Cancellation Of Debt

[Edward]

s About Taxes)/Cancellation of Debt Advertisement Expert: John Stancil, CPA - 3/27/2013 Hi,

My husband is in the military and we were stationed in Hawaii where we purchased a condo in 2006. In August 2011 we got orders to move to Missouri and rented out our condo. We were tried to sell our condo while it was being rented out and in September 2012 it finally sold, but it was done through a short sale. We received a 1099-C for the difference in price sold and price owed to the bank. Now, we are trying to see if we qualify for The Mortgage Forgiveness Debt Relief Act and Debt Cancellation. We were told by H&R Block that we do not qualify because it was not considered our primary residence since it was used as a rental property. My question is concerning the definition of "primary residence". Wouldn't the condo still be considered our primary residence based on the ownership and use test? Also, because we received orders to move from the military wouldn't we still qualify for the Debt Relief Act based on IRS Publication 17(2012) under Business Use or Rental of Home? This portion states that a period of non-qualified use does not include: "any period(not to exceed an aggregate period of 10 years) during which you(or your spouse) are serving on qualified official extended duty as a member of the uniformed service". So, doesn't that mean that although the condo was being used as a rental property it would still be considered our primary residence which in turn would qualify us for the Mortgage Forgiveness Act?

ANSWER: Dee,

Sorry the other person couldn't answer your question. I think I can give you an answer.

Unfortunately, Block was correct.  Once the condo became a rental, the debt ceased to be qualified principal residence debt.  IRS regulations state that when a principal residence is converted to rental use, the debt no longer qualifies as acquisition indebtedness under Sec. 163(h)(3)(B). Under IRS regulations, a change in use of the property requires the debt to be reallocated to reflect the new use [Treas. Reg. Sec. 1.163-8T(j)(1)(i)(B)].

So, while your condo does qualify as your principal residence for exclusion of any gain on the sale, it does not qualify for exclusion of cancellation of debt income.

Hope this helps.  Sorry I can't give you better news.

John Stancil, CPA

---------- FOLLOW-UP ----------

Hi John, Thank you for your response, but it has got me quite confused. So, I can money from my home and not be have to pay taxes but if I lose money on it, I have to pay taxes? That doesn't make sense to me. Even though it was a debt incurred for tax purposes isn't it considered a gain and wouldn't that allow us to be qualified for the exclusion? Also, I was just informed that VA(because it was a VA loan)paid for the difference in the short sale. So, does that mean that I would still have to pay it even though VA paid for the amount on the 1099-C?

[Rally]

There are two different issues.  One is the loss on the sale of the unit, the other issue is the income you have from cancellation of debt.  

You pay taxes on the money you borrowed but did not repay.

If you have a loss on the sale of the condo it is a deductible loss.

Because it was no longer your primary residence, but had been converted to a rental, you are not entitled to an exclusion. The VA paid it, you didn't, you are still on the hook for the taxes.

John Stancil, CPA