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07 Feb. 2017 - 03:55:24

Taxing times: rental property foreclosures and short sales.

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 See. 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.


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


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 what is foreclosurre 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) [paragraph]5046, 87-2 USTC (CCH)

[paragraph]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.

RELATED ARTICLE: Defining Examples

Example 1

* January 2007: Residential rental property purchased for $355,000

($55,000 down, $300,000 interest-only recourse loan).

* January 2008: FMV property $200,000, loan balance $300,000 (in

default), lender forecloses, cancels $300,000 loan, adjusted basis

$350,000 ($355,000 minus $5,000 depreciation).

This results in:

* $100,000 CODI ($300,000 debt minus $200,000 FMV).

* Form 982 filed with 2008 return to elect $100,000 QRPBI


* Due to QRPBI exclusion, adjusted real estate companies list basis is reduced to $250,000.

* $50,000 loss on foreclosure ($200,000 FMV minus $250,000 adjusted


* Same results for California purposes.

Example 2

* May 2000: Principal residence purchased for $400,000 ($80,000

down, $320,000 nonrecourse loan)

* January 2004: FMV residence $1 million, loan balance $300,000,

refinanced for $800,000 (proceeds placed in savings account).

* January 2005: Converted residence to rental, used $500,000 in

savings account to buy new principal residence.

* January 2009: FMV rental property $600,000, loan balance $750,000

(in default), "short sale" for $600,000 (proceeds to lender),

lender cancels $150,000 balance owed, adjusted basis $360,000 ($400,000

minus (4 years x $10,000) depreciation).

This results in:

* $150,000 CODI ($750,000 debt, minus $600,000 FMV).

* Cannot use Qualified Principal Residence exclusion since property

is a rental.

* Only $300,000 of debt is "qualified acquisition

indebtedness" since $500,000 of $800,000 refinance loan wasn't

used to acquire, reconstruct or improve the property.

* No QRPBI exclusion, since qualified debt ($300,000) doesn't

exceed FMV ($600,000) [IRC Sec. 108(c)(2)(A)].

* $240,000 gain on "short sale" ($600,000 FMV, minus

$360,000 adjusted basis).

* Same results for California purposes.

David M. Fogel, CPA is a Roseville-based tax consultant. You can

reach him at [email protected]
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