Foreclosures, home equity loans
The tax return preparation business is a whole lot more complicated today than it was when I started preparing taxes back in 1978. The Internal Revenue Service has to deal with many more preparers today than in 1978. Of course, we probably have to deal with more IRS people today than were employed in 1978. There have been thousands upon thousands of pages of regulations, publications, rules, and clarifying instructions added since 1978.
The technology of preparing returns is more complicated today. Back then, we used pencils, carbon paper, and predominantly one publication called Pub. 17. Today, the process is all computerized with fully interactive software. I can access all of the publications, regulations, rules, court cases, and commentary right from my software. It’s great. I only use a pencil to keep notes and a pen to sign items. Carbon paper? I doubt if kids of today even know what carbon paper is. There is not one piece of carbon paper in any tax office today.
Some things don’t change, though. There are preparers who didn’t follow the rules then and there are preparers who don’t follow the rules now. However, I believe today the IRS has a better handle on preparers as a whole. All preparers who sign returns today are required to apply for and receive a Preparer Tax Identification Number (PTIN). For information purposes, anyone who receives compensation for preparing a return is required to sign that return. Along with the application for the PTIN is a $63 fee that allows the IRS to maintain a database of preparers. This is not a bad thing for the thousands of legitimate tax preparers nationwide who are preparing good returns based on the tax laws as written.
In conjunction with the PTIN is a requirement that all preparers, other than CPAs, Enrolled Agents (EAs), and attorneys, must pass a Registered Tax Return Preparer (RTRP) test by December 31, 2013. All preparers must also take a minimum of 15 hours of continuing education annually with at least two of the hours based on the subject of ethics. This sounds very fair to me. The way things change in the field of taxation, even 15 hours might not be enough.
An area that has changed dramatically in the past few years is the topic of the foreclosure of a personal residence. This could result in taxable income to the party who was foreclosed upon.
For example, a taxpayer buys a home for $210,000 in 2005 with a mortgage for $200,000. By 2011, unfortunately the home was worth only $150,000 and the mortgage due was still $198,000. After the taxpayer lost his initial job and replaced it with a lower-paying job, he made the painful decision to walk away from the home in 2012. The bank takes the home back and subsequently resells it for $150,000. The taxpayer then receives a 1099-C for Cancellation of Debt (COD) for the difference between the amount owed of $198,000 and the sales price of $150,000 or $48,000.
Normally, as we saw last week, this COD would be considered taxable income. However, Congress, in this case, wisely created a Personal Residence Exception that says that as long as the debt forgiven arises from a mortgage that was used to buy, build or improve a personal residence, there is no COD taxable income. The taxpayer completes and files a Form 982 with his Form 1040 that eliminates the potential taxable income. This is a good thing. Having to declare COD income on a lost residence is called adding salt to the wound in my humble opinion.
A complicating tax situation arises when the taxpayer has a home equity loan as part of the mortgage due. Let’s change the above example to show how a home equity loan can affect our answer. The taxpayer purchased the home above 10 years earlier, in 1995, for $210,000. By 2005, he had paid the mortgage down to $175,000 but the value of the home had increased to $300,000. At that time, he still needed a car, his older daughter was attending the University of Michigan, and his younger daughter began to attend Michigan State University. It still didn’t take long to deplete his savings, and the best alternative at the time was still to take out a home equity loan for $80,000. There was plenty of equity between the $300,000 value and his balance due on his mortgage of $175,000. Unfortunately, by 2011, the home had declined in value to $208,000, a little below his original purchase price, but he still owed $233,000 on the two mortgages: $158,000 on the first mortgage and $75,000 on the home equity. He still lost his job so he gave the home back to the bank and they sold it for $185,000 so he still gets a 1099-C for $48,000 of COD income. This is the difference between the total amount owed of $233,000 and the bank selling price of $185,000.
Congress looks at the debt forgiveness differently in this case because the debt forgiven was not actually used to buy, build or improve the residence. The $48,000 was used to buy a car and put his daughters through college. The taxpayer by rule can’t use the Personal Residence Exclusion to not pay tax on the COD income. Unless he can apply one of the other exclusions we talked about last week, such as bankruptcy or insolvency, he is going to have to pay tax on the $48,000. Congress’ logic here does make some sense, because if the taxpayer had not taken out the home equity loan, he very well might not have lost the home.
These are very complicated tax situations. When dealing with these situations, it would probably pay to retain a tax professional to ensure the forms are completed properly and the correct amount of COD, if any, is claimed as income. This is Jerry Coon signing off.
Jerry Coon is an Enrolled Agent. He owns Action Tax Service on Northland Drive in Rockford. Jerry’s e-mail is email@example.com.