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Like me, Richard Cohen is a CPA who hails from the Garden State. Unlike me, Richard Cohen just lost millions of dollars at the hands of an apathetic IRS.

Cohen’s wife served as an executrix for an estate which held uncashed dividend checks from a public corporation. Due to some shenanigans, Cohen started to suspect that the corporation was retaining the proceeds from these uncashed dividend checks without including the amounts in taxable income.

In pursuit of hard evidence, Cohen requested information from the State comptroller under the Freedom of Information Law, and also reviewed allegations in pleadings from a civil case against the corporation. Cohen’s findings only buoyed his belief that the corporation was up to no good; with the amount of improperly retained unclaimed assets possibly reaching into the hundreds of millions.

At that point, Cohen filed a whistleblower claim with the IRS on Form 211, Application for Award for Original Information. As you may or may not know, Section 7623 provides that an individual who provides information that leads the IRS to pursue an administrative or judicial action against a taxpayer is entitled to receive an award equal to a percentage of the tax dollars collected by the IRS. [Ed note: pick the right taxpayer, and you can get paid $100 million, even if you're a convicted criminal].

Despite the fact that Cohen felt the IRS had a strong case against the corporation, a mere two weeks after he filed his application he was notified by the IRS that no action was commenced and no tax dollars recovered from the corporation; thus, Cohen was not entitled to an award.

Understandably frustrated, Cohen sued the IRS, presenting the Tax Court with an issue of first impression: Could the court force the IRS to pursue a case against the corporation, so that Cohen would be eligible for a future whistleblower award?

Interpreting the statute literally, the Tax Court held against Cohen and declined to compel the IRS to reopen the whistleblower case. In reaching its decision, the court noted that Section 7623 requires a condition precedent to the issuance of a whistleblower award: the IRS must first commence an administrative or judicial action against the accused taxpayer, and tax dollars must ultimately be collected.

In this case, because the IRS did not see fit to pursue the corporation for its alleged unclaimed assets, no award could be given. Equally as important, the Tax Court established a precedent for future whistleblower decision by concluding that it lacked the authority to direct the IRS to pursue a case; rather, it’s jurisdiction was limited to determining whether an award should be given after a case has been pursued and tax revenue collected.

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The Obama administration addresses the math behind Mitt Romney’s $1 trillion $5 trillion tax cut. Wait…what?

Nation’s pastors agree to take a Sunday off from decrying same-sex marriage; taunt IRS instead.

From the WSJ: Be advised, the last chance to undo a Roth IRC conversion is October 15, 2012.

Xzibit — of “Pimp My Ride” fame — owes the IRS $130,000 for 2011. Weird, I would have thought that a guy who installs custom fish tanks into Honda Civics would understand the need for conservative spending and sound investment.

Could the U.S. really do away with corporate interest deductions?

Often ignored in the presidential campaigning is the growing problem of violence in the suburbs:

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The following question came into Double Taxation HQ last night:

If I have a client with a 1,200,000 mortgage that was taken out to acquire a home and no home equity loan, am I limited to deducting interest on only $1,000,000 of mortgage, since it is all acquisition debt, or can I treat an additional $100,000 of the mortgage as home equity debt even though it’s “really” acquisition debt?

It’s an interesting question, because Section 163 provides a deduction for interest on $1,100,000 of mortgage interestfor “qualified residence interest,” which is further defined as “interest paid on acquisition indebtedness or home equity indebtedness…”

Section 163(h)(3)(B)(i) further provides that acquisition indebtedness is any indebtedness that is incurred in acquiring, constructing, or substantially improving a qualified residence and is secured by the residence. However, Section163(h)(3)(B)(ii) limits the amount of indebtedness treated as acquisition indebtedness to $1,000,000 ($500,000 for a married individual filing separately). Accordingly, any indebtedness described in Section 163(h)(3)(B)(i) in excess of $1,000,000 is, by definition, not acquisition indebtedness.

Under Section 163(h)(3)(C)(i) home equity indebtedness is any indebtedness secured by a qualified residence other than acquisition indebtedness, to the extent the fair market value of the qualified residence exceeds the amount of acquisition indebtedness on the residence. However, § 163(h)(3)(C)(ii) limits the amount of indebtedness treated as home equity indebtedness to $100,000 ($50,000 for a married individual filing separately).

