Maybe I’m overthinking this, but here’s something that’s bothered me for a long time: what is the definition of “principal residence” for purposes of determining if cancelled debt is taxable?

Background

The general rule for canceled debt is that the debt cancellation results in taxable income. For example, if the credit card company forgives $5,000 of credit card debt, you have $5,000 of taxable income. A similar concept would apply to foreclosures of homes.

There are a number of exceptions to the general rule. For example, if you’re insolvent, cancelled debt is not taxable. There’s also an exclusion that says cancelled debt isn’t taxable if it’s related to your principal residence. This is where my “overthinking” comes into play.

What if the Person Has Moved Out?

My question is. what if the homeowner moves out before the foreclosure process is complete? This happens a lot.

Section 108, which governs taxation of canceled debt, says that the Section 121 definition of “principal residence” is to be used, but that doesn’t help much because Section 121 simply says that a “principal residence” is determined based on “all the facts and circumstances.”

So what would the “facts and circumstances” be for a person going through a foreclosure who moves out of the house prior to the completion of the foreclosure and now lives in an apartment? The foreclosure isn’t complete so the debt hasn’t been cancelled yet. Is the apartment the new principal residence?

I asked this question during a seminar I attended about debt cancellation. The presenter was a tax attorney with more than 30 years of experience. His response was that his firm has grappled with this question and that there’s not a good answer.

I have found no IRS guidance. Everything just says, essentially, if it’s your principal residence you can exclude the cancelled debt.

I have always employed the common sense test. If a person was living in an apartment or a rental and the foreclosure is completed in a reasonable time frame after the move, I would argue that the person still could call their foreclosed home their principal residence. But if the person moves to, say, a new state or somehow manages to buy a new home while going through foreclosure (yes, I have encountered this!), I would say they couldn’t call their foreclosed home their principal residence.

So tax pros — am I overthinking this? Am I missing something?

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