Chapter 4
Detailed Examples(p12)

These examples use actual forms to help you prepare your income tax return. However, the information shown on the filled-in forms is not from any actual person or scenario.

In 2005, Nancy Oak bought a main home for $435,000. Nancy took out a $420,000 mortgage loan to buy the home and made a down payment of $15,000. The loan was secured by the home. The mortgage loan was a recourse debt, meaning that Nancy was personally liable for the debt. In 2006, Nancy took out a second mortgage loan (also a recourse debt) in the amount of $30,000 that was used to substantially improve her kitchen.

In 2009, when the outstanding principal of the first and second mortgage loans was $440,000, Nancy refinanced the two recourse loans into one recourse loan in the amount of $475,000. The FMV of Nancy's home at the time of the refinancing was $500,000. Nancy used the additional $35,000 debt ($475,000 new mortgage loan minus $440,000 outstanding principal of Nancy's first and second mortgage loans immediately before the refinancing) to pay off personal credit cards and to pay college tuition for her son. After the refinancing, Nancy has qualified principal residence indebtedness in the amount of $440,000 because the refinanced debt is qualified principal residence indebtedness only to the extent the amount of debt is not more than the old mortgage principal just before the refinancing.

In 2011, Nancy was unable to make her mortgage loan payments. On August 31, 2011, when the outstanding balance of her refinanced mortgage loan was still $475,000 and the FMV of the property was $425,000, Nancy's bank agreed to a loan modification (a "workout") that resulted in a $40,000 reduction in the principal balance of her loan. Nancy was neither insolvent nor in bankruptcy at the time of the loan modification.

Nancy received a 2011 Form 1099-C from her bank in January 2012 showing canceled debt of $40,000 in box 2. To determine if she must include the canceled debt in her income, Nancy must determine whether she meets any of the exceptions or exclusions that apply to canceled debts. Nancy determines that the only exception or exclusion that applies to her is the qualified principal residence indebtedness exclusion.

Next, Nancy determines the amount, if any, of the $40,000 of canceled debt that was qualified principal residence indebtedness. Although Nancy has $440,000 of qualified principal residence indebtedness, part of her loan ($35,000) was not qualified principal residence indebtedness because it was used to pay off personal credit cards and college tuition for her son. Applying the ordering rule, the qualified principal residence indebtedness exclusion applies only to the extent the amount canceled is more than the amount of the debt (immediately before the cancellation) that is not qualified principal residence indebtedness. Thus, Nancy can exclude only $5,000 of the canceled debt as qualified principal residence indebtedness ($40,000 amount canceled minus $35,000 nonqualified debt).

Because Nancy does not meet any other exception or exclusion, Nancy checks only the box on line 1e of Form 982 and enters $5,000 on line 2. Nancy must also enter $5,000 on line 10b and reduce the basis of her main home by the $5,000 she excluded from income, bringing the adjusted basis in her home to $460,000 ($435,000 purchase price plus $30,000 substantial improvement minus $5,000). Nancy must also include the $35,000 nonqualified debt portion in income on Form 1040, line 21.

Following are Nancy's sample forms.

In 2003, John and Mary Elm bought a main home for $335,000. John and Mary took out a $320,000 mortgage loan to buy the home and made a down payment of $15,000. The loan was secured by the home and is a recourse debt, meaning John and Mary are personally liable for the debt.

John and Mary became unable to make their mortgage loan payments and on March 1, 2011, when the outstanding balance of the mortgage loan was $315,000 and the FMV of the property was $290,000, the bank foreclosed on the property and simultaneously canceled the remaining mortgage debt. Immediately before the foreclosure, John and Mary's only other assets and liabilities were a checking account with a balance of $6,000, retirement savings of $13,000, and credit card debt of $5,500.

John and Mary received a 2011 Form 1099-C showing canceled debt of $25,000 in box 2 ($315,000 outstanding balance minus $290,000 FMV) and an FMV of $290,000 in box 7. In order to determine if John and Mary must include the canceled debt in income, they must first determine whether they meet any of the exceptions or exclusions that apply to canceled debts. In this example, John and Mary meet both the insolvency and qualified principal residence indebtedness exclusions.

John and Mary complete the insolvency worksheet and determine that they were insolvent immediately before the cancellation because at that time their liabilities exceeded the FMV of their assets by $11,500 ($320,500 total liabilities minus $309,000 FMV of total assets). However, because the entire debt canceled is qualified principal residence indebtedness, the insolvency exclusion only applies if John and Mary elect to apply the insolvency exclusion instead of the qualified principal residence exclusion.