In the question above, it would be reasonable to conclude that interest on only $1,000,000 of the $1,200,000 mortgage would be deductible, because there is only acquisition indebtedness; there is no home equity debt. In two court cases — Pau v. Commissioner, T.C. Memo 1997-43 and Catalano v. Commissioner, T.C. Memo 2000-82 — the Tax Court embraced this exact theory, denying a taxpayer an interest deduction on their mortgage balance in excess of $1,000,000 when there was ONLY acquisition debt.

In Revenue Ruling 2010-25, however, the IRS announced that it would not follow the Tax Court’s decisions in Pau and Catalano. Instead, in the fact pattern above, the IRS will allow the taxpayer to treat the first $1,000,000 of mortgage debt as acquisition debt, and a second $100,000 piece of the same debt as home equity debt, even though it is simply an additional part of the original debt. The theory being that by definition, acquisition debt cannot exceed $1,000,000 for purposes of Section 163(h)(3)(B)(ii).

This means that the first $100,000 debt in excess of that amount satisfies all the requirements of home mortgage debt: it is secured by the residence, it is not acquisition debt, and it does not exceed the FMV of the home.

Thus, even though the taxpayer has only one mortgage with a balance of $1,200,000 that was used to acquire the property, only $1,000,000 is treated as mortgage debt, and the next $100,000 is treated as home equity debt. This gives the taxpayer an interest deduction on an additional $100,000 of debt than was given to the taxpayers in Pau and Catalano.

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After we discussed some of the questions surrounding Mitt Romney’s mid-week proposal to achieve the necessary base broadening necessary to pay for his proposed 20% across-the-board tax rate cuts by implementing a $17,000 cap on a taxpayer’s deductions, Bloomberg reached out to me to crunch some numbers in order to determine the impact such a cap would have on a hypothetical family of four.

The Bloomberg article is here, but the full computations are below:

Assumptions:

  • Family income is all ordinary income from wages: $150,000
  • Family has an outstanding 30 year mortgage at 5 percent with a beginning balance in 2012 of $300,000. This gives rise to deductible mortgage interest for 2012 of $13,666.
  • Family lives in Ohio, where it pays real estate taxes on its home of $5,000 annually.
  • Family contributes $4,000 to charity.
  • Family withholds $6,000 in deductible Ohio state tax from wages
  • Family’s taxable income would fall in what is currently the 25% bracket, but would be the 20% bracket under Romney’s proposed 20% across-the-board reductions. The rates would be 8% on the first $17,400 of income, 12% on the next $53,300 of income, and 20% after that.
  • Under proposed Obama rates, (Scenario 2), the rates would be 10%/15%/25%.

Analysis:

Scenario 1: Using Romney’s Projected 2012 Tax Rates; No Cap on Deductions

AGI: $150,000

Itemized deductions: $28,666

Taxable Income: $106,535

Exemptions:   $15,200

Taxable Income: $106,134

Federal Income Tax: $14,874

Scenario 2: Using  Obama’s Projected 2012 Tax Rates; No Cap on Deductions

AGI: $150,000

Itemized deductions: $28,666

Taxable Income: $106,535

Exemptions:   $15,200

Taxable Income: $106,134

Federal Income Tax: $18,783

Scenario 3: Using Romney’s Projected 2012 Tax Rates; $17,000 Cap on Itemized Deductions Only; Personal Exemptions Allowed in Full.

AGI: $150,000

Itemized deductions: $17,000

Taxable Income: $133,000

Exemptions:   $15,200

Taxable Income: $117,800

Federal Income Tax: $17,208

Scenario 4: Using Romney’s Projected 2012 Tax Rates; $17,000 Cap Applies to BOTH Itemized deductions AND Personal Exemptions

AGI: $150,000

Itemized deductions: $17,000

Taxable Income: $133,000

Exemptions:   $0

Taxable Income: $133,000

Federal Income Tax: $20,248

 Summary

As you will see, because of the effect of Romney’s reduction in the tax rates by 20%, even when he caps a taxpayer’s itemized deductions — but only his itemized deductions  — (Scenario 3: Federal Tax of $17,208), our hypothetical family of 4 will stay pay-less under Romney’s plan than it would under that of Obama (Scenario 2: Federal Tax of $18,783).

