Basis of Rental Property with delinquent payments added to princiapal

[Bay ArEA]

I have a client who's purchase price of a rental property is $376,000. He got a loan modification several years back that brought his mortgage balance up to $420,000 by adding in missed payments to the principal. (I think this is called capitalization of interest?) He is now short selling the property. I've read about four publications now and old posts here and can't seem to find anything about weather the additional principal amount is added to basis or not.

Since it was in order to keep the house, it seems like the money went back into the property and should count as basis I feel, however it wasn't quite used to upgrade the house or buy something new for it. I'd really like to find something concrete if any of you have dealt with this before and can point me in the right direction, I'd sure appreciate it!

[Burke]

It is simply money he borrowed from the bank. I guessed they based it on equity. He can deduct the interest. The principal is not added to basis. Only capital improvements or additions would qualify for that.

[Rapid Robert]

Isn't this more a Cancelation of Debt issue? Amounts of debt canceled that would have been deductible if paid, such as interest, are not counted as COD income (CODI). I agree that additional borrowing against a property does not change its basis.

[Bay ArEA]

That makes sense, basis is unaffected, but instead he gets to deduct the interest because it was all effectively paid this year at once. He did get a 1099C for the cancellation of debt, and I was using the 982 to reduce the basis of the property by that same amount. However if I can add back in all the interest paid at the short sale which is close to the amount forgiven, that should help a lot.

[Snaggletooth]

Deduct when Paid

The interest is not capitalized, and your basis is not increased. The increase in the mortgage appears to be strictly a case where unpaid payments were added creating a new principle.

"New principle", however, is a misnomer. All of the additional debt is interest, but he cannot deduct it until he pays it. The existence of forgiven debt is a separate subject and would only occur if part of the original indebtedness was forgiven.