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Discussion:Reduction of Tax Attributes for Rental Short Sale
Discussion Forum Index --> Tax Questions --> Reduction of Tax Attributes for Rental Short Sale
GTSEA09 (talk|edits) said:
Client has 1st loan on his rental of 637,000 and 2nd for 10,000. Total debt 647,000. This is a recourse loan. The house would short sale by end of 2009 for 350,000. He would have cancellation of debt of 297,000. He is insolvent by 216,000 so I believe 81,000 is going to be taxable cancellation of debt income on line 21 of 1040. When calculating the sale of the rental property on form 4797 the sale price will be 350,000 and the original cost basis was 416,000. Depreciation taken was 21,000. Do I reduce the original cost basis of 416,000 by the canceled debt of 216,000 reducing his basis to 200,000 thereby causing him to have a phantom gain of 171,000?
Or is he not required to reduce the tax attribute because this was an insolvency or bankruptcy exclusion and the property is no longer in his possession.
Thank You for your help. Reduction of tax attributes is very confusing and complex.
GTSEA09
when did the cancellation of debt occur? There have been a slew of these discussions lately.
oh I see the property isn't even sold yet.
try to get the sale to happen in the same tax year as the COD income.
GT, you may not reduce the basis of the property sold by the insolvency amount. The $216,000 attribute reduction will take place on January 1 of the year following the cancellation. Attributes will be reduced in the order listed on Form 982.
However, consider making a QRPBI election for the $81,000 in COD income. This will involve reducing the basis of the property sold by $81,000. This effectively converts ordinary Sch E income into a Section 1231 gain.
Riley - wouldn't the benefits of the QRPBI route depend on weather the taxpayer has any other tax attributes/basis to reduce the following year? If they do not, I would think it better to have the attribute deduction take place the following year since there would be no tax consqequences.
Thank you for your input. I freaked out my customer because I told him he would owe some 50,000 in taxes because I thought I had to reduce the basis in the year the property is sold for the insolvency exclusion. As it says in the publications and per your discussion above it is in the following year that you reduce the attribute and therefore he would have no tax consequences. That is going to be a big relief for my customer. Has any of you looked at the IRS code or did you just go by the publications. I am going to look at the code tonight and see if I can confirm it is the same as the publications. Thank You again. As Tax Pros we are going to run into this problem more and more and more so I am grateful that we can ask each other questions to sharpen our own minds.
EZTAX, solvent taxpayers who are not in bankrutptcy have very few choices to make. In other words, a solvent taxpayer is not really allowed to reduce other tax attributes.
Mfenedickcpa (talk|edits) said:
I have some follow up questions to this fact pattern:
The $216,000 would reduce tax attributes in the following year. If no attributes exist, the $216,000 goes to die, so to speak?
If QRPBI is elected for the $81,000 of COD income, would you need to file two form 982's, one for the $216,000 for the insolvency (Box 1B) and one for the $81,000 of QRPBI (Box 1D)?
Here are my comments on this transaction. I have written many articles about the tax consequences of foreclosures and short sales and have taught several seminars on the topic.
Since, in a short sale, the lender had to approve the sale, you can pretty much assume that the lender has agreed to cancel the remaining debt. Now this would apply to the first mortgage of $647,000, but I don’t know if it applies to the second mortgage of $10,000. Will the lender of the second mortgage be canceling the loan, or since it’s a recourse loan, will the lender be pursuing the taxpayer for the balance owed?
Let’s assume that both loans are canceled after the short sale. Remember that the extent of the taxpayer’s insolvency must be measured after the short sale but just before the lender cancels the loan, so it should not include the $350,000 FMV of the rental property. See IRC §108(d)(3).
Since the debts are recourse, the amount of COD income will be the difference between the principal amount of debt and the FMV of the property ($647,000 - $350,000 = $297,000). If the taxpayer is insolvent (again, measured just before the debts are canceled) to the extent of $216,000, then $216,000 of the COD income will be excludable under IRC §108(a)(1)(B). Let’s assume for the time being that the Qualified Real Property Business Indebtedness (QRPBI) exclusion doesn’t apply.
