Tax loss on foreclosed investment property

7 Replies

Say a person let's his investment property go back to the bank in a completed foreclosure by publication. He paid $185,000 and owes $160,000 and the bank's loss after selling and holding cost expenses is $20,000. What would the investors exposure be to the IRS? The state is Minnesota.

Based on the information given, you have 180K exposure.

On personal residences bought in a certain period you will have no phantom gain.

Residences outside of that time period and investor owned properties there are different strategies you can use.

Many look at form 941 I believe which is an insolvency form saying at the time the phantom gain was issued your liabilities far exceeded your assets so you owe nothing on the forgiven debt.

I always tell sellers to consult a tax attorney or similar to discuss ramification and strategies to limit exposure.

I am not a tax person - not even close.

This being investment property the personal residence rules will not apply. There are situations where if you can show insolvency the debt forgiveness can be netting against some of these losses. Not knowing your situation you will need to discuss this with a CPA that understands these rules. A tax attorney may prove useful, but a CPA at tax time will be far more useful.

The 941 is a business tax return for reporting FICA & federal withholding to the IRS, so it has nothing to do with insolvency.

Yes sorry Charles I just quoted the wrong form.

There are so many! :)

If part of the forgiven debt doesn't qualify for exclusion from income under this provision, is it possible that it may qualify for exclusion under a different provision?
Yes. The forgiven debt may qualify under the insolvency exclusion. Normally, you are not required to include forgiven debts in income to the extent that you are insolvent. You are insolvent when your total liabilities exceed your total assets. The forgiven debt may also qualify for exclusion if the debt was discharged in a Title 11 bankruptcy proceeding or if the debt is qualified farm indebtedness or qualified real property business indebtedness. If you believe you qualify for any of these exceptions, see the instructions for Form 982. Publication 4681 discusses each of these exceptions and includes examples.

I have talked with some short sale attorneys and CPAs over the last several months and there is some gray areas of the law that some are pushing the envelope on. Insolvency can mean several different things in the tax codes. There are other ways to significantly reduce this income but planning is necessary and it needs to be properly documented. Audits are becoming more likely with some of the changes happening in the IRS.

Publication 4681 is useful to read, but I would caution an investor trying to make some of these claims on their own. You will want to have any tax position you take well documented so that it can be supported. The time to talk to a tax attorney though is before the actual sale. Once the event has happened some of your options for the transaction are gone. The cat is out of the bag and everyone can see it is a cat. Perhaps the cat has some hidden problems, but it is still a cat.

Charles I definitely agree and I am not even close to being a tax person.

When I do commercial short sales the sellers ask about the 1099 phantom gain and how that will be huge to deal with.I tell them if they can to try and do a loan mod or interest rate reduction first.

Some bought at the height of the market and are pouring money into an over leveraged property. In these cases they don't want to keep pouring money into a property or do a workout on something where even when the market recovers it will be worth less than their mortgage balance.

In other words there is no reason for them to go down with a sinking ship.

In these cases I tell them to consult their tax accountant for legal advice and that I am not a tax person.

I do tell them if they do nothing and it forecloses the 1099 will likely be higher than in the short sale.The reason is markets continue to decline in value and unemployment is still high. Usually once the tenants get wind of a foreclosure the occupancy drops as tenants jump ship to another landlord close by.

So usually by the time the bank forecloses and takes over the complex the value has eroded even further.

I am not a tax expert but it would seem easier to mitigate a small 1099 versus a large one.

Also if it forecloses depending on what type of loan it is they won't be able to get financing for xx numbers of years moving forward.

So as you say many things to consider.

Sellers are always looking for a totally clean break from a bad situation and it doesn't exist.I tell them you have options and have to try to make the least painful and most in your favor as you can.

The bank is trying to get what they want and the seller is trying to get what they want and both have to give to get somewhere.

With taxes some are very risk adverse,some test the waters a little,and others swim with the sharks and hope not to get eaten.

At the end of the day it's a personal choice for everyone how they conduct business and live with the choices they make.

Charles do you have a blog on taxes and planning on BP that you do??

I have a general blog here on BP, perhaps I should consider a tax and planning blog as well. Hmmm. Not a bad thought.

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