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Henry Hawkins
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1 Cancellation of Debt

2 Important Terms Foreclosure/ Repossession Forms A or C Non-recourse Debt Recourse Debt Debt Discharge Income (DDI) Insolvency

3 IRS Tax Provisions Tax Provisions Involved: Emergency Economic Stabilization Act of 2008 (exclusion applies to debt discharged after 2006 and before 2013) The Heartland Disaster Tax Relief Act of 2008 (allows qualified individuals to exclude from gross income discharges of certain indebtedness because of mid-western disasters)

Heartland Disaster Tax Relief Act of 2008 (allows qualified individuals to

4 IRS Tax Provisions Tax Provisions Involved: Mortgage forgiveness Debt Relief Act of 2007 (applies only to forgiven or cancelled debt used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes.)

or cancelled debt used to buy, build or substantially improve

5 General Rule: DDI is Taxable as Ordinary Income IRC section 61 provides that gross income means all income from whatever source derived. Section 61 (a) (12) specifically includes income from discharge of indebtedness as an item of gross income.

6 Foreclosure/Repossession Repo: When lender tries to repossess the property, the court can grant the borrower equitable right of redemption. Foreclose: Lender seeks to foreclose borrower s right. Both treated as a sale Gain or loss realized, even if borrower voluntarily returns the property to the lender If lender cancels all or part of the remaining loan balance, borrower may realize ordinary income.

Both treated as a sale Gain or loss realized, even if borrower voluntarily returns the property to

7 Non-Recourse Debt For real property typically Loan is secured by the pledge of the collateral. Borrower is not personally liable when defaults. Lender s recovery is limited to the collateral. Lender pays out the difference. Most CA housing loans

8 Recourse Debt Borrower is personally liable whether the loan is collateralized or not. Sales price is the lesser of the FMV or the debt outstanding, when repossessed. Borrower is still liable for any balance. Write-off of remaining debt will result in DDI (Debt Discharge Income).

Sales price is the lesser of the FMV or the debt outstanding, when

9 Tax Treatment of Non-recourse Debt Lender agrees to loan modification that results in reduction of the principal balance of debt. Borrower may still have ordinary income from the cancelled debt since no disposition was involved, only a workout.

10 Tax Treatment of Non-Recourse Debt Example 1: Lily paid $200,000 for her home. She paid $15,000 down and borrowed $185,000 from a bank. She s not personally liable but pledged the house as security. GAIN/LOSS LOAN BALANCE $180,000 FMV $170,000 ADJ. BASIS $175,000 DDI REPORTABLE GAIN $5,000 $180,000 $180,000 -$175,000 -$170,000 $10,000 (Receive 1099-C)

She s not personally liable but pledged the house as security.

11 Tax Treatment of Non-recourse Debt Example 2: Tara bought a new car for $15,000. She paid $2,000 down and borrowed $13,000 from dealer s credit company. Tara is not personally liable, but pledged the new card as security which was repossessed. GAIN/LOSS LOAN BALANCE $10,000 FMV $9,000 ADJ. BASIS $15,000 DDI REPORT LOSS $10,000 $10,000 - $15,000 -$9,000 -$5,000 (Non-deductible) $1,000 (Receive 1099-c)

Tara is not personally liable, but pledged the new card as security which was repossessed.

12 Tax Treatment of Recourse Debt Example 1 (Loan Modification): In 2002, Nancy purchased a principal residence for $435,000. She took out a $420,000 mortgage loan which was secured by the principal residence. In 2003, Nancy took out a 2 nd loan, a recourse debt of $30,000 that was used to improve her kitchen. In 2006, when the outstanding principal of the 1 st and 2 nd loan was $440,000, Nancy refinanced into 1 recourse loan of $475,000. Nancy used the additional $35,000 to pay off personal credit card debt. In 2008, Nancy was unable to make payments. On Aug 31, 2008, the bank agreed to a loan modification (a workout ) that resulted in a $40,000 reduction in the principal balance.

In 2003, Nancy took out a 2 nd loan, a recourse debt of $30,000 that was used to improve her kitchen.