There seems to be some disagreement from others about reduction of the taxpayer’s tax attributes. Assuming that the taxpayer doesn’t have any NOL, tax credit or capital loss carryovers, under IRC §§108(b)(2)(E) and 1017(a), the basis of the taxpayer’s properties would be reduced by the amount of the insolvency exclusion on Jan. 1st after the year in which the debts are canceled. Assuming that the taxpayer sells the property by 12/31/09, then the property wouldn’t exist on 1/1/10 to reduce its basis. The basis of other property would have to be reduced.
The insolvency exclusion takes precedence over the QRPBI exclusion. See IRC §108(a)(2)(B). If the COD income is $297,000 and the insolvency exclusion is $216,000, then that leaves $81,000 in COD income that might be excludable under the QRPBI provision of IRC §108(c) (see below). If the QRPBI exclusion is $81,000, then the basis of the property would be reduced by this amount. See IRC §108(c)(1). This would reduce the basis to $314,000 ($416,000 cost - $21,000 depreciation - $81,000 QRPBI exclusion), and a gain of $36,000 would result ($350,000 - $314,000).
However, I question whether the taxpayer is eligible for the QRPBI exclusion. The original cost of the property was $416,000, yet the first mortgage is $637,000. This indicates to me that the mortgage loan was refinanced at some time and that funds were withdrawn. Since the facts don’t mention anything about improvements, I am going to assume that the refinance proceeds were used for some other purpose. The QRPBI exclusion is limited to acquisition indebtedness. See IRC §§108(c)(3) and (4). As a result, the taxpayer might not be eligible for the QRPBI exclusion.
My guess is that you calculated the taxpayer’s insolvency of $216,000 by taking into account that the rental property was an asset worth $350,000. Since insolvency is measured immediately before the debt is canceled, you should probably remove this asset from your calculation, and as a result, the extent of the taxpayer’s insolvency is probably more like $566,000. This would entitle the taxpayer to exclude all of the COD income under IRC §108(a)(1)(B). If the only tax attribute that the taxpayer has is property (i.e., no NOLs, tax credit, or capital loss carryovers, etc.), then the basis of the property, including the taxpayer’s personal residence, cars, retirement accounts, etc. would be reduced by the excluded COD income.
CPACPA (talk|edits) said:
With all due respect, I don't agree on a couple of Dave Fogel's interpretations. I will assume the same assumption, that all the debt was recourse debt, since it was refinanced debt. Here's my opinion after reading extensive publications, code sections, and taking a Spidell seminar.
Dave states that "you should probably remove this asset from your insolvency calculation, and as a result, the extent of the taxpayer’s insolvency is probably more like $566,000." I don't agree with this. The taxpayer is definitely insolvent by only $216,000, and that leaves $81,000 in COD income to be included on the return. Yes, correct, you measure insolvency immediately before the debt is canceled, but nowhere in the code does it state a time frame for "immediately," and Dave seems to be overboard on this assumption. I believe it would be prudent and reasonable to include the $350,000 asset in the insolvency calculation, resulting in a $216,000 insolvency, not a $566,000 insolvency.
Also, I believe Dave's interpretation on reduction of the taxpayer's attributes is way too liberal. According to my Spidell seminar (I don't have the manual with code sections at the present time, as I'm at home), on a short-sale, the taxpayer would immediately be required to reduce the basis of the rental property by the excluded COD income of $216,000, unless other tax attributes exist to write-down, such as carryover passive activity losses of Form 8582.
COD income of $81,000 on return.
Form 4797 Sale of Property calculation
Sales Price       $350,000
Adj Cost basis     179,000 ($416,000 cost, minus $21,000 depreciation, minus $216,000 excluded debt)
Gain on sale      $171,000
CPACPA, you are completely wrong.
You said: nowhere in the code does it state a time frame for "immediately,"
Try reading the Code, particularly, IRC §108(d)(3):
"(3) INSOLVENT.—For purposes of this section, the term “insolvent” means the excess of liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer’s assets and liabilities immediately before the discharge."
