Archive for the ‘qualified real property business indebtedness’ Tag
Foreclosures and Short-Sales – Part VI – Rental Properties
Filed under: Foreclosures and Short-Sales | Tags: cancelled debt, Foreclosure, qualified real property business indebtedness, recourse, rental properties, Short-Sale
Leave a comment 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.
Foreclosures and Short-Sales – Part II – Exclusions from Income
Filed under: Foreclosures and Short-Sales | Tags: bankruptcy, cancelled debt, Foreclosure, insolvency, qualified farm indebtedness, qualified principal residence indebtedness, qualified real property business indebtedness, section 108, Short-Sale, tax attributes
Leave a comment Originally published in the Pacific Grove Hometown Bulletin
July 6, 2011
In the last issue I went over the basic concepts of foreclosures and short-sales and explained that your debt forgiven in these transactions is considered taxable income. It is difficult to face a tax bill in congruence with losing a property so Congress provided some options to possibly exclude the cancelled debt from your taxable income.
Section 108 of the Internal Revenue Code will likely be your hero. This code section and its related code sections and regulations are not for the faint of heart as I have witnessed by the glazed eyes of a sea of tax professionals trying to grasp the nuances in the rules, as well as phone calls I have received from other CPAs and attorneys.
Based on my experience with over 80 of these transactions, if you distill the mess of complex code down to its core, you will find after the dust settles and the house is gone, if you truly have nothing left, you will typically get off the tax hook. For everyone else, to the extent you have a positive net worth or future tax benefits, these code sections swallow your benefits or act as a deferral of tax to a later date – do not be misled, however, this is still a great stamp in your passport (summer cliché). To receive these benefits, however, you have to apply the code and file the forms and additional statements correctly with an original, timely filed return. If you foresee the future chance of losing a property, consult early to strategize how to best “lose the property” – it may save you a lot of money.
Section 108 covers all discharges of debt, but I will focus on it from the perspective of debts discharged due to the loss of a home or rental property. The circumstances that may qualify you to exclude the debt or part of the debt from income are: bankruptcy, insolvency (you have more liabilities than assets), qualified farm indebtedness, qualified real property business indebtedness (typically rental property debt falls here), and qualified principal residence indebtedness (debt on your main home usually qualifies here). You see the word qualified in a number of these exclusions because not all debt is eligible. The escape hatch may get smaller, for instance, if you lived off the equity of your home and did not reinvest refinance proceeds back into improving it.
Once it is determined how much debt can be excluded from income (which can come from a combination of exclusions), we then apply tax attribute reduction rules – on the chopping block include items that could have saved you tax in the future: net operating losses, general business credits, minimum tax credits, capital loss carryovers, tax basis in your other assets (most people have at least some of this), passive activity loss and credit carryovers, and foreign tax credit carryovers. The order, timing, and calculation of these rules are different depending on which of the previously mentioned exclusions you are using. Next issue, I will focus on the principal residence exclusion.
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.
Travis H. Long, CPA, Inc. Blog 