John and Mary do not elect to apply the insolvency exclusion instead of the qualified principal residence exclusion because under the insolvency exclusion their exclusion would be limited to the amount by which they were insolvent ($11,500). Instead, John and Mary check box 1e of Form 982 to exclude the canceled debt under the qualified principal residence exclusion. Under the qualified principal residence exclusion, the amount that John and Mary can exclude is not limited because their qualified principal residence indebtedness is not more than $2 million and no portion of the loan was nonqualified debt. As a result, John and Mary enter the full $25,000 of canceled debt on line 2 of Form 982. Because John and Mary no longer own the home due to the foreclosure, John and Mary have no remaining basis in the home at the time of the debt cancellation. Thus, John and Mary leave line 10b of Form 982 blank.

John and Mary must also determine whether they have a gain or loss from the foreclosure. John and Mary complete Table 1-1 and find that they have a $45,000 loss from the foreclosure. Because this loss relates to their home, it is a nondeductible loss.

Following are John and Mary's sample forms and worksheets.

taxmap/pubs/p4681-006.htm#en_us_publink1000266606

taxmap/pubs/p4681-006.htm#en_us_publink1000244172

Insolvency Worksheet—John and Mary Elm Date debt was canceled (mm/dd/yy) 03/01/11 Part I. Total liabilities immediately before the cancellation (do not include the same liability in more than one category) Liabilities (debts) Amount Owed Immediately Before the Cancellation 1. Credit card debt $ 5,500 2. Mortgage(s) on real property (including first and second mortgages and home equity loans) (mortgage(s) can be on personal residence, any additional residence, or property held for investment or used in a trade or business) $ 315,000 3. Car and other vehicle loans $ 4. Medical bills owed $ 5. Student loans $ 6. Accrued or past-due mortgage interest $ 7. Accrued or past-due real estate taxes $ 8. Accrued or past-due utilities (water, gas, electric) $ 9. Accrued or past-due child care costs $ 10. Federal or state income taxes remaining due (for prior tax years) $ 11. Judgments $ 12. Business debts (including those owed as a sole proprietor or partner) $ 13. Margin debt on stocks and other debt to purchase or secured by investment assets other than real property $ 14. Other liabilities (debts) not included above $ 15. Total liabilities immediately before the cancellation. Add lines 1 through 14. $ 320,500 Part II. Fair market value (FMV) of assets owned immediately before the cancellation (do not include the FMV of the same asset in more than one category) Assets FMV Immediately Before the Cancellation 16. Cash and bank account balances $ 6,000 17. Homes (including the value of land) (can be main home, any additional home, or property held for investment or used in a trade or business) $ 290,000 18. Cars and other vehicles $ 19. Computers $ 20. Household goods and furnishings (for example, appliances, electronics, furniture, etc.) $ 21. Tools $ 22. Jewelry $ 23. Clothing $ 24. Books $ 25. Stocks and bonds $ 26. Investments in coins, stamps, paintings, or other collectibles $ 27. Firearms, sports, photographic, and other hobby equipment $ 28. Interest in retirement accounts (IRA accounts, 401(k) accounts, and other retirement accounts) $ 13,000 29. Interest in a pension plan $ 30. Interest in education accounts $ 31. Cash value of life insurance $ 32. Security deposits with landlords, utilities, and others $ 33. Interests in partnerships $ 34. Value of investment in a business $ 35. Other investments (for example, annuity contracts, guaranteed investment contracts, mutual funds, commodity accounts, interests in hedge funds, and options) $ 36. Other assets not included above $ 37. FMV of total assets immediately before the cancellation. Add lines 16 through 36. $ 309,000 Part III. Insolvency 38. Amount of Insolvency. Subtract line 37 from line 15. If zero or less, you are not insolvent. $ 11,500

In 2009, 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 main home. Kathy and Frank made a $400,000 down payment and took out a $2,600,000 mortgage to finance the remaining cost of the house. Kathy and Frank are personally liable for the mortgage loan, which is secured by the home.

In November 2011, 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 5, 2011, sold the property to another buyer for $1,750,000. On December 26, 2011, the lender canceled the remaining debt. Kathy and Frank have no tax attributes other than basis of personal-use property.

The lender issued a 2011 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 application of 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 2011.

