Example 1—Mortgage loan modification.   In 2001, 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 2002, 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 2005, 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 2007, Nancy was unable to make her mortgage loan payments. On August 31, 2007, 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 2007 Form 1099-C from her bank on January 31, 2008, 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.

  Following are Nancy's sample forms.

Example 2—Mortgage loan foreclosure.   In 1999, John and Mary Elm purchased a principal residence for $335,000. John and Mary took out a $320,000 mortgage loan to buy the principal residence and made a down payment of $15,000. The loan was secured by the principal residence and is a recourse debt, meaning John and Mary are personally liable for the debt.

  John and Mary became unable to make their mortgage loan payments and on March 1, 2007, when the outstanding balance of the mortgage loan was $315,000 and the FMV of the property was $290,000, the bank foreclosed on the property and simultaneously canceled the remaining mortgage debt. Immediately before the foreclosure, John and Mary's only other assets and liabilities were a checking account with a balance of $6,000, retirement savings of $13,000, and credit card debt of $5,500.

  John and Mary received a 2007 Form 1099-C showing canceled debt of $25,000 in box 2 ($315,000 outstanding balance minus $290,000 FMV) and a FMV of $290,000 in box 7. In order to determine if John and Mary must include the canceled debt in income, they must first determine whether they meet any of the exceptions or exclusions that apply to canceled debts. In this example, John and Mary meet both the insolvency and qualified principal residence indebtedness exclusions.

  John and Mary were insolvent immediately before the cancellation because at that time their liabilities exceeded the FMV of their assets by $11,500 ($290,000 FMV of the personal residence plus $6,000 checking account balance plus $13,000 retirement savings minus $315,000 balance on mortgage loan minus $5,500 credit card debt). However, because the entire debt canceled is qualified principal residence indebtedness, the insolvency exclusion only applies if John and Mary elect to apply the insolvency exclusion instead of the qualified principal residence exclusion.

  John and Mary do not elect to apply the insolvency exclusion instead of the qualified principal residence exclusion because under the insolvency exclusion their exclusion would be limited to the amount by which they were insolvent ($11,500). Instead, John and Mary check box 1e of Form 982 to exclude the canceled debt under the qualified principal residence exclusion. Under the qualified principal residence exclusion, the amount that John and Mary can exclude is not limited because their qualified principal residence indebtedness is not more than $2 million and no portion of the loan was nonqualified debt. As a result, John and Mary enter the full $25,000 of canceled debt on line 2 of Form 982. Because John and Mary no longer own the home due to the foreclosure, John and Mary have no remaining basis in their principal residence at the time of the debt cancellation. Thus, John and Mary leave line 10b of Form 982 blank.

  John and Mary must also determine whether they have a gain or loss from the foreclosure. John and Mary complete Table 1-1 and find that they have a $45,000 loss from the foreclosure. Because this loss relates to their personal residence, it is a nondeductible loss.

  Following are John and Mary's sample forms and worksheet.

Example 3—Mortgage loan foreclosure with debt exceeding $2 million limit.   In 2005, Kathy and Frank Willow got married and entered into a contract with Hive Construction Corporation to build a house for $3,000,000 to be used as their personal residence. Kathy and Frank took out a $2,600,000 mortgage loan to build the home and put down the remaining $400,000. Kathy and Frank are personally liable for the mortgage loan, which is secured by the principal residence.

  In November 2007, when the outstanding principal balance on the mortgage loan was $2,500,000, the FMV of the property fell to $1,750,000 and Kathy and Frank abandoned the property by permanently moving out. The lender foreclosed on the property and, on December 3, 2007, sold the property to another buyer for $1,750,000. On December 26, 2007, the lender canceled the remaining debt. Kathy and Frank have no tax attributes other than basis of personal use property.

  The lender issued a 2007 Form 1099-C to Kathy and Frank showing canceled debt of $750,000 in box 2 (the remaining balance on the $2,500,000 mortgage debt after $1,750,000 satisfaction through the foreclosure sale proceeds) and $1,750,000 in box 7 (FMV of the property). Although Kathy and Frank abandoned the property, the lender did not need to also file a Form 1099-A because the lender canceled the debt in connection with the foreclosure in the same calendar year. Kathy and Frank are filing a joint return for 2007.

