Should I Short Sale My Underwater Home in theEastBayArea or Tri-Valley of California Now or Wait & Short Sale Later? Now is Most Likely Better for you.
Do I have to Pay Taxes if I Short Sale My Home? Maybe.
What is THE PRINCIPAL RESIDENCE EXCLUSION?
What is THE INSOLVENCY EXCLUSION?
It it important to know how the different federal and state laws may apply to you and how you can use them in your benefit to avoid paying taxes of the cancelled debt of your under water property. This document goes into detail of that by sharing notes on the subject from the 2012/2013 Fall Federal and California Tax Update Seminar Real Estate Spidell Publishing, Inc.® 7-16-7-19 ©2013
Please be aware that these notes were written for tax preparers so they do get a bit technical, but they do provide good examples to help with understanding. I would be review your situation with you from a layman’s perspective (I am not a rax professional) and I would be happy to refer you to my trusted tax advisor if you would like a profession consultation.
The Principal Residence Cancellation of Debt (COD) Exclusion Extended through 2013!!!!
The American Taxpayer Relief Act of 2012 extended the COD exclusion for principal residence
Californiafully conforms to the insolvency exclusion under IRC §108.California partially
conforms to the residency exclusion. Like federal law, Californias residency exclusion expired on
December 31, 2012.
The California Legislature must extend the residency exclusion or it will be unavailable in 2013.
If the exclusion is not extended, a taxpayer must look to insolvency to exclude COD income on a
THE PRINCIPAL RESIDENCE EXCLUSION
Under IRC §108(a)(1)(E) and (h), a taxpayer may exclude from income up to $2 million of COD
income from the discharge of qualified principal residence indebtedness on or afterJanuary 1, 2007,
and beforeJanuary 1, 2013. (IRC §108(a)(1)(E) and (h))
California conforms, with these major exceptions:
Qualified principal residence indebtedness is limited to $800,000 ($400,000 formarried filing
separate) instead of the federal $2million ($1 million for married filing separate); and
The maximum COD income exclusion is further limited to $500,000 ($250,000 for
taxpayers married filing separately).
Californias principal residence exclusion also no longer applies to sales or exchanges on or
after January 1, 2013. (R&TC §17144.5)
THE INSOLVENCY EXCLUSION
If the qualified principal residence exclusion is not an option for some of your clients, you must
consider insolvency.California conforms to the insolvency provision, so this exclusion will apply for
federal and state purposes. (R&TC §17131)
A taxpayer may exclude from income a discharge of indebtedness that occurs while the taxpayer
is insolvent (but not involved in bankruptcy proceedings) up to the amount by which he or she is
insolvent. (IRC §108(a)(1)(B), (a)(2)(A), and (a)(3))
The term insolvent means that there is an excess of liabilities over the FMV of assets,
determined on the basis of the taxpayers assets and liabilities immediately before the discharge.
(IRC §108(d)(3)) See below for a discussion of the assets included in the insolvency calculation.
Liabilities include contingent liabilities or liabilities that the taxpayer has guaranteed if it is more
likely than not that the taxpayer will be called upon to pay them. (Merkel v. Comm. (1999) 192 F.2d
844) A taxpayer must be able to prove insolvency. (Rinehart v. Comm.,TCM 2002-71)
For many taxpayers, especially those who have frequently refinanced their residence, the
insolvency provisions will allow them to exclude most of their discharge.
The excluded amount is applied to reduce tax attributes in the order listed on Form 982,
Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).
However, an insolvent taxpayer may elect to apply all or a portion of the excluded amount first to
reduce basis in depreciable assets or in real property held as inventory, rather than to reduce the tax
For more information on the basis adjustments, see the instructions for Form 982.
Note: A taxpayer may use the insolvency exclusion even if the COD income forgiven exceeds the
amount of his or her tax attributes, or if he or she has no tax attributes. The amount of COD income
in excess of the amount by which the taxpayer is insolvent is treated like COD income of a wholly
solvent taxpayer and will generally be included in income. (IRC §§61(a)(12), 108(a)(3))
Example of excess COD income
Tina has $250,000 ofCODincome.
Tina is insolvent, but her liabilities only exceed her assets by $160,000. Tina will pay
tax on $90,000 of her COD income ($250,000COD- $160,000 of insolvency).
