Taxes & Debt Forgiveness on Rental Properties

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I’ve gotten some questions on my blog posts here about Form 1099-C and tax issues on debt forgiveness of a rental property. A lot of people are justifiably concerned about taxes they didn’t expect when they’ve had to either walk away from a property, do a short sale or get a loan modification.

In the case of a rental property, it’s not as bad as you may think it is. In the case of an investment property, though, it could be devastating. Here are some examples.

Let’s say you buy a property for $400,000 and hold it, waiting for the value to go up. In this case, you have an investment property. Let’s assume you have a loan of $360,000 on the property. And you end selling it through a short sale for $250,000. The lender forgives the extra debt of $110,000 ($360,000 – $250,000). And he then gives you a 1099-C that shows $110,000 of debt forgiveness, in other words, income. In this case, you also have a loss. Your basis in the property was $400,000 and you just sold it for $250,000. That means you have a loss on the property of $150,000 ($400,000 – $250,000).

Now here is where it gets dicey. Because it’s an investment property, you have a CAPITAL loss on the property. That means you can take the capital loss against your capital income and then take an additional $3,000. If your loss is $150,000, you have 50 years of $3,000 per year of loss ahead of you. Yikes.

But let’s say you put the property in service first, now you have a rental property. That means any gain or loss you have on the disposal is an ORDINARY gain or loss.

Let’s use the same numbers: $400,000 with a loan of $360,000. You get a short sale of $250,000. You still have an income issue of $110,000 from the debt forgiveness. But you also have a loss of $150,000. In this case, though, you have an ordinary loss on the property. That means it works against other income, not just capital income.

In you have an investment property, turn it into a rental property before you sell it at a loss. Learn more about this, and other tricks to maximize real estate losses, in my program Tax Implications of Real Estate Losses.

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