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Anne
Anne, Master Tax Preparer
Category: Tax
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Experience:  Enrolled Agent with 25 Years Experience specializing Individual and Small Businesses
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Hello. I have an income tax question. I own several rental

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Hello. I have an income tax question. I own several rental properties and for various reasons have been finding it difficult to keep up with mortgage payments, taxes and insurance. I understand that if I default, the bank will foreclose. I also understand that the IRS treats a foreclosure as a disposition of property such that I could be potentially subject to income tax liability following foreclosure. My question is this: other than making an offer in compromise, is there any process by which the IRS will consider excusing a tax liability that a foreclosure sale might generate? If the foreclosure happens, I will likely be insolvent. Thanks.

Anne :

Hi

Anne :

Thank you for using justanswer.

Customer:

Sure.

Anne :

You've done some homework I see, since you know that this will be considered a canceled debt

Anne :

If you let the property go back to the bank, do you really think you will have a gain ?

Customer:

I have read that tax generated from income arising from forgiveness of debt by a lender can be waived by the IRS if one files an affidavit of indigency. There would not be any forgiveness of debt in my situation. Let's say, for example, that the fmv of my property is $100K, my adjusted basis in the property is $45K, and the property is sold at foreclosure sale for $55K. Is there any way I can escape paying tax on that gain?

Anne :

Or would this be a loss (after taking into account depreciation)

Customer:

There is a fairly good possibility since my basis in some of the properties is low.

Anne :

This is how you would show the IRS that you are insolvent

Customer:

I have for example an apartment building for which I paid $289K about 12 years ago. It is subject to depreciation of probably $10K/year, such that my adjusted basis is now probably around $150K or so. The fmv of the property is around $475K. The bank at a foreclosure sale will bid at least 50% of fmv under Maryland law to ensure that the court does not set aside the sale. There would be a potential gain in this case.

Anne :

You will list your assets and liabilities on the 982

Anne :

You may or may not be TOTALLY insolvent

Anne :

However,

Customer:

My understanding is that for purposes of determining whether the IRS will waive tax on forgiveness of debt, the definition of insolvency is total outstanding liabilities being greater in amount that total assets. Would that same definition apply to waiver of tax on gain occurring as a result of a foreclosure sale?

Customer:

Also, is there an IRS publication that explains form 982 that I could read?

Anne :

If, for example, you have assets of $50,000 and liabilities of $70,000 , then you can claim $20,000 in insolvency

Anne :

Can you give me just a second here......I want to read something and see if it would help you

Customer:

okay.

Anne :

Forgive me if I tell you things you already know.....

Anne :

You would report the sale (from foreclosure) on Form 4797 page 2

Anne :

You must still fill out the form, even if you file the 982

Customer:

understood.

Customer:

I'm just trying to get a sense of what type of standard the IRS applies when considering the 982.

Customer:

Sorry if it seems that I'm dragging this on a bit.

Anne :

No you're fine

Anne :

It doesn't matter how long we chat

Anne :

I just want you to understand your rights

Customer:

I must be honest: I am trying to get some ideas in mind about what my options are in the event the worst should happen.

Anne :

I'm not fully understanding what you mean by the type of standard the IRS applies

Customer:

I have done some research and have learned that in Florida, a person's primary residence is not subject to attachment by a judgment creditor.

Anne :

You SHOULD be wanting to know your options

Anne :

that's why we're here

Customer:

The scenario that seems plausible to me now is this: I get a couple of properties sold before the bank forecloses; enough go generate sufficient funds to permit me to buy a small home in florida. I will have a very modest monthly pension which will be protected from creditor attachment under ERISA.

Customer:

For me, the big unknown is the IRS.

Customer:

I would expect to have to pay the tax on any gain for property that I am able to sell voluntarily; however, if I subsequently go into default and the Bank foreclosures, I won't have the means to pay tax on any gain that could be generated from the foreclosures. I'm essentially trying to find out if I will have to worry about the IRS in that case, or if instead they will accept an affidavit of insolvency similar to that which I understand the IRS accepts in cases of forgiveness of debt.

Anne :

There's a worksheet I'm looking for..........

Anne :

should have it in minute

Anne :

Do you know if this is a recourse or non recourse loan?

Customer:

recourse

Anne :

ok

Anne :

There are different ways of handling this...(since its real property)..........and I'm looking for the most advantageous way for you.....

Customer:

okay. thanks

Anne :

You may want to choose the option of treating this debt as "Qualified Real Property Business Indebtedness"

Customer:

okay.

Customer:

Since these are rental properties, I would think they would qualify as such.

Anne :

I'm sorry for the delays......my computer doesn't want to scan today

Anne :

Yes, they qualify

Customer:

I briefly skimmed the publication. It seems to deal with "cancelled" debts. I don't think my debts would meet that definition.

Anne :

This is for form 982

Anne :

You stated that once the bank took back the rental property you would likely be insolvent

Customer:

I'm looking at Publication 4681.

Customer:

Yes, once the bank takes back the property, I will be insolvent; however, that's not to say the bank will forgive or cancel the debt (i.e., difference between amount owed and sales price at foreclosure sale).

Customer:

Here's the way I see it:

Customer:

1. If the Bank foreclosures, I am at risk of tax in the event the foreclosure sales price exceeds my adjusted basis in any single asset.

Customer:

2. The bank will not forgive any deficiency in the amount I owe after foreclosure (measured as the difference between the foreclosure sales price and amount owed).

Customer:

3. By the time the foreclosure sales occur, I will not have enough money to repay all of the deficiencies.

Customer:

4. At some point in time, I would likely have to file personal bankruptcy; however, I have to wait two years to do that in Florida in order to establish residency there. Florida permits one to retain a personal residence in bankruptcy; Maryland (where I now live) does not.

Anne :

This puts a little different spin on this

Customer:

5. In that interim period of two years, the Florida homestead laws will protect my residence from attachment by judgment creditors; but again, if I owe the IRS taxes that I can't pay, then I worry that it can lien the house.

Anne :

You may only file form 982 if there is a cancellation of debt

Customer:

Okay. That won't occur here.

Anne :

My best advice at this point is for you to enter into a payment plan with the IRS

Customer:

I thought that's probably what it would boil down to.

Customer:

I need to wind this down now and let you go.

Customer:

Thanks for the help. You have given me some good direction.

Anne :

as long as you make your payments timely, the IRS will have no reason to put a lien on your property

Anne :

If you have follow up questions, please come back

Customer:

Okay. Thanks for that offer.

Customer:

Goodbye for now.

Anne :

Comes with the service

Anne :

try and have a good day

Customer:

Appreciate it. I will certainly leave positive feedback.

Anne :

Thank you

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