In my column, Foreclosure and Short Sales, a Time Bomb for the Panhandle, I shared the possible tax consequences of losing a home to foreclosure or “short sale” (a sale in which the home sells for less than the amount of debt secured by the property).  One reader commented on the that the article overlooked an income exclusion provided by the Mortgage Debt Relief Act of 2007 which “allows almost everyone who had a cancellation of debt (foreclosure or short sale) on their principal residence between 2007 and 2012, to have up to $2 million of forgiven debt ($1 million if married filing separately).”  The comment went on to quote the IRS website: “Qualified Principal Residence Indebtedness: This is the exception created by the Mortgage Debt Relief Act of 2007 and applies to most homeowners.”

Unfortunately, this is NOT TRUE for “most” debt secured by homes in the Panhandle.

The Mortgage Debt Relief Act of 2007 did create the Qualified Principal Residence Indebtedness Exclusion. Unfortunately, however, widespread misunderstanding regarding this exclusion and its proper application is the primary reason many area homeowners face (or will face) tax bills – bills that could have been avoided or minimized. 

The purpose of today’s column is to correct two of the most consequential misunderstandings regarding the Qualified Principal Resident Indebtedness Exclusion.

Myth 1: All loans secured by a principal residence qualify for exclusion.

Fact: The Qualified Principal Resident Indebtedness exclusion only applies to “Acquisition Debt.”  The IRS defines Acquisition Debt as 1) debt used to build, buy, or substantially improve your main home AND 2) debt that is secured by that home.  Generally, this is original mortgage debt (or any portion of that debt that has been refinanced) and loans used to make Capital Improvements to the property.  That is all. 

Countless Panhandle homeowners refinanced their homes during the 2002-2008 “boom” and used the proceeds for something OTHER than substantially improving their main home.  Many have been told these secured, non-acquisition loans qualify for the 2007 Act’s exclusion.  THEY DO NOT

Others have been told that home equity loans qualify as Acquisition Debt if used to buy furniture, bedroom suits, and televisions.  THEY DO NOT

Individuals who believe this “tax-myth” and short-sell or walk away from a home are often devastated when they learn that this canceled debt may be taxable unless another exclusion applies.  For most, the Insolvency exclusion is the only remedy available.  Unfortunately, however, taxpayers who own other properties or have vested retirement accounts are often not insolvent by IRS definition.  The result: a tax bill that can only be paid by withdrawing from retirement their account – creating another tax bill plus an additional 10% penalty for those under age 59 ½. 

Had these individuals talked to a professional BEFORE losing/selling the property, they would have learned the truth about its tax consequences.  They would have been able to make an informed decision and possibly avoid the tax altogether.  How?  By consulting an attorney to ascertain whether bankruptcy (another exclusion) is a viable option.

Myth 2: Canceled debt that “qualifies” does not have to be reported on your tax return.

Fact: Canceled Debt Income MUST be properly reported and excluded.  Even if your debt qualifies for the Qualified Principal Residence Indebtedness exclusion you must properly report and exclude the income.  You must also reduce what are called “tax attributes.”  Reducing tax attributes is relatively simple for Qualified Principal Residence Indebtedness and more complex for other exclusions. 

The fact is that if cancelled debt is ignored or not properly reported, the IRS will not know the income could have been excluded.  The lender will report the income to the IRS and the IRS will check to see if you reported/excluded the income.  If you didn’t, you will most likely receive a tax bill plus interest and penalties.  If you could have excluded the debt, you must now amend your return and prove that you were entitled to the exclusion.  If you were not entitled to the exclusion (but thought you were), you now owe a great deal more due to interest and penalties.

The take away – if you are facing foreclosure or considering short sale, please do not listen to “tax myths.”  Talk to a professional BEFORE you lose or sell the property.

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