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The Tax Consequences of a Short Sale or Foreclosure: Vacation Homes (Part 3)

The Tax Consequences of a Short Sale or Foreclosure: Vacation Homes
By Glenn Schanel, CPA, CFP®

(This article is the third in a three part series on the tax consequences of short sales and foreclosures. This installment will cover properties that qualify as vacation residences or second homes.)

A vacation or second home is a residence that is used for personal purposes but which does not qualify as a principal residence. Unfortunately, when it comes to a foreclosure or short sale, a transaction involving a vacation home is the situation most likely to result in an unfavorable tax situation.

Tax on Gains

The gain/loss on a short-sale or foreclosure transaction is calculated as the market price or sale price minus the cost basis. The cost basis on a vacation home is the sum of the purchase price, the purchase costs, and capital improvements. Any gains that result from the transaction must be reported as a taxable capital gain. Losses, however, are not deductible, because a vacation home is considered personal-use property.

Debt Forgiveness Income

Even if a vacation home is sold at a loss through a short sale or foreclosure, the taxpayer may still be subject to debt forgiveness income.

Debt forgiveness income is the difference between the loan amount at the time of the foreclosure or short-sale and the market price or sale price. As a general rule, debt forgiveness income is taxable as ordinary income, but there are several exceptions. Debt forgiveness income does not need to be included as income if:

(1) the debt discharge occurs as a result of a Title 11 bankruptcy case.
(2) the taxpayer is insolvent at the time of discharge (your liabilities exceed your assets).
(3) the loan is non-recourse (the lender cannot pursue you personally).

There is a catch, however. If a taxpayer elects to avoid taxes on debt cancellation income, other tax benefits (called attributes) must be reduced to the extent that the income is not recognized. In other words, the relief is temporary because it only defers the tax consequences into the future. The taxpayer can choose to reduce the basis of the depreciable property or to follow a prescribed ordering of tax attribute reductions. These include net operating losses, capital loss carryovers and passive loss carryovers.

In summary, the foreclosure or sale of a second/vacation home is likely to result in a very unfavorable tax situation. Capital losses are not deductible, but gains are taxable, and any related cancellation of debt can result in higher taxes now or in the future.

Consult with a Tax Professional

This can be a complicated issue, so we recommend that anyone involved in one of these transactions consult with a tax professional to review their particular situation. If you or someone you know is involved in a foreclosure or a short sale and is concerned about the possible tax consequences, please feel free to contact our offices at (561) 624-2118 to schedule a consultation.

Glenn Schanel, CPA, CFP® is the President of Schanel & Associates, PA, Certified Public Accountants. The firm provides tax, accounting, and consulting services to clients throughout South Florida and the United States.

The information contained in this communication is intended as general guidance on matters of interest only. The application and impact of laws can vary widely based on specific facts involved. Given the changing nature of laws, rules and regulations, and the inherent hazards of electronic communication, there may be delays, omissions, or inaccuracies in information contained in this transmission. The information contained herein should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisors. Pursuant to Regulations Governing Practice Before the Internal Revenue Service, any tax advice contained in this communication, unless explicitly provided otherwise, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Jupiter

The Tax Consequences of a Short Sale or Foreclosure: Rental Property (Part 2)

By Glenn Schanel, CPA, CFP®

(This article is the second in a three part series on the tax consequences of a short sale or foreclosure. This installment covers properties that qualify as rentals.)

You may be one of the many South Floridians who purchased one or more investment properties at or near the height of the real estate boom and now are left holding a property that has significantly depreciated in value. Meanwhile, the mortgage, along with insurance, taxes and other costs of ownership are putting a severe strain on your monthly cash flow. Renting the property can help alleviate some of this pressure, but with so many rental properties on the market, the rent can be considerably less than the monthly carrying costs. As a result, you may be considering a short sale arrangement or even a foreclosure.

However, before going forward with a short sale or foreclosure on a rental property, it is not only important to understand the legal implications, but it is also critical to understand all of the potential tax consequences, because they can be significant.

Tax on Capital Gains

The tax law treats both a short sale and a foreclosure of your rental property as a sale. The gain or loss is calculated as the market price or sale price minus your cost basis. In most cases, there will be a loss, and unlike with a personal residence, the loss on a sale of rental property is immediately deductible. This is generally referred to as a Section 1231 loss. This means that the loss is likely to qualify as an ordinary, as opposed to a capital loss. As a result, the tax benefit of the loss is at higher, ordinary tax rates. This is the one primary advantage over properties held for personal use.

Debt Forgiveness Income

Debt forgiveness income is the difference between the loan amount at the time of the foreclosure or short-sale and the market price or sale price. While Congress did provide tax relief for debt forgiveness income related to a principal residence, debt forgiveness income continues to be taxable for rental properties. However, there are two basic exceptions to this general rule:

(1) When the amount forgiven/deficiency is included in a bankruptcy filing.

