Loan Modification

[MARIADURAN]

Example 1—Mortgage loan modification. In 2002, Nancy Oak purchased a principal residence for $435,000. Nancy took out a $420,000 mortgage loan to buy the principal residence and made a down payment of $15,000. The loan was secured by the principal residence. The mortgage loan was a recourse debt, meaning that Nancy was personally liable for the debt. In 2003, Nancy took out a second mortgage loan (also a recourse debt) in the amount of $30,000 that was used to substantially improve her kitchen.
In 2006, when the outstanding principal of the first and second mortgage loans was $440,000, Nancy refinanced the two recourse loans into one recourse loan in the amount of $475,000. The FMV of Nancy's principal residence at the time of the refinancing was $500,000. Nancy used the additional $35,000 debt ($475,000 new mortgage loan minus $440,000 outstanding principal of Nancy's first and second mortgage loans immediately before the refinancing) to pay off personal credit cards and to pay college tuition for her son. After the refinancing, Nancy has qualified principal residence indebtedness in the amount of $440,000 because the refinanced debt is qualified principal residence indebtedness only to the extent the amount of debt does not exceed the amount of refinanced debt.
In 2008, Nancy was unable to make her mortgage loan payments. On August 31, 2008, when the outstanding balance of her refinanced mortgage loan was still $475,000 and the FMV of the property was $425,000, Nancy's bank agreed to a loan modification (a “workout”) that resulted in a $40,000 reduction in the principal balance of her loan. Nancy was neither insolvent nor in bankruptcy at the time of the cancellation.
Nancy received a 2008 Form 1099-C from her bank on January 31, 2009, showing canceled debt of $40,000 in box 2. To determine if she must include the canceled debt in her income, Nancy must determine whether she meets any of the exceptions or exclusions that apply to canceled debts. Nancy determines that the only exception or exclusion that applies to her is the qualified principal residence indebtedness exclusion.
Next, Nancy determines the amount, if any, of the $40,000 of canceled debt that was qualified principal residence indebtedness. Although Nancy has $440,000 of qualified principal residence indebtedness, part of her loan ($35,000) was not qualified principal residence indebtedness because it was used to pay off personal credit cards and college tuition for her son. Applying the ordering rule, the qualified principal residence indebtedness exclusion applies only to the extent the amount canceled exceeds the amount of the debt (immediately before the cancellation) that is not qualified principal residence indebtedness. Thus, Nancy can exclude only $5,000 of the canceled debt as qualified principal residence indebtedness ($40,000 amount canceled minus $35,000 nonqualified debt).
Because Nancy does not meet any other exception or exclusion, Nancy checks only the box on line 1e of Form 982 and enters $5,000 on line 2. Nancy must also enter $5,000 on line 10b and reduce the basis of her principal residence by the $5,000 that she excluded from income, bringing the adjusted basis in her principal residence to $460,000 ($435,000 purchase price plus $30,000 substantial improvement minus $5,000). Nancy must also include the $35,000 nonqualified debt portion in income on Form 1040, line 21.

[maggie]

Thank you for that great information Maria.

[manuel11]

Thats a great article Maria!!! Keep them coming.