 to be applied to reduce the general business credit to $3,000 (33.3 on the dollar). c) Tom makes the election to reduce part of the basis of his depreciable property first. He applies $1,000 to basis reduction and allocates the remaining $12,000 of debt cancellation proportionally to the NOL and general business credit. Incorrect. Tom may elect to apply only $1,000 to basis reduction. The $12,000 must first be applied to reduce his NOL to $0. The remaining $2,000 is used to reduce the general business credit carryover by $667 (33.3 on the dollar). d) Tom decides not to make the election to reduce basis first. He first reduces his NOL to $0, and uses the remaining $3,000 to reduce his general business credit carryover to $2,000. Incorrect. Reduction of Tom s NOL is dollar-for-dollar, so the NOL is reduced to $0. But reduction of credit carryovers are 33.3 on the dollar. Tom s general business credit carryforward is reduced to $4,000, not $2,000. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 4 75

81 NOTES 2) Jim s credit card company cancelled $5,000 of his debt on May 1, The $4,000 balance on his boat loan was cancelled when the boat was repossessed on August 1, The FMV of his home has been $100,000 since he bought it early in He makes interest-only payments on his $90,000 mortgage and has various other debts. Just before the credit card debt was cancelled, Jim s total liabilities were $150,000 and the total FMV of his assets was $155,000. Just before his boat loan was cancelled, his total liabilities were $146,000 and the total FMV of his assets had dropped to $140,000. Jim received a 2014 Form 1099-C for each of the cancelled debts. He was not in a Title 11 case during 2014 would like to apply the insolvency exclusion so that he does not have to pay taxes on his cancelled debt income. How should he calculate the extent of his insolvency? a) Jim excludes his home from his insolvency calculations. He completes a separate insolvency worksheet for each date of debt cancellation and determines that he was insolvent to the extent of $5,000 on May 1, 2014, and $6,000 on August 1, He can exclude all of his cancelled debt from income. Incorrect. The FMV and amount of qualified principal residence indebtedness are omitted from the insolvency calculation only when qualified principal residence indebtedness has been cancelled, which is not Jim s situation. b) Jim completes an insolvency worksheet for each date and determines that his assets exceeded his liabilities by $5,000 on May 1, 2014, but that the extent of his insolvency on August 1, 2014 was $6,000. He can exclude $1,000 (= $6,000 $5,000) of the cancelled debt from his income. Incorrect. The insolvency calculations are date-specific and should not be netted together. c) Jim completes an insolvency worksheet for each date and determines that his assets exceeded his liabilities by $5,000 on May 1, 2014, but that the extent of his insolvency on August 1, 2014 was $6,000. He can exclude $4,000 of the cancelled debt from his income. Correct. Since Jim was not insolvent immediately before the $5,000 credit card debt was cancelled, none of the $5,000 can be excluded. But on August 1, 2014, the boat loan cancellation amount was less than the extent of his insolvency immediately before the cancellation. He can exclude the $4,000 cancelled debt. d) Jim completes an insolvency worksheet for each date and determines that his assets exceeded his liabilities by $5,000 on May 1, 2014, but that the extent of his insolvency on August 1, 2014 was $6,000. He can exclude $6,000 of the cancelled debt from his income. Incorrect. The amount of cancelled debt that can be excluded from income depends on the extent of insolvency immediately before the debt was cancelled. Even though the extent of Jim s insolvency on August 1, 2014 was $6,000 his exclusion is limited to the amount of debt cancelled that day. 76 Chapter 4 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

82 3) Donna owes $125,000 for equipment used on her soybean farm and $250,000 her home, which is located on the farm. On March 5, 2014, she received a home modification resulting in the cancellation of $25,000 in qualified principal residence indebtedness, of which $5,000 is allocable to land. Her 2014 crops were damaged by a flood and she was unable to make some of the loan payments on her equipment due to her decreased income. Her lender cancelled $15,000 of the amount owing on her equipment. Donna does not qualify to use the bankruptcy or insolvency exclusions and she has no tax attributes other than the basis in the property she owns. How should she complete her 2014 Form 982? a) Donna checks boxes 1c (discharge of qualified farm indebtedness) and 1e (discharge of principal residency indebtedness). She enters $40,000 on line 2 and on line 10a. Incorrect. Donna has filled out Part I of Form 982 correctly. But she must use line 10b to report a basis reduction of $25,000 for her principal residence. The remaining $15,000 can be reported on line 11a as a basis reduction of depreciable property used in the business of farming. NOTES b) Donna checks box 1d (discharge of qualified farm indebtedness and enters $40,000 on line 2. She enters $15,000 on line 11a, $5,000 on line 11b, and $20,000 on line 11c. Incorrect. Donna s principal residence is not part of the trade or business of farming. Neither the portion of the cancelled debt allocable to the building nor the portion allocable to the land should be included with other discharged qualified farm indebtedness. Instead, she should check box 1e and enter $25,000 on line 10b. c) Donna checks boxes 1c (discharge of qualified farm indebtedness) and 1e (discharge of principal residency indebtedness). She enters $40,000 on line 2, $25,000 on line 10b, and $15,000 on line 11b. Incorrect. Donna has done everything correctly except for line 11b. Line 11b is reserved for reduction in the basis of land used in the business of farming. She should report the cancelled $15,000 business equipment loan on line 11a. d) Donna checks boxes 1c (discharge of qualified farm indebtedness) and 1e (discharge of principal residency indebtedness). She enters $40,000 on line 2, $25,000 on line 10b, and $15,000 on line 11a. Correct. The exclusion of cancelled $25,000 qualified principal residence indebtedness is indicated by marking box 1e and reducing the home s basis by $25,000 on line 10b. The exclusion of $15,000 cancelled qualified farm indebtedness is indicated by marking box 1c and reducing basis in depreciable farm equipment on line 11a. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Chapter 4 77

