Note cancellation and basis

[quicksam]

Client purchased rental property for $25,000 in August of 2015. A private lender loaned him the $25,000 on the property. I am finishing the 2015 tax return now. It hasn't been filed as of yet.

The private lender needed his money back the beginning of Sept 2016, so the client paid him $13,000 to cancel the remaining debt of $21,503. The client had paid $3,497 in principal on the loan.

(Not considering land value at the moment)
The basis is $25,000 for the 2015 tax return, but then do we need to change the basis on next years 2016 return? Or would we keep the basis at the $25,000 since that is what was paid for the property, and then count the $8,503 note reduction as some other kind of income for 2016?

I have thought about just using the reduce basis for the 2015 return, so the future years basis would be correct. It would not affect the 2015 depreciation very much at all. However, I'm not sure the basis should even be reduced.

Does anyone have any ideas on how to handle this?

Thanks

[spanel]

Sounds like he should pickup $8503 in cancellation of debt income & leave the basis alone in the property.

Chris

[Burke]

I agree. The $8,503 is Cancellation of Debt Income and reported on Line 21 of the 1040.

[Roland Slugg]

If the $25,000 loan was secured by the property ... i.e. "qualified acquisition indebtedness" ... then the taxpayer can elect to exclude the canceled portion of the debt ($8,503) from income. If he elects to do this, the basis in the property is reduced dollar-for-dollar. Code §108(a)(1)(D), §108(c)(2(A) and §108(c)(3(C).

To make the election file form 982 with the return for the year elected. Depreciation for the year 2015 should be based on the pre-reduction cost, and for 2016 it should be based on the post-reduction basis. This is not an especially difficult calculation.

If the loan was NOT secured by the property, or if the T/P does not wish to make the election to reduce the property's basis, then the canceled dept amount should be reported as ordinary income on the borrower's return for the year the debt is canceled.

[quicksam]

Thanks

Thanks everybody. My mind kept thinking about the "cancellation of debt" income for ty2016. Also, thanks Roland on the idea about excluding the income and reducing the basis.