Short Sale of a Rental Property: Reporting the COD (1099-C)

                                                                      By: Art Javier

     To date, I have already intimated you my dear readers regarding foreclosures and short sale on personal residences as well as last week's issue on foreclosure of rental properties. Unfortunately, I have not written anything yet regarding short sale on rental residences. In this article, I will attempt to explain the tax implications of short sale on  rental properties.

    Short sale is an alternative to foreclosure. By definition, short sale is the sale of property for less than the outstanding mortgage and closing costs. While foreclosure as we have defined in my previous article/s,is the process that allows a lender to take title to or force the sale of property in satisfaction of a mortgage. They say short sale has less damaging effects on the individual, especially in our credit reports, compared to a foreclosure. But at this time, this would be anachronistic on our subject matter at hand. Our interest at this time is to dissect and understand the ins and outs of a short sale in a rental property, particularly the tax implications to the taxpayer. 

     To understand the tax side of short sale on rental properties, let's take an example. Let me give credit to the EA Journal where I have researched the material for our illustration purposes.

     Our taxpayer has two rental homes which will be sold short. For both properties combined: (1) The cost is $300,000.00; (2) accumulated depreciation is $45,000, and (3)outstanding mortgages, which are recourse, totals to $220,000.(5) The Fair Market Value (FMV) of both properties combined is $145,000.00. (6) We assume that our taxpayer had made previous arrangement to have his Insolvency Report prepared and determined that he is insolvent by $258,000.00.  (7) If we assume further that the taxpayer is insolvent by more than the debt cancelled (COD), does the cancelled debt (COD) get reported on Form 982 as a non-taxable item? 

            My quick response to this is that whenever a rental home which is secured by a recourse loan is sold short, two things will happen. First, The taxpayer will incur a loss on the disposition of the property. He will need to prepare a report on this sale. Second, he will need to report the income from the cancellation of debt (COD) or its exclusion. 

The COD income will be excluded from the gross income of the taxpayer to the extent that he or she is insolvent. Therefore, in our example above, the taxpayer's insolvency ($258,000) exceeds the debt cancelled,($220,000). Therefore, none of the COD income will ever be included in gross income. Taxpayer is compelled to file Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) which is used to reduce certain tax attributes.

            Let me elaborate further: The short sale of each rental property is reported as if it were just a regular sale. The amount realized upon the disposition is compared with the taxpayer's adjusted basis. To over simplify: The FMV of the property which is used as the sale price, $145,000 less the taxpayer's adjusted basis of $255,000 ($300,000 less accumulated depreciation of $45,000) gives us a negative difference of  $110,000. This difference is reported as a loss from the (short) sale of the rental property using Form 4797 (Sale of Business Property Part 1). Please remember that this is a Sec 1231 ordinary loss and  not a capital loss.

            The second part is the COD Income. I cannot overemphasize the fact that there is no COD income since the amount of insolvency will exclude all COD income implication.

            While we have presumed insolvency in our example above, another possibility to exclude income in such a situation is by virtue of bankruptcy which is provided under Sec 108(a) of the Internal Revenue Code. This exclusion, through bankruptcy, in the same manner as in an insolvency case, must also be claimed on Form 982.

            At this point, let me play some trivia.  I have intentionally not covered in this article, and in any articles I have written in the past, wherein the short sale or foreclosure of a rental property will actually lead to an exclusion of income by virtue of bankruptcy, but where the taxpayer realized capital gains in the transaction? The question or trivia, I will pose to you at this time is: In the event of bankruptcy, will the capital gains realized in a short sale or foreclosure on a rental property be taxable or will it be excludable from the gross income of the taxpayer?

            You guys research that or see your tax professional for the answer or see me at my office so we can debate on this topic. Good luck in your hunt for the answer