In December, 2007, the Federal Government passed The Mortgage Forgiveness Debt Relief Act of 2007 which generally allows taxpayers to exclude income from the discharge of debt on their principal residence.
According to the IRS, debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualify for this relief. This provision applies to debt forgiven in 2007, 2008 or 2009. Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). The exclusion doesn’t apply if the discharge is due to services performed for the lender or any other reason not directly related to a decline in the home’s value or the taxpayer’s financial condition. The amount excluded reduces the taxpayer’s cost basis in the home. More information on claiming this exclusion will be coming from the IRS.
That’s great if you are a beleaguered homeowner; but what about investors in commercial properties who are facing a Possible Commercial Foreclosure?
What is Cancellation of Debt?
If you borrow money from a commercial lender and the lender later cancels or forgives the debt, you may have to include the cancelled amount in income for tax purposes, depending on the circumstances. When you borrowed the money you were not required to include the loan proceeds in income because you had an obligation to repay the lender. When that obligation is subsequently forgiven, the amount you received as loan proceeds is reportable as income because you no longer have an obligation to repay the lender. The lender is usually required to report the amount of the canceled debt to you and the IRS on a Form 1099-C, Cancellation of Debt.
Here’s a very simplified example. You borrow $1,000,000 and default on the loan after paying back $200,000. If the lender is unable to collect the remaining debt from you, there is a cancellation of debt of $800,000 plus any accrued interest or fees, which generally is taxable income to you.
Is Cancellation of Debt income always taxable?
Not always. There are some exceptions. The most common situations when cancellation of debt income is not taxable involve:
• Bankruptcy: Debts discharged through bankruptcy are not considered taxable income.
• Insolvency: If you are insolvent when the debt is cancelled, some or all of the cancelled debt may not be taxable to you. You are insolvent when your total debts are more than the fair market value of your total assets. Insolvency can be fairly complex to determine and the assistance of a tax professional is recommended if you believe you qualify for this exception.
• Non-recourse loans: A non-recourse loan is a loan for which the lender’s only remedy in case of default is to repossess the property being financed or used as collateral. That is, the lender cannot pursue you personally in case of default. Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income.
Figuring Cancellation of Debt Income.
(Note: For non-recourse loans, skip this section. You have no income from cancellation of debt; but you may have a recapture of depreciation taken during your holding period).
1. Calculate the total amount of the debt immediately prior to the foreclosure.
2. Estimate the fair market value of the property as you would from Form 1099-C, Box 7.
3. Subtract line 2 from line 1. If less than zero, enter zero. ___________ The amount on line 3 will generally equal the amount shown in box 2 of Form 1099-C. This amount is taxable unless you meet one of the exceptions in question 2. Enter it on line 21, Other Income, of your Form 1040.
Please consult with your accounting professional.
Figuring Gain from Foreclosure
1. Enter the fair market value of the property foreclosed. For non-recourse loans, enter the amount of the debt immediately prior to the foreclosure.
2. Enter your adjusted basis in the property. (Usually calculate your purchase price plus the cost of any major improvements and see below regarding Depreciation Recapture issue)
3. Subtract line 5 from line 4. If less than zero, enter zero.
The amount on line 6 is your gain from the foreclosure of your commercial property. Please consult with your accounting professional.
Figuring the Depreciation Recapture
Please consult your accounting professional.
The difficulty in this environment is that an investor can be facing the loss of a valuable property and the investor’s equity; the possible consequence of a cancellation of debt liability; and the recapture of depreciation taken during your period of Ownership which serves as a “Quadruple Whammy”.
CIRCULAR 230 DISCLOSURE: This communication is not a tax opinion. Pursuant to Internal Revenue Service regulations, to the extent that this contains tax advice, it is not intended or written to be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer or for promoting to another party any tax related matter addressed herein.