Graham and Lucy purchased their home in 2003 for $400,000 . They finance the purchase with a $350,000 mortgage. In 2011, when their original mortgage balance was $340,000, they took out a second mortgage for $100,000 and added a second garage. In 2017,
they fall upon hard times and cannot make the mortgage payments. The mortgage company sells their home for $350,000 . At the time of the sale, the mortgage balances are $330,000 on their home and $90,000 on their second mortgage. The mortgage company cancels the remaining debt. What are the income tax consequences of the sale of the residence and cancellation of the debt by the mortgage company?
Graham and Lucy have $70,000 [$350,000 - ($330,000 + $90,000)] of income from the cancellation of the debt. However, taxpayers can elect to exclude from income up to $2 million of acquisition indebtedness on the taxpayer's principal residence. Acquisition debt is debt secured by the taxpayer's principal residence that is used to acquire, construct, or substantially improve the residence. A taxpayer can only have one principal residence. The exclusion does not apply to debt discharges on second homes, business property, or rental property.
Because the mortgages are secured by the residence and used to acquire and substantially improve the residence, both of the mortgages are qualified principal residence indebtedness. Because the total debt canceled is less than $2 million, Graham and Lucy do not have to recognize any income from the mortgage debt cancellation.
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