Short Sale/Cancellation of Debt

[Linda Mathey]

I have a very similar situation to Deb. My client bought a condo in Las Vegas which he paid $615,000 three years ago. His son lived in it for a while and rented part of it for $1,500 a month. He left his son keep the money and forgot about it and we never reported it as a rental property.

Real estate agents have told him the current value of it is between $150,000-$175,000 and the bank is willing to cooperate in a short sale. Should we amend the old returns and now claim it as a rental property? How will the IRS view that? He had an interest only loan so he still owes the full $615,000 and will have COD income of abt. $465,000. He can sell it in 2009 or wait until 2010. Which would be better?

Do we consider it a sale with proceeds of $150,000 plus the COD of $465,000 against basis of $615,000 so no gain or loss? How do we report it? Do we report anything if it is considered personal residence? What form do we use?

Any suggestions or assistance with how to properly handle and report this would be greatly appreciated. I am at a loss and do not want to give him bad advice. Thanks in advance for your responses.

[jainen]

>>What form do we use?<<

According to the Instructions to Schedule D, "if you had a loss from the sale or exchange of real estate held for personal use for which you received a Form 1099-S, you must report the transaction on Schedule D even though the loss is not deductible.... enter -0- in column (f)."

There can be no question this property was held for personal use, as the residence of the owner's son. Presumably the son was reporting rental income, but that is nothing to the owner.

[Linda Mathey]

>>What form do we use?<<

According to the Instructions to Schedule D, "if you had a loss from the sale or exchange of real estate held for personal use for which you received a Form 1099-S, you must report the transaction on Schedule D even though the loss is not deductible.... enter -0- in column (f)."

There can be no question this property was held for personal use, as the residence of the owner's son. Presumably the son was reporting rental income, but that is nothing to the owner.

Jainen,

Thanks so much for your response. So just to make sure I am perfectly clear, in my situation I would show cost as $615,000 and proceeds equal to cost so that the gain/loss in column f is zero? The bank will write off whatever the difference is between proceeds and remaining mortgage(which has never changed and is still cost)so he will have no gain/loss. I assume that even if his cost had included a down payment we would still force column f to a 0 by making proceeds equal to cost? Or in that case would I show proceeds as COD plus sale proceeds and let there be a difference but force column f to a zero? Sorry to drage this out, but the whole thing was a surprise to me and I am just anticipating that he may say oh by the way I put $100,000 down too.

[Joel]

Linda,

In ATX on Sch D entry there is a code for personal loss. Enter the actual sales price and cost and select the personal loss code. The result will be 0.

[jainen]

>>$100,000 down too<<

Down payment is irrelevant. His basis is purchase price plus transaction costs, including fees related to the sale. I'm guessing that it was a non-recourse loan, so the amount realized on sale would equal the debt canceled. If it was a recourse loan, the amount realized would be the lower FMV (presumably the sale price). Use those numbers and override column (f).

There is ordinary income from cancellation of debt ONLY if it was a recourse loan. The bank might send a 1099-C anyway, so READ the loan docs and keep a copy in your file.

[Linda Mathey]

Linda,

In ATX on Sch D entry there is a code for personal loss. Enter the actual sales price and cost and select the personal loss code. The result will be 0.

Thanks Joel

[Linda Mathey]

>>$100,000 down too<<

Down payment is irrelevant. His basis is purchase price plus transaction costs, including fees related to the sale. I'm guessing that it was a non-recourse loan, so the amount realized on sale would equal the debt canceled. If it was a recourse loan, the amount realized would be the lower FMV (presumably the sale price). Use those numbers and override column (f).

There is ordinary income from cancellation of debt ONLY if it was a recourse loan. The bank might send a 1099-C anyway, so READ the loan docs and keep a copy in your file.

Thanks Jainen,

The only way the down payment would be relevant would be if he told me the cost was $615,000 (referring to his mortgage amount) and forgot that he also made a down payment. In that case the cost would be the mortgage plus down payment.

Isn't the purchase of residential property usually non recourse debt? Is there verbage I should look for in the original loan docs?

[jainen]

>>Isn't the purchase of residential property usually non recourse debt?<<

In my state (California) a purchase loan for a PRIMARY residence is generally non-recourse. For other mortgages, the lender may have an option to foreclose on the deed of trust (non-recourse) or the promissory note (recourse, through a judicial proceeding). I don't know the law in Nevada, where property is often bought as a second home or investment. Like as not, your client's purchase was mischaracterized as owner-occupied, so just read through the whole loan package and see what it says.