13 Tax Treatment of Recourse Debt Example 1 (Loan Modification): GAIN/LOSS LOAN BALANCE (New Loan) $475,000 FMV $500,000 ADJ. BASIS (1st $420, nd $30,000) $450,000 DDI NEW LOAN $475,000 (1st + 2nd) -$440,000 NON-QUALIFIED INDEBTEDNESS $35,000 CANCELLED DEBT $40,000 NON-QULIFIED DEBT -$35,000 QUALIFIED PRINCIPLE RESIDENCE INDEBTEDNESS (QPRI) $5,000 $40,000 (Received 1099-C)

BASIS (1st $420,000 + 2nd $30,000) $450,000 DDI NEW LOAN $475,000 (1st + 2nd) -$440,000

14 Tax Treatment of Recourse Debt Example 2: Eddie bought a rental property in 1999 for $85,000. It was repossessed in 2008 when he still owed $65,000. The loan was a recourse loan. GAIN/LOSS DDI LOAN BALANCE $65,000 $65,000 FMV $50,000 -$50,000 PURCHASE PRICE $85,000 DEPRECIATION -$28,000 ADJ. BASIS $57,000 FMV $50,000 ADJ. BASIS -$57,000 LOSS ON SALE (Reportable) -$7,000 $15,000 (Receive 1099-A) (Reportable)

GAIN/LOSS DDI LOAN BALANCE $65,000 $65,000 FMV $50,000 -$50,000 PURCHASE PRICE $85,000 DEPRECIATION

15 Tax Treatment of Recourse Debt Example 3 (Foreclosure): In 2000, John and Mary purchased a home for $335,000 by taking out a loan of $320,000. The loan was secured by the principal residence and is a recourse debt. On March 1, 2008, they became unable to make loan payments when the balance was $315,000 and the FMV was $290,000. The bank foreclosed on the property and simultaneously cancelled the remaining debt.

The loan was secured by the principal residence and is a recourse debt.

16 Tax Treatment of Recourse Debt Example 3 (Foreclosure): GAIN/LOSS DDI LOAN BALANCE $315,000 FMV $290,000 ADJ. BASIS $335,000 $315,000 FMV $290,000 -$290,000 ADJ. BASIS -$335,000 LOSS NON-DEDUCTIBLE -$45,000 $25,000 (Receive 1099-C) Cancelled Debt = Ordinary income

BASIS $335,000 $315,000 FMV $290,000 -$290,000 ADJ.

17 Tax Treatment of Recourse Debt Example of 1099-C

18 Short Sale Selling for a net sales price (after subtracting commissions and closing costs) Sold less than the outstanding loan balance Non-deductible personal loss when net sales price is less than your adj. basis in the property Example: GAIN/LOSS DDI LOAN BALANCE $350,000 $350,000 FMV? SHORT SALE PRICE $300,000 -$300,000 ADJ BASIS -$415,000 PERSONAL LOSS (Non-Deductible) -$115,000 $50,000 (Receives 1099-C)

adj. basis in the property Example: GAIN/LOSS DDI LOAN BALANCE $350,000 $350,000 FMV?

19 Exceptions & Exclusions Bankruptcy: A title 11 case under title 11 of the U.S. code approved by the court Insolvency: Borrower was insolvent immediately before the cancellation. Qualified Principal Residence Indebtedness (QPRI): Debt incurred in acquiring, constructing, improving or refinancing for the same purposes Qualified Real Property Business Indebtedness (QRPBI): Debt incurred in connection with real property used in a trade or business

Qualified Principal Residence Indebtedness (QPRI): Debt incurred in acquiring, constructing, improving or

20 Exceptions & Exclusions Bankruptcy: Cancellation of debt must take place during the bankruptcy proceedings in order for the exclusion to apply Insolvency: Statement to state that liabilities exceed assets immediately before the cancellation QPRI: Only 1 principal residence applies Maximum limit to $2 million Must reduce basis by the amount cancelled QRPBI: Make an election to exclude from income Must reduce the basis of the depreciable real property

the cancellation QPRI: Only 1 principal residence applies Maximum limit to $2 million Must reduce basis by the

21 Alerts Taxpayer s responsibility to verify the correctness of 1099-A and 1099-C; bank could mess up on amounts IRS will audit some insolvency cases. Interest included in cancelled debt: Non-deductible on personal loan Deductible on business loan Cancellation of debt is a complicated issue; better seek help from the tax professional.

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