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Lev
Lev, Tax Advisor
Category: Tax
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Experience:  Taxes, Immigration, Labor Relations
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Cancellation of Debt and Rental Property

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Hello, 


Here is the tax situation I am trying to solve. I short sale my home in Florida on August 2011 for $175,000 not including about $21,000 in selling expenses. When I placed this house for rent in July 2010 (moved out of state) the FMV I included in my 2010 tax return was $206,000 excluding the land. This was my personal residence from June 2006 - June 2010. Rented property from July 2010 - August 2011. I depreciated $1,710 in 2010 (50% personal use/50% rental property). Here is my dilemma. As part of the short sale, there was of course a cancellation of debt of about $161,000 in the first mortgage and ~ $10,000 in the second loan. Because this was my primary residence for more than 2 years of the last 5 years, I can exclude from income (Mortgage Debt Relief Act - I think). That is not the problem or issue. My question is what to do in regards XXXXX XXXXX loss from a rental property perspective (Business Asset Sale). Since the FMV of the house at time of rent was, $206,000 and I sold for $175,000 minus selling expense in theory I could have a LOSS that I can use to offset ordinary income. I also have NOL or carrying loss from the six month I rented property in 2010 of about $2,700 plus the loss I generated by renting in 2011 for 8 months (maybe another $10k w/o including depreciation for 2011).


 Question - Can I exclude from income the cancellation of debt and report a loss from the rental side of things?


Do I need to allocate a percent of the cancellation of debt to the rental property sale? I.e. rented for 13 months of 60 months = 22%.


If so, how do I report a modification to the adjusted basis of the property for the portion of the cancellation of debt attributable to the rental property?


Any other considerations? I am of course trying to minimize my taxes given the massive loss I have in this property. Excluding all of this I have probably have AGI ~ $233,000 with ~ $16,000 in itemized deductions. 3 dependents. Married filing jointly


Thank you, Victor

Submitted: 2 years ago.
Category: Tax
Expert:  Lev replied 2 years ago.

Hi and welcome to Just Answer!

1. The basis for depreciation and for the calculation of your capital gain of the sale is the price you paid for the property adjusted by improvements and depreciation. You may not use FMV of the property at the time it was converted to the rental as your basis.

2. You may exclude the canceled debt for the rental property - that is not an issue - on the form 982 - www.irs.gov/pub/irs-pdf/f982.pdf - check the box 1d.

3. Regardless what exclusion you will use to exclude canceled debt from taxable income - qualified principal residence indebtedness or qualified real property business indebtedness - you need to reduce the basis by that amount - and report that amount on line 4.

4. Yes - you may deduct all your rental losses

5. If you have a gain because of the basis adjustments - you need to recapture the depreciation.

Let me know if you need any help.

Lev, Tax Advisor
Category: Tax
Satisfied Customers: 23237
Experience: Taxes, Immigration, Labor Relations
Lev and other Tax Specialists are ready to help you
Customer: replied 2 years ago.

Hello, Thank you for prompt response.

 

From what I understand in order to calculate the depreciation of the rental property in 2010 I had to use FMV at the point home was converted to rental. Is that solely for purpose of depreciation? Should I have used the purchase price + improvements? I purchased the house on June 2006 for $405,000, probably had maybe another $15,000 in improvements over 4 years. Are you saying that I can use $420,000 ($405k + $15k) as the starting basis for the property? Do you add anything to cost basis related to purchase expenses? A rough calculation would give me the following:

 

$420k adjusted basis of property - $1.7k depreciation in 2010 + $21k selling expenses - $171k debt discharge - $175k selling price = -$93.3 (loss). Does this make sense?

 

What do you mean with recapture depreciation?

 

 

Expert:  Lev replied 2 years ago.

Sorry for confusion.

The basis of property used in a rental activity is generally its adjusted basis when you place it in service in that activity. This is its cost or other basis when you acquired it, adjusted for certain items occurring before you place it in service in the rental activity.

However...

When you change property you held for personal use to rental use (for example, you rent your former home), the basis for depreciation will be the lesser of fair market value or adjusted basis on the date of conversion.

Because your property decreased in value - the basis for depreciation is its FMV for depreciation purposes - so you are correct - sorry again for confusion.

However for capital gain purposes you will use your purchase price + improvements minus depreciation plus selling expenses minus forgiven debt as the basis.

Your are correct with estimating your loss.