When comparing Romney’s plan without a cap (which would be nearly impossible if he plans to keep the rate cuts revenue neutral) to that of his plan with a $17,000 cap on itemized deductions, our family of four saw their federal tax increase by $2,333.

Now, if we assume Romney will cap the benefit of BOTH itemized deductions and personal exemptions at $17,000, as his campaign seems to have indicated this week — our family of four would pay more (Scenario 4: Federal Tax of $20,248) than it would under the Obama plan (Scenario 2: Federal Tax of $18,783).   This would also increase our family of four’s taxes by $5,374 when compared to a Romney baseline with no cap, and $1,465 when compared to a Romney baseline where the cap applies only to itemized deductions.

The devil, of course, is in the details, and at this point, they are sorely lacking. On Wednesday night, Romney again referenced the possibility of using a cap to pay for his tax cuts, but this time quoted “$25,000 or $50,000″ as a potential solution, which would obviously change the results dramatically.

Lastly, and perhaps most importantly, the Romney campaign clarified this week that it would not seek to change the current tax-free nature of employer paid health insurance coverage, a change that would have greatly increased the tax burden of the middle class.

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One hundred thousand views in a little over a year. That’s not too shabby. Though a closer inspection of this site’s hits reveals that many of our guests have stopped by unintentionally, and by the looks of it, left considerably disappointed. Below is a list of the Top 6 search terms that have led internet users to Double Taxation since its inception:

Canyonero: 886 (The fact that nearly 1,000 people came here because they were searching for the fictional SUV endorsed by The Simpsons’ Krusty the Clown warms my heart and renews my faith in humanity.)

Power Rangers Porn: 620 (For obvious reasons, this instantly renews my disgust for humanity)

Double Taxation: 606 (Picking a good blog title is key. Search engine optimization!)

Power Ranger Porn: 391 (You should all be ashamed of yourselves. Perverts.)

Tax Law Changes for 2013: 270 (I’m not sure what it says about the content of this site that it took until our fifth search term to yield a result that I actually wrote about.)

Things get slightly more comforting when we look at the most-read posts in our 16-month history:

Tax Planning for the 2013 Law Changes 3,038
IRS Clarifies Interplay Between Luxury Auto Depreciation   Limits and 100% Bonus Depreciation, Long National Nightmare Finally Over   2,403
IRS Issues Luxury Audit Limits, Fails To Acknowledge   Potential Problem 1,873
Power Ranger Porn, Google Rip-Offs, and Homicidal   Accountants: Just Another Day in the Tax Court 1,591
Presidental Candidate Tax Comparison: Update 1,345

Two things can be gleaned from this data:

1. People really seem to care about luxury audit for some reason, and

2. If you want to get page hits, here’s a simple yet full-proof business plan for any blog:

Phase 1: Put “porn” in title

Phase 2: ?????

Phase 3: PROFIT!

On the tax front, in advance of tonight’s presidential debate, Mitt Romney has finally started to cave to continuing pressure to share some details regarding his tax proposals; particularly, how he plans to keep his 20% acr0ss-the-board rate cuts revenue-neutral while not shifting the tax burden away from the rich and towards the middle class. In a speech given this week, Romney indicated that he might cap deductible itemized deductions at $17,000 per individual.

There are still a number of details missing — particularly whether the $17,000 would be doubled for MFJ and how the cap would handle credits — but according to Bloomberg, this cap is just the first in a three-part plan to achieve Romney’s tax goal of a cutting tax rates by 20% while remaining revenue neutral and progressive. From Bloomberg:

A second cap would apply to personal exemptions and a third cap would apply to the health care exclusion. The amount and details of the caps could be changed to meet Romney’s targets for revenue and distribution of the tax burden. The aide emphasized that the three-cap idea is only one option being considered.

