Travis H. Long, CPA, Inc. Blog

Originally published in the Pacific Grove Hometown Bulletin

September 7, 2011

The last five issues I went over the basic concepts of foreclosures and short-sales, an overview of ways to exclude the resulting taxable income, the effects of recourse/nonrecourse debt, and principal residence and insolvency exclusions. If you missed these articles they are re-published on my website at www.tlongcpa.com/blog. This issue I will specifically discuss the exclusion typically available for rental properties.

When someone loses real property through short-sale or foreclosure, potential taxable income can result since recourse cancelled debt is taxable income.  As I have discussed in prior issues, there may be ways to exclude this income on the tax return.  With solid, early planning, we may be able to even change the characteristic of a property and drive the outcome to the most tax favorable result should a short-sale or foreclosure occur.  All or part of the cancellation of debt income associated with losing a rental property may qualify for the Qualified Real Property Business Indebtedness exclusion assuming you are not going through a bankruptcy and you are not insolvent, in which case other exclusions take precedence.  Another key issue is whether or not a rental property is a business.  This concept is requisite to use the exclusion.  The courts have a long history of upholding this construct, but the IRS does not always agree, and it comes down to facts and circumstances.

Notice the word, “Qualified,” in the name of the exclusion.  This is a subtle hint that certain criteria must be met to receive this treatment, and is sometimes misunderstood by preparers not well-versed in the governing code sections.  As with other exclusions discussed in past articles, the cancelled debt must have been used to purchase or construct the property, additions, remodels, etc.  If you borrowed against the equity in the property to finance your personal life or to purchase or renovate another property, that portion will not qualify for the exclusion.  There are also limitations on the amount of income that can be excluded relating to the fair market value of the property, basis in depreciable property, and other factors.

The amount determined to be excludable then becomes a reduction of your cost basis in the property (the timing and calculation of this basis reduction is affected by several other factors as well).  This is important, because we also have to calculate a gain or loss when you dispose of the property, and yes, in ugly situations, you can have a gain on sale even if you owe a lot more than the property is worth.  Ouch!  For example, ignoring transaction costs, depreciation, loan payments, etc., assume you bought a property for $250K, refinanced and took another $400K out to live-on as the property value soared to $750K and now it is only worth $350K and is foreclosed.  You have $300K ($650K Debt – $350K Value) of cancelled debt and a taxable gain of $100K ($350K Value – $250K Cost).

When handling one of these transactions, it is a bifurcated process whereby we handle the cancellation of debt issue on the one hand, and the gain/loss calculation on the other.  The two dance a bit, but are generally separate calculations.  The beauty of rental properties, unlike personal residences, is if a loss is generated, it may be deductible, whereas, losses created by the disposition of personal residences are nondeductible.   This is where planning comes in to play.

This is just a summary of some of the key provisions. There are many other circumstances and specific rules that could affect you, and you need to consult with a qualified professional to review your situation. Consult as soon as you can foresee the possibility of losing a home in order to plan the most tax efficient way to lose it.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, Pacific Grove, CA, 93950. He can be reached at 831-333-1041.