Depreciation recapture means that if you sell the depreciable property with the gain - you need to add your depreciation to your taxable income.

Since you will likely not have any taxable income - that will not be your concern.

Lev, Tax Advisor
Category: Tax
Satisfied Customers: 23237
Experience: Taxes, Immigration, Labor Relations
Lev and other Tax Specialists are ready to help you
Customer: replied 2 years ago.

Thank you again!

 

Just to confirm, if I just treat this event as business transaction and exclude the cancellation of debt from income on the basis of qualified business indebtness and adjust the basis of the property by such amount it really does not bring into account the fact that it was my primary residence at some point in the last five years.That would only come into play if it would be my residence at the point in which the sale occur and I wanted to exclude cancellation? The other fact is on my favor is that I did hold the rental property for more than a year July 2010 - August 2011 making the loss deductable.

 

Lastly, the loss is going to be significant overall and reduce my AGI and perhaps reduce my tax liability to zero. I have paid in taxes this year ~ $37,000 and last around ~ $63,000, would I be limited in the refund I can receive or how much of the loss I can applye intor ordinary income? I dont think so given the sale of the property but want to make sure.

 

Thaks for your timely response. What do I need to do to pay for the answer? I have this unlimited program.

Expert:  Lev replied 2 years ago.

Your understanding is correct - you may use any of these two reasons to exclude the forgiven debt - and in most situations - the result will be same.

Because the property was rented more than a year and you claim the depreciation deduction in previous years - and consider today real estate market situation - I do not see any issue for deducting a loss realized from the sale of your rental property.

 

Please be sure that the amount of forgiven debt will reduce your basis and will reduce your loss.

 

You are correct that the loss from the selling your rental property is fully deductible against your other taxable income. If will be reported on form 1040, line 14 - and it is not limited by $3000 as a capital loss. If your taxable income becomes negative - you might have NOL - that will be different situation.

Let me know if you need any help.

 

Please be sure to accept the answer. Experts are only credited when answers are accepted.

Lev, Tax Advisor
Category: Tax
Satisfied Customers: 23237
Experience: Taxes, Immigration, Labor Relations
Lev and other Tax Specialists are ready to help you
Customer: replied 2 years ago.

Great, very helpful. Just a few more for clarification and support.

 

Should I probably then claim no depreciation this year for the 8 months I had the rental so as to not to further reduce the basis of the property?

 

Yes, I will reduce the forgiven debt and use the following formula: purchase price + improvements + selling expenses - depreciation - forgiven debt - selling price. The difference would be my loss or gain. Is this correct? Do I need to submit support for this calculation or just keep for my records?

 

On Schedule E, I will show the operating loss of the rental for 2011 including the NOL carryover from 2010.

 

So the loss on from Form 4797 and the operating loss from Schedule E will together reduce my taxble income?

Expert:  Lev replied 2 years ago.

Should I probably then claim no depreciation this year for the 8 months I had the rental so as to not to further reduce the basis of the property?

If the property was rented in 2010 and disposed in 2011 - you will have to recapture depreciation regardless if you claim it or not - so I suggest to claim the depreciation and take a deduction that you are eligible.

For 2011 - because the property is disposed in 2011 - you do not claim depreciation.

Yes, I will reduce the forgiven debt and use the following formula: purchase price + improvements + selling expenses - depreciation - forgiven debt - selling price. The difference would be my loss or gain. Is this correct? Do I need to submit support for this calculation or just keep for my records?

That is correct - but you need do calculations in two steps (1) calculate the basis (2) calculate the gain.

On Schedule E, I will show the operating loss of the rental for 2011 including the NOL carryover from 2010.

That is not NOL. These are disallowed passive losses realized from your rental activity - which are allowed in 2011 because you dispose your rental property.

So the loss on from Form 4797 and the operating loss from Schedule E will together reduce my taxable income?

That is correct.

Lev, Tax Advisor
Category: Tax
Satisfied Customers: 23237
Experience: Taxes, Immigration, Labor Relations
Lev and other Tax Specialists are ready to help you
Customer: replied 2 years ago.

Hello, thanks.

 

I was just reading Publication 551 and on page 10 they talk about how to calculate gain or loss for a property that changed to business or rental use from personal use. They say that to calculate loss I have to use the lesser of the adjusted basis or FMV at the time it was placed on rental use. Does this apply to me? I am confused now... If I do so then should I claim the exclusion of debt cancellation using the qualified principal residence indebteness and use the FMV when I turn the property to rent to calculate any gain or loss?

