Discharge of indebtedness on principal residences and business real property.

• Author: Zimmerman, John C.

The meltdown in real estate values in recent years has led to numerous debtor defaults and to creditors' lowering the carrying values of mortgages. This article discusses the differing tax consequences under Sec. 108(a)(1)(E) of a borrower's default and/or indebtedness discharge on recourse versus nonrecourse loans on principal residences. It then addresses the unresolved issue of what constitutes business indebtedness for purposes of the Sec. 108(a)(1)(D) exclusion from taxation for discharge of qualified real property business indebtedness. Planning opportunities are presented in each section.

Principal Residence Indebtedness

Sec.61(a)(12) provides that gross income includes income from the discharge of indebtedness. However, as introduced by the Mortgage Forgiveness Debt Relief Act of 2007 (1) and extended by the Emergency Economic Stabilization Act of 2008, (2) Sec. 108(a)(1)(E) excludes from gross income qualified principal residence indebtedness discharged after 2006 and before January 1, 2013. Sec. 108(h)(2) states that qualified principal residence indebtedness is "acquisition indebtedness" as defined in Sec. 163(h)(3)(B), except that the total indebtedness excluded for purposes of Sec. 108 is $2 million, not the $1 million mentioned in Sec. 163(h)(3)(B)(ii).

Sec.163(h)(3)(B)(i) defines acquisition indebtedness as indebtedness that is incurred in acquiring, constructing, or substantially improving any qualified residence and is secured by the residence. The term also includes refinancing indebtedness as long as the refinanced loan does not exceed the original indebtedness. However, if the refinanced indebtedness in excess of the original acquisition indebtedness is used to substantially improve the principal residence, it will also be considered ac-quisition indebtedness. The above definition of acquisition indebtedness excludes home equity indebtedness unless the taxpayer uses the equity debt to make improvements to the principal residence. Hence, absent finding some other provision that would exclude discharged home equity indebtedness from income (i.e., title 11 bankruptcy under Sec. 108(a)(1)(A)) or insolvency under Sec. 108(a)(1)(B), such discharge will result in income recognition.

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Sec.108(h)(5) defines a principal residence as having the same meaning as used in Sec. 121. Sec. 121(a) provides that for a residence to qualify as a principal residence, the taxpayer must own and use the residence for two of the five years preceding the sale by the taxpayer. The ownership and use tests need not be concurrent. The exclusion is limited to $250,000 in the case of an individual and $500,000 in the case of a married couple filing jointly. Sec. 121(a)(2)(A) provides that for a married couple, both spouses must meet the use requirement but only one spouse must meet the ownership requirement.

When a creditor reduces a loan balance on the principal residence, Sec. 108(h)(1) provides that the basis of the residence shall be reduced (but not below zero) by the amount of the discharge. However, Sec. 108(h)(3) states that the general rule of nontaxability will not apply if the reason for the discharge is services performed by the debtor for the lender or any other factor not related to the decline of the property's value or the taxpayer's financial condition.

Further, under Sec. 108(a)(2)(A) the general exclusion rule on principal residence indebtedness discharge will not apply if the discharge occurs in a title 11 bankruptcy case. Rather, the exclusion under Sec. 108(a)(1)(A) will apply. However, Sec. 108(a)(2)(C) provides that the principal residence exclusion rule will take precedence over the insolvency exclusion rule listed in Sec. 108(a)(1)(B) unless the taxpayer elects otherwise. A taxpayer who uses any of the income exclusion provisions under Sec. 108 must file with the tax return Form 982, Reduction of Tax Attributes due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

As noted above, the total amount of principal residence indebtedness that qualifies for relief is $2 million. However, there will be no limit on the amount of relief if the debt is a purchase money mortgage as described in Sec. 108(e)(5). This means that the property's seller is carrying the mortgage. This is not an unusual occurrence for very large mortgages where a third party may not be willing to extend credit. Debtors who have purchase money mortgages simply reduce their basis in the property by the amount of the indebtedness discharge. It should be emphasized that the provisions of Sec. 108(e)(5) apply to all property, not only principal residences. However, the exclusion will not apply in a title 11 case or when the purchaser is insolvent.

Recourse and Nonrecourse Debt

The tax consequences of principal residence acquisition indebtedness discharge can have differing impacts depending upon whether the debt is recourse or nonrecourse. Recourse debt means that the debtor can be held personally liable in the event of default. Thus, if the fair market value (FMV) of the property that secures a loan is not sufficient to cover the outstanding principal of the loan in the event of default, a creditor can attach other property owned by the debtor to cover the loan balance. Nonrecourse debt means that the creditor can seize only the property that secures the loan, even if the FMV of that property is not sufficient to cover the loan balance. For example, principal residences are sold in California on a nonrecourse basis. Hence, homeowners can walk away from their loans without fear of being pursued by the creditors.

The regulations provide that relief of a nonrecourse loan will be sufficient consideration received for property that is in default. (3)

Example 1: Taxpayer T defaults on a nonrecourse mortgage loan of $300,000. The principal residence basis is $320,000, and the FMV is $250,000. The property is considered to be sold for $300,000, and its FMV is irrelevant for purposes of determining liability relief. (4) T has an unrecognized $20,000 loss because the property is personal use property. However, there are no further tax consequences as a result of the default. The taxpayer can simply walk away from the loan. The lender issues the taxpayer Form 1099-A, Acquisition or Abandonment of Secured Property. The taxpayer does not file a Form 982 because there has been no discharge of indebtedness. The taxpayer reports the sale on a Form 1040, Schedule D, Capital Gains and Losses. Since a loss cannot be recognized, the sale price (i.e., the balance of the nonrecourse loan) and property's basis will be the same: $300,000.

However, if the nonrecourse lender cancels part of the debt for $600 or more under the repossession (e.g., a lender cancels part of the debt and then later in the year forecloses), the lender must file Form 1099-C, Cancellation of Debt. In that case, it can report the repossession information in boxes 4, 5, and 7 of Form 1099-C instead of filing Form 1099-A. (5) The taxpayer files Form 982 and Schedule D.

In the above example, if the lender has recourse against the taxpayer for property other than the property securing the loan, the treatment changes. (6) The borrower automatically has discharge of indebtedness income of $50,000, the difference between the property's FMV ($250,000) and the loan balance on the property ($300,000). The property is then considered sold for the remaining $250,000 debt securing the property. This results in a $70,000...