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Columns: Tax Talk
George Saenz, CPA   Expert: George Saenz, CPA
Tax Talk
Tax reprieve from falling home values
Tax Talk

Short-sale debt forgiveness

Dear Tax Talk,
I bought a home in California in 2005, and lived in it for about 20 months before moving due to a military job change. We decided to rent it for almost a year in hopes of a market recovery. Now (with about a 40-percent loss in the value of the home) we are in the middle of a short sale.

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My question is: Will I have to pay taxes on the "gain" I receive through the forgiveness of that debt? Does the (Mortgage Forgiveness) Debt Relief Act of 2007 help me since I originally bought the house as a primary residence?
-- Steve

Dear Steve,
Just as the president depends on your military service, you can depend on him in tough times. Facing a looming crisis in the home and mortgage industry, Congress and the president worked out the Mortgage Forgiveness Debt Relief Act.

An individual usually recognizes income when a debt is settled for less than its outstanding balance. Further, an individual cannot recognize a loss on a personal use asset such as his home.

When an individual converts a personal residence to rental use, his basis for later determining loss is the value at the time of conversion. This all means that when you short-sell the rental property, your loss may not be sufficient to offset the gain from the forgiven debt.

For example, assume that the home was purchased in 2005 for $220,000. The value of the home at the time it was rented was $200,000 and has further declined to $180,000. The mortgage balance is $220,000, including arrearages. The bank accepts the short sale for $180,000. The result is a nondeductible loss of $20,000 ($220,000-$200,000) a loss on the rental activity of $20,000 ($200,000-$180,000) and cancellation of debt income of $40,000 ($220,000-$180,000). Without relief you would be stuck with $20,000 in net income from the cancellation.

Under the debt relief act, you should be able to exclude the $20,000 in cancellation of debt income as the home was your principal residence. The home should still be considered your principal residence even though you didn't reach the usual two years of ownership and use due to a job-necessitated move. Form 982 is used to report forgiven home mortgage debt.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

Bankrate.com's corrections policy -- Posted: July 3, 2008
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