In the case of Weiderman v. Commissioner, T.C. Memo. 2020-109,[1] the taxpayer found that simply using a loan to purchase a residence isn’t sufficient to make it into qualified principal residence indebtedness.  The taxpayer was looking to claim an exclusion from cancellation of indebtedness income under IRC §108(a)(1)(E).

Qualified Principal Residence Indebtedness Exclusion of Cancellation of Indebtedness Income

A provision that was originally “temporarily” added as part of the economic relief packages that were enacted as a reaction to the 2008 real estate crash, the exclusion from income for cancellation of indebtedness on qualified principal residence debt has been extended multiple times, most recently as part of the 2019 end of year tax package.

The provision reads:

(a)Exclusion from gross income

(1) In general

Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—

…

(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged—

(i) before January 1, 2021, or

(ii) subject to an arrangement that is entered into and evidenced in writing before January 1, 2021.

Qualified principal residence indebtedness is defined at IRC §108(h)(2) as:

(2) Qualified principal residence indebtedness

For purposes of this section, the term “qualified principal residence indebtedness” means acquisition indebtedness (within the meaning of section 163(h)(3)(B), applied by substituting “$2,000,000 ($1,000,000” for “$1,000,000 ($500,000” in clause (ii) thereof and determined without regard to the substitution described in section 163(h)(3)(F)(i)(II)) with respect to the principal residence of the taxpayer.

The cross reference to IRC §163(h)(3)(B) ties the definition to the one used for home mortgage interest that is deductible on Schedule A, but with a $2 million rather than $750,000 limit on the amount of such debt—acquisition indebtedness.

Two key tests must be met for debt to be treated as acquisition indebtedness, and thus potentially eligible for special treatment under §108(a)(1)(E)’s debt forgiveness exclusion:

• The debt is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and

• The debt is secured by such residence.

Debt Used to Acquire Residence

In this case, the Tax Court provides us with the following information regarding the debt in question:

Following negotiations, by letter dated December 11, 2006, K-Swiss offered Mrs. Weiderman employment as vice president — marketing, directly reporting to the chief executive officer of K-Swiss, and a salary of $25,000 monthly (December 11, 2006, letter). Mrs. Weiderman was required to move to Southern California where K-Swiss was located, and as outlined in the December 11, 2006, letter K-Swiss would (among other things) grant her an interest-free loan of $500,000 to help finance the purchase of a home in that area, provide her up to 180 days of temporary housing in a furnished executive apartment, reimburse her travel expenses for three three-day trips for her and Mr. Weiderman, and pay her moving expenses from Massachusetts to California.

…

Meanwhile, petitioners offered to purchase a home in Agoura Hills, California (Agoura Hills property), and this purchase was consummated in February 2007. They paid $1,950,000 for the Agoura Hills property (plus settlement charges and prorated county taxes and homeowner association dues) by (1) providing a deposit or earnest money of $50,000, (2) obtaining a $1,450,000 mortgage and a $75,000 bridge loan from Wells Fargo, and (3) providing an additional deposit of $385,993, which was wired into the escrow account established for the purchase from petitioners' Wells Fargo checking account six days after their receipt of the $500,000 loan proceeds via wire transfer. [2]

Under the tracing rules applicable to interest, the taxpayer was allowed to trace $385,993 of the employer loan as being used to acquire the residence.  But merely using the debt to acquire the residence is not enough to qualify the debt as acquisition indebtedness.

Security Requirement

The new job didn’t work out and, under terms of the note, the taxpayers had to repay the note due to the loss of the position.  The Court describes what happened as follows:

On December 1, 2008, K-Swiss terminated Mrs. Weiderman’s employment. Because her employment was terminated and in accordance with the February 15, 2007, promissory note, K-Swiss demanded that petitioners repay the $500,000 loan. Knowing that the only way they could pay back this loan was to sell the Agoura Hills property and thus concerned about their repayment ability, petitioners listed (with the assistance of a real estate agent) the Agoura Hills property for sale and hired Mary Lee Wegner, a Sherman Oaks, California, employment attorney, to negotiate a settlement with K-Swiss. Initially, K-Swiss offered to cancel $250,000 of the $500,000 loan in lieu of a cash severance payment. Ultimately petitioners agreed to having K-Swiss cancel $220,000 of the loan and pay them $30,000.

