Chapter 4
Detailed Examples(p12)

In 2006, Kathy and Frank Willow got married and entered into a contract with Hive Construction Corporation to build a house for $3,000,000 to be used as their personal residence. Kathy and Frank took out a $2,600,000 mortgage loan to build the home and put down the remaining $400,000. Kathy and Frank are personally liable for the mortgage loan, which is secured by the principal residence.

In November 2008, when the outstanding principal balance on the mortgage loan was $2,500,000, the FMV of the property fell to $1,750,000 and Kathy and Frank abandoned the property by permanently moving out. The lender foreclosed on the property and, on December 3, 2008, sold the property to another buyer for $1,750,000. On December 26, 2008, the lender canceled the remaining debt. Kathy and Frank have no tax attributes other than basis of personal use property.

The lender issued a 2008 Form 1099-C to Kathy and Frank showing canceled debt of $750,000 in box 2 (the remaining balance on the $2,500,000 mortgage debt after $1,750,000 satisfaction through the foreclosure sale proceeds) and $1,750,000 in box 7 (FMV of the property). Although Kathy and Frank abandoned the property, the lender did not need to also file a Form 1099-A because the lender canceled the debt in connection with the foreclosure in the same calendar year. Kathy and Frank are filing a joint return for 2008.

Because the foreclosure occurred prior to the debt cancellation, Kathy and Frank first calculate their gain or loss from the foreclosure of their principal residence using Table 1-1. Because Kathy and Frank still remained personally liable for the $750,000 remaining debt after the foreclosure ($2,500,000 outstanding debt immediately before the foreclosure minus $1,750,000 satisfied through the sale of the residence securing the loan), Kathy and Frank enter $1,750,000 on line 1 of Table 1-1 ($2,500,000 outstanding debt immediately before the foreclosure minus the $750,000 for which they remained liable). Completing Table 1-1, Kathy and Frank find that they have no ordinary income from the cancellation of debt upon foreclosure and that they have a $1,250,000 loss. Because this loss relates to their personal residence, it is a nondeductible loss.

Because the lender later canceled the remaining amount of the debt, Kathy and Frank must also determine any taxable portion of their income from the cancellation of debt. Immediately before the cancellation, Kathy and Frank had $15,000 in a savings account, $17,000 in a retirement account, a car with a FMV of $10,000, and $18,000 in credit card debt. Kathy and Frank also had the $750,000 remaining balance on the mortgage loan at that time. The $17,000 retirement account is made up of $15,000 of deductible contributions and $2,000 of nondeductible contributions. The car that Kathy and Frank owned at the time of cancellation had been fully paid off (so there was no related outstanding debt) and was originally purchased for $16,000. Kathy and Frank had no adjustments to the cost basis of the car. Kathy and Frank had no other assets or liabilities at the time of the cancellation. Kathy and Frank complete the insolvency worksheet to calculate that they were insolvent to the extent of $726,000 immediately before the cancellation ($768,000 of total liabilities minus $42,000 FMV of total assets).

At the beginning of 2009, Kathy and Frank had $9,000 in their savings account, $17,000 in their retirement account, and $15,000 in credit card debt. Kathy and Frank also owned the same car at that time (still with a FMV of $10,000 and basis of $16,000). Kathy and Frank had no other assets or liabilities at that time. Kathy and Frank no longer own the home because the lender foreclosed on it in 2008.

The insolvency exclusion does not apply if the indebtedness is qualified principal residence indebtedness unless Kathy and Frank elect to apply the insolvency exclusion instead of the qualified principal residence indebtedness exclusion. The maximum amount that Kathy and Frank can treat as qualified principal residence indebtedness is $2,000,000. The remaining $500,000 ($2,500,000 outstanding mortgage loan minus $2,000,000 limit on qualified principal residence indebtedness) is not qualified principal residence indebtedness. Because only a part of the loan is qualified principal residence indebtedness, Kathy and Frank must apply the ordering rule to the canceled debt. Under the ordering rule, the qualified principal residence indebtedness exclusion applies only to the extent that the amount canceled ($750,000) exceeds the amount of the loan (immediately before the cancellation) that is not qualified principal residence indebtedness ($500,000). This means that Kathy and Frank can only exclude $250,000 ($750,000 amount canceled minus $500,000 nonqualified debt) under the qualified principal residence indebtedness exclusion.

Kathy and Frank do not elect to have the insolvency exclusion apply instead of the qualified principal residence exclusion. Nonetheless, they can still apply the insolvency exclusion to the $500,000 nonqualified debt because such debt is not qualified principal residence indebtedness. Kathy and Frank can exclude the remaining $500,000 canceled debt under the insolvency exclusion because they were insolvent immediately before the cancellation to the extent of $726,000. Thus, Kathy and Frank check the boxes on lines 1b and 1e of Form 982 and enter $750,000 on line 2 ($250,000 excluded under the qualified principal residence indebtedness exclusion plus $500,000 excluded under the insolvency exclusion).

Next, Kathy and Frank reduce their tax attributes using Part II of Form 982. Because Kathy and Frank no longer own the home due to the foreclosure, Kathy and Frank have no remaining basis in their principal residence at the time of the debt cancellation. Thus, Kathy and Frank leave line 10b of Form 982 blank. However, Kathy and Frank are also excluding nonqualified debt under the insolvency exclusion. As a result, Kathy and Frank must reduce the basis of property they own based on the amount of canceled debt they are excluding from income under the insolvency rules. Because Kathy and Frank have no tax attributes other than basis of personal use property to reduce, Kathy and Frank figure the amount they must include on line 10a of Form 982 by taking the smallest of:

• The $18,000 bases of their personal use property held at the beginning of 2009 ($16,000 basis in the car plus $2,000 basis in retirement account based on non-deductible contributions),
• The $500,000 of the nonbusiness debt (other than qualified principal residence indebtedness) that they are excluding from income on line 2 of Form 982, or
• The $30,000 excess of the total bases of the property and the amount of money they held immediately after the cancellation over their total liabilities immediately after the cancellation ($15,000 in savings account plus $17,000 in retirement account plus $16,000 adjusted basis in car minus $18,000 credit card debt).

Kathy and Frank enter $18,000 on Form 982, line 10a and reduce their bases in the car and the retirement account to $0.

Following are Kathy and Frank's sample forms and worksheets. taxmap/pubs/p4681-006.htm#en_us_publink1000164718