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Under Federal law, a 1099 received after foreclosure, of a primary home is not considered income, and she need not worry about declaring it.
The Mortgage Debt Relief Act of 2007 allows taxpayers to exclude income from the discharge of debt on their principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. This provision applies to debt forgiven in calendar years 2007 through 2012. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately).
Pub 4681 page 7 (Qualified Principal Residence Indebtedness) says: Qualified principal residence indebtedness also includes any debt secured by your main home that you used to refinance a mortgage you took out to buy, build, or substantially improve your main home, but only up to the amount of the old mortgage principal just before the refinancing. So in the facts I gave I mentioned that the house, purchased in 1996 for $160k was refinanced in 2007 for $300k. The principal balance right before the refi was probably somewhere close to $160k. So the extra $140k is the part I'm worried about. The way I read it, the $140k ($300k minus $160k) cannot be excluded under the Debt Relief Act. If this is correct can the $140k be excluded because she was technically insolvent at the time of foreclosure? Does the fact we were married in May and Washington's community property law effect the insolvency? Are my assets at the time of foreclosure included in calculating her insolvency? Do we file form 982?
Under IRS regulation the refinanced loan would only qulaify to the extent that the principal balance of the old mortgage, immediately before the refinancing, would have qualified. So you are correct, the $140,000 would be included.
She need not include your separate assets or your share of community assets in your computation, if the debt was solely hers and not community debt.
Can the $140k be excluded because of insolvency (form 982)?
Yes, if she was insolvent, and since the debt was not community debt, she can file for insovency if her assets were less than her debts.
As long as you can prove the debt was not incurred while married she is fine.
Is form 982 the correct (and only) form to use to claim the exclusion?
Her divorce decree should state that the property was part of her prior marriage.
Is there any need to file a separate return this year (I would not like to do that)?
No, you would not have to file a separate form, she however will have to file for insolvency to get rid of the debt for herself.
She can also File IRS Form 982, with your tax return, however you will need to send the IRS a detailed letter with a financial statement showing her insolvency, and why it is not part of your debt.
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