Also, you said that the basis of the property must be reduced in the year of the discharge when the taxpayer uses the insolvency exclusion. If you have some authority for your position, then cite it (your recollection of what was said at a Spidell seminar is not authority). Again, try reading the Code, particularly IRC §§108(b)(1) and (b)(4)(A):
"(b) REDUCTION OF TAX ATTRIBUTES.—(1) IN GENERAL.—The amount excluded from gross income under subparagraph (A), (B), or (C) of subsection (a)(1) shall be applied to reduce the tax attributes of the taxpayer as provided in paragraph (2)." [subparagraph (B) is the insolvency exclusion]
"(4) ORDERING RULES.—(A) REDUCTIONS MADE AFTER DETERMINATION OF TAX FOR YEAR.—The reductions described in paragraph (2) shall be made after the determination of the tax imposed by this chapter for the taxable year of the discharge."
I agree with your statement, "insolvency is measured immediately before the debt is canceled," so why are you interpreting this to mean that the $350,000 FMV of the rental should "probably" (as you state) be removed from the insolvency calculation? "Immediately before" (what time frame are you interpreting?) the debt was canceled, the property was still owned by the taxpayer, so why are you stating this should "probably" be removed from the insolvency calculation? You don't sound certain.
I'll get back to you tomorrow regarding the Spidell seminar stating IMMEDIATE basis reduction in the year of sale on a short sale transaction, and I will include authoritative code to support what I previously stated.
In a foreclosure or short sale, the remaining debt is canceled after the property satisfies part of the debt, so immediately before the remaining debt is canceled, the taxpayer no longer has the property, and accordingly, it shouldn't be counted as an asset.
I hope you will get back to me regarding the material in the Spidell seminar, because I wrote a large part of the material on cancellation of debt.
With all due respect, I see your rational on this, but I would say that approach is a bit too liberal. I prefer to take a more conservative stance to avoid any potential audit. I tend to believe that what the IRS means when they state "immediately before" means even before the asset is given up, as well as the liability forgiven.
Regarding the annual Spidell seminar on Federal Taxation held in January 2010, here's what page 4-11 states.
"Applying the basis reduction: The discharge of indebtedness income excluded under IRS 108(c) must be applied as a basis reduction to depreciable real property held by the taxpayer using the rules of IRC 1017. The reduction is applied as of the beginning of the taxable year following the taxable year in which the discharge occurs (IRC 108(c)(1), 1017(a)(2), 1017(b)(3). However, IF THE TAXPAYER DISPOSES OF DEPRECIABLE REAL PROPERTY BEFORE THE FIRST DAY OF THE NEXT TAXABLE YEAR, THE REDUCTION IN BASIS OF SUCH PROPERTY IS MADE AS OF THE TIME IMMEDIATELY BEFORE ITS DISPOSITION (IRC 1017(b)(3)(F)(iii).
So I'm interpreting this to mean immediate basis reduction in the year of short-sale. I see your position and I hope it's true, but after reading this Spidell blurb, I'm a bit confused.
Please note that the section you have quoted from Spidell's 2009 Federal Fall Seminar materials, as it clearly indicates, is referring to the Qualified Real Property Business Indebtedness (QRPBI) exclusion of IRC §108(c), which has different rules for the reduction of tax attributes than the insolvency exclusion. If the taxpayer claims the QRPBI exclusion, the basis of the property must be reduced immediately before its disposition as stated in IRC §§108(c)(1)(A) and 1017(b)(3)(F)(iii). As I have indicated above, there are different rules for reducing tax attributes when the exclusion is based on insolvency, and one of those different rules is that there is no requirement to reduce the basis of the property immediately before its disposition.
You can be as conservative as you wish. I am very conservative because I follow the Internal Revenue Code as it is written.
I apologize, you are correct about IRC 108(c) referring to QRPBI. So I will reduce tax attributes for this individual's residential rental the following year, as you correctly recommend.
However, I'm still in debate regarding excluding the $350k FMV of the asset from the insolvency calculation, but if you were right about the basis reduction, I'm going to have to presently assume that you are also correct about this. I will call the IRS to inquire about what they mean by calculating insolvency "IMMEDIATELY BEFORE" the debt it canceled.
