Cincinnati Estate Tax Rules Relating to Debt Discharged in Connection With Your Personal Residence

The Mortgage Forgiveness Debt Relief Act of 2007 and subsequent amendments allow taxpayers to exclude up to $2 million of income from the discharge of indebtedness as a result of debt discharge on their principal residence. This applies to debt forgiven in calendar years 2007 through 2012. This applies to foreclosures as well as short sales, so it is not required that the taxpayers stay in the home until the foreclosure.

The amount of cancellation of debt income on recourse loans is the amount of debt immediately prior to the cancellation minus the fair market value of the property (there is never any cancellation of debt on non-recourse loans). The cancellation of debt income is excluded from gross income by filing Form 982 with the taxpayer’s tax return for the year of discharge.

If the taxpayers stay in the same principal residence as part of a loan modification, they must reduce their basis in the home (but not below zero) by the amount of cancellation of debt income excluded. If the taxpayers no longer own the residence there are no basis adjustments required.

There may also be a gain on the foreclosure. The gain is the excess of the fair market value of the residence over the taxpayer’s basis (purchase price plus cost of major improvements) in the residence. If the property was owned and used as a personal residence for any two of the last five years prior to the date of foreclosure the taxpayers may exclude up to $500,000 ($250,000 if filing separate)of the gain from income. Any loss on the foreclosure of a personal residence is not deducted.

In conclusion The Mortgage Forgiveness Debt Relief Act of 2007 provides that taxpayers will not have to include any cancellation of debt income unless the amount of debt forgiven is over $2 million.