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Lev
Lev, Tax Advisor
Category: Tax
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Experience:  Taxes, Immigration, Labor Relations
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I am in the process of negotiating a deed in lieu with the

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I am in the process of negotiating a deed in lieu with the bank on a rental property and I am trying to estimate the tax implications on canceled debt. I understand since this is not my primary residence I am not eligible for relief under the Mortgage Forgiveness Act, but what about what IRS Pub. 4681 (Canceled Debts, Foreclosures, Repossessions, and Abandonments) refers to as "Qualified Real Property Business Indebtedness"? It seems to state that qualified properties include those used for rental income.

Thanks in advance - C

Lev :

Hi and welcome to Just Answer!
You are correct - you may not exclude the canceled debt from taxable income based on the Mortgage Forgiveness Act of 2007 as your primary residence simply because that is NOT your primary residence, but definitely may use other exemptions - including the one you mentioned.
The cancelled debt related to a rental property does qualify as "Qualified Real Property Business Indebtedness."
No need to verify insolvency - still you will need the tax attribute reduction - means the basis should be reduced by the amount of debt forgiven.
Use Form 982 - www.irs.gov/pub/irs-pdf/f982.pdf - specifically - for rental property - check the box 1(d) - Discharge of qualified real property business indebtedness , and put the forgiven amount on the line 2 and on line 4 and line 10a. The line 10 is specifically to reduce the basis (tax attribute).

Lev :

The disposition of the property is reported on Form 4797 - http://www.irs.gov/pub/irs-pdf/f4797.pdf - is to report the disposition of business property - rental property in your situation. To calculate your gain or loss - you will use an adjusted basis reduced by the amount of debt forgiven - but not below zero.
Your basis is your original purchase price - regardless if you used your own funds or took a loan - whatever you paid for the property is your basis. Plus purchase expenses. Later the basis is adjusted by all your improvement expenses - again - regardless if you used your own funds or borrowed the money.
Similarly - when you exclude forgiven debt from taxable income (on form 982) - your basis is adjusted (reduced) by the amount you excluded.
On disposition due to deed in lieu - for tax purposes you treat that as the sale at the property's fair market value - which is reported on the form 1099A or 1099C you should receive from the creditor.
So - your gain or loss is calculated as (sale price) - (adjusted basis) - that is reported on form 4797.

Lev :

Because the basis will be reduced by the forgiven debt amount - it is possible that you realize the gain. In this case - a part of the gain attributable to depreciation recapture will be taxed as ordinary income and the rest - as a capital gain.
In additional - if you had rental losses - all are deducted (including those carried over from previous years).

Customer:

Thanks for the quick response! Do you suggest that I put this in the hands of CPA come tax time or should any tax/accounting business be familiar with the steps you laid out?

Lev :

While that is not required - using a qualified tax professional is always recommended.
You definitely may prepare your tax return on your own. However if you do not feel confident - than yes - you better to use a CPA.
Qualified CPA most likely does't need that information - but you are welcome to pass this answer to your tax preparer.

Lev :

I will help you to estimate possible tax liability (if any) when you provide required amounts as mentioned above.

Customer:

While I have yet to receive paperwork I can estimate. Right now I am just trying to prepare myself with info - The mortgage balance is $152,500 (canceled debt) and fair market value is (sadly) approximately $44,000 (a real estate agent I met with with considering a short sale gave me this). The original purchase price was $169,900. Closing costs were approximately $8,000 and another $8,000 was made in improvements (I am assuming these expenses were used in previous years tax returns - does that matter?)

Lev :

We need to know when you purchased and start renting this property?

Lev :

I am assuming these expenses were used in previous years tax returns - does that matter?
We may not deduct same expenses twice...
Improvements may not be deducted in the year paid - instead they must be capitalized (added to the basis) and depreciated over 27.5 years for residential rental property. Only repair expenses may be deducted in the year they were paid - so you need clear separate repair and improvement expenses.

Customer:

The property was purchased in 2/2008 and the property was rented the same month.

Customer:

Don't know if this matters but for the past year I have had no renters. Last tenants damaged the unit and it was unrentable for some time until I had repairs made late last year.

Customer:

Again estimates, but I'd say repair expenses made last year were $2000 and improvement expenses done at the same time totaled $6000.

Lev :

So far - estimated basis $169,900(purchase price) + $8,000(purchase expenses) + $8,000(improvements) = $185.900
Expected cancelled debt $152,500(mortgage balance) - $44,000( fair market value) = $108,000
So - your estimated adjusted basis $185.900 - $108,000 = $77,900
Estimated depreciation for five years - $185.900 / 27.5 * 5 = $33,800
Thus - your adjusted basis after deducting depreciation is $77,900 - $33,800 = $44,100.
So far your estimated gain loss would be $44,000(selling price = fair market value) MINUS $44,100(adjusted basis) - will be about zero - and most likely - there will not be any additional taxable income.
Please be aware - these are very raw estimations.

Customer:

Thanks - I understand. If I was to get hit with a $10-20,000 tax bill from the IRS I needed to know now. Having this info will help me sleep better between now and next April. Thank you!

Lev :

Because that is a very simple raw estimate - it is possible that you will have a small taxable income or a small destructible loss - but again - that should not be large - and based on information you provided - it is very unlikely to expect any surprises related to taxes.

Lev and other Tax Specialists are ready to help you

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