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BK-CPA
BK-CPA, Certified Public Accountant (CPA)
Category: Tax
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Experience:  Owner of a CPA firm
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I sold some rental properties a few yers ago and reported the

Customer Question

I sold some rental properties a few yers ago and reported the sale on the tax return for that year. I took back a note for the sale in the amount of $275,000. A demand was made for the balancve of the note and the party was not abel to repay the entiree balance. I had to forgive $138,000 of the note. Can I write off the $138,000 as a business bad debt? If so, whrere do I put it on ghe tax return?
Submitted: 4 years ago.
Category: Tax
Expert:  Lev replied 4 years ago.

Seems as you had an installment sale - if you sell a property at a gain where at least one payment is to be received after the tax year in which the sale occurs.

Generally - you are required to report the sale under the installment method unless you "elect out" on or before the due date for filing your tax return (including extensions) for the year of the sale.

If you elect out, you report all the gain as income in the year of the sale.

That is my understanding of your situation.

 

If an installment obligation is canceled or otherwise becomes unenforceable, it is treated as a disposition other than a sale or exchange. Your gain or loss is the difference between your basis in the obligation and its FMV at the time you cancel it. If the parties are related, the FMV of the obligation is considered to be no less than its full face value.

 

If you accept part payment on the balance of the buyer's installment debt to you and forgive the rest of the debt, you treat the settlement as a disposition of the installment obligation. Your gain or loss is the difference between your basis in the obligation and the amount you realize on the settlement.

 

Because the property was not repossessed - you have a loss. Because you included the full gain in income in the year of sale, so the loss is a bad debt.

A business bad debt is a loss from the worthlessness of a debt that was either:

-- Created or acquired in your trade or business, or

-- Closely related to your trade or business when it became partly or totally worthless.

A debt is closely related to your trade or business if your primary motive for incurring the debt is business related.

 

There are two methods to claim a business bad debt.

-- The specific charge-off method.

-- The non accrual-experience method.

Generally, you must use the specific charge-off method. However, you may use the non accrual-experience method if you meet certain requirements.

How to deduct business bad debts - see chapter 10 of Publication 535, Business Expenses - www.irs.gov/pub/irs-pdf/p535.pdf .

 

Let me know if you need any help.

 

Customer: replied 4 years ago.
If I use the specific charge off method which you say I should use, what tax form do I use on the 1040? How do I report the loss?
Expert:  BK-CPA replied 4 years ago.

I'll answer this two ways:

 

#1

 

Schedule D would have been used for any installment sale reporting (see Form 4797) over the years. Your original basis in the property would have been eaten up slowly each year under the installment method.

 

When you reclaimed the property, you were no longer owed a debt. If anything, you would have owed the person who paid half your loan but didn't get the property, save that you could attribute their loan payments to rent given their use of the property, kind of like a rent-to-own contract were the property never gets owned, just rented.

 

Upon reclaiming the property, you would in theory undo the sale and be subject to all the additional income you retained as rent, given that is now the true nature of the transaction and there is no more cost of sales to you. If you were to do this and immediately sell again though, the effect would be a wash.

 

The correct treatment therefore, would be to just treat it like a sale in the year sold. Your gain is the purchase price less your basis. Your basis is your original purchase price less the percentage of your basis used to reduce gain on your installment sale in past years on the contract that didn't work out.

 

You have no forgiveness of debt income, no.

 

 

 

 

#2

 

You sold a property originally. You did not use the installment method and recognized a full gain originally, even though you had received no money originally, just a note. The person then defaulted on the note. You reclaimed the property in satisfation of the note. Your basis in the property is now equal to your basis in the note. Again, there is no forgiveness of debt income if you take a property in full satisfaction of the note. Again, you should owe them if they lost their property after paying for half of it and after assuming title originally (you are allowed to secure their property for the purpose of resale generally speaking, where they keep the difference between what they owed you and what the house was sold for..).

 

If you reclaimed a house, sold it, and still couldn't get what was owed to you, then the remainder, finally, is a bad debt. I believe you have a non-business bad debt filed as a short term capital loss on Schedule D, in that case, unless you are in the business of developing or otherwise selling houses.

 

 

I'll continue to clarify if you need it.

 

Thank you for your question.



Edited by BK-CPA on 7/2/2010 at 6:36 PM EST
BK-CPA, Certified Public Accountant (CPA)
Category: Tax
Satisfied Customers: 823
Experience: Owner of a CPA firm
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