The details of their agreement were memorialized by a separation agreement and general release executed by Mrs. Weiderman and K-Swiss in January and February 2009, respectively (2009 separation agreement), along with a promissory note secured by a deed of trust executed by petitioners on January 29, 2009, in favor of K-Swiss (January 29, 2009, promissory note). As stated in appendix A of the 2009 separation agreement, K-Swiss was obligated to pay Mrs. Weiderman $30,000 in one lump sum without payroll or other deductions on the eighth calendar day after she delivered a signed copy of the 2009 separation agreement to K-Swiss. Additionally, as stated therein, with respect to the $500,000 loan memorialized by the February 15, 2007, promissory note, K-Swiss forgave $220,000 of that debt (leaving a balance owing of $280,000) and would mark that note “Cancelled”, and petitioners were obligated to sign (1) a new promissory note for $280,000 in favor of K-Swiss, replacing the February 15, 2007, promissory note and (2) a deed of trust also in favor of K-Swiss and recordable against the Agoura Hills property to secure payment of the $280,000. The January 29, 2009, promissory note reiterated K-Swiss’ agreement to cancel the February 15, 2007, promissory note. It also set forth the conditions for repayment of the $280,000; to wit, that the amount would be due and payable in full upon the sale of the Agoura Hills property or, if the net proceeds from that sale were insufficient to pay this amount, then the amount would be due on January 31, 2010.

On January 29, 2009, in accordance with appendix A of the 2009 separation agreement, petitioners signed a deed of trust in favor of K-Swiss, securing the $280,000 loan with the Agoura Hills property. Petitioners delivered the signed deed of trust to K-Swiss and K-Swiss recorded it with the Los Angeles County, California, Registrar-Recorder. On February 6, 2009, in accordance with appendix A of the 2009 separation agreement, K-Swiss wired the $30,000 into petitioners’ checking account with Bank of America.3 An unnamed representative of K-Swiss wrote “CANCELLED” across the February 15, 2007, promissory note.

On May 20, 2009, the Agoura Hills property sold for $1,665,000. Shortly before the sale Mrs. Weiderman and K-Swiss agreed to amend the 2009 separation agreement to reflect an additional forgiveness of petitioners’ outstanding debt this time, $35,000 of the $280,000 loan.

The details of this agreement were memorialized in a May 12, 2009, letter from K-Swiss to Mrs. Weiderman that she countersigned on May 15, 2009 (May 12, 2009, letter). As stated in the May 12, 2009, letter, Mrs. Weiderman’s indebtedness to K-Swiss was reduced from $280,000 to $245,000, with repayment of the $245,000 to occur as follows: (1) $200,000 to be paid upon the sale of the Agoura Hills property and (2) the balance to be paid in two equal installments on January 31, 2010 and 2011, respectively. Additionally, as stated therein, petitioners were obligated to sign a new promissory note to reflect the $245,000 debt.

In accordance with the May 12, 2009, letter petitioners executed an “[a]mended and [r]estated” promissory note for $245,000 in favor of K-Swiss and K-Swiss was paid the $200,000 upon the sale of the Agoura Hills property. Petitioners, however, failed to make the January 31, 2010, installment payment of $22,500. After letters dated February 12 and April 6, 2010, were sent by K-Swiss to Mrs. Weiderman regarding this failure, petitioners retained Carl D. Hasting, an attorney and a certified public accountant (C.P.A.) at CDH Associates, Inc., in Westlake Village, California, as legal counsel to explore settling the outstanding $45,000 debt. In June 2010, as a result of settlement discussions, petitioners and K-Swiss executed a settlement and release agreement whereby petitioners would pay K-Swiss $15,000 and K-Swiss would forgive the remaining $30,000 of outstanding debt (June 2010 settlement agreement). At times not established by the record petitioners and K-Swiss met the terms of this agreement.[3]

Eventually the taxpayer reported $255,000 as excludable cancellation of indebtedness income from qualified principal residence indebtedness.