83 78 Chapter 4 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

84 Final Exam Go to and click on Login to Education Center to take the Final Exam. Do not mail. CPE/CE Circle the correct answer. 1) Recourse debt is defined as: a) The amount of mortgage debt in excess of FMV of foreclosed property. b) The amount of debt forgiven in foreclosure proceedings. c) A debt the borrower is personally liable to repay. d) The principal balance of a refinanced mortgage. 2) When a foreclosure occurs, which form will the borrower receive from the lender? a) Form 1099-A, Acquisition or Abandonment of Secured Property, only. b) Form 1099-C, Cancellation of Debt, only. c) Either Form 1099-A and/or Form 1099-C. d) Neither Form 1099-A nor Form 1099-C are filed until 60 days after the property is repossessed. 3) How is taxable nonbusiness cancelled debt reported on the borrower s individual income tax return? a) Ordinary income on line 21, Form b) Capital gains on Form 8949, Sales and Other Dispositions of Capital Assets. c) Directly on line 13, capital gain or (loss), on Form 1040 if there are no other capital transactions to report. d) Adjustment to income, line 36, Form ) A loan modification can be described as follows. a) A temporary reduction in interest rate. b) A permanent change in one or more terms of a borrower s loan. c) Permanent reduction in interest rate that will result in cancellation of debt income. d) Prepayment of a mortgage loan. 5) Randy purchased his home from his parents on a contract for deed. When he had $50,000 in principle remaining on the loan, his parents forgave the loan as a gift to Randy. How is the cancelled debt treated for tax purposes? a) The entire $50,000 debt forgiveness is included as taxable income on Randy s return for the tax year the loan was forgiven. b) The amount of scheduled payments of principal are included as taxable income on Randy s return each year of the original payment schedule. c) The rules for below-market loans apply, creating imputed income for Randy. d) The Internal Revenue Code provides that gross income does not include the value of property acquired by gift. DO NOT MAIL Go to and click on Login to Education Center to take the Final Exam. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Final Exam 79

85 DO NOT MAIL Go to and click on Login to Education Center to take the Final Exam. 6) Under what circumstances must Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment) be filed with a taxpayer s return? a) When a taxpayer applies an exclusion from taxation for cancelled debt. b) When a taxpayer claims an exception from taxation of a cancelled debt because the payment would have been a deductible expense. c) When a taxpayer claims an exception from taxation of a cancelled debt related to cancellation of a qualified student loan. d) When a taxpayer claims an exception from taxation of a cancelled debt related to a price that was reduced after purchase. 7) What is the maximum amount of debt that can be excluded under the Mortgage Forgiveness Debt Relief Act of 2007? a) $1,000,000 ($500,000 MFS). b) $2,000,000 ($1,000,000 MFS). c) $3,000,000 ($1,500,000 MFS). d) $4,000,000 ($2,000,000 MFS). 8) Which party is responsible for completing an abandonment of property? a) The seller. b) The financial institution holding the debt. c) The buyer of a foreclosed property. d) Abandonment is an action taken by the borrower. 9) Form 1099-A, Cancellation of Debt, may be required if a lender cancels at least the following amount of debt. a) $400 b) $600 c) $1,800 d) $10,000 10) When a taxpayer is insolvent, the extent of the insolvency is the amount by which the taxpayer s liabilities exceed: a) The FMV of the foreclosed property. b) The basis of foreclosed property. c) The taxpayer s assets. d) The potential amount of income from cancellation of debt. 11) For purposes of determining the insolvency exclusion, liabilities include: a) Recourse debts. b) Nonrecourse debts. c) Nonrecourse debt in excess of FMV of the property that secures the debt to the extent the debt is forgiven. d) All of the above. 80 Final Exam TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