While devoid of the details necessary to formulate any meaningful conclusion, it’s hard to see how this is a step in the right direction in achieving progressive, revenue-neutrual tax reform while also cutting rates. A study conducted by the Tax Policy Center earlier this year concluded that Romney would have to eliminate all deductions for those taxpayers earning in excess of $200,000 before limiting those deductions to a lesser extent to those earning below the threshold in order to pay for his tax cuts in a progressive manner. Clearly this proposal does not accomplish those goals, as it allows those earning over $200,000 to retain some of their deductions, while providing the same limitation to those earning below the threshold.

The key, in my mind, is how the third cap would treat excludable health care benefits, as this preference largely benefits the middle class. Do away with the Section 105 exclusion, and you will likely be right back to shifting the burden of tax increases to those taxpayers earning less than $200,000.

What I do like about Romney’s proposal, however, is that he could avoid the morass of trying to eliminate deductions and preferences from the Code, as any attempt to do so would leave special interest groups fighting to the death for their particular provision. By instituting a cap,  you leave the mortgage interest deduction untouched, leave the state and local tax deduction, and leave the charitable contribution deduction in the Code, but cap their benefit. While this doesn’t neceessarily achieve the simplicity one seeks when base broadening, as it leaves those provisions in the Code, as we’ve discussed here before, sweeping Code reform isn’t particularly likely anyway.

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So last night, as I was trolling the Drudge Report for the latest in election news and teacher-student sex scandals, I noticed an article tilted “These are the Top 5 Worst Taxes ‘Obamacare’ Will Impose in 2013.”

Apparently, the list was first authored by the Grover Norquist-founded Americans for Tax Reform, a Section 501(c)(4) lobbying group that opposes “all tax increases as a matter of principle.”

In running through the list, I came upon #2: The ‘Obamacare’ ‘Haircut’ for Medical Itemized Deductions, which read as follows:

Currently, those Americans facing high medical expenses are allowed a deduction to the extent that those expenses exceed 7.5 percent of adjusted gross income (AGI). This tax increase imposes a threshold of 10 percent of AGI. By limiting this deduction, Obamacare widens the net of taxable income for the sickest Americans. This tax provision will most harm near retirees and those with modest incomes but high medical bills.

This, as you might expect, led to a spate of misspelled, grammatically incorrect reader comments about how Obamacare unfairly punished the elderly. There’s just one problem with this sentiment: it’s not accurate.

Yes, Section 213(a) of the Code was amended to increase the AGI threshold from 7.5% to 10% starting in 2013, meaning taxpayers will now have to generate medical deductions in excess of an extra 2.5% of their adjusted gross income before they begin reaping tax benefits. This much is true. But when the Americans for Tax Reform write — This tax provision will most harm near retirees  – and readers pile on by decrying President Obama’s willingness to screw over the elderly —  it tells me that these people didn’t actually read the new law.

Had they bothered to continue reading a few lines further into Section 213, they would have discovered that Section 213(f) was also amended, and it now provides:

(f) Special rule for 2013, 2014, 2015, and 2016.
In the case of any taxable year beginning after December 31, 2012, and ending before January 1, 2017, subsection (a) shall be applied with respect to a taxpayer by substituting “7.5 percent” for “10 percent” if such taxpayer or such taxpayer’s spouse has attained age 65 before the close of such taxable year.

In other words, the increase to the AGI threshold will not, as the AFTR’s report states, harm near retirees or the elderly, because for the next four years, the AGI threshold is not increased if either the taxpayer or the spouse is over 65. For all of those 65 and over in 2013, their medical expenses will be treated the exact same way in they were in 2012. And let’s be honest, in today’s economy, if you’re retiring before 65, you’ve got enough money that your medical expenses probably aren’t going to exceed 7.5, 10, or even 30% of your adjusted gross income.

Now that I’ve addressed that tiny bit of legislative minutiae and done my part to stem the spread of tax misinformation among people who are so rational they are still calling for the President’s birth certificate four years after his election, I can rest knowing that I’ve left the world a slightly better place.

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Yesterday, the Supreme Court of the United States denied certiorari to a tax case on an issue of first impression from the U.S. Court of Appeals for the Eighth Circuit — David E. Watson P.C. v. U.S., 668 F.3d 1008 (8th Cir., 2012).

You may remember Watson from our previous discussion here, or from this brilliantly written article in the Tax Adviser. Either way, Watson directly impacts tax advisors as it provides a long-awaited roadmap for quantifying a “reasonable compensation” amount for shareholder/employees in personal service S corporations.

