1099-c on a short sale in 2012 -rental that was primary

[Marty Gangler]

Hello.  I had a house in the suburban Chicago area for 5 years.  The first 3 years it was a primary residence.  Then once we decided to increase our family we bought a new house and converted the first house to a rental in 2010.  The market was horrendous then so there was no way we could sell.  After 2 years of renting we could no longer carry the house and losses mounted.  So we short sold the house (as a rental) in 2012.  We received a 1099-C in year 2015 and now have to put it on our taxes.  It's for 125k.  Do we have to pay taxes on this amount forgiven because it was a rental?  I went to a tax person and they are researching it - and scaring the bejesus out of my wife and I.  I remember being told (in 2012) that as we lived in the place for 2 of the first 5 years it would be included in the Mortgage relief act, but it's hard to find this clause anywhere.  Has anyone dealt with this situation?   

[Steven Hamilton II]

Qualified Principal Residence Debt Taxpayers may exclude income from cancellation of qualified principal residence indebtedness for discharges of debt occurring after 2006 and before 2015. The exclusion is limited to $2 million ($1 million MFS) of acquisition debt. Acquisition debt has the same meaning as acquisition debt for purposes of the mortgage interest deduction rules except that the $1 million debt limit is increased to $2 million ($1 million MFS) for purposes of the exclusion rule.  Any amount excluded reduces the taxpayer’s basis in the residence. The exclusion does not apply to debt discharged on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or the financial condition of the taxpayer. The exclusion for discharge of debt on a qualified principal residence is used before the insolvency exclusion, unless the taxpayer elects to apply the insolvency exclusion instead. If a portion of a loan that is discharged is not qualified principal residence indebtedness, the exclusion is limited to the amount discharged that exceeds the amount of the loan that is not qualified principal residence indebtedness. Qualified principal residence. For purposes of exclusion from income of qualified principal residence indebtedness, a qualified principal residence has the same definition as is used for the exclusion of gain on the sale of a principal residence. [IRC §108(h)(5)]

Principal residence defined. A principal residence is the taxpayer’s main home, which is the home where he or she ordinarily lives most of the time. A taxpayer can only have one main home at any one time.

Nor will this meet the two of five years rule for the Section 121 Exclusion. Your first bet would be to look at insolvency.  When did you report the disposition of the rental?  Are you sure this was done properly?  There were certain circumstances that could have been done then to mitigate this issue; however, not many took advantage of it. Your main bet would be insolvency at the time. it was cancelled which is something we can discuss.

Feel free to PM and I'm happy to discuss details.