Insolvency Issues Related to the Qualified Principal Residence Exclusion

The first part of tax season has come and gone, yet Congress has still not renewed or made permanent many tax extenders. One of the extenders is the qualified principal residence exclusion. This allows taxpayers to exclude from income cancelled debt from a mortgage secured by their primary residence. This is a common occurrence when a primary home is foreclosed or short sold.

Many tax professionals advised their clients to file extensions, then wait to see if Congress will extend the tax bill through 2018 or longer. However, as of this writing, corresponding legislation has not been introduced in the U.S. House of Representatives, and there is a growing concern that taxpayers may have to pay tax on their cancellation of debt income. Despite the uncertainty around extending the exclusion, forgiven debt can be often be excluded from income using the insolvency exclusion.

A taxpayer must meet certain criteria to use this exclusion, and reduce certain attributes after the exclusion is used. It can be confusing for the average do-it-yourselfer, and for this reason, many affected people seek help from their tax accountant. Although the exclusion isn’t new, it has taken a back seat to the much-easier qualified personal residence exclusion. So, let’s brush up on the finer points of insolvency.

To figure out if a taxpayer is insolvent, start by using the insolvency worksheet in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments (for individuals). A taxpayer is insolvent to the extent their total liabilities exceed their total assets on the day before the cancellation of debt occurred. The remainder of liabilities after assets are subtracted becomes the limit of cancellation of debt income that can be excluded using insolvency.

For example, if your client had assets worth $365,500 and liabilities of $561,000, then they are insolvent to the tune of $195,500. Therefore, if the lender forgave $150,000 of mortgage debt, they would not pay tax on any of it.

Now consider the same situation, but remove the student loan debt from the equation. This lowers the liabilities to $511,000, so now your client would be insolvent by only $145,500. Therefore, they could exclude $145,500 and would pay tax on the remaining $4,500.

Now that you know if your client qualifies and how much to exclude, you can prepare the tax return. To show that you are excluding canceled debt from income under the insolvency exclusion, complete Form 982, parts 1 and 2, and check the box on line 1b. On line 2, include the smaller of the amount of the debt canceled or the amount by which the client was insolvent. The 1099-C in full is reported on line 21 of Schedule 1 as income. A subtraction is entered on line 21 for the insolvency amount; this can be labeled “see 982” or “insolvency exclusion.”

Finally, after you calculate the insolvency, report the 1099-C and complete Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), you must reduce certain tax attributes by the amount excluded. The reduction happens on the first day of the next tax year, so it is proper to do this step after you figure your client’s tax liability for the previous year.

Attributes must be reduced in order, and no attributes are reduced below zero:

• Net operating loss.
• General business credit carryover.
• Minimum tax credit.
• Net capital loss and capital loss carryovers.
• Basis of the property held at the beginning of 2019, business and personal.
• Passive activity loss and credit carryovers.
• Foreign tax credit.

Here are several other points to keep in mind:

• Your client can elect to reduce the basis of depreciable property held at the beginning of 2019 before reducing other tax attributes.
• If there are no attributes to reduce, you must reduce the basis in personal use property, such as a home, a car or personal belongings.
• Taxpayers who erroneously pay taxes on forgiven debt can go back and amend prior years’ tax returns for up to three years, and could get a refund for those years.

Editor’s note: Updated on July 29, 2019, to correct an inaccuracy. Check out the first article on the Intuit® Tax Pro Center in a six-part series on basis in tax.