Many people have questions regarding the tax impact of cancellation of debt on rental or investment real estate. During the real estate boom many pe...
Many people have questions regarding the tax impact of cancellation of debt on rental or investment real estate. During the real estate boom many people made significant investments in real estate only to wind up losing them through foreclosure or a short sale. There can be significant tax consequences for many of these investors. Dealing with tax issues associated with rental or investment property can be very challenging. Taxpayers need to make sure that they work with a CPA or other qualified tax professional.
Whether or not there is forgiveness of debt income first depends on whether the mortgage debt is recourse or nonrecourse. Debt is recourse if you are personally liable for the indebtedness. Debt is nonrecourse if the property itself is the only collateral for the debt and the lender may not pursue a deficiency against the owner. For nonrecourse debt, since the lender can only take the property back in satisfaction of the debt, there is no occurrence of cancellation of debt. For recourse debt, once the property is sold or foreclosed upon and the lender agrees to forgive the remaining balance of debt, income from cancellation of debt must be addressed.
For a rental property, the tax accounting can get complex. When a rental property is foreclosed or sold through a short sale the owner must address both the cancellation of debt and the gain/ loss on the sale of the property.
If the debt is nonrecourse debt, the amount of the outstanding debt is used as the sales price and the basis is then subtracted. The basis is normally the purchase price less the allowable depreciation (but may include other adjustments). Since the mortgage is nonrecourse there is no cancellation of debt income.
If the debt is recourse debt, the calculation is a little different. Let’s assume that upon foreclosure of the property the bank cancels the remaining debt. You must first calculate the gain or loss on the disposition of the property and then calculate any taxable cancellation of debt income. Since it is recourse debt, the sales price represents the fair value of the property and then you subtract the basis. Since the lender forgave the remaining debt balance (difference between the outstanding debt balance less the property’s fair value), this amount may be taxable income (unless another exclusion applies).
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