Example of insolvency
Garybought his house for $200,000. He refinanced the property several times, and
used the proceeds to send his kids to college, take vacations, purchase a boat, etc. The
value of the house had risen to $700,000, and the balance of his mortgage was $650,000.
All of the debt was recourse debt, and only $150,000 was acquisition indebtedness.
The home’s value has fallen to $500,000. He has other assets worth $50,000 and other
liabilities of $80,000.
Garyis insolvent to the extent of $180,000 (total assets = $550,000; total liabilities =
Californiaconforms to the insolvency exclusion. (R&TC §17024.5)
Assets for purposes of the insolvency exclusion
The Code provides only for assets. Thus, a taxpayer must count cash, stocks and bonds, and
other business and investment assets, along with personal assets such as a personal residence, auto,
and household goods.
More controversial are exempt assets. Both theIRSand the Tax Court have previously held that
assets exempt from creditors claims are excluded when taking account of a taxpayers assets in determining insolvency. (Babin v. Comm., TCM 1992-673; Hunt v. Comm., TCM 1989-335; Estate of
Marcus v. Comm.,TCM 1975-9;PLR 9125010) However, these cases were decided under the judicial
insolvency exclusion that preceded the statutory exclusion.
More recently, both the Tax Court and theIRShave ruled the opposite way; that is, they have
ruled that assets exempt from creditors are counted, including pension assets. (Carlson v. Comm.
(2001) 116 TC 87;PLR199932013;TAM199935002; SCA 1998-039)
For purposes of valuing pension assets, defined contribution plans are valued as the FMV of the
participants account on the date of discharge.
Defined benefit plans are valued in one of two ways, depending on whether the participant has
started receiving benefits:
Has started to receive benefits: Actuarial present value of the payments to be made using
the interest rate and mortality tables at Treas. Regs. §20.2031-7; or
Has not started receiving benefits: Greater of the actuarial present value of the accrued
benefit payable at normal retirement age, or the amount of any single-sum distribution that
the participant could receive under the plan as of the discharge date.
Documentation is important
Taxpayers were denied an insolvency exclusion because they were unable to provide sufficient
evidence to support their insolvency calculation. (Shepherd v. Comm.,TCM 2012-212)
In 2008, the taxpayers came to a settlement agreement with their credit card company, and
$4,412 of their outstanding debt was cancelled. The taxpayers received a 1099-C listing the cancelled
debt. However, they did not claim the $4,412 as income on their return because they claimed they
The IRS disagreed with the taxpayers insolvency calculation. Specifically, they questioned the
FMV used for two homes owned by the taxpayers, and the husbands pension in theNew Jersey
Public Employees Retirement System.
The value of the homes
To support the value of their beach house the taxpayers presented a settlement between them
and the city where the property is located, which established the value of the property for the 2010
year for property tax purposes. This evidence was problematic for two reasons:
1. The Tax Court has previously held that the value placed on property for purposes of local
taxation is not acceptable to determine FMV for income tax purposes (Pierce v. Comm. (1974)
61 TC 424); and
2. Taxpayers are required to demonstrate they are insolvent immediately before the debt is
cancelled. In this case, that was 2008, not 2010.
The Court noted that the taxpayers did not present evidence of comparable sales for the period
immediately before the debt cancellation, which would have been acceptable evidence.
To support the value of their principal residence, the taxpayers presented:
1. A letter datedMarch 29, 2011, fromChase Bank showing the value of the principal residence; and
2. A 2008 Final/2009 Preliminary Tax Bill.
Again, a property tax valuation is not sufficient to support FMV for income tax purposes, and
the evidence must support value immediately prior to the cancellation.
The Court also stated that the letter from Chase Bank was not sufficient to establish value
because it did not describe the property or the method used to establish value.
Although the Court found that the taxpayers were not insolvent because of the lack of evidence
to support FMV of the two homes, they still addressed the issue of the husbands pension.
They specifically noted that the taxpayers did not include the husbands pension in their list of
assets, but did include a loan from the pension in their list of liabilities. The Court stated that for
consistency purposes, the taxpayer must either remove the loan as a liability or include the collateral
that secures the loan (the pension) as an asset. However, the Court also noted that the portion of
the pension that could have been withdrawn as a loan is an asset for purposes of insolvency.
I hope you found this information as useful as I did! If you would like to discuss your situation with me, I would be happy to prodvide you with a free, no obligation consultation. My direct number is 925-577-8692.