Cancellation of the mortgage of a foreclosed rental property

[NotEasy]

Taxpayer's rental property got foreclosed in 2008 and he received a 2009 Form 1099-C with the amount of debt canceled in it. Is there any tax relief act that can possibly exclude the debt canceled of a rental property?

[Koss]

Yes

Cancellation of debt is not taxable income to the extent that the taxpayer was insolvent immediately before the debt was cancelled. The calculations that are used to determine insolvency include the debt that was cancelled.

The short definition of insolvency is when your liabilities exceed your assets.

Unfortunately, it's a little more complicated than that.

To see whether the some or all of the cancelled debt is taxable or nontaxable, you'll need to prepare a Form 982...

BMK

[GTS1101]

Qualified Real Prop Business Debt Exclusion

Insolvency is the first option and must be applied first. Also bankruptcy is another option. But for rental properties there is also the Qualified Real Prop Business Debt Exclusion. See Pub 4681 for information on how to apply this exclusion. It will save a lot of your clients from paying tax on the cancellation of debt for rental properties.

GTS1101

[NotEasy]

Insolvency is the first option and must be applied first. Also bankruptcy is another option. But for rental properties there is also the Qualified Real Prop Business Debt Exclusion. See Pub 4681 for information on how to apply this exclusion. It will save a lot of your clients from paying tax on the cancellation of debt for rental properties.

GTS1101

Thank you for the information.

I have read about the Qualified Real Prop Business Debt Exclusion. But they did mention that the exclusion is for real property used in 'trade or business'. Is a rental property considered used in 'trade or business'?

[gkaiseril]

Yes, but not normally subject to SE tax.

[NotEasy]

Yes, but not normally subject to SE tax.

Thank you.

Is there a clear-cut definition from a IRS publication that a rental property is considered a "trade or business" activity?

I want to show it to my colleague who holds a different opinion.

[GTS1101]

After reading your posts I had to go back and really think about this exclusion and using it for rental properties. I am going to continue to research as it seems to be a very grey area. I couldn't find anything in the tax code or the publications that indicate that a rental property that is on Schedule E is considered a business. But if you are renting a property to make a profit I would believe that it would be considered a business and not an investment property. Otherwise if it is not considered a business why do they let you write off all of your business rental expenses and claim a loss. If not a business and not renting for profit than I would assume that would be investment only. Also you are depreciating real property. Depreciation is an expense for a business. Why would the IRS allow you to write off depreciation if you are not using the rental home for business use. I will keep you updated if I find out anything new.

GTS1101

[gkaiseril]

Is a farm a business since it is not reported on a schedule C? The net income is subject to SE. There are people who rent real property as a business or have a business managing rental property.

A Rental is a passive income producing activity, except for real estate professionals that have made some elections. You are allowed to claim business expenses against your rental income. The sale of the rental property is reported on form 4137 with depreciation recovery as necessary. There are also the active participation rule and passive loss limitations. But there are some exceptions for small lower income owners.

Have you looked at page 6 of IRS Pub 527:

"You use the property in your business or income-producing activity (such as rental property)"

Have you looked at page 12 of IRS Pub 527 and the section under the "Which Forms to Use" and the subsection "Schedule C (Form 1040)"?

There are many sections within Title 26 of the U.S. Code that detail how to handle Real Estate. If you do not like the treatment allowed,, then you just need to compute the tax the gross rental receipts and not take any expenses, depreciation, amortization, etc. I do not think the IRS would stop you.

This is a forced sale of a business property, even if it is passive activity business any gain or loss is computed on Form 4797. For relief see IRS Pub 4681 page 10 and 11 for instructions and a worksheet, Qualified Real Property Business Indebtedness. And you could use Form 982 to write down other assets to defer recognizing the income created by the abandonment and forgiveness of the debt.

To learn how rental activity can not be treated as passive activity see Schedule E instructions page E2 section entitled 'Activities That Are Not Passive Activities'.