  Because the foreclosure occurred prior to the debt cancellation, Kathy and Frank first calculate their gain or loss from the foreclosure of their principal residence using Table 1-1. Because Kathy and Frank still remained personally liable for the $750,000 remaining debt after the foreclosure ($2,500,000 outstanding debt immediately before the foreclosure minus $1,750,000 satisfied through the sale of the residence securing the loan), Kathy and Frank enter $1,750,000 on line 1 of Table 1-1 ($2,500,000 outstanding debt immediately before the foreclosure minus the $750,000 for which they remained liable). Completing Table 1-1, Kathy and Frank find that they have no ordinary income from the cancellation of debt upon foreclosure and that they have a $1,250,000 loss. Because this loss relates to their personal residence, it is a nondeductible loss.

  Because the lender later canceled the remaining amount of the debt, Kathy and Frank must also determine any taxable portion of their income from the cancellation of debt. Immediately before the cancellation, Kathy and Frank had $15,000 in a savings account, $17,000 in a retirement account, a car with a FMV of $10,000, and $18,000 in credit card debt. The $17,000 retirement account is made up of $15,000 of deductible contributions and $2,000 of nondeductible contributions. The car that Kathy and Frank owned at the time of cancellation had been fully paid off (so there was no related outstanding debt) and was originally purchased for $16,000. Kathy and Frank had no adjustments to the cost basis of the car. Kathy and Frank had no other assets or liabilities at the time of the cancellation. Thus, immediately before the cancellation, Kathy and Frank had total liabilities of $768,000 ($750,000 remaining balance on mortgage loan plus $18,000 in credit card debt) and total assets with a FMV of $42,000 ($15,000 in savings account plus $17,000 in retirement account plus $10,000 FMV of car). This means that immediately before the cancellation, Kathy and Frank were insolvent to the extent of $726,000 ($768,000 of total liabilities minus $42,000 FMV of total assets).

  At the beginning of 2008, Kathy and Frank had $9,000 in their savings account, $17,000 in their retirement account, and $15,000 in credit card debt. Kathy and Frank also owned the same car at that time (still with a FMV of $10,000 and basis of $16,000). Kathy and Frank had no other assets or liabilities at that time. Kathy and Frank no longer own the home because the lender foreclosed on it in 2007.

  The insolvency exclusion does not apply if the indebtedness is qualified principal residence indebtedness unless Kathy and Frank elect to apply the insolvency exclusion instead of the qualified principal residence indebtedness exclusion. The maximum amount that Kathy and Frank can treat as qualified principal residence indebtedness is $2,000,000. The remaining $500,000 ($2,500,000 outstanding mortgage loan minus $2,000,000 limit on qualified principal residence indebtedness) is not qualified principal residence indebtedness. Because only a part of the loan is qualified principal residence indebtedness, Kathy and Frank must apply the ordering rule to the canceled debt. Under the ordering rule, the qualified principal residence indebtedness exclusion applies only the extent that the amount canceled ($750,000) exceeds the amount of the loan (immediately before the cancellation) that is not qualified principal residence indebtedness ($500,000). This means that Kathy and Frank can only exclude $250,000 ($750,000 amount canceled minus $500,000 nonqualified debt) under the qualified principal residence indebtedness exclusion.

  Kathy and Frank do not elect to have the insolvency exclusion apply instead of the qualified principal residence exclusion. Nonetheless, they can still apply the insolvency exclusion to the $500,000 nonqualified debt because such debt is not qualified principal residence indebtedness. Kathy and Frank can exclude the remaining $500,000 canceled debt under the insolvency exclusion because they were insolvent immediately before the cancellation to the extent of $726,000. Thus, Kathy and Frank check the boxes on lines 1b and 1e of Form 982 and enter $750,000 on line 2 ($250,000 excluded under the qualified principal residence indebtedness exclusion plus $500,000 excluded under the insolvency exclusion).

  Next, Kathy and Frank reduce their tax attributes using Part II of Form 982. Because Kathy and Frank no longer own the home due to the foreclosure, Kathy and Frank have no remaining basis in their principal residence at the time of the debt cancellation. Thus, Kathy and Frank leave line 10b of Form 982 blank. However, Kathy and Frank are also excluding nonqualified debt under the insolvency exclusion. As a result, Kathy and Frank must reduce the basis of property they own based on the amount of canceled debt they are excluding from income under the insolvency rules. Because Kathy and Frank have no tax attributes other than basis of personal use property to reduce, Kathy and Frank figure the amount they must include on line 10a of Form 982 by taking the smallest of: Kathy and Frank enter $18,000 on Form 982, line 10a and reduce their bases in the car and the retirement account to $0.

  Following are Kathy and Frank's sample forms and worksheet.