As we transverse the calendar from 2012 to 2013, the horizon is veiled in a fog of financial uncertainty.  If we do not steer clear of this proverbial fiscal cliff, the average taxpayer will face a major tax increase as the Bush Era tax cuts expire.  The Adoption Credit will disappear for most adoptive parents.  Changes in the Standard Deduction will resurrect the marriage tax penalty.  The Dependant Care Credit and Education Credits will be slashed as the Child Tax Credit is cut in half.  As uncertain as these skies may seem, however, underwater homeowners (debt on their home exceeds its value) facing the prospect of short-sale and/or foreclosure may soon face another dilemma: a sea of tax debt caused by the expiration of Qualified Principal Residence Indebtedness Exclusion. 

The Qualified Principal Residence Indebtedness Exclusion was created by the Mortgage Debt Relief Act of 2007.  The exclusion was scheduled to expire in 2009 but was extended through 2012 by the Emergency Economic Stabilization Act of 2008.  The Qualified Principal Residence Indebtedness Exclusions (QPRIE) allows homeowners to exclude up to $2 million dollars of cancelled debt (reported via Form 1099-C) from taxable income.  To qualify the debt must have been secured by their principal residence.  It must have also been acquisition debt (used to build, buy, or improve the property).  This QPRIE has saved countless thousands of housing bubble buyers countless millions in taxes.  Currently, there are at least six bills in Congress that will extend the QPRIE through 2013.  Unfortunately, however, only one, Senate Bill 3521: Family and Business Tax Cut Certainty Act, has made it out of committee as of the time of this writing.  If the exclusion is not extended, homeowners will have to pay tax on cancelled acquisition debt unless they are insolvent (via the Insolvency Exclusion) or have had the debt discharged in bankruptcy.

Financial + Tax Trauma: Imagine losing your home because you cannot afford to make your payments. Then, as if this trauma were not enough, you receive the kick in the gut: a huge tax bill because the bank cancelled the remainder of a debt you were too broke to pay.  For example: Consider John who owes $300,000 on his primary residence.  He purchased the home at top of the housing bubble and today its value is $185,000.  If the Qualified Principal Residence Indebtedness Exclusion is not extended and John’s home is foreclosed upon or sold-short for $185,000, the remaining $115,000 debt may be taxable to John if the bank forgives it and he does not qualify for one of two other cancelled-debt exclusions: insolvency and bankruptcy.

If John was not insolvent (meaning his total assets are greater than their total liabilities) just prior to the debt’s cancellation and/or the debt was not discharged in bankruptcy, he will owe tax on the cancelled debt.  How much tax?  John will receive a Form 1099-C for $115,000 from his mortgage company which he will have to add to his taxable income on his 2013 income tax return.  John will owe over $35,000 in additional federal and state taxes (assuming a federal and state tax rate of 25% and 6% respectively).  And did I mention, other than having a relatively small retirement nest-egg, John is broke.  To pay the tax, John will probably have to remove the money from his retirement account, creating another taxable event plus a 10% penalty if John is under age 59 ½.

Will the Exclusion be extended?  As stated earlier, there are currently at least half-a-dozen congressional bills that will extend this the QPRIE through 2013.  One of these bills may become part of fiscal-cliff legislation or it could be passed in 2013 and made retroactive.  These possibilities, however, provide little solace for under-water homeowners who are financially pressed to make a decision.  For those seeking certainty, your best option may be contacting your congressional representatives.

This article (or any article) should not be relied upon to make tax or financial decisions.  If you have questions regarding assistance regarding taxation a particular tax issue or have a question regarding how Health Care Reform may impact you and/or your business’s tax obligations, please feel free to contact our office to consult with a tax professional.

amzn_assoc_placement = “adunit0”;
amzn_assoc_enable_interest_ads = “true”;
amzn_assoc_tracking_id = “acallresite-20”;
amzn_assoc_ad_mode = “auto”;
amzn_assoc_ad_type = “smart”;
amzn_assoc_marketplace = “amazon”;
amzn_assoc_region = “US”;
amzn_assoc_linkid = “01358b91be20242b95628fb5fe5ad2ab”;
amzn_assoc_fallback_mode = {“type”:”search”,”value”:”Today Deals”};
amzn_assoc_default_category = “All”;
amzn_assoc_emphasize_categories = “1064954”;