Recently in Income and Deductions Category

May 4, 2011

Short Sales, Foreclosures, and Debt Forgiveness

The present economic environment has led many folks to lose their homes because of inability to satisfy their mortgages. Transactions take several forms, but foreclosures and short sales have become fairly common. While homeowners typically think of these deals as giving rise to a "loss," such is not always the case for tax purposes.

Generally speaking, a taxpayer realizes some form of income when a debt is cancelled, forgiven, or reduced by the lender. And lender actions of this nature often come into play when a taxpayer restructures the acquisition debt on his principal residence, loses a principal residence in a foreclosure, or sells his principal residence in a short sale.

But the Mortgage Relief Act, effective for debt discharged on or after January 1, 2007 and before January 1, 2013 generally allows taxpayers to exclude up to $2 million of such mortgage debt relief associated with their principal residence. The tax return for the year in which an event of this kind takes place should contain IRS Form 982, "Reduction of Tax Attributes Due to Discharge of Indebtedness". Though income may be excluded, the price of this favor bestowed by the IRS is reduction of the basis in the principal residence (though not below zero). More information from the IRS on cancelled or forgiven debt is here.

Note that these provisions relate only to one's principal residence -- there will be no exclusion for debt forgiven with respect to a vacation or second home, business property, or rental property.

Also, the mortgage debt exclusion may not fully apply in the case of a mortgage which has been refinanced. Refinanced principal residence debt is eligible for the exclusion up to the amount of the previous mortgage before the refinance.

And there may be further complications in any given situation -- don't confuse the issue of debt reduction (and how it's taxed) with any actual gain which might still arise on the sale of the house. In short sales, taxpayers might sustain gain from the sale of the property instead of or in addition to income from discharge of debt. Of course, another rule (IRC Section 121, allowing some joint filers to exclude gain of up to $500,000 on sale of their residence) might exempt some or all of such gain. It gets complicated. Do-it-yourselfers beware.

Learn more in Nolo's article Canceled Mortgage Debt: What Happens at Tax Time?

February 15, 2011

Are Punitive Damages Excludable From Income?

You've got to hand it to the Greenbergs. It was a nice try, attempting to read between the lines of the Internal Revenue Code in an effort to justify excluding a punitive damages award from their income tax return.

Unfortunately, they couldn't convince the Tax Court. In a recent decision, the Court not only slapped the Greenbergs down in affirming a tax deficiency of over $1 million, but further hammered the folks in sanctioning the IRS imposed accuracy-related penalty, because the taxpayers had neither substantial authority, nor reasonable cause underlying their posture on the damage award. (The decision is Gary L. Greenberg, et ux. v. Commissioner, TC Memo 2011-18.)

Seems Mr. Greenberg, owner of a disability income policy, became disabled, thus precipitating a claim. The insurer paid some benefits, but not as much as Greenberg thought was proper, so he sued, alleging breach of contract and insurance bad faith. And, by golly, he won a damage award which included $2.4 million of punitive damages, which the taxpayers excluded from their return, justifying the exclusion on the basis of Internal Revenue Code Section 104(a)(3). (Learn more from Nolo: I won a lawsuit; do I have to pay tax on my damage award?)

Unfortunately that section only permits exclusion of "amounts received through accident or health insurance.....for personal injuries or sickness...." which "amounts" Mr. Greenberg liberally interpreted to include the punitive damages.

But the Court wasn't buying it, noting that, "In general, exclusions from income are narrowly construed," and with specific reference to IRC Section 104, that the Supreme Court had clearly spoken in the O'Gilvie case, to the effect that punitive damages received in a suit for personal injuries are not received "on account of" the personal injuries, themselves, but rather in connection with assessing a form of punishment on the offending party. Bottom line: punitive damages are taxable.

Attempting a novel twist on words, the Greenbergs also claimed that the punitive damages they received were not punitive, but "bad faith damages" (whatever that means), and that "damage awards that serve both to compensate and punish are excludable."

Perhaps the Greenbergs would have gotten farther had they found some citation in the published authority for this position, which they apparently did not.

One last point, of course, should be notation of the fact that the current application of IRC 104 only pertains to exclusion of compensatory damages "on account of personal physical injuries or physical sickness."

Pain and suffering just won't cut it.