WE talked about tax consequences of short sales, foreclosures, and abandonments of homes. Let us now talk about tax consequences of cancelled debt on qualified real property – including rental units.
Debt forgiven from short sales, foreclosures, and abandonments creates debt relief income – taxable income, taxed at ordinary rates. Hard for property owners who lose their properties to foreclosures, then find themselves paying tax on debts that are forgiven, reduced, or cancelled.
There are laws that protect property owners, first under bankruptcy and insolvency rules. Second, the Mortgage Forgiveness Act of 2007 comes to the aid of homeowners. Third, the Revenue Reconciliation Act helps rental owners. Let us explore how you, as rentals owners, can exclude income from debt relief.
Qualified acquisition indebtedness. Debt relief income can be excluded by landlords from qualified acquisition debt. This is debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property. It also includes debt resulting from refinancing, as long as the new loan does not exceed the amount of old loan. It does not cover funds used to pay off car loans, credit cards, travel, or college costs. It does not apply to bankruptcy cases. It does not apply directly to insolvency cases when your assets are less than your debts immediately before the cancellation. The insolvency exclusion must be applied prior to seeking relief for cancelled qualified real property business debt.
Qualified Real Property Business Debt. Taxpayers other than corporations may exclude debt forgiveness from qualified real property business indebtedness and where the insolvency exception does not apply. The question is – can rental properties be eligible for the Qualified Real Property Business Debt Exclusion? The debt must be incurred or assumed in connection with a trade or business. It is based on the taxpayer’s involvement in the rental activity. For this purpose, rentals are “trade or business property” even if a management company is hired. Rentals conducted as net leases do not qualify.
Exclusion limit. Exclusion is limited to your equity in depreciable properties and the basis cannot be reduced below to zero.
How to elect the qualified real property business debt exclusion. You must make an election to exclude cancelled qualified real property business debt. The taxpayer makes the election on Form 982 (PDF), which must be attached to a timely filed (including extensions) 2015 federal income tax return. Check the box on line 1d of Form 982. Include the amount of canceled qualified real property business debt on line 2 of Form 982. Reduce your tax attributes in Part II of Form 982. If you filed but missed this election, you can still make the election by filing an amended return within 6 months of the due date of the return. Enter “Filed pursuant to Section 301.9100-2” automatic extensions on the amended return and file it at the same place you filed the original return.
Example: Let us say that you own a $550K ($550,000) worth fourplex with a first mortgage of $510K and a second of $90K. The second trust deed holder agrees to reduce the second loan from $90K to $30K. Your debt discharged is $60K. The maximum debt that you can exclude from income tax is loan balance immediately before the discharge of $600K minus the fair market value of $550K. You may elect to exclude $50K from your income.
In accordance with IRS Circular 230, this communication is not to be considered a “covered opinion” or other written tax advice and should not be relied upon for IRS audit, tax dispute, or any other purpose.
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Sy Al-os Accountancy Corporation provides accounting and tax services to individuals, corporations, LLCs and business entities. The Firm has a niche in defending taxpayers audited by the IRS and other governmental agencies. (Advertising Supplement)
