Last minute question - Rental Foreclosure

[BulldogTom]

This is a better question for the client's lawyer, and I am wary of giving any advice....but.....

Client had a rental home for 2 years. Could not make the payments and walked away. Filed Bankruptcy. Included the home debt in the bankruptcy filing. Bank says they cannot include the debt in bankruptcy and the client must go through foreclosure. Bank has offered to take a Deed in Lieu of Foreclosure from the client. Here are my questions/statements

Can the bank force the issue out of bankruptcy? Could they even add the debt to the bankruptcy filing (this is the question they should ask their bankruptcy lawyer).

I know if a debt is discharged in bankruptcy, there is no income.

I know if a Deed in Lieu is delivered, it is a sale and the client has to prove insolvency to get relief. Is the bankruptcy proof of insolvency?

Thanks for your help.

Tom

Lodi, cA

[kcjenkins]

The bankruptcy would normally be proof of insolvancy. But do the worksheet in the Pub if in any doubt, and keep it in your file.

[David1980]

Normally rental property foreclosures don't matter too much.

Let's say someone buys a rental house for $500,000. The house is foreclosed on when the fair market value is $250,000. To keep things simple, no depreciation & no payments (so amount owed is still $500,000.) Buyer is personally liable for the debt.

Normally, the difference between FMV and balance outstanding would be reported as ordinary income on Schedule E. So there is $250,000 income on Schedule E for cancellation of debt. There is also of course a sale of rental property. Cost is $500,000. Sell price will be the FMV since FMV is smaller than the balance outstanding on the loan. $500,000 cost $250,000 sale price, $250,000 loss showing on 4797.

This results in a net of $0 on the tax return.

If you exclude the debt due to insolvency, you would then have a reduction of tax attributes. If the rental home was the only non-personal asset and there's no NOL's, business credits, etc... Would you not then have a Schedule E with no cancellation of debt and a sale at basis $250,000 and sale price $250,000? The result being exactly the same, except an extra form used? (I'm not sure on that, so it's a real question.)

[LindaB]

Normally rental property foreclosures don't matter too much.

Let's say someone buys a rental house for $500,000. The house is foreclosed on when the fair market value is $250,000. To keep things simple, no depreciation & no payments (so amount owed is still $500,000.) Buyer is personally liable for the debt.

Normally, the difference between FMV and balance outstanding would be reported as ordinary income on Schedule E. So there is $250,000 income on Schedule E for cancellation of debt. There is also of course a sale of rental property. Cost is $500,000. Sell price will be the FMV since FMV is smaller than the balance outstanding on the loan. $500,000 cost $250,000 sale price, $250,000 loss showing on 4797.

This results in a net of $0 on the tax return.

The problem with this scenario is that the loss on the 4797 goes to sch. D and is a capital loss, limited to $3000 a year.

[LindaB]

I know if a debt is discharged in bankruptcy, there is no income.

I know if a Deed in Lieu is delivered, it is a sale and the client has to prove insolvency to get relief. Is the bankruptcy proof of insolvency?

If the client abandoned the property, I think that it is going to be reported as a sale either on his personal return if the property is not part of the bankruptcy estate, or on the return for the bankruptcy estate itself if the property is part of the bankruptcy. If it's on his personal return, you can't get rid of any gain or loss because of the bankruptcy or because of insolvency. I'm not sure, but I think that if the sale is reported on the bankruptcy estate the gain or loss would pass through to the individual. What you can exclude because of bankruptcy or insolvency is the ordinary income from the cancellation of debt. That's not the same as gain/loss from the sale.

I wonder if this is a nonrecourse loan, and that's why the bank said it can't go into the bankruptcy--for a nonrecourse loan there would be no cancellation of debt income anyway. Or maybe if the client abandoned the property before filing for bankruptcy, he lost the option of transfering the property to the bankruptcy estate.

I hope your client will find out from his attorney what's going on with this bank before he signs anything from the bank. Big banks have too much power.

[LindaB]

This is from Pub. 908:

Bankruptcy law determines which of the debtor's assets become part of the bankruptcy estate. These assets are treated the same in the estate's hands as they were in the debtor's hands.

[David1980]

The problem with this scenario is that the loss on the 4797 goes to sch. D and is a capital loss, limited to $3000 a year.

If it's a gain it would go to schedule D. If it's a loss, it's just the 4797. See line 7 of a 4797.

"Individuals, partners, S corporation shareholders, and all others. If line 7 is zero or a loss enter the amount from line 7 on line 11 below and skip lines 8 and 9. If line 7 is a gain ..."

It will carry from line 7 to line 11, from line 11 to 17, 17 to 18b and 18b to 1040 line 14. All deductible in the year of sale.