Question: My daughter is well behind on her home mortgage payments and her house will likely be lost by foreclosure or otherwise. Will she have to pay tax on the unpaid mortgage balance?
Answer: There are various tax issues that need to be considered in determining the consequences of losing a residence. The general tax principle is that when a taxpayer’s debt is forgiven or discharged, the taxpayer must report gain and pay tax on the unpaid debt. There are, however, some applicable exceptions which taxpayers can utilize to avoid paying tax in these circumstances.
Based on a temporary Federal tax statute enacted in 2007, now extended through 2025, taxpayers with qualified personal residence indebtedness (“QPRI”) need not pay tax on debt forgiven or discharged on home mortgage loans. QPRI is debt used to acquire a taxpayer’s principal residence, limited to $750,000 for married couples filing joint income tax returns and and individuals and $375,000 for married taxpayers which file income tax returns separately from their spouses. The debt must have been incurred to acquire, construct or improve the residence and must also be secured by the residence. Any debt incurred to refinance original acquisition debt also qualifies as QPRI with some modifications, as discussed below.
There are various obstacles which taxpayers must be aware of. The residence to which the forgiven debt pertains must be the taxpayer’s principal residence; debt forgiveness on a vacation home or any other real estate property will not qualify as QPRI. Taxpayers must, as noted above, be mindful of the inapplicability of the QPRI rule to refinanced debt where the amount of such refinanced debt exceeds the sum of the indebtedness used to acquire the home and debt incurred to construct or improve the residence.
For example, assume Glen borrowed $200,000 to purchase a principal residence and later refinanced the original debt with a $300,000 loan and used the excess loan proceeds for purposes of paying college tuition and other non-residence related expenses. In this case, if Glen’s full debt is forgiven, through foreclosure or some other arrangement between Glen and the lender, some portion of the forgiven debt will be excludable from income as QPRI while some portion will be taxable as the refinancing proceeds were used in part for non-residence expenses.
For the many taxpayers who do refinance their mortgage debt and use the excess proceeds only to add improvements to their residences, the discharged debt may qualify in full as QPRI. Persons in this situation should keep accurate records establishing the application of the refinancing proceeds towards the cost of home improvements in the event the IRS challenges the qualification of some portion of the discharged debt as QPRI. Keeping track of home improvement expenses is important for other reasons as well as the amount so expended increases a taxpayer’s basis in the residence which may impact the taxation of gain that may have to be reported on the sale of the home.
It is noteworthy that QPRI treatment is available not only to loans discharged through mortgage foreclosures but in other circumstances as well. In many cases, a homeowner will work with a lender in a so-called short sale and transfer the home to the lender in full satisfaction of the mortgage balance, even where the home is worth less than the unpaid balance of the mortgage. Although the lender does not pursue its claim against the homeowner for the balance of the unpaid indebtedness, the QPRI rules are available to exclude the full discharged debt from the taxpayer’s taxable income just as if the home was lost through foreclosure.
One other general exception to the taxability of debt discharge income is the insolvency exemption. Taxpayers whose debt is discharged while they are insolvent need not report the discharged debt as income to the extent of their insolvency. There are some other intricacies of this rule that must be considered.
There are several avenues available to your daughter to avoid taxable gain at this most unfortunate time in her life. Careful consideration of the applicable tax rules may provide some helpful relief from taxation.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions, you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to firstname.lastname@example.org.