Exclusion for discharge of debt on principal home

[vegasrealtor]

I am a Realtor and not a tax guy.

I have read about the exclusion for discharge of debt for principal residence and I am often asked about refinance debt. Example; Bill purchases home in 2001 for $100,000 with a $80,000 loan then refinances in 2006 for $200,000 and uses $50,000 to put in a pool and spends the rest on hookers and gambling.

If Bill short sales his house and the bank ends up with $70,000 and discharges $130,000 in debt is he going to be required to pay taxes on the $70,000 he spent freely or on the entire $120,000 pulled out in the refinance?

In this example the home is a principle residence the entire time.

Thank you for your response.

Vegas Realtor

[commentator]

The portion of the debt attributable to the acquisition of a primary residence, including renovations and upgrades, is excludible. The portion attributable to personal expenditures, including hookers and gambling, is not excludible.

Note that principle payments reduce the non-acquisition balance first until that balance is zero.

[mwcpa]

I concur, the exclusion applies only to the mortgage used to acquire/improve one's home, not for refinancing used for the "hookers and gambling"....

In the instant case, based on the facts the only portion that would be excludible seems to be the balance of the 80K loan when it was refinanced and the 50K to improve the home... so, the maximum that could be excluded is 130K.... so, 70K would be taxable COD income.... (please note if the original 80K loan was paid down to say 75K when the refinance occured then the excludible amount is 75 + 50 or 125, making 75 taxable, based on the facts presented).

here's a recent article from the IRS
www.irs.gov/newsroom/article/0,,id=205004,00.html

[cpadvisor]

any additional comments on debt discharged due to insolvency?

www.irs.gov/pub/irs-pdf/f982.pdf

[mwcpa]

insolvency.... cpa, what other details do you want to know....

insolvency is defined as "negative" worth immediately before the discharge of the debt... ALL assets are included at FMV... all cash, bank accounts, retirement accounts, value of home, personal property, car, jewels, art, etc., etc.... and debts are at amounts owed.... many think they are insolvent when they really are not when you run the numbers.... and IRS does check these claims... a few years ago a client filed the 982 and reported that he was insolvent... first IRS sent a CP-2000 stating the canceled debt was not reported when in fact it was... then after the reply they wanted proof of insolvency... luckily we reviewed out clients math (and kept his schedule) and did not just take his word for it when we prepared his filings for the year of debt forgiveness... and luckily he followed our advise and kept all of his "statements" (bank and debt) and a list of all of his other assets, that made life so much easier...

[cpadvisor]

I too have clients that I have had fill out a worksheet to show their insolvency and keep their records handy to support the position...

just thought the OP might like to know about that option as well...

[mwcpa]

good point cpa....

there is an out (tax wise) for those who qualify for the various 108 exclusions, but it does come with a cost.....

personally, I do not feel we taxpayers should reward by subsidizing the bad behavior of borrowing for what was noted by the original post (hookers and gambling), but that is only my personal opinion...

[commentator]

Hey, mw, hookers and gamblers have to eat, too. Besides, isn't being a hooker more respected than being a member of Congress (the outfit who writes tax laws)?