Cancellation of Debt on residence convert to rental

[deserttax]

The more I research this, the more confused I get. I have a client that that short sold their residence on 10/16/12. They received a 1099-C on a second mortgage for $43,201. Both the 1st and 2nd were purchase money loans (80 - 10). They originally purchased it on Jun 15, 2005. On Jul 1, 2010 they converted it into a rental. Based on my calulations, they meet the 2yr out 5 yr sec 121 exclusion, however does converting it to a rental preclude it from the personal residence exclusion? There won't be a gain. They purchased a new home (residence) on 7/6/2010.

Here are some particulars:
Purchased price: 265k
Deprec Basis: 212k (land 53k)
Depr taken thru 10/16/2012: $17,345
Sold for 156k
1099-C on 2nd of $43,201
*no 1099-C on 1st but debt wioed out of $47,306

*Based on 1098 on first mortage, the principal amount "paid off/applied" was $203,306. However, no 1099-C had been recieved for any difference; for which I calculate to be $47,306.

My main questions is: What is the correct way to handle the disposition? Based on the fact that it's purchase money loans, they should be nonrecourse loans. AZ has an anit-deficiency law; for which the client meets the eligibilty requirements.

1) If nonrecourse, the gain/loss calc is "sale proceeds (outstanding debt regardless of FMV of property) minus basis". should the basis be reduced by the amount of 43,201 or 90,507 (43,201 + 47,306)? The loss is either <$113,947> or <$66,641>. Since it's nonrecourse, can it be excluded on the 982 under the "applied to reduce basis of depr & nondepr property?

2) Should this transaction be treated in a different manner?

Any guidance/assistance would be much appreciated.

Thanks in advance.

Sincerely
Dazed and Confused.

[appelman]

Whoa, there!

First of all, are you sure that the 2nd is non-recourse? If it is, there should be no 1099-C and no debt cancellation. Also no 982 and no basis adjustment. Strictly a sale, where the sale price is the GREATER of loan balance or FMV. If you have a non-recourse 1st and a recourse 2nd, things get more complicated. I am pretty certain that the conversion to rental will disqualify your client for the principal residence exclusion. If there is a recourse loan, and any exclusion does apply, such as the insolvency exclusion, the basis reduction is applied at the end of the year (except for the real property business indebtedness exclusion), at which time your client no longer owns the property.

[mactoolsix]

Non-Qualified Use does not include:

1. Any period before January 1, 2009;
2. Any portion of the five-year period which is after the last date that the property was used as the taxpayer’s (or taxpayer’s spouse’s) principal residence (referred to as the “look-back” period);
3. Any period (not to exceed a total of ten years) during which the taxpayer or the taxpayer’s spouse is serving on qualified official extended duty for the uniformed services, foreign service or intelligence community; or
4. Any other period of temporary absence (not to exceed a total of two years) due to change of employment, health conditions, or such other unforeseen circumstances as may be specified by the IRS


Thus per the op - they converted to a rental in July 2010. Assuming they did not move back in prior to the sale, this is the last date the property was used as the taxpayer's primary residence (#2 above), and it is within the 5 year look-back period - thus no "non-qualified" use. Sec. 121 applies. However there is a huge loss, so no gain to exclude anyway.

As for receiving a 1099-C on the second loan - banks get this wrong all the time - they will say it is recourse most of the time. Check the original loan docs and file accordingly.

They should not receive a 1099-C on the first mortgage - non-recourse so there would be no debt to cancel.

If no recourse, it is a sale with a loss:
Sale price of 156,000 (less expenses)
Less basis of 247,655 (265,000 - 17,345)
Loss of 91,655

Mike

[appelman]

Sec. 121, yes; principal residence indebtedness exclusion, NO!

See my answer to the posting by klyonscpa.