Foreclosure ATG - Chapter 5 - Rental Real Estate Property
Publication Date - February 2015
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
- Qualifying Dispositions under IRC §469(g)
- Non-qualifying Dispositions under IRC §469(g)
- Depreciation Recapture
- Character of Property at Disposition
- Lease with Option to Buy Property
- Rental Audit Strategies
In addition to the rules discussed earlier, if the property is rental real estate property, current and suspended passive losses should be considered. Losses are not allowed unless the disposition is a qualifying disposition under IRC §469(g)(1)(A).
Qualifying Dispositions under IRC §469(g)
A taxpayer must dispose of his entire interest in the activity in order to trigger the recognition of loss. If he disposes of less than his entire interest, then the issue of ultimate economic gain or loss on his investment in the activity remains unresolved. A disposition of the taxpayer's entire interest involves a disposition of the taxpayer's interest in all entities that are engaged in the activity, and to the extent held in proprietorship form, of all assets used or created in the activity. . . . If the taxpayer has adequate records of the suspended losses that are allocable to that activity, and includes in income the gain (if any) allocable to his entire interest in the activity, such losses are allowed in full upon the disposition. IRS CCA 201415002; 2014 IRS CCA LEXIS 29.
If the taxpayer has a qualifying disposition under IRC §469(g), the current and suspended passive losses on the activity are allowed in full assuming the taxpayer has basis and at-risk. The three tests under IRC §469(g) that must be met as a qualifying disposition are:
- Disposition must be made to an unrelated party (IRC §267) and
- The disposition must be fully taxable. All gain/loss must be realized and recognized (a foreclosure is considered a fully taxable disposition) and
- The property must be disposed of entirely or substantially (Treas. Reg. §1.469-4).
Cancellation of debt income is added to gross rents received on Form 1040 Schedule E, when the debt is related to non-business, non-farm rental of real property. The cancellation of debt income is reported on Form 4835 for certain farming rental activities.
Chief Counsel Advice Memorandum IRS CCA 201415002; 2014 IRS CCA LEXIS 29 provides detailed guidance on the interaction of sections 108 and 469(g) of the Internal Revenue Code. The memorandum addresses whether a foreclosure on real property subject to recourse debt comprising a taxpayer's entire interest in a passive (or former passive) activity qualifies as a fully taxable disposition for purposes of IRC §469(g)(1)(A), where the foreclosure triggers cancellation of indebtedness (COD) income that is excluded from gross income under IRC §108(a)(1)(B).
Chief Counsel concluded that a foreclosure on real property subject to recourse debt comprising the taxpayer's entire interest in a passive (or former passive) activity is a fully taxable transaction for purposes of IRC §§1001 and 469(g)(1)(A), regardless of whether any CODI from the cancellation of recourse debt is excluded under IRC §108(a)(1)(B). Thus, the losses from the activity are treated as not from a passive activity under IRC §469(g)(1)(A). Additionally, these losses are not reduced by any excluded CODI under IRC §108(b)(2)(F).
Multiple examples are provided in this CCA to illustrate the interaction of sections 108 and 469(g) of the Internal Revenue Code. For example, Taxpayer A has disposed of the property in a fully taxable transaction under IRC §1001 and realizes and recognizes $25,000 of gain on the foreclosure. Thus, the transaction is a fully taxable transaction for purposes of IRC §469(g)(1)(A), and the $100,000 of suspended passive losses are treated as losses not from a passive activity under IRC §469(g)(1)(A). Additionally, Taxpayer A may exclude the $75,000 CODI from the cancellation of the recourse mortgage under IRC §108(a)(1)(B) because A is insolvent to the extent of $200,000.
Taxpayer A does not reduce the $100,000 of non-passive losses by the $75,000 CODI excludable under IRC §108(a)(1)(B). Under IRC §108(b)(2)(F) any CODI from the taxable year of the discharge reduces any passive activity loss and credit carryover of the taxpayer under IRC §469(b) from the year of the discharge. However, under IRC §108(b)(4), reductions to tax attributes required by IRC §108(b) are made after determination of tax for the year of discharge.
In this case, in determining Taxpayer A's tax for the year of the discharge, all previously suspended losses under IRC §469(b) are freed-up and fully allowable upon the taxable foreclosure. Therefore, there are no remaining IRC §469(b) suspended loss carryovers that are reduced under section IRC §108(b)(2)(F).
Revenue Ruling 92-92, 1992-2 C.B. 103 states that, "For purposes of section 469 of the Code, COD income is characterized as income from a passive activity to the extent that, at the time the indebtedness is discharged, the debt is allocated to passive activity expenditures". Any amount of the debt that was not used for passive activities is allocated to nonpassive activities.
Non-qualifying Dispositions under IRC §469(g)
When a disposition is non-qualified, the current and suspended passive losses on the activity remain on Form 8582 until passive income is reported.
The following do not qualify as fully taxable dispositions (not an exhaustive list):
- Abandonment (qualifying disposition if abandonment rules are met in IRC §165).
- Bankruptcy which has not been finalized; IRC §1398(f)(1), Treas. Regs. §§1.1398-1(c) and (d)(1).
- Related party transfers.
- Rental property converted to personal use.
- Transfer due to divorce (treated as gift; IRC §469(j)(6) & §1041(b)).
- Foreclosure of a property with recourse debt where the foreclosure sale has not occurred This is not a qualifying disposition under IRC §469(g) and any losses (disposition or suspended operational) are not currently deductible.
