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Tax Aspects of ForeclosuresCalifornia CPA October 2009Details on the tax consequences of foreclosures and short sales on rental properties.By David M. Fogel, CPA I recently reviewed the tax consequences of foreclosures and short sales involving a taxpayer’s principal residence (January/February California CPA, Page 11), but what happens if the property involved is a rental? Is there a similar exclusion of cancellation-of-debt income (CODI) under Internal Revenue Code Sec. 108 for rental properties? Recourse or Nonrecourse Debt? Nonrecourse debt: lender cannot hold the borrower personally liable for it and may go only against the value of the property that is securing the debt to collect. Recourse debt: lender can hold the borrower personally liable for it beyond the value of the property that is securing the debt. If there is any doubt about whether the debt is nonrecourse or recourse, a real estate attorney should be hired to review the loan documents and make the determination. For purposes of this article, assume the rental property debt is recourse debt. Tax Consequences If a lender discharges any part of a debt, then the taxpayer must recognize the amount discharged as ordinary income [IRC Sec. 61(a)(12)]. Where the unpaid indebtedness is recourse, the foreclosure, or short sale, transaction is split into two parts: CODI equal to the outstanding principal amount of debt owed minus the fair market value of the property; and gain or loss equal to the fair market value of the property, minus its adjusted basis [Treas. Reg. Sec. 1.1001-2(a)(2)]. If the borrower qualifies, one or more of the relief provisions available under Sec. 108 may be used to exclude the CODI. One such provision is the Qualified Real Property Business Indebtedness (QRPBI) exclusion [Sec. 108(a)(1)(D)], to which California conforms. To qualify for this exclusion, the debt must be incurred or assumed by the taxpayer before Jan. 1, 1993, in connection with real property used in a trade or business (or if incurred or assumed after that date, is “qualified acquisition indebtedness”) and is secured by the real property [Sec. 108(c)(3)(A) and (B)]. The taxpayer must make an election to exclude the CODI [Sec. 108(c)(3)(C)]. If the taxpayer qualifies for this exclusion, then the CODI is excluded from gross income and applied instead to reduce the taxpayer’s adjusted basis of the property [Sec. 108(c)(1)]. The exclusion is limited to the excess of the principal amount of the qualified debt over the fair market value of the property [Sec. 108(c)(2)(A)], and also limited to the taxpayer’s basis in the property [Sec. 108(c)(1)(A)]. The exclusion is limited overall to the taxpayer’s aggregate adjusted bases of all depreciable real properties [Sec. 108(c)(2)(B)]. If the taxpayer is insolvent, then the insolvency exclusion [Sec. 108(a)(1)(B)] takes precedence over the QRPBI exclusion [Sec. 108(a)(2)(B)]. Is Renting Considered a Business? As stated above, the real property must be used in a business. Historically, the courts have held that the rental of even a single property may constitute a trade or business [Curphey v. Comm., 73 T.C. 766, 773 (1980)]. However, the ownership and rental of property does not always constitute a business, such as when the taxpayer is essentially an investor or the lease is a “net lease” [Neili v. Comm., 46 B.T.A. 197 (1942); Rev. Rul. 73-522, 1973-2 C.B. 226]. In Technical Advice Memorandum 8350008, the IRS took the position that the mere rental of real property does not constitute a trade or business under Sec. 1231. As a result, taxpayers may be concerned about whether the IRS will allow the QRPBI exclusion to be used for rental property. The only guidance comes from several IRS letter rulings issued after the 1983 TAM, holding that a multitenant office building held by a limited partnership and a multiunit residential building held by a general partnership, qualified as businesses for purposes of the QRPBI exclusion (private letter rulings 9426006–9426019; 9840026). Ultimately, the issue depends upon the facts and circumstances. If the taxpayer rents the property continuously to an unrelated party for a fair market rent, then it will probably be considered a business [e.g. Mayes v. U.S., 60 AFTR2d (RIA) ¶5046, 87-2 USTC (CCH) ¶9478 (W.D.Mo. 1986)]. Qualified Acquisition Indebtedness Also, as stated above, if the debt was incurred or assumed by the taxpayer after Jan. 1, 1993, it must constitute “qualified acquisition indebtedness.” This means that the debt must have been incurred to acquire, construct, reconstruct or substantially improve the property [Sec. 108(c)(4)]. Refinancing indebtedness also qualifies, but only to the extent that it doesn’t exceed the principal balance of the debt paid off by the refinance loan [last sentence of Sec. 108(c)(3)]. To the extent that the proceeds from the refinance loan are used to substantially improve the property, that portion will qualify [H. Rept. No. 100-391, Omnibus Reconciliation Act of 1987 (P.L. 100-203), 10/19/87]. Making the Election The QRPBI election must be made on a timely-filed return (including extensions) for the year in which the taxpayer has CODI. The election is made by filing Form 982 with the return [Treas. Reg. Sec. 1.108-5(b)]. Principal Residence Converted to Rental If a taxpayer’s principal residence is converted to rental use, and there is CODI from a foreclosure or short sale, does the taxpayer claim the Qualified Principal Residence Indebtedness exclusion or the QRPBI exclusion? It depends upon the kind of debt that is discharged [secs. 108(a)(1)(D) and (E)]. If, at the time that the debt is canceled, the property is being used as a rental, then the QRPBI exclusion applies. Defining Example 1
This results in:
Defining Example 2
This results in:
David M. Fogel, CPA is a Roseville-based tax consultant. |