Rental Property

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.

Rental Property

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.