In the usual situation, the cancellation or forgiveness of a debt results in taxable income for the taxpayer who owes the debt. However, homeowners can benefit from a special tax exemption on mortgage forgiveness. This tax break could save tens of thousands of dollars in taxes. However, as a new case shows, Weiderman, TC 2020-109 memo, 07/15/20, certain conditions must be fulfilled.
Background: Typically, a taxpayer must pay debt forgiveness tax in the year the debt is actually forgiven. This applies to personal debts of any kind, including those involving intra-family loans. But Congress gave a one-time tax break to mortgage debts. More specifically, it provides a tax exclusion for the forgiveness of up to $ 1 million of debt on an eligible residence for a single filer and $ 2 million for joint filers.
To this end, debt must be incurred to acquire, build or substantially improve your primary residence. In other words, you cannot claim tax exemption for the purchase, construction or improvement of a second home, such as a vacation home. In addition, the mortgage must be guaranteed by the main residence.
This provision, which has expired and been reinstated several times in the past, was recently reactivated and extended until 2020 by the Taxpayer Certainty and Disaster Tax Relief Act. There is a good chance that it will be extended again if Congress succeeds this year or perhaps retroactively in 2021.
In the new case, the taxpayer was hired to head the marketing department of a California company. The company granted him an interest-free loan of $ 500,000 to help finance the purchase of a house in this area, provided him with up to 180 days of temporary accommodation in a furnished company apartment, reimbursed him for his travel expenses for several three-day trips and paid his moving expenses from Massachusetts.
The loan was materialized by a promissory note. The taxpayer then bought a house in an affluent suburb.
Subsequently, the company terminated the use. Pursuant to the promissory note, she demanded repayment of the loan of $ 500,000. The parties ultimately agreed to settle the matter by charging the taxpayer only half of the outstanding amount. The company agreed to waive the other half of the obligation.
In her tax returns for the tax years in question – 2009 and 2010 – the taxpayer excluded from tax the amount of loan forgiveness under the special provision of the Tax Law on mortgage debts. But the IRS disputed the use of the exclusion.
Tax result: Unfortunately for the taxpayer, the arrangement did not meet all the requirements set out in the tax law. On the one hand, the house was not used as collateral for the loan. On the other hand, the promissory note was not correctly recorded in the county registers. 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 customers may find themselves in similar situations due to the COVID-19 pandemic or other extenuating circumstances. Make sure they have followed the letter of the law to benefit from the tax exclusion.