Mike’s Real Estate Show

Thanks for the question you raised on my blog: www.MikesRealEstateShow regarding “debt foregiveness”. In your case, if you move back into your residence and do a “Short-Sale” on the property then this bill allows you to receive debt foregiveness and NOT have it reported as “ordinary income” which would be added to your regular income in the year of the sale. 

Your regular income tax rate would prevail in this scenario. Here’s the scenario as to how this would happen:

You bought your home for $650,000. 
Your loan when you buy the property is $600,000
You do a “short-Sale” with the lender for $450,000.

A “Short-Sale” refers to a sale where the properties market value is below what is “owed” on the property. In this example that would be $600,000. Therefore, your “Debt Foregivness” by the lender would be $150,000. Current law states the lender will report this to the IRS in a 1099 as “Debt Foregiveness” and the IRS computes it as “ordinary income”. Say you made $40,000 the year of the sale. Add the $150,000 to the $40,000 and your “income” for the year is $190,000!!! You now get to pay your income taxes at the much higher tax bracket!! Double whammy-you loose your house but get nailed for the “debt foregiveness”

This house bill will NOT allow this to keep happening. However, it reduceds your basis in your home by the amount of “debt foregiveness” which may affect your exception ($250,000 filing single, $500,000 jointly). So if you have to pay it will be at  the Long Term Capital Gains rate instead of the Income Tax Rate. This is substantially different.

What you seem to be doing is fine but with one BIG CAVEAT!! You stated in your email: “We recently left our primary residence and moved into our rental. We are now turning it into our primary residence. If we live here as a primary residence for 2 years will we still be exempt from the gain when we sell it? Or will HR 3648 make us liable to pay some taxes? How much?”
  Here the CAVEAT!! If you aquired this “rental” via a tax 1031 deferred exchange, that is you had another rental property and “exchanged” into the current rental,  you could be in for a rude awakening!  If you did a regular investment “purchase” without an exchange your in good shape. Here’s the issue. The IRS got hip to all the investors with exchanged properties moving in to the rental, live there two years and then walk away with a nice tax foregiveness. They now make you live in the rental for 5, yes, 5 years (obviously check with your CPA for ALL Tax Advice!!) before you can get this treatment! But here’ an even more onerous development—the IRS is thinking about eliminating this ALL TOGETHER!!  I belive regardless of HOW you got the rental!!
  So be careful out there!
 Below is a snyopsis of the house bill and its current status:

/4/2007–Passed House amended.
Mortgage Forgiveness Debt Relief Act of 2007 - Amends the Internal Revenue Code to exclude from gross income amounts attributable to a discharge of indebtedness incurred to acquire a principal residence. Limits to $2 million the excludable amount of such indebtedness. Reduces the basis of a principal residence by the amount of discharged indebtedness excluded from gross income. Disallows an exclusion for a discharge of indebtedness on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer. Sets forth rules for determining the allowable amount of the exclusion for taxpayers with nonqualifying indebtedness and who are insolvent.