A taxpayer may be able to exclude income from the cancellation of qualified principal residence indebtedness. This exclusion applies to debt discharged after 2006 and before 2026. If the exclusion is used, the taxpayer must reduce the basis of the principal residence by the amount excluded (but not below zero).
Principal Residence
A principal residence is the home where the taxpayer lives most of the time. Only one property can qualify as a principal residence at any given time.
Examples include:
- House
- Condominium
- Cooperative unit
- Mobile home
- Houseboat
Qualified Principal Residence Indebtedness
Qualified principal residence indebtedness is debt that:
- Was incurred to acquire, construct, or substantially improve a principal residence
- Is secured by the principal residence
Refinanced debt qualifies only up to the amount of the original acquisition/improvement debt. Cash taken out during refinancing does not qualify.
Amount Eligible for Exclusion
The maximum amount a taxpayer may treat as qualified principal residence indebtedness is $750,000 ($375,000 if married filing separately).
This exclusion cannot be used if the discharge occurs:
- As payment for services performed for the lender
- Due to reasons not related to a decline in the home’s value
- Due to reasons not related to the taxpayer’s financial condition
Basis Reduction Requirement
If the taxpayer excludes canceled qualified principal residence debt, they must reduce the basis of the home by the excluded amount. This prevents a double tax benefit (exclusion + inflated basis).
Key Points for EA Exam
- Applies only to principal residence
- Applies only to acquisition/improvement debt
- Refinancing qualifies only up to original debt amount
- Exclusion applies through 2025
- Basis must be reduced
- Cannot exclude if cancellation is compensation for services
- Cannot exclude if cancellation is unrelated to value decline or financial hardship