(2) When you are insolvent at the time the debt is forgiven.

One more exception applies if your rental qualifies as Section 1231 property. In this case, you may be able to reduce the cost basis of the rental property without being insolvent. The result is that you don’t report the income from the debt forgiveness but you have a lower loss on the “sale’ of your property. To use this strategy, you must make an election and the debt forgiven must be “qualified acquisition indebtedness,” (i.e. debt incurred to acquire, construct or improve a property.)

Consult with a Tax Professional

This can be a complicated issue, so we recommend that anyone involved in one of these transactions consult with a tax professional to review their particular situation. If you or someone you know is involved in a foreclosure or a short sale and is concerned about the possible tax consequences, please feel free to contact our offices at (561) 624-2118 to schedule a consultation.

Glenn Schanel, CPA, CFP® is the President of Schanel & Associates, PA, Certified Public Accountants. The firm provides tax, accounting, and consulting services to clients throughout South Florida and the United States.

The information contained in this communication is intended as general guidance on matters of interest only. The application and impact of laws can vary widely based on specific facts involved. Given the changing nature of laws, rules and regulations, and the inherent hazards of electronic communication, there may be delays, omissions, or inaccuracies in information contained in this transmission. The information contained herein should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisors. Pursuant to Regulations Governing Practice Before the Internal Revenue Service, any tax advice contained in this communication, unless explicitly provided otherwise, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Jupiter

The Tax Consequences of Short Sales and Foreclosures: Principal Residences

By Glenn Schanel, CPA, CFP®

(This article is the first in a three part series on the tax consequences of a short sale or foreclosure. This installment will cover properties that qualify as a principal residence.)

The last thing a person involved in a foreclosure or short sale needs is a crushing tax bill, so it is important to understand and be aware of potential tax consequences. When it comes to a qualified principal residence, taxes can be avoided in most, but not all, circumstances.

A principal residence for tax purposes is a home that a taxpayer has owned and lived in for at least two of the past five years. Keeping that definition in mind, we will consider both the capital gains tax and the tax on debt forgiveness income that could result from a short sale or foreclosure.

Tax on Capital Gains

The gain/loss on a short-sale or foreclosure transaction is calculated as the market price or sale price minus the taxpayer’s cost basis. In the event there is a loss, there is nothing to report for tax purposes, because a loss on a principal residence or any personal property is not deductible. If there is a gain on the residence, then the taxpayer is eligible to exclude up to $250K (or up to $500K for a married couple that files married filing jointly) of this gain.

Therefore, when it comes to a foreclosure or short sale on a principal residence, unless the capital gain exceeds the exclusion maximums, there will be no capital gains tax.

Debt Forgiveness Income

Debt forgiveness income is the difference between the loan amount at the time of the foreclosure or short-sale and the market price or sale price. As a general rule, debt forgiveness income is taxable, but there are some exceptions.

The Mortgage Forgiveness Relief Act of 2008 says that debt forgiveness income can be excluded if the debt can be considered “Qualified Principal Residence Indebtedness” (QPRI). QPRI is any debt that is secured by a principal residence and was incurred to acquire, construct or improve a principal residence.

Therefore, a potential income recognition problem does exist if a taxpayer had refinanced and used any “cash-out” proceeds for some purpose other than home improvement. In that case, the income would be taxable unless the taxpayer qualifies for an exclusion under the bankruptcy or insolvency exceptions.

Consult with a Tax Professional

This can be a complicated issue, so we recommend that anyone involved in one of these transactions consult with a tax professional to review their particular situation. If you or someone you know is involved in a foreclosure or a short sale and is concerned about the possible tax consequences, please feel free to contact our offices at (561) 624-2118 to schedule a consultation.

Glenn Schanel, CPA, CFP® is the President of Schanel & Associates, PA, Certified Public Accountants. The firm provides tax, accounting, and consulting services to clients throughout South Florida and the United States.

The information contained in this communication is intended as general guidance on matters of interest only. The application and impact of laws can vary widely based on specific facts involved. Given the changing nature of laws, rules and regulations, and the inherent hazards of electronic communication, there may be delays, omissions, or inaccuracies in information contained in this transmission. The information contained herein should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisors. Pursuant to Regulations Governing Practice Before the Internal Revenue Service, any tax advice contained in this communication, unless explicitly provided otherwise, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Jupiter

The Need For Buy-Sell Agreements in Small Business

THE NEED FOR A BUY-SELL AGREEMENT IN SMALL BUSINESSES
By Glenn G. Schanel, CPA

All your working life you have strived to develop a successful business. The investment you make in your business is much more than just money or capital. It includes a substan tial amount of your time and hard work.