Because the foreclosure occurred prior to the debt cancellation, Kathy and Frank first calculate their gain or loss from the foreclosure using Table 1-1. Because Kathy and Frank remained personally liable for the $750,000 debt remaining after the foreclosure ($2,500,000 outstanding debt immediately before the foreclosure minus $1,750,000 satisfied through the sale of the home), 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 home, it is a nondeductible loss.

Because the lender later canceled the remaining amount of the debt, Kathy and Frank must also determine whether that canceled debt is taxable. Immediately before the cancellation, Kathy and Frank had $15,000 in a savings account, household furnishings with an FMV of $17,000, a car with an 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 household furnishings originally cost $30,000. The car 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 2012, Kathy and Frank had $9,000 in their savings account and $15,000 in credit card debt. Kathy and Frank also owned the same car at that time (still with an FMV of $10,000 and basis of $16,000) and the same household furnishings (still with an FMV of $17,000 and a basis of $30,000). 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 2011.

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 the home 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 $46,000 bases of their personal-use property held at the beginning of 2012 ($16,000 basis in the car plus $30,000 basis in household furnishings),
• 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 $43,000 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 $30,000 basis in household furnishings plus $16,000 adjusted basis in car minus $18,000 credit card debt).

Kathy and Frank enter $43,000 on Form 982, line 10a and reduce their bases in the car and the household furnishings in proportion to the adjusted bases in all their property. Kathy and Frank reduce the basis in the car by $14,956.52 ($43,000 x $16,000/$46,000). And they reduce the basis in the household furnishings by $28,043.48 ($43,000 x $30,000/$46,000).

Following are Kathy and Frank's sample forms and worksheets.

taxmap/pubs/p4681-006.htm#en_us_publink1000266723

taxmap/pubs/p4681-006.htm#en_us_publink1000266717

Insolvency Worksheet—Frank and Kathy Willow Date debt was canceled (mm/dd/yy) 12/26/11 Part I. Total liabilities immediately before the cancellation (do not include the same liability in more than one category) Liabilities (debts) Amount Owed Immediately Before the Cancellation 1. Credit card debt $ 18,000 2. Mortgage(s) on real property (including first and second mortgages and home equity loans) (mortgage(s) can be on personal residence, any additional residence, or property held for investment or used in a trade or business) $ 750,000 3. Car and other vehicle loans $ 4. Medical bills owed $ 5. Student loans $ 6. Accrued or past-due mortgage interest $ 7. Accrued or past-due real estate taxes $ 8. Accrued or past-due utilities (water, gas, electric) $ 9. Accrued or past-due child care costs $ 10. Federal or state income taxes remaining due (for prior tax years) $ 11. Judgments $ 12. Business debts (including those owed as a sole proprietor or partner) $ 13. Margin debt on stocks and other debt to purchase or secured by investment assets other than real property $ 14. Other liabilities (debts) not included above $ 15. Total liabilities immediately before the cancellation. Add lines 1 through 14. $ 768,000 Part II. Fair market value (FMV) of assets owned immediately before the cancellation (do not include the FMV of the same asset in more than one category) Assets FMV Immediately Before the Cancellation 16. Cash and bank account balances $ 15,000 17. Homes (including the value of land) (can be main home, any additional home, or property held for investment or used in a trade or business) $ 18. Cars and other vehicles $ 10,000 19. Computers $ 20. Household goods and furnishings (for example, appliances, electronics, furniture, etc.) $ 17,000 21. Tools $ 22. Jewelry $ 23. Clothing $ 24. Books $ 25. Stocks and bonds $ 26. Investments in coins, stamps, paintings, or other collectibles $ 27. Firearms, sports, photographic, and other hobby equipment $ 28. Interest in retirement accounts (IRA accounts, 401(k) accounts, and other retirement accounts) $ 29. Interest in a pension plan $ 30. Interest in education accounts $ 31. Cash value of life insurance $ 32. Security deposits with landlords, utilities, and others $ 33. Interests in partnerships $ 34. Value of investment in a business $ 35. Other investments (for example, annuity contracts, guaranteed investment contracts, mutual funds, commodity accounts, interests in hedge funds, and options) $ 36. Other assets not included above $ 37. FMV of total assets immediately before the cancellation. Add lines 16 through 36. $ 42,000 Part III. Insolvency 38. Amount of Insolvency. Subtract line 37 from line 15. If zero or less, you are not insolvent. $ 726,000