8137 / What is qualified principal residence indebtedness and does its discharge require a reduction of tax attributes?

Pursuant to the Mortgage Debt Relief Act of 2007, the discharge of qualified principal residence indebtedness of up to $2 million dollars is excluded from gross income. Although the relief was due to sunset in 2010, it was subsequently made permanent by the Protecting Americans Against Tax Hikes Act of 2015 (PATH).

“Qualified principal residence indebtedness” is a secured loan used to acquire, construct or substantially improve a principal residence. For this reason, it does not include a home equity loan that is not used to substantially improve the principal residence. A refinanced loan is also considered qualified principal residence indebtedness to the extent of the outstanding balance of the loan it is to replace. Any additional borrowing from the refinanced loan is not considered qualified principal residence indebtedness unless the proceeds are used to substantially improve the principal residence.

Example: A lender approved a short sale of Asher’s principal residence for $700,000. Asher’s home was secured by recourse debt of $1,000,000 of which only $800,000 was qualified principal residence indebtedness and the balance was a home equity loan used to pay off personal debt. After applying the $700,000 proceeds from the short sale to the outstanding loan, the lender forgave the remaining $300,000. Under this scenario, only $100,000 of the discharged debt (the qualified principal residence indebtedness) is excluded from gross income. As to the remaining $200,000, unless some other discharge of debt exclusion applies, it would be included in gross income.