Background

In late 2010, an Iowa district court held that David Watson, a partner with a CPA firm who paid himself only $24,000 in annual salary while taking out over $200,000 in annual distributions, had avoided payroll taxes by failing to pay himself reasonable compensation. Because Watson actually reported some compensation, however, the court was facing an issue of first impression: determining just what constituted “reasonable compensation” for Watson’s services. The resulting analysis provided the first court-approved roadmap for tax advisers to use in setting appropriate salary amounts for their S corporation shareholder-employee clients.

In setting Watson’s salary, the IRS engaged the services of a general engineer, who first sought to determine the health of Watson’s CPA firm. By analyzing financial ratios published by the Risk Management Association — particularly profits/sales and compensation/sales – the engineer found that Watson’s firm was very healthy, and that compared to similarly healthy firms, Watson’s compensation was unreasonably low.

The court then looked internally at Watson’s firm, noting that Watson was paid less than those subordinate to him. In fact, Watson’s salary was less than what the firm was paying recent college graduates.

Finally, to quantify the appropriate salary, the engineer utilized MAP surveys conducted by the AICPA, which indicated that the average non-owner director of a CPA firm the size of Watson’s would be paid $70,000. The engineer then grossed up this salary by 33% to account for Watson’s stake as a shareholder, resulting in “reasonable” compensation of $93,000 for each of 2002 and 2003.

The District Court agreed, citing Watson’s experience, expertise, and time devoted to his role as one of the primary earners at a well-established firm.

In February 2012, the Eighth Circuit Court of Appeals affirmed the District Court’s decision. Watson appealed once more to the Supreme Court, but saw that dream die yesterday.

With Watson apparently in the books as concluded tax law, now is an appropriate time to remind ourselves what we can take away from this important decision:

What Can We Learn?

Above all else, Watson established that the IRS is taking a formal, quantitative approach towards determining reasonable compensation, so to adequately advise our clients, we must be prepared to do the same thing. At a minimum, in setting the compensation of our S corporation shareholder-employee clients, we must consider the following:

1. Nature of the S Corporation’s Business. It is no coincidence that the majority of reasonable compensation cases involve a professional services corporation, such as law, accounting, and consulting firms. It is the view of the IRS that in these businesses, profits are generated primarily by the personal efforts of the employees, and as a result, a significant portion of the profits should be paid out in compensation rather than distributions.

2. Employee Qualifications, Training and Experience, Duties and Responsibilities, and Time and Effort Devoted to Business. A full understanding of the nature, extent, and scope of the shareholder-employee’s services is essential in determining reasonable compensation. The greater the experience, responsibilities and effort of the shareholder-employee, the larger the salary that will be required.

3. Compensation Compared to That of Non-shareholder Employees or Amounts Paid in Prior Years.  Here, common sense rules the day. In Watson, a CPA with significant experience and expertise was  paid a smaller salary than recent college graduates. Clearly, this is not advisable.

4. What Comparable Businesses Pay for Similar Services. Tax advisors should review basic benchmarking tools such as monster.com, salary.com, Robert Half, and Bureau of Labor Statistics wage data to determine the relative reasonableness of the shareholder-employee’s compensation when compared to industry norms.

5. Compensation as a Percentage of Corporate Sales or Profits. Tax advisors should utilize industry specific publications such as the MAP to determine the overall profitability of the corporation and the shareholder-employee’s compensation as a percentage of sales or profits. Whenever possible, comparisons should be made to similarly sized companies within the same geographic region. If the resulting ratios indicate that the S corporation is more profitable than its peers but paying less salary to the shareholder-employee, tax advisors should determine if there are any differentiating factors that would justify this lower salary, such as the shareholder’s reduced role or the corporation’s need to retain capital for expansion. If these factors are not present, an increase in compensation to the industry and geographic norm provided for in the publications is likely necessary.

6. Compensation Compared With Distributions. While large distributions coupled with a small salary may increase the likelihood of IRS scrutiny, there is no requirement that all profits be paid out as compensation. Though the District court in Watson recharacterized significant distributions as salary, it permitted Watson to withdraw significant distributions in both 2002 and 2003. Perhaps the court was content to recharacterize just enough distributions to ensure that Watson’s compensation exceeded the Social Security wage base in place for the years at issue. In doing so, the payroll tax savings on Watson’s remaining distributions amounted only to the 2.9% Medicare tax.

