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Cancelled Debt on Residential Rentals


DeductiuonHound

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If someone does a short sale on a multi-unit can they exclude the cancelled debt from ordinary income? Does it fall under the "Qualified Real Property Business Indebtedness" clause shown in Pub 4681? Note: They are not insolvent nor filing bankruptcy under Title 11.

Clent paid $400,000 each for 3 separate 4-plexes in 2005. Can not continue to make payments so he wants to list them for sale but they're only worhth around $250,000 now. The bank would have to aprove a short sale. If he still owes $350,000 on his loans and the bank accepts a contract for $250,000, will the bank issue a 1099-C for the difference?

What would be the tax consequence of this action?

I.E. Cancelled debt taxable as ordinarry income and / or Adjustment of Cost Basis?

We have many clients facing real estate problems with this market. With the Personal Residence I believe the Cancelled Debt can be excluded as long as it does not exceed the amount that was used to either purchase or improve the home. But Not sure how the Investment properties are handled.

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If someone does a short sale on a multi-unit can they exclude the cancelled debt from ordinary income? Does it fall under the "Qualified Real Property Business Indebtedness" clause shown in Pub 4681? Note: They are not insolvent nor filing bankruptcy under Title 11.

Clent paid $400,000 each for 3 separate 4-plexes in 2005. Can not continue to make payments so he wants to list them for sale but they're only worhth around $250,000 now. The bank would have to aprove a short sale. If he still owes $350,000 on his loans and the bank accepts a contract for $250,000, will the bank issue a 1099-C for the difference?

What would be the tax consequence of this action?

I.E. Cancelled debt taxable as ordinarry income and / or Adjustment of Cost Basis?

We have many clients facing real estate problems with this market. With the Personal Residence I believe the Cancelled Debt can be excluded as long as it does not exceed the amount that was used to either purchase or improve the home. But Not sure how the Investment properties are handled.

If the bank approves the short sale for the 250K, your client will definetly recieve a 1099C for the differnce of the outstanding balance. Since these properties are probably rental properties, he will have to report the 1099-C amount as rental income and not on line 21 of 1040. From the quickfinder book, there are some exceptions:

Generally, debt forgiveness is taxable, unless one of the exclusions from Section 108 applies - that is, debt forgiveness:

1) Occurs under Title 11 bankruptcy

2) Occurs when the taxpayer is insolvent

3) Is qualified farm indebtedness or

4) Is qualified real property business indebtness (other than C corporation)

If one the property would of been his personal residence, he would of qualified for the Mortgage Forgiveness Debt Relief Act of 2007.

Mortgage Forgiveness Debt Relief Act of 2007

In December 2007, President Bush signed the Mortgage Forgiveness Debt Relief Act of 2007. It will rescue many families facing foreclosure on their personal residences (see H.R.3648 and S.1394, Mortgage Forgiveness Debt Relief Act of 2007). Referring to the House version that passed on October 4, 2007, House Ways and Means Committee Chair Charles B. Rangel (D-N.Y.) said:

It is just not right or fair that families struggling through a foreclosure would then face a tax bill in addition to losing their homes when they have seen no increase in their net worth. This bill rights that wrong and provides tax relief to millions of American families. [see Tax Analysts 2007 TNT 194-1.]

The new law excludes from gross income up to $2 million of COD income by reason of debt reduction of a qualified principal residence indebtedness for foreclosures between January 1, 2007, and December 31, 2009 [new IRC section 108(a)(1)(E)].

Other provisions of the law include:

Qualified principal residence indebtedness is defined as any indebtedness incurred in acquiring, constructing, or substantially improving the principal residence of a taxpayer if the debt is secured by the residence. In addition, committee reports state that any indebtedness secured by the principal residence resulting from refinancing is allowed if the refinanced debt does not exceed the debt immediately prior to refinancing. For example, qualified principal residence indebtedness refinanced to obtain a lower interest rate is allowed.

The basis of the individual’s principal residence is reduced by the amount excluded from income. This will increase the gain or decrease the loss on the foreclosure sale; however, because a personal loss is disallowed and the first $500,000 ($250,000 for single filers) gain is excluded, there will likely be no effect on the taxability of the foreclosure.

The new law does not eliminate all COD income for taxpayers. Home equity loan debt used for any purpose other than to substantially improve the principal residence is not excluded. Debt relief on mortgage debt not related to the home, such as educational, medical, and consumer debt, remains subject to COD income.

The new law is effective for discharges of indebtedness between January 1, 2007, and December 31, 2009. The sunset provision was included because Congress remains committed to the all-inclusive income concept stated in IRC section 61(a)(12), that cancellation of debt is income because it increases a taxpayer’s wealth. Senate Finance Committee Chair Max Baucus (D-Mont.) stated:

From a tax standpoint, a forgiven loan is income. Hopefully we’re in a temporary situation here [with the housing crisis], and that’s why in my judgment the exemption should be temporary. [see 2007 TNT 96-26, S.1394.]

The COD exemption applies to a taxpayer’s personal residence as defined in IRC section 121. Vacation homes or other real estate investments do not qualify for the exemption.

The COD exemption does not apply if the loan is discharged in exchange for services or if the taxpayer is in Title 11 bankruptcy. The exemption does apply if the taxpayer is insolvent, unless the individual elects to use the insolvency rules

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>>Does it fall under the "Qualified Real Property Business Indebtedness" clause<<

If these properties were used in a rental activity reported on Schedule E they are not a trade or business and the cancellation of debt can not be excluded. If, for example, significant personal services were provided to the tenant or they were rented at a daily rate, they would have been reported on Schedule C.

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