Hi and welcome to our site!You do need to adjust tax attributes - in your case the basis of the property regardless if you are insolvent.
The gain should be allocated between depreciation recapture and capital gain.
My next question then is in regards XXXXX XXXXX 982, we would check boxes 1b and 1d. The instructions for 1d state:
The second sentence seems to mean, do not include the amount for which you are insolvent into the basis of depreciable real property.
Or am I understand the instructions wrong.
Well... if you exclude canceled debt and do not reduce any tax attributes - the sale transaction will result a loss - and that would be double dipping - you may not take double benefits from exclusion.
The sentence from instructions you mentioned is not related to reduction of tax attributes - it simply mentioned two different types of exclusion and priority in which they should be applied. However regardless which type of exclusion is claimed - you still need to reduce tax attributes - in your case that is the basis of the property.
No need to be insolvent. Considering your situation - you do qualify to exclude the canceled debt 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. .
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.
The gain of $37k will be treated as following:
$7k will be depreciation recapture and will be taxed as ordinary income
$30k will be taxed as capital gain.
Also - if you have any rental losses including carried over from previous years - they are deducted against your gain.