 

If I have to use FMV at rental point and adjust basis by debt cancellation I can end up paying more taxes.

 

http://www.irs.gov/pub/irs-pdf/p551.pdf

Customer: replied 2 years ago.

Does any of this matters since I held the property more than a year as rental? Can I use the original purchase price as the starting point for calculating adjusted basis?

 

 

Expert:  Lev replied 2 years ago.
Please let me some time to review - and I will be back to you shortly...
Expert:  Lev replied 2 years ago.
Please see for reference
§ 1.167(g)–1 Basis for depreciation. - http://edocket.access.gpo.gov/cfr_2011/aprqtr/pdf/26cfr1.167(g)-1.pdf
The basis upon which the allowance for depreciation is to be computed with respect to any property shall be the adjusted basis provided in section 1011 for the purpose of determining gain on the sale or other disposition of such property. In the case of property which has not been used in the trade or business or held for the production of income and which is thereafter converted to such use, the fair market value on the date of such conversion, if less than the adjusted basis of the property at that time, is the basis for computing depreciation.

So your cost basis in the property is your original purchase price $405,000 plus $15,000 in improvements = $420,000.
When the property was converted from rental to personal - its FMV was $206,000 plus land.
Because that value is less that the adjusted basis of the property at that time - the FMV should be used for depreciation.
So you should keep track of two basis.
1. $420,000 - $161,000 - $10,000 (cancellation of debt) - $1,710 (depreciation) = $247290
2. $206,000 plus $50,000(land) - $161,000 - $10,000 (cancellation of debt) - $1,710 (depreciation) = $83290

When the property is sold for $175,000 - you need to use the first basis to determine the gain and the second to determine the loss - so you have neither gain nor loss.
In additional - you may deduct previously disallowed passive losses $2,700.
Sorry for confusion.
Lev, Tax Advisor
Category: Tax
Satisfied Customers: 23237
Experience: Taxes, Immigration, Labor Relations
Lev and other Tax Specialists are ready to help you
Customer: replied 2 years ago.

Thanks for clarification - why do you say neither gain or loss. One offset the other?

 

I dont follow you here. What about selling expenses of $21,000 dont they increase the adjusted basis, I think they do?

 

Can I by any chance simply waive cancellation of debt from a principal residence and calculate gain or loss in retal property using the basis at FMV. The fact is the house is so underwater that forgiven debt can be argue was before it was placed as a rental. Then from moment I made that a rental it lost value.

 

 

Customer: replied 2 years ago.
I may have answered my question my self. I also talked to a tax attorney and what he said was that I should treat the cancellation of debt as a principal residence and forget about doing business asset sale. The fact is that the tenants left the house on June 2011 and the house cameback to me as personal residence until I sold. It was note available for rent either. I can deduct the losses generate for the one year of rental in schedule e and that is it. I cant double dip and creat a business asset sale and exlclude debt because I have to use FMV at the point it was put as a rental. This is to me a good outcome as I will just simply exclude the cancelation of debt under the princiapl residence provision and report the one year rental losses in schedule e.
Expert:  Lev replied 2 years ago.

Thanks for clarification - why do you say neither gain or loss. One offset the other?

Because to determine the gain or the loss - you are required to use different basis - you will use your original basis to determine the gain and reduced basis to determine the loss. The first basis resulted no gain, and the second produced no loss.

What about selling expenses of $21,000 don't they increase the adjusted basis, I think they do?

Yes - selling expenses are added to both basis. Please be aware that rental losses that previously were disallowed are not added to the basis and are deducted separately.

Can I by any chance simply waive cancellation of debt from a principal residence and calculate gain or loss in rental property using the basis at FMV.

Yes - you may use "qualified principal residence indebtedness" for exclusion - however - you still need to adjust your basis regardless which exclusion you are using.

The fact is the house is so underwater that forgiven debt can be argue was before it was placed as a rental. Then from moment I made that a rental it lost value.

The issue here is the time when the debt was canceled - if that occurs after the property was converted to rental - see date on 1099C form - you have no choice and should adjust each basis.

Just fro illustration - see this article - http://www.cpa-connecticut.com/loss-on-sale-of-home.html

Sorry I wish having better information for you.

Lev, Tax Advisor
Category: Tax
Satisfied Customers: 23237
Experience: Taxes, Immigration, Labor Relations
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