86 12) Whether a mortgage debt is recourse or nonrecourse is determined by: a) Whether the loan is for real or personal property. b) The loan documents. c) Agreement between the lender and the borrower. d) State law. 13) If a fraudulent debt due to identity theft is cancelled, how is that cancellation of debt reported on the taxpayer s income tax return? a) The amount of fraudulent debt cancelled is reported on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), and is eligible for an exclusion from income. b) The taxpayer must obtain an Identity Theft PTIN from the IRS and include the fraudulent debt discharged as an adjustment to income on Form c) A fraudulent debt due to identity theft is not considered the taxpayer s liability, and any related forgiveness of debt should not be reported on Form 1099-C. d) The amount of the debt is claimed as a Miscellaneous Itemized Deduction on Schedule A of Form ) Eric and Mary are jointly and severally liable for a debt that was cancelled. The lender issues Form 1099-C, Cancellation of Debt, to both Eric and Mary. How should the debt be allocated between the two? a) The lender can use any reasonable method to allocate the debt between co-owners. b) Both Eric and Mary will each receive a Form 1099-C showing the entire amount of the debt. c) The debt will be allocated based on each individual s percentage of ownership. d) The 1099-C showing the full amount of the debt will be issued only to the individual whose name is listed first on the loan documents. 15) Todd operates his business as a sole proprietorship. In connection with his business he incurred a debt that he was unable to repay. The lender cancelled the debt. In what manner does Todd report income from cancellation of debt. a) Other income, line 21, Form b) Schedule C, Profit or Loss from Business. c) Schedule D, Capital Gains and Losses. d) Form 4797, Sales of Business Property. 16) Qualified principal reductions under the Home Affordable Modification Program (HAMP) are treated in the following manner for tax purposes. a) The amount of principal reduction taxable income from cancellation of debt. b) The amount of principal reduction reduces the taxpayer s basis in the home. c) The amount in excess of $1,000 per year is treated as taxable cancellation of debt income. d) Qualified principal reductions under HAMP are not treated as income by the taxpayer. DO NOT MAIL Go to and click on Login to Education Center to take the Final Exam. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Final Exam 81

87 17) Debt cancelled in a Title 11 bankruptcy case is not included in the debtor s gross income in the following situation. a) The cancellation of debt is granted by the court. b) The taxpayer s liabilities exceed the value of the taxpayer s assets. c) The debt cancelled was qualified farm indebtedness. d) The debt cancelled was qualified real property indebtedness. DO NOT MAIL Go to and click on Login to Education Center to take the Final Exam. 18) Anti-deficiency laws are designed to protect a debtor from the following. a) A deficiency judgment against the borrower for the amount of a second mortgage. b) A deficiency judgment against the borrower for the amount of a home equity loan. c) A deficiency judgment against the borrower after the lender has foreclosed on a principal residence. d) A deficiency judgment against the borrower for defaulting on a mortgage on a second home. 19) A short sale of real estate is defined as follows. a) A short sale of real estate occurs when a lender allows a borrower to sell his or her property for less than the outstanding mortgage. b) A short sale is an expedited process where the title to property is transferred in a shorter period of time than with a normal sales transaction. c) A short sale allows a borrower under foreclosure to sell property when the sales price is more than the amount of the outstanding mortgage. d) A short sale occurs as part of the foreclosure process when a new buyer enters into a contract to purchase an abandoned home. 20) Bessie sold her home on a contract for deed. Gain on the sale was eligible for the exclusion of gain on the sale of a principal residence. The buyers stopped making payments and Bessie was forced to repossess the home. How soon must Bessie resell the home in order for the gain on the resale to be treated as part of the original sale for purposes of the exclusion of gain from the sale of a principal residence. a) 60 days from the date of the original sale. b) Six months from the date of the original sale. c) One year from the date of the original sale. d) Two years from the date of the original sale. 82 Final Exam TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

88 INSTRUCTIONS Final Examination Instructions Expiration Date Reminder: The Final Exam must be completed online within one year from your date of purchase or shipment. CPE/CE credits are not available more than one year after your date of purchase or shipment. All Final Exams are administered online at It is recommended that you review the Final Exam at the end of the course before taking it online. Final Exams mailed in will not be graded. Follow the instructions below: 1) Go to 2) Click on Login to Education Center, where you will find a location to log in to the Final Exam. 3) Enter your User Name in the self-study CPE/CE login location. The address associated with your account at Tax Materials, Inc. is your User Name. If you do not have an address, or have not provided one, please call our toll-free number at to be assigned a User Name. 4) Enter your Password. The zip code associated with your account is your password. If you are having difficulty logging onto the Final Exam, please call our toll-free number at ) Select the Foreclosures, Repossession, and Cancelled Debt Exam and click the Take Exam button. 6) You will be taken to the Final Exam. First confirm your First Name and Last Name are correct. This is how your name will appear on your Certificate of Completion should you achieve a score of 70% or higher. Take the Final Exam. Read the questions carefully and answer them to the best of your ability. At the bottom of the exam, click on Submit Answers when finished. You will instantly know if you have passed the test. If you failed, you are able to retake the test. If you passed, the Certificate of Completion will be available for you to print. DO NOT MAIL Go to and click on Login to Education Center to take the Final Exam. TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Final Exam 83

