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.
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?
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
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