This form of cancellation of debt is not that common but can seriously affect the rental property owner who is forced to relinquish the property by either foreclosure or short sale. The amount of debt discharged is reported to the debtor on Form 1099-C. Let’s begin by reviewing the basics.
Federal tax law allows a rental property to be considered a business and therefore can be included for purposes of Cancellation of Debt Income (CODI), subject to limitations. Short sales and foreclosures operate under the same rules. The basic rule here is whether the property is recourse or non-recourse. In Florida we follow recourse rules because Florida is a “recourse state” (by state law). It means that the business indebtedness is secured by the property and the owner is personally liable. So, in making our calculations we will follow the federal tax rules for a recourse debt cancellation.
Therefore, there are two calculations that must be made. The first is to determine if any part of the cancellation of debt income (the amount of debt discharged, or CODI), is exludible from taxation. The second is to calculate a gain or loss on the disposition of the property. The key point here is that these situations are independent and affect the Form 1040 tax return in separate ways. Complex rules and calculations ensue!
Any amount that is determined to be excludible from taxation is reported on Form 982. Any amount of non-excluded CODI is reported as taxable income on Schedule E of Form 1040. So, we need to determine how much is excludible by calculating the amount of outstanding principal debt that exceeds the fair market value of the property. The positive value is the amount that can be excluded from taxation. A negative result precludes exclusion. Too bad!
The second tax consequence for a recourse mortgage note is, quoting from IRS, “the calculation of the gain or loss from the foreclosure (or short sale). The gain or loss is calculated as the amount realized plus any proceeds received from the sale.” The amount realized is defined as the lesser of the fair market value of the property or the outstanding debt balance. This final calculation is very complex, but the bottom line is that it will result in a gain or loss reported on Form 4797. Gains are then reported on Schedule D as a long term gain. Losses generally are ordinary (can be fully deducted in the current year) and are reported on Form 1040, line 14, Other Gains and Losses.
If this explanation has given you a headache, then you need tax help! Jeffrey Mitchell, Enrolled Agent, is your local Jacksonville tax help.