THE TAX ATTIC with Jerry Coon

Giving up a rental to foreclosure

Jerry Coon

“Be well… Do good things… Keep in touch.” This is one of Garrison Keillor’s more famous, if not the most famous, quotes from “The Writer’s Almanac.” It’s short, but it sure does say a mouthful.

I have a nephew, Andrew Veenstra, who graduated from Sparta High School last week. One of the speakers used this quote as the central point of her speech. The three points of the quote should apply to us all year long and are timeless, but they can be especially applied to those graduates who are just starting on their life’s journey.

While it’s true that getting through high school is a big step, in reality it is just a step in the right direction. There are bigger steps to be taken down the road, such as perhaps graduating from college, getting married and perhaps raising a family, and hopefully finding an occupational field that you enjoy working in. High school can definitely set the tone.

Doing what Mr. Keillor suggests over the long term can also set the tone of a lifestyle. Think of the words as you say them to yourself: “Be well… Do good things… Keep in touch.” That’s timeless advice to give to someone and for each of us to follow. You are wishing them good health and well-being. You are advising them to do good because the human spirit and psyche is positively empowered by doing good things. By keeping in touch with loved ones, friends and acquaintances, we let them know they are important to us.

Thank you, Garrison Keillor for your genius in putting these eight words together in a quote that we can all use to live by.

The final situation I would like to discuss in our ongoing series on the topic of foreclosures involves having rental property. Giving a rental up to foreclosure is one of the more complicated tax situations that we as tax professionals get to deal with. Let’s go through an example:

Joe buys a rental in 1990 for $110,000. In 2005, it was appraised at $205,000 without Joe having made any appreciable improvements to the property. Joe needed a car and his two daughters were in college, so he was in need of funds. He was able to tap into the appreciation of the rental and took out $80,000 as an equity loan. In 2008, the housing downturn hit Joe’s rental neighborhood so hard that by 2011, the property had decreased in value to $130,000. Unfortunately, Joe still owed $90,000 on the original mortgage and the full $80,000 on the equity loan. He gave the property back to the bank late in 2011 and they acknowledged that fact by issuing a 1099-A, Acquisition or Abandonment of Secured Property, on December 1, 2011.

Joe was issued the 1099-A because this was a rental property. If it had been his personal residence, no 1099-A would have been issued. The 1099-A requires Joe to treat the abandonment as a sale of the rental at the lower of the fair market value of the property or the balance due on the loans of the property. The loans owed on the property were a total of $170,000 ($90,000 mortgage and $80,000 equity loan). The fair market value was $130,000. The sales price used to calculate gain or loss on the rental would be $130,000. Using the $130,000, Joe actually may have had a profit on the sale since he bought it for $110,000 and had depreciated or written off the majority of the purchase price since 1990.

In addition to the 1099-A, Joe will receive a 1099-C, Cancellation of Debt (COD), that could require him to claim COD income on the difference between the amount of debt forgiven and the fair market value of the property Joe gave up. The amount of debt that Joe was forgiven was $170,000 ($90,000 mortgage and $80,000 equity loan). The fair market value of the property given up was $130,000. The difference between the two is $40,000 ($170,000 – $130,000). Joe would have COD income and would pay tax on the $40,000. Since he had used that $40,000 for the personal reasons of buying a car and putting his daughters through college, he would include the $40,000 on line 21 of his form 1040 as ordinary income.

Let’s summarize Joe’s tax return. He gave his rental—that at one time was worth over $200,000—up for foreclosure. The result of the foreclosure is most likely that Joe has a gain on the sale based on a sale price being equal to the current fair market value of the property. In addition, he has to pay tax on the debt he is forgiven above that fair market value of the property.

This is a return that is difficult to complete and the taxable gain and COD income also a challenge to explain.

There are two ways, however, that Joe could legally escape paying taxes, but they are both painful. First, if Joe had declared bankruptcy and the rental disposition was part of the bankruptcy, Joe would not have a sale nor would he have income to report. The bankruptcy trustee would be responsible for the disposition and the bankruptcy trustees are not subject to the same tax rules as Joe.

As a second alternative, if Joe was insolvent at the time the 1099-C was issued, he would not have to pay tax on the COD income.

If either of these situations applies to Joe, he may walk away without the property but not be penalized in the form of paying taxes on the disposition. This is definitely one of the times that contracting with a competent tax professional may be well worth the price of admission. This is Jerry Coon signing off.

 

Jerry Coon is an Enrolled Agent. He owns Action Tax Service on Northland Drive in Rockford. Contact Jerry at www.actiontaxservice.com.

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