Regarding the insolvency calculation, I think we are essentially saying the same thing. In the example above, the principal balance of the 1st and 2nd mortgage loans were $647,000 and $10,000, respectively, and the FMV of the property was $350,000. If these were the only assets, and if you determine insolvency immediately before the short sale, the extent of insolvency would be $307,000 ($647,000 + $10,000 - $350,000). Now let's assume that the short sale satisfies $350,000 of the 1st mortgage, reducing it from $647,000 to $297,000. After the short sale but immediately before the debts are canceled, the extent of insolvency would be the same amount, $307,000 ($297,000 + $10,000).
Rozfortin (talk|edits) said:
Hi, I have another concern on a short sale transaction that's related to this which I am not too sure how to handle. My client is able to claim an exemption on all of his cancelled debts of $ 158,000 by virtue of his being insolvent. However Form 4797 is showing a loss on the disposal of $ 58,000, obviously because the sales price was lower than the original basis (sale price of $ 170,000 vs basis of $ 235000 + depreciation 6629).
The business loss is enough to wipe out all his regular income, thus he is getting a huge refund. This does not seem to be an equitable treatment because the taxpayer stands to profit from the short sale transaction.
Please advise how you would handle this. Thanks.
(sigh) Have you read the messages posted in this discussion? They answer your question. Nobody ever claimed that the tax laws were equitable.
DaveFogel,
You seem pretty well versed in this area. I think I can interpret your posts as the following:
TP short sales rent, resulting in $100K 1231 loss and $200K in COD (TP has NO other assets and all $200K qualifies as excluded from insolvency)
1231 loss generates NOL of $50K.
NOL is reduced in full on Form 982, since no other assets to depreciate (broke), remaining $150K is gone forever.
If the taxpayer's only "tax attribute" is the NOL, then it is reduced before carrying the unused NOL to any other year. may be used in the current year and carried back to other years, but must be reduced before carrying it over to the next tax year. See Treas. Reg. §1.108-7(b). [corrected]
I'm working on a similar situation with a client's 2009 T/R and something in this thread made me rethink how I was handling this.
This was a rental property that was foreclosed on in 2009, resulting in COD income of $107,770 (which went to Sch E and was further reduced by 2009 rental expenses of $3,483 - end result, Sch E income of $104,287). However, the disposal of the rental asset resulted in a loss of ($94,487) reported on 4797.
Originally I was off-setting the disposal loss against the Sch E income and took the remainder - $9,800 - as the COD income I would exclude on 982. However now I'm wondering if I just exclude the entire $104,287 (or $107,770??) on 982 and the client still gets to use the entire 4797 loss this year to reduce other income items. That didn't seem "fair" to the IRS so I just presumed it wouldn't be allowed but after Dave's *sigh* comment above, I want to be certain I'm not selling my client short (forgive the pun).
I would also presume, since he wouldn't be able to utilize the entire NOL in 2009, that the remaining carryforward NOL is reduced as a tax attribute in play on 1/1/2010.
What's the basis for the exclusion? Insolvency? QRPBI?
You cannot reduce COD income by the loss on disposal unless you are making a QRPBI election.
Also, consider carrying the NOL back 2 years.
There really isn't much to consider in carrying the NOL back two years now is there? Unless an election was made on a timely filed return and this is an amendment I'd say it is the only course of action.
Not sure that the loss originated in 2009.
@DaveFogel - TP filed for BK in '09 - thus the exclusion.
Technically I have 2 losses in play. A $6,983 S-Corp loss from 2008 the client didn't have basis to take (but he'll get to use all of it in 2009 as an off-set against K-1 income).
The other is the $94,487 loss on disposal of this rental property in 2009.
The $107,770 of COD income is excludable under IRC §108(a)(1)(A) in 2009; it is reported and excluded on Form 982.
The 2009 NOL is carried back unless a timely election was made under IRC §172(b)(3) to forego the carryback period. Any remaining NOL that's not used in 2009 or prior years must be reduced as a "tax attribute" when carried forward to 2010. See Reg. 1.108-7(b).
The loss on disposal should be deductible in 2009. It sounds like the NOL is from a year prior to 2009. Yes, the NOL will be reduced as of 1/1/10.
CPAexpat (talk|edits) said:
I find this area very confusing.
I have several clients who have had foreclosures/short sales while they are now living overseas. They have lived in the properties for 2 out of the last 5 years but are not currently using them as their main home.