Over the years, the small business you started will grow based on your hard work. As a reward of this growth, a business’s income will increase and be available to you. In addition, the value of the business will also increase over time.

However, following your death, the business will have to be valued and that value will be added to your estate to compute the estate taxes due. The real question at this point is how to convert this illiquid business interest into cash to pay the estate taxes and other estate administration costs.

The general solution appears to be to simply sell the business or liquidate. Liquidation is not an attractive alternative because it is unlikely the liquidation value is equivalent to the business’s full fair market value. The better alternative is for the estate is to sell the business. But who will buy a closely held business interest? What is a fair price? When will the sale be made? Where will the funds come from?

This “dispositio n dilemma” is easily resolved when a buy-sell agreement is established. This agreement provides that:

• someone (e.g., the business entity, the surviving owners, or a key employee) will purchase a deceased owner’s interest, minimizing the possibility that the business might fall into the hands of outsiders
• at an agreed -upon price, minimizing the possibil ity that the parties involved will not be able to agree on a proper value for the business, and
• the deceased owner’s estate is obligated to sell the interest at that price, minimizing the chances that the parties may not live up to their agreement.

A properly drafted buy-sell agreement also minimizes the possibility that funds will be unavailable to make the purchase, and provides a deceased owner’s estate with needed liquidity by converting an illiquid asset into cash. It’s easy to see why a buy-sell agreement is so valuable. It helps assure business continuity for the surviving owners and fair treatment of the deceased owner’s heir(s).

The advantages of implementing a Buy-Sell plan are somewhat obvious: continuity of management; to create a ready market for the business interest; to provide a fair and reasonable price; and to peg the value of the business interest for federal estate tax purposes.
There are several types of Buy-Sell Agreements. Which one to use depends on several factors,including the number of business owners, the relative ages and health status of the owners,concern about the Alternative Minimum Tax, and whether a step-up in cost basis is desired by the surviving owners. Some of the most common types of Buy-Sell Agreements are the Entity or
Stock Redemption, Cross Purchase, Wait-and-See, Mixmaster, and the One Way Buyout.

Once the type of plan is chosen, it is very important to decide how the liability for the purchase price will be funded. Several possibilities exist:

• Surplus, which consists of an existing fund of the purchaser
• Sinking Fund, also known as a savings account or savings plan
• Borrowing, obtaining financing from a third party, such as a bank
• Installment Sale, financing from the seller
• Life Insurance, which may provide a death benefit and a sinking fund

Each of these funding options has advantages and disadvantages. However, the disadvantages generally outweigh the advantages in all of them except for the use of life insurance, which by its nature provides the cash, in the amount needed, at exactly the time it’s needed, usually without taxation. For this reason, life insurance is most often the preferred funding vehicle in buy-sell planning. The annual premium provides an ascertainable cost and the policy provides a benefit no other plan accomplishes — guaranteed funds in the event of a premature death. The policy, if a whole life policy, may also act as a savings or sinking fun since the cash value in the policy is accumulated on a tax deferred basis. And the death benefit is income tax free!

In sum, life insurance meets the client’s objectives. First, it not only has an ascertainable cost, but it also is the least expensive. Second, the availability of the funds is certain in the case of a premature death. It may also act as a sinking fund.

Lastly, the use of the insurance allows the surviving owner to continue the business free and clear. It also allows the deceased owner’s family to receive the cash for the decedent’s interest, since they are paid in full and there is no installment sale, borrowing, or a shortfall of funds.

Glenn G Schanel, CPA and Associates, PA

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Glenn G. Schanel of Glenn G Schanel, CPA and Associates, PA represents American General Life Insurance Company (AGL), with securities offered through American General Securitie s Incorporated (AGSI), 2727 Allen Parkway, Houston, Texas, 77019. Member NASD and SIPC. AGL and AGSI are member companies of American International Group, Inc. (AIG). Glenn G Schanel, CPA and Associates, PA is a separate entity from any member of AIG. Mr. Schanel can be reached by calling (561) 624-2118.

The U.S. Chamber of Commerce has endorsed for its members the products and services of member companies of American International Group, Inc. (AIG), the leading U.S.-based international insurance and financial services organization. American General Life Insurance Company, a member company of AIG, provides a broad portfolio of top-tier financial products for businesses, families and individuals.

The comments in this article are those of the presenter and not necessarily those of AIG American General. Neither AIG American General nor its agents provide legal or tax advice. You should always consult with your tax and legal advisors about the appropriateness of this concept to your business, and ask your life insurance representative for the best product with which to fund this plan.

AIG American General is the marketing name for the life insurance companies and affiliates of American International Group, Inc. (AIG), that comprise AIG’s Domestic Life Operations, including American General Life Insurance Company.

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