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New Tax Court Case Confirms Specific Criteria Must be Met for Mortgage Loan Forgiveness

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When a mortgage loan debt is forgiven, the taxpayer might not actually have to pay anything. However, as a new Tax Court case shows, the IRS will only grant the break if the individual fills out the paperwork properly.

Aug 18th 2020
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In the usual situation, cancellation or forgiveness of a debt results in taxable income to the taxpayer who owes the debt. However, homeowners may qualify for a special tax exemption on mortgage loan forgiveness. This tax break could save tens of thousands of tax dollars. Nevertheless, as shown in a new case, Weiderman, TC Memo 2020-109, 7/15/20, certain requirements must be met.

Background: Generally, a taxpayer must pay tax on debt forgiveness in the year that the debt is actually forgiven. This applies to personal debts of all kinds, including those involving intra-family loans. But Congress carved out a unique tax break for mortgage debts. Specifically, it provides a tax exclusion for forgiveness of up to $1 million of debt on a qualified residence for a single filer and $2 million for joint filers.

For this purpose, the debt must be incurred to acquire, build or substantially improve your principal residence. In other words, you can’t claim the tax exclusion for buying, building or improving a second home, like a vacation home. Furthermore, the mortgage must be secured by the principal residence.

This provision, which has expired and been reinstated several times in the past, was recently revived and extended through 2020 by the Taxpayer Certainty and Disaster Tax Relief Act. There’s a good chance it will be extended again if Congress gets around to it this year or maybe retroactively in 2021.

In the new case, the taxpayer was hired to head up a California firm’s marketing department. The firm granted her an interest-free loan of $500,000 to help finance the purchase of a home in that area, provided her with up to 180 days of temporary housing in a furnished executive apartment, reimbursed her travel expenses for several three-day trips and paid her moving expenses from Massachusetts.

The loan was memorialized by a promissory note. The taxpayer then purchased a home in an affluent suburb.

Subsequently, the firm terminated the taxpayer’s employment. In accordance with the promissory note, it demanded repayment of the $500,000 loan. The parties eventually agreed to settle the issue by having the taxpayer pay only half of the outstanding amount. The firm agreed to forgive the other half of the obligation.

On her tax returns for the tax years in question—2009 and 2010—the taxpayer excluded from tax the loan forgiveness amount under the special tax law provision for mortgage debt. But the IRS challenged the use of the exclusion.

Tax outcome: Unfortunately for the taxpayer, the arrangement didn’t meet all the requirements spelled out in the tax law. For one thing, the home was not used as collateral for the loan. For another, the promissory note wasn’t properly recorded in the county records. Therefore, the loan forgiveness is taxable.

Lesson to be learned: There is often a huge amount of tax money at stake in these cases. Your clients may find themselves in similar situations due to the COVID-19 pandemic or other extenuating circumstances. Make sure they have complied with the letter of the law to qualify for the tax exclusion.   

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By Lewis C. Taishoff
Aug 19th 2020 17:23

The promissory note is not recorded; the mortgage (or, in CA, a deed of trust) is what is recorded. But the terms of the bailout statute expressly limit the use of the loan proceeds.

"Although [shoe company] recorded the deed of trust with the Los Angeles County, California, Registrar-Recorder, the $280,000 debt was not “incurred in acquiring, constructing, or substantially improving” the [residence] property. Indeed, the ... promissory note conditioned repayment of the $280,000 upon the sale of the [residence] property. Like the indebtedness of $500,000, the indebtedness of $280,000 was therefore not acquisition indebtedness, and thus [shoe company]'s cancellation of $35,000 of that indebtedness... shortly before the sale of the [residence] property was not cancellation of qualified principal residence indebtedness." 2020 T. C. Memo. 109, at p. 27.

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