They do not qualify for the principal residence exclusion as they are not currently using as their main home.
Many do, however, qualify for an insolvency exclusion. Here is an example:
Sorry - my above post got cut off before i was done.
Mortgage on short sold house 692K Other personal debt 68K
Total 760K
Cash and Retirement Accounts 109K Personal Property 10K Home which was short sold 449K
Total 568K
Amount insolvent 192K
The debt forgiven in this case was about 172K. I have a 1099-C for this amount. The TP executed a promissory note to pay back the remainder of the mortgage (obviously unsecured note).
Since the principal residence exclusion on debt cancellation does not apply, we are excluding the debt under the insolvency exception.
I understand from the above that I do not have to reduce the tax attributes (basis) of the property which was sold. I need to reduce the tax attributes of other property as of 1/1/2011. All he has is cash, retirement accounts, and about 10K of personal property. I understand that I would reduce the basis of personal property, but what happens to the rest of the COD income excluded under insolvency. I have a hard time believing he is off the hook for the rest of the debt excluded under insolvency?!
There is nothing else such as MTC, FTC, Capital losses to reduce.
Any help would be greatly appreciated and hope I can repay the favor in some way.
Is there any basis in the retirement accounts? If so, then this must be reduced as well.
If the client doesn't have any of the other "tax attributes" specified in Sec. 108(b)(2), then nothing else gets reduced.
Drsncrs2 (talk|edits) said:
I have the following situation (I hope there's a better solution then mine):
Taxpayers have basis in rental of $300K less $25K depreciation. Property owned for 6 years. Loan of $500K ($200K not acquisition debt). Property sold for $330K; COD income of $170K. Taxpayers were insolvent exceeding $170K. So, am I correct stating the basis is reduced by the $170K COD ($275K less $170K = $105 basis) and the 1231 gain is $225K ($330K less $105K)? If the taxpayers were solvent then am I correct stating that they would have $170K COD income and a $55K 1231 gain ($330K less a $275K basis)? If the two situations are correct then the insolvency just changes the nature of the gain not the amount. Correct? Thank you
Sorry, but I don't think you're correct. If the insolvency exclusion is used to exclude the COD income, then you reduce the taxpayers' "tax attributes" such as NOL carryover, general tax credit carryover, minimum tax credit carryover, the basis of property, etc. in the order listed in Sec. 108(b)(2), and these "tax attributes" are reduced on the first day of the following tax year.
As a result, the gain is $55K ($330K sales price minus $275K adjusted basis). The gain is treated as $25K unrecaptured section 1250 gain (the extent of depreciation taken) and $30K IRC §1231 (capital) gain.
You might benefit by reading my article "Reducing Tax Attributes Due to Canceled Debt Income Exclusion".
Thank you, Dave; I did read your article (and many others), but I guess I didn't get the picture.
Since the additional $200K debt ($300 to $500) wasn't acquistion debt, it's hard grasping that the don't have to reduce the basis of their rental property by the COD income when they walk on it.
Anyway, once again, your expertise is greatly appreciated.
Taxditty (talk|edits) said:
Hi guys, great discussion/thread. If one of you (Dave?) can chime in on my situation, I'd greatly appreciate it. I had a rental property that was foreclosed on in 2011. I received a 1099-C with $108K of debt canceled in Box 2, and I was insolvent to the extent of $65K. I recorded this $65K exclusion on Line 2 of Form 982 and picked up $43K on Line 21 of page 1 of my 1040. That much, I believe, is clear/straightforward. Now what confuses me is how I record the sale on Form 4797 and the extent (if any) that I have to reduce my tax attributes. The FMV of the property, which is Sect 1231, is $100 per the 1099-C, and the basis is $112K, which results in an ordinary loss of $112K. This loss would far exceed the income on Line 21 so it gives me pause. Do I have to reduce my cost basis of this Sec 1231 property of $112K by the insolvency exclusion of $65K, or do I reduce any tax attributes I currently have, such as a large capital loss carryover, by that amount? Please let me know your thoughts. Thanks!
You'll probably have a better chance of getting a response if you'd fill in your user page profile, as asked to do before making any post. Otherwise most people will ignore you.
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