The Tax Court looked at the issue of whether the debt in question was secured by a qualified principal residence.  The Court noted the following definition of what constitutes a debt being secured for these purposes:

For these purposes, secured debt is any debt that is on the security of any instrument (such as a mortgage, deed of trust, or land contract) that makes the debtor’s interest in the qualified residence specific security for the payment of the debt (1) under which, in the event of default, the residence could be subjected to the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated and (2) is recorded or otherwise perfected in accordance with the applicable State law. Sec. 1.163-10T(o)(1), Temporary Income Tax Regs., 52 Fed. Reg. 48417 (Dec. 22, 1987). In California, the State in which the Agoura Hills property was situated, a mortgage or deed of trust is perfected by recordation of the document at the office of the county recorder. Cal. Civ. Code secs. 1213 and 1214 (West 1989).[4]

The Court notes that the initial loan, which was used for acquiring the residence, was not secured in accordance with this definition:

In accordance with the December 11, 2006, letter K-Swiss granted Mrs. Weiderman a $500,000 loan to help finance the purchase of a home in Southern California, and petitioners used most of the loan proceeds to purchase the Agoura Hills property. Although the loan was memorialized by the February 15, 2007, promissory note, this note did not provide that the indebtedness was secured by the Agoura Hills property. Additionally, the February 15, 2007, promissory note was not recorded with the Los Angeles County, California, Registrar-Recorder.14 The $500,000 loan was therefore unsecured debt. Since it was unsecured debt, it was not acquisition indebtedness within the meaning of section 163(h)(3)(B)(i), and thus K-Swiss' cancellation of $220,000 of that indebtedness as memorialized by appendix A of the 2009 separation agreement was not cancellation of qualified principal residence indebtedness within the meaning of section 108.[5]

But a later loan that refinanced this loan did have such a deed of trust recorded to perfect the lien—didn’t that fix the problem?  Unfortunately for the taxpayer, recording that loan did not solve the problem since this new debt now failed the first test—it was not used in acquiring, constructing or substantially improving the property.  As the opinion continues:

In accordance with appendix A of the 2009 separation agreement petitioners signed the January 29, 2009, promissory note which created an indebtedness of $280,000 in favor of K-Swiss, together with a deed of trust also in favor of K-Swiss and recordable against the Agoura Hills property to secure payment of that new indebtedness. Although K-Swiss recorded the deed of trust with the Los Angeles County, California, Registrar-Recorder, the $280,000 debt was not “incurred in acquiring, constructing, or substantially improving” the Agoura Hills property. Indeed, the January 29, 2009, promissory note conditioned repayment of the $280,000 upon the sale of the Agoura Hills property. Like the indebtedness of $500,000, the indebtedness of $280,000 was therefore not acquisition indebtedness, and thus K-Swiss’ cancellation of $35,000 of that indebtedness as memorialized by the May 12, 2009, letter shortly before the sale of the Agoura Hills property was not cancellation of qualified principal residence indebtedness.

Finally, in accordance with the May 12, 2009, letter, petitioners executed an “[a]mended and [r]estated” promissory note for $245,000 in favor of K-Swiss. Like the February 15, 2007, promissory note, the note for $245,000 did not provide that the indebtedness was secured by the Agoura Hills property. Additionally, like the $280,000 debt, the $245,000 debt was not “incurred in acquiring, constructing, or substantially improving” the Agoura Hills property; indeed, similar to the repayment of the $280,000, repayment of ($200,000 of) the $245,000 was conditioned upon the sale of the Agoura Hills property. The indebtedness of $245,000 was therefore no different from the indebtedness of $500,000 and $280,000 — it was not acquisition indebtedness, and thus K-Swiss’ cancellation of $30,000 of the outstanding indebtedness to it of $45,000 in accordance with the June 2010 settlement agreement was not cancellation of qualified principal residence indebtedness.[6]

Note that under IRC §163(h)(3)(B) a refinancing of debt that is already qualified principal residence debt will not cause a problem.  The resulting new debt will inherit the status of the old.  But in this case the debt being refinanced was not qualified debt, thus the refinancing didn’t fall under the special rule found at the end of IRC §163(h)(3)(B).

[1] Weiderman v. Commissioner, T.C. Memo. 2020-109, July 15, 2020, https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=12289 (retrieved July 16, 2020)

[2] Weiderman v. Commissioner, T.C. Memo. 2020-109, pp. 3-5

[3] Weiderman v. Commissioner, T.C. Memo. 2020-109, pp. 5-8

[4] Weiderman v. Commissioner, T.C. Memo. 2020-109, p. 25

[5] Weiderman v. Commissioner, T.C. Memo. 2020-109, pp. 25-26

[6] Weiderman v. Commissioner, T.C. Memo. 2020-109, pp. 26-28