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?