The unfortunate collapse of the real estate market over the last few years has brought about some challenging tax issues. During this time, I encountered my first Form 1099-C, Cancellation of Debt. Cancellation of debt can be frustrating and difficult to understand if the right questions are not answered. Below are a few questions that may ease the process when encountering debt discharge income, relating to a real estate foreclosure:
- Was the borrower personally liable for the debt; in other words, is the debt considered recourse debt?
- If the answer is yes, then proceed to the following questions:
o What was the fair market value of the property at the time of the foreclosure?
o What was the amount of debt owed at the time of foreclosure?
o Is the taxpayer solvent?
You’ve determined the debt qualifies as recourse debt, now what? The entity should record the fair market value of the property as sales proceeds on the “sale” or transfer of the property to the lender. The basis of this property can then be netted against the fair market value, or sales proceeds, to determine whether there is a gain or loss on the disposition of this property. This gain or loss may be ordinary or investment, depending on the nature of the business activities.
Once any gain or loss has been determined, the remaining difference between the amount of debt due to the lender and the fair market value of the property transferred is recorded as debt discharge income. Next, the taxpayer’s solvency must be taken into consideration.
If the taxpayer is facing bankruptcy or insolvency, the IRS allows for the reduction of certain tax attributes to reduce or eliminate the amount of taxable debt discharge income. These tax attributes include net operating losses, general business credits, minimum tax credits, capital loss carryovers, property basis, passive activity loss and credit carryovers and foreign tax credits.
In the event the taxpayer is determined to be solvent, the ability to make tax attribute reductions is lost and the debt discharge income is taxable. However, one exception applies for the discharge of qualified real property business debt. Generally, real property business debt can be defined as debt related to the real property that is used in the taxpayer’s trade or business and is secured by the real estate. By making this election, the taxpayer must first reduce the depreciable basis of the real property secured by the debt being discharged. Any excess debt discharge should proportionately reduce all other depreciable real property.
If the taxpayer has no personal liability to the debtor, the debt is nonrecourse debt. The entire loan balance at the time of the transfer of the property is treated as sales proceeds on the sale of the property. In this instance, there would be no debt discharge income and the entire loan balance being forgiven contributes to either a gain or loss on the property disposal.
By asking the questions ahead of time, taxpayers can be prepared for the potential tax implications of debt discharge income. Planning not only can make you aware of tax liabilities, it also may present strategies and opportunities to reduce potential tax liabilities. Please contact our office for more information on how we can help you work through the tax consequences of your debt cancellation/foreclosure.