Frankly, I'm not positive that for taxes a short sale is treated the same as a foreclosure anyway. But I think so.

[Linda Mathey]

>>Isn't the purchase of residential property usually non recourse debt?<<

In my state (California) a purchase loan for a PRIMARY residence is generally non-recourse. For other mortgages, the lender may have an option to foreclose on the deed of trust (non-recourse) or the promissory note (recourse, through a judicial proceeding). I don't know the law in Nevada, where property is often bought as a second home or investment. Like as not, your client's purchase was mischaracterized as owner-occupied, so just read through the whole loan package and see what it says.

Frankly, I'm not positive that for taxes a short sale is treated the same as a foreclosure anyway. But I think so.

Here is the response from the Loss Mitigation Attorney working with my client. "It actually goes by State. Nevada IS a recourse state…..however……Troy’s job is to have the bank agree to issuing a 1099. Once the bank does that, they are done and will not pursue a deficiency judgment."

Jainen my question is if the bank issues a 1099 do we still report the transaction on Sch D? The client confirmed that the actual cost was $640,000, $25,000 was the down payment. The loan is still $615,000 and the sale proceeds will be approx. $150,000. Would we still have a zero gain/loss situation? If yes then the Sch D would show basis of $640,000 proceeds of $150,000 and $465,000 COD for a total proceeds of $615,000 and a non-deductible loss of $25,000. What I was concerned about was that the $465,000 would be ordinary income.

[jainen]

>>the $465,000 would be ordinary income<<

That's what it looks like. For a recourse loan, the amount realized from sale is the lower of debt or FMV. So Schedule D will show basis of $640K plus expenses, proceeds of $150K, and -0- in column (f). Line 21 on the 1040 will show the amount of debt relief. There is still hope, however, in the calculation of insolvency.

[Linda Mathey]

Thanks for the response. Unfortunately or fortunately depending on how you look at it, he has a lot of personal wealth so insolvency is not even an issue. Looks like he can expect a huge tax bill next year. No matter how much money you have losing this kind of money and then getting taxed on it is a big pill to swallow. I appreciate so much you taking your time to respond to me.

[jainen]

>>losing this kind of money and then getting taxed on it is a big pill to swallow<<

Oh no, I won't go with you that far, Linda. He knew perfectly well that he was employing extreme leverage. But instead of accepting the implications of that risk like a decent investor, he's just walking away from it. We're not talking hard luck here. He has "a lot of personal wealth" to honor his obligations in full, but from day one he never paid a dime on that loan. You say he just "forgot about it." Yeah, sure, he forgot that he gave his kid a half million dollar condo with a fat monthly allowance!

LOSING money? That's a laugh--he is GAINING $315,000 in net worth out of this one transaction. Not too shabby for a two bit investment in the worst real estate market around. That's right -- 25 is all this big gambler ever put on the table.

So let him pony up his fair share of taxes like all us other slobs. Then the government can bail out the banks he stiffed.

[kcjenkins]

I'm with Jainen on this one. Sounds like he 'earned' that tax bill by his own actions and inactions. If he has the resources, why would he take an 'interest only' loan? And then, having done that, pay not a cent on it, nor make sure that his son was paying it? I'm guessing he thought he'd sell it in a few years for a lot more than he paid for it, making some easy money that would be cap gains income at that.

[jainen]

>>he 'earned' that tax bill by his own actions and inactions<<

Even with that, kc, I think you are being too kind. This joker's own attorney says "Troy's goal" is to manipulate the tax system so the bank is forced to give up its rights under state law. Rights to sue his sorry assets to pay back what he promised just a few years ago. Well, it's legal but it ain't right. It's another example of how the last administration didn't really foster a capitalist economy. Greedy investors grabbed whatever they could, and then asked the government to guarantee it.

[OldJack]

LOSING money? That's a laugh--he is GAINING $315,000 in net worth out of this one transaction. Not too shabby for a two bit investment in the worst real estate market around. That's right -- 25 is all this big gambler ever put on the table.

I fail to understand how he is gaining $315,000, could you clarify that?

It looks to me like the most he might be gaining would be $125,000 (sale $150,000-down $25,000). Am I missing something?