89 84 Final Exam TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

90 Index CPE/CE A Abandonment, 1, 14, 45 Acquisition indebtedness, 31 B Bankrupt taxpayers, 39 Basis of property, 62 C Cancelled debt, 65 Capital loss carryovers, 62 Chapter 1 cancelled debt, 1 Chapter 2 cancelled debt as income, 19 Chapter 3 foreclosures and repossessions, 37 Chapter 4 Form 982, 59 Course completion instructions, ii Course overview, i CPE/CE credit hours, i D Debt, 12 Debt cancellation, 5, 19 Deed in lieu of foreclosure, 37 Discharge of indebtedness, 59 Dispositions of property, 13 E Examination instructions, ii Exception, 19 Exclusion, 19 Expiration date, i F Farm indebtedness, 29 Final exam, 79 Final examination instructions, ii, 83 Foreclosure, 1, 37 Foreign tax credit, 64 Form 982, 70 Form 1099-A, 4 Form 1099-C, 4 G General business credit, 61 Guarantor, 49 H HAMP, 21 Home Affordable Modification Program, 21 I Identity theft, 5 Information return filing, 48 Insolvency, 28, 39, 65 Insolvent, 19, 59 Insolvent taxpayers, 39 Investment property, 15 L Learning objective 1-A self-quiz, 4 Learning objective 1-B self-quiz, 10 Learning objective 1-C self-quiz, 16 Learning objective 2-A self-quiz, 23 Learning objective 2-B self-quiz, 27 Learning objective 2-C self-quiz, 33 Learning objective 3-A self-quiz, 41 Learning objective 3-B self-quiz, 48 Learning objective 3-C self-quiz, 54 Learning objective 4-A self-quiz, 65 Learning objective 4-B self-quiz, 69 Learning objective 4-C self-quiz, 74 Learning objectives, iii Lender reporting, 3 Loan modification, 19 M Making Home Affordable Program, 19, 21 Married taxpayers, 68 MHA, 19, 21 Minimum tax credits, 62 Mortgage Forgiveness Debt Relief Act of 2007, 37 N NASBA, i National Association of State Boards of Accountancy, i Net operating loss, 61 Nonbusiness debt, 11 Nonrecourse debt, 1 Nonrecourse mortgage debt, 40 O Overview, i P Passing grade, i Passive activity loss, 64 Prerequisites, i Principal residence, 37 Principal residence indebtedness, 33, 38, 40 Program content, i Publication date, i R Real property business indebtedness, 31 Recommended participants, i Record retention, i Recourse debt, 1 Recourse mortgage debt, 40 Repossession, 1, 37 Residence indebtedness exclusion, 33 S Sale of residence, 41 Sales, 13 Short sale, 37, 45 Student loans, 24 Surety, 49 T Tax attribute, 59 Title 11 case, 59 TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Index 85

91 86 Index TheTaxReview Foreclosures, Repossessions, and Cancelled Debt

92 Course Evaluation 2015 Foreclosures, Repossessions, and Cancelled Debt Self-Study CPE/CE CPE/CE Please comment on all the following evaluation points for this program and assign a number grade, using a 1 5 scale, with 5 as the highest. Grade (1 5) 1) Were the stated learning objectives met? Comments: 2) Were the prerequisite requirements appropriate? Comments: 3) Were program materials accurate? Comments: 4) Were program materials relevant? Comments: 5) Did the program materials contribute to the achievement of the learning objectives? Comments: 6) Was the time allotted to the learning activity appropriate? Comments: 7) Was the use of the online test-taking satisfactory? Comments: 8) Did the online grading system work well? Comments: 9) Was the study guide appropriate and complete with regard to assisting with learning the material? Comments: 10) Did the layout and overall visual presentation make the study guide easy to read and understand? Comments: Other feedback or suggestions: Please mail to: Tax Materials, Inc Minnetonka Ind. Rd., Ste 221, Minnetonka, MN Thank you for helping us improve our CPE/CE course offerings! TheTaxReview Foreclosures, Repossessions, and Cancelled Debt Course Evaluation 87