Tax Question: What Constitutes a "Qualified Principal Residence"?

[Mississippi Mudstache]

I was released from a mortgage as of September 2013 by signing over the deed to the bank (a deed-in-lieu). I need to know whether or not the forgiven deficiency balance will be counted as taxable income or not. I am expecting it to be around $40,000, most of which would be taxed in the 15% bracket. I have read IRA Pub 4681, but my situation is complex and the publication does not seem to directly address my case.

Here is a timeline of events:

Jan 2008 – Purchased primary residence. $126,000, 100% mortgage.

July 2010 – Moved away from primary residence, rented another home in another city.

January 2011 – Home underwater, decided to rent it. Signed 1-year lease agreement. Mortgage was $1080/mo. Rent covered $650/mo.

January 2012 – Tenant was a f#@%ing disaster, finally got rid of him at the end of the month.

February 2012 – Listed home with real estate agent. He informed me that home was worth, best case scenario, ~$90k. Still owed $120k.

April 2012 – Missed my first mortgage payment. Began working with bank for a short sale. My real estate agent got multiple offers in the ~$70k-$75k range over the next year, but the bank turned them all down (They were adamant that the home was worth $80k).

June 2013 – Bank finally sent me a letter informing me that they would accept a deed-in-lieu.

September 2013 – The loan cancellation was recorded at the courthouse and in the books.

So here is my dilemma: The IRS does not count debt cancellation from a “Qualified Principal Residence” as taxable income, but I do not know whether or not the home counts as a qualified principal residence. My research indicates that you had to live there 2 of the last 5 years, but when does the clock start ticking and stop ticking? I lived in the home all of 2008 and 2009, and half of 2010, but none of 2011, 2012, or 2013. I’m also not sure whether or not the fact that I rented the home for a year complicates matters or not. I really don’t want to screw this up. If I owe the tax, then fine, I’ll pay it. But I certainly don’t want to pay the extra $6000 if I don’t have to, and I want to make sure my position is defensible. Any help, guys?

[Numbers Man]

http://www.realtor.com/home-finance/homebuyer-information/understand-the-two-year-real-estate-resale-tax-rules.aspx?source=web

[Mississippi Mudstache]

Thanks for the link, Numbers Man, but it doesn't seem to address my question.

Maigahane- I would appreciate you keeping my situation in mind. I was aware of the insolvency exemption, but my understanding was that the taxes would be applicable once I was no longer insolvent. Is this correct? Also, do retirement accounts count towards my total assets? Because, if so, the point is moot. Thanks in advance.

[clutchy]

ok so this is pretty complex, but I'll try to give you a quick run down.

Did you file a schedule E on your taxes when the house was rented?  Was the house depreciated at all?  If it wasn’t; it should have been.  You’ll have depreciation recapture on a portion of the house since it was basically a business asset.

Regarding the other matter; principal residence is your primary residence.  The clock counts backwards so calendar 2013 back.  It doesn’t appear that you would qualify but it also doesn’t appear it was rented out the whole time so you may have some wiggle room there.

You need to figure out what the bank valued or resold your house for because basis matters in this scenario.  Debt less amount recovered = your COD income.

be aware there are 2 types of exclusions; insolvency and principal residence indebtedness.  If you were in fact insolvent you can exclude debt up to the amount that you were insolvent.

Keep in mind you’ll probably be receiving a 1099-C for your 2013 taxes.  I’d see what shows up and go from there.

Also if you do get one you’ll probably have to pay a CPA to do it for you.  My mother in law had this happen and went to a EA and he fucked it up big time.  I had to some major scramble work to fix it…

[Mississippi Mudstache]

Thanks clutchy. At least you have confirmed for me that my situation is actually complex and I'm not just being a doofus for not figuring it out on my own.

Yes, the house was depreciated when I rented it. I have a good CPA who has filed my taxes for the last 2 years, ever since the rental income started coming in. I will definitely see him once all of my tax paperwork comes in. I am expecting to receive a 1099-C, but I'm guessing I won't get it until next year, when the rest of my tax documents start coming in. 

The reason I am interested in finding out now what I will owe is because it affects how much I plan to contribute to my 401(k) this year. I guess I will just go ahead and max it out since it sounds like I'm going to be in a higher tax bracket this year.

[Nords]

January 2011 – Home underwater, decided to rent it. Signed 1-year lease agreement. Mortgage was $1080/mo. Rent covered $650/mo.
I’m also not sure whether or not the fact that I rented the home for a year complicates matters or not. I really don’t want to screw this up. If I owe the tax, then fine, I’ll pay it. But I certainly don’t want to pay the extra $6000 if I don’t have to, and I want to make sure my position is defensible. Any help, guys?

This might be a dumb question, but would the home be treated as a rental property? 

You effectively disposed of it for a honkin' huge capital loss, which means that it'd be subject to depreciation recapture and perhaps some sort of loss limit.  No matter what sort of phantom income you received from the deed-in-lieu transaction, it might have been all wiped out by the accumulated losses.

[clutchy]

January 2011 – Home underwater, decided to rent it. Signed 1-year lease agreement. Mortgage was $1080/mo. Rent covered $650/mo.
I’m also not sure whether or not the fact that I rented the home for a year complicates matters or not. I really don’t want to screw this up. If I owe the tax, then fine, I’ll pay it. But I certainly don’t want to pay the extra $6000 if I don’t have to, and I want to make sure my position is defensible. Any help, guys?

This might be a dumb question, but would the home be treated as a rental property? 

You effectively disposed of it for a honkin' huge capital loss, which means that it'd be subject to depreciation recapture and perhaps some sort of loss limit.  No matter what sort of phantom income you received from the deed-in-lieu transaction, it might have been all wiped out by the accumulated losses.

this might work also.  The characterization of the property at the time of "disposal" will matter.  So you may just have losses that cover the COD income. 

it's certainly something to look into.