[kcjenkins]

If you 'lose' an obligation, isn't that the same thing as making money? He's gong to 'lose' the entire debt, for only the cost of the tax on the forgiveness. So his Net Worth will go up, right?

[kcjenkins]

>>he 'earned' that tax bill by his own actions and inactions<<

Even with that, kc, I think you are being too kind.

Well, unlike my favorite 'contrarian' I have a habit of being kind, you know! At least I try to be.

[Linda Mathey]

One final question, so I am clear on this.....if the property had been a rental property would it have fallen under the qualified real property business indebtedness exclusion for COD?

If yes, then wouldn't the recourse debt be written off using Form 982 and the depreciable basis reduced by the debt forgiveness? If I am thinking about it correctly, the basis would be then reduced by the excess of the principal amount of the debt over the FMV of the property. Since the debt is $615,000 and FMV is $150,000 the exclusion would be for the $465,00.

Since cost basis was $640,000 this would reduce basis to $175,000. Since the sale proceeds are $150,000 there would be an ordinary loss and no ordinary income?

This is not his case but if it were, could this possibly be correct?

[BulldogTom]

OK, this may sound stupid, but aside from the tax implications, why is this guy short selling if he has wealth?

Can he afford the payments?

Just wondering.

Tom

Lodi, CA

[OldJack]

If you 'lose' an obligation, isn't that the same thing as making money? He's gong to 'lose' the entire debt, for only the cost of the tax on the forgiveness. So his Net Worth will go up, right?

No... he is losing on his net worth because before the housing crash he had a house worth probably much more than the mortgage of $615,000 (plus the $150,000) and it is now going to sell for $150,000. When he was relieved of the obligation it cost him taxes and did not put a penny of money in his pocket nor did it increase his assets. How can you say relief of debt is the same as making money when he has no money to spend from the debt?

[jainen]

>>How can you say relief of debt is the same as making money when he has no money to spend from the debt? <<

I didn't say relief of debt is the same as making money. I said THIS TRANSACTION is increasing his net worth, that is, his total assets minus total liabilities. That balance is his key to obtaining further credit, which he CAN spend as he has so dramatically proven.

Yes, he lost net worth when the property value dropped, but that is ancient history. Now he is looking at whatever position he is currently in, and inquiring about taxation of a proposed transaction. Well, for some reason his tax consultant had an emotional reaction to his history. My point is that even with the taxation he will come out of this ahead of where he is now. In fact, what the tax consultant calls a bitter pill is exactly what his legal counsel is recommending as most desirable. I agree with the lawyer, but only from the taxpayer's point of view. I also had an emotional reaction--not to the way his speculation plans turned out, but to what he now plans to do about it.

[kcjenkins]

No, he does not have the money, but he does not have the debt either. Yes, he lost net worth back WHEN THE PRICES FELL, but now he actually improves his net worth by removing the debt from his balance sheet for much less than he owed.

[Linda Mathey]

In answer to the question regarding why he is short selling....when he bought the place he intended to use it as a rental. Then his son started a business in Vegas and he told him he could stay there until he got on his feet. The son needed the money so he rented part of it out to a friend. Now the son's business (landscaping) has gone belly up. He left Vegas and my client has no one close to monitor it and rents in that building have fallen to about $1,500 a month. The interest only payments on the $615,000 were over $39,000 last year not counting insurance, taxes and condo fees. Since the real estate market there has collapsed he feels he is throwing good money after bad to keep it, try to rent it and pay over $45,000 a year with nothing going to reduce the mortgage. He decided to walk away if the attorney's could make it possible.

Jainen while I appreciate your comments and insight I do not appreciate your opinion of my response as "emotional". My job is to advocate for my client while preparing an accurate tax return. If anyone's response to this question is emotional, it is yours!

[jainen]

>>If anyone's response to this question is emotional, it is yours! <<

Yes, I admit I am uncomfortable with the proposal, and I can only plead that my bias interfered with understanding what you were saying. Your background and questions are almost entirely numerical. You did not express any personal opinion about how your client got into his current circumstances or the best way to get out, other than which numbers are bigger than others. I mischaracterized your position, Linda, and I apologize for that.

[kcjenkins]

Also, Linda, since you are a realatively new member here, and an infrequent poster, you may not be aware that Jainen is our Official Contrarian. [I just designated him as such! ] His tax advice is almost always spot-on, but he does love to take the opposite side whenever possible. So try not to take anything he says too personally, he's not attacking the poster, usually, just the post.