Cancellation of Debt

[Steve M]

I have a client who is insolvent. He has a rental income property that he received a 1099-C for $250,000. The bank stated that the FMV was $155,000. (non-recourse) My understanding is that if I put the $250,000 in box 5 of Part II, Form 982, that reduces his basis in the property by $250,000, which also happens to be his original purchase price. Am I correct in understanding that by doing so, I am reducing his basis in the property sale on Form 4797 to $0 and he has to pay income tax on a profit of $250,000 (not including depreciation)? If so, what is the advantage of cancelling the debt in the first place? Is there a tax benefit? I have spent over an hour on the phone with IRS, but they're not very helpful and could not explain.

Steve M

[Tax Prep by Deb]

I have a client who is insolvent. He has a rental income property that he received a 1099-C for $250,000. The bank stated that the FMV was $155,000. (non-recourse) My understanding is that if I put the $250,000 in box 5 of Part II, Form 982, that reduces his basis in the property by $250,000, which also happens to be his original purchase price. Am I correct in understanding that by doing so, I am reducing his basis in the property sale on Form 4797 to $0 and he has to pay income tax on a profit of $250,000 (not including depreciation)? If so, what is the advantage of cancelling the debt in the first place? Is there a tax benefit? I have spent over an hour on the phone with IRS, but they're not very helpful and could not explain.

Steve M

Are you sure it was a non-recourse loan? It was my understanding that if it's non recourse there is no cancellation of debt. They agreed to take the property back and pursue no other recourse therefore no cancellation of debt.

Are you sure he received a 1099C and not a 1099A?

Deb!

[Steve M]

Are you sure it was a non-recourse loan? It was my understanding that if it's non recourse there is no cancellation of debt. They agreed to take the property back and pursue no other recourse therefore no cancellation of debt.

Are you sure he received a 1099C and not a 1099A?

Deb!

Yes, Deb, I am holding the 1099-C and it states in box 5 - are you personally liable for repayment, and the answer is no. That is a non recourse loan.

[jainen]

>>That is a non recourse loan<<

Not necessarily. For some reasons a lot of finance companies haven't figured out how to use the form. (Well, these ARE the same idiots who made the basically unsecured loans to deadbeats in the first place!) Sometimes they will issue a 1099-C just out of spite for a borrower who stiffed them on a non-recourse loan. Other times they misinterpret "personally liable" because the debt was cancelled. Generally I would expect a mortgage on rental property to be a recourse loan, which is consistent with using Form 1099-C even if Box 5 is wrong.

[Tax Prep by Deb]

>>That is a non recourse loan<<

Not necessarily. For some reasons a lot of finance companies haven't figured out how to use the form. (Well, these ARE the same idiots who made the basically unsecured loans to deadbeats in the first place!) Sometimes they will issue a 1099-C just out of spite for a borrower who stiffed them on a non-recourse loan. Other times they misinterpret "personally liable" because the debt was cancelled. Generally I would expect a mortgage on rental property to be a recourse loan, which is consistent with using Form 1099-C even if Box 5 is wrong.

Perhaps, however I have had clients in the past who purchased rental property and when they filled out the loan doc's they were advised to put down that they would be owner occupied. In fact most of the rentals around here in the past several years have been purchased this way. That being the case it could be a non-recourse. Oh aren't we having loads of fun?

Deb!

[Steve M]

Sorry to cause all this confusion, but it's nothing compared to the IRS confusion. I did one very similar last year; a client actually had several rental properties that he received 1099C's for. I filled out the 982 because he was insolvent just prior to relinquishing the properties. I did a 1045 to reclaim prior year taxes and the IRS corrected my return and gave him an additional $2000 refund on top of the $140K refund I had already calculated for him. I know they checked that return over pretty carefully. I had not reduced his basis in the tax attributes because of the following par. in Pub 908:

"Bankruptcy and insolvency reduction limit. The reduction in basis for canceled debt in bankruptcy or in insolvency cannot be more than the total basis of property held immediately after the debt cancellation, minus the total liabilities immediately after the cancellation. This limit does not apply if an election is made to reduce basis before reducing other attributes. This election is discussed later".

So he walked away with over $400K in rental cancellations with no tax liability, received back $142K of prior taxes paid and the IRS put their stamp of approval on it. Now I have this similar situation and the IRS still can not give me a straight answer. And Deb, if you are right about no cancellation of debt for non-recourse loans, then his return just shows the rental as a sale on 4797 with a capital loss. It just doesn't seem right, but who am I to say? Thanks for your input.

Steve M