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Coming on the heels of my Friday post regarding the impending expiration of the COD exclusion for mortgages secured by a taxpayer’s primary residence, Roger McEowen of Iowa State University published this wonderful 5-page chart detailing 1) those provisions set to expire at 12.31.2012 as part of the sunset of the Bush tax cuts, 2) those provisions set to expire at 12.31.2012 unrelated to the Bush tax cuts and 3) those provisions that previously expired at 12.31.2011 and may be candidates for a Lazarus-like revival. With year-end planning just around the corner, it’s a must read.

Hat tip: Joe Kristan at Roth & Co.

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Boy, that Tebow trade has really added a dynamic new element to the Jets’ offense, no?

A few pictures from a Sunday spent in and around Leadville, CO, the highest (think altitude, not reefer) incorporated city in the U.S.

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So this is why my college years were so lonely. All the chicks with loose morals were economic majors.

If everyone’s so fired up about the 47% of Americans who don’t pay income tax, perhaps we should tax them. Howard Gleckman has five ways you could do it. His most novel suggestion: fix the economy and get people working again.

Hey, maybe Romney’s plan to cut rates while keeping tax revenue level is possible. After all, it worked for Reagan.

From the WSJ: Is your political contribution tax-deductible?

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If you are one of the 97% of Americans whose home is worth significantly less than when they purchased it, you’ve likely been seeking out some type of debt modification with your lender. Or perhaps things have gotten so bad that you’re contemplating a foreclosure or short sale.

Here’s the thing: anytime a mortgage is modified (i.e., reduced), the borrower is required to recognize cancellation of indebtedness (COD) income under Section 61(a)(12). Similarly, if a property is sold at foreclosure or in a short sale and the underlying mortgage is recourse (meaning the borrower has personal responsibility for any excess loan deficiency remaining after the sale), then to the extent the remaining deficiency is forgiven, the borrower will again recognize COD income.

In the foreclosure or short sale context, this COD income is NOT treated as gain from the sale of the property, and thus is not eligible for exclusion under Section 121 (allowing a $500,000 exclusion for MFJ taxpayers who have owned/used the home as their principal residence for 2 of prior 5 years).

When the sh*t hit the fan in the real estate market in 2006 Congress recognized that something had to be done, as it seemed patently unfair to tax homeowners on COD income when they couldn’t even afford to service the underlying mortgage. And while exclusions to COD income have always existed under Section 108, prior to 2007 those exclusions were only of use to a homeowner if the homeowner were insolvent or bankrupt.

As a result, in 2007 Congress enacted Section 108(a)(1)(E), which provides that a taxpayer that is neither insolvent nor in bankruptcy can still exclude up to $2,000,000 of COD income related to the discharge (in whole or in part) of qualified principal residence indebtedness. This exclusion applies where a taxpayer restructures his or her acquisition debt on a principal residence, loses his or her principal residence in a foreclosure, or sells a principal residence in a short sale.

For these purposes:

  • Qualified principal residence indebtedness is debt that meets the Section 163(h)(3)(B) definition of acquisition indebtedness for the residential interest expense rules but only with respect to the taxpayer’s principal residence (i.e., does not include second homes or vacation homes), and with a $2 million limit ($1 million for married filing separate taxpayers) on the aggregate amount of debt that can be treated as qualified principal residence indebtedness.
  • Acquisition indebtedness includes refinanced debt to the extent the refinancing does not exceed the amount of the refinanced acquisition indebtedness.
  • For purposes of these rules, a principal residence has the same meaning as under the Section 121 home sale gain exclusion rules.

Why do you care? Because as of today, this exclusion is set to expire on December 31, 2012. That means you have to ask yourself: How much do you trust Congress to get an extension done before year end? If you do, then by all means, take your time with your debt modification/foreclosure/short sale efforts. But if you don’t, you might want to get a sense of urgency about getting something done with your bank prior to year end, so you can take advantage of Section 108(a)(1)(e) while it’s here.

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