- Loss on foreclosure of a rental property where the taxpayer has aggregated rentals. Disposition of one rental is not "complete" under IRC §469(g). In years that a taxpayer is NOT a real estate professional, the election under Treas. Reg. §1.469-9(g) is not binding.
There is no depreciation recapture for IRC §1250 property for which ACRS or MACRS depreciation deductions are computed using the straight-line method. Depreciation must be recaptured if straight-line method was not used. The recapture amount is treated as ordinary income.
Depreciation recapture for IRC §1250 property generally is the lesser of the additional depreciation or the excess of the amount realized (in the case of a sale, exchange, or involuntary conversion) or the fair market value of such property (in the case of any other disposition), over the adjusted basis of such property.
Additional depreciation is the depreciation claimed or for property held more than one year, the excess of the depreciation actually claimed over the amount that would have been claimed had the straight-line method been used.
The basis reduction special rule for depreciation is determined before any basis reduction. Basis reductions, when CODI is excluded from income, are treated as depreciation for purposes of the depreciation recapture provisions, IRC §1017(d)(1)(B), even if the property otherwise would not be subject to those provisions, IRC §1017(d)(1)(A).
Character of Property at Disposition
IRC §1221 provides in part that the term capital asset means property held by the taxpayer (whether or not connected with his trade or business) but does not include property, used in a trade or business, of a character which is subject to the allowance of depreciation provided in IRC §167.
IRC §1231(b)(1) provides in part that the term "property used in a trade or business" means property used in a trade or business, of a character which is subject to the allowance of depreciation provided under IRC §167, held for more than 1 year.
The disposition of investment property, second home, vacation home, and personal residence are all reported on Schedule D. The disposition of rental real estate property that is not a trade or business is also reported on Schedule D. The disposition of rental real estate property that is a trade or business is reported on Form 4797.
Lease with Option to Buy Property
If a rental agreement gives the tenant the right to buy the rental property, the payments received by the lessor under the agreement are generally rental income. If the tenant exercises the right to buy the property, the payments the lessor receives for the period after the date of sale are considered part of the selling price.
Example 30. Martha operated a Schedule C business as a divorce attorney and she is not a real estate professional. In 2005, she took out a recourse loan for $800,000 and purchased an apartment building as an investment. A property management company managed the property. During 2008 through 2010, some of the tenants moved out and others were evicted when they stopped paying rent. In 2009, Martha applied for a loan modification that was declined due to the low rents. In 2010, she depleted her savings and was unable to pay the mortgage, therefore, the lender foreclosed on the property in 2012. The property was sold in 2012 for $460,050 and Martha was issued a Form 1099-C with a forgiveness of debt of $189,950.
Immediately before the foreclosure, the recourse loan balance was $650,000, the FMV of the apartment building was $460,050, adjusted basis was $704,545, and suspended passive losses were $65,364.
Martha's 2012 cancellation of debt income is $189,950 ($650,000 outstanding loan balance minus $460,050 FMV). Martha's rental real estate income reported on 2012 Schedule E is $74,586 ($50,000 gross rents plus 189,950 other rental income, CODI, minus $100,000 rental expenses minus $65,364 prior years' passive losses).
Martha's realized loss from the foreclosure sale of the apartment building in 2012 was $244,495 ($460,050 amount realized (FMV) minus $704,545 adjusted basis add zero depreciation recapture in excess of straight line).
Martha would report $189,950 of CODI on Schedule E in 2012 as additional rent and she would report the disposition loss of $244,495 on Schedule D. The capital loss deduction would be limited.
Example 31. Charlie owned and rented a single family residence that he used in his business as a real estate professional. He did not make the election under Treas. Reg. §1.469-9(g) to group his rental properties. He purchased the residence in 2000 for $480,000. Later, he refinanced the recourse loan and received $30,000 that was used to make improvements on the property. In 2012, the outstanding loan balance was $470,000 and Charlie faced difficult health and financial challenges and returned the property to the lender through an approved deed in lieu of foreclosure agreement. Although, a Form 1099-C was not issued, the lender forgave $20,000 in 2012 according to the agreement. The home was sold in 2013. Charlie was insolvent by $65,000.
At the time of the deed in lieu of foreclosure agreement, the fair market value was $450,000, adjusted basis was $425,000 and suspended passive losses were $35,364. Although, a Form 1099-C was not issued, Frazier v. Commissioner 111 T.C. 243, 246 (1998), will be relied upon and $20,000 is income from the discharge of indebtedness per IRC §61(a)(12).
However, the entire $20,000 of cancellation of debt income is excluded from income under the insolvency exclusion. The insolvency exclusion takes precedence over the qualified real property business exclusion.
Charlie's recognized ordinary gain for the deed in lieu of foreclosure disposition reported on Form 4797 is $25,000 ($450,000 FMV minus $425,000 adjusted basis add zero depreciation recapture in excess of straight line). Although, the loan is recourse, the outstanding loan balance was resolved through the deed in lieu of foreclosure agreement. The outstanding recourse loan was resolved despite any future sale of the property.
Passive losses are released upon the disposition of the property in 2012, the year that the deed in lieu of foreclosure agreement is made and the resolution of the outstanding recourse loan balance is made. Charlie's passive losses from this rental are $45,795.
The disposition of the property is a qualifying disposition under IRC §469(g). The disposition is reported on Form 4797 in Part III. Charlie is also allowed to exclude $20,000 CODI under IRC §108(a)(1)(B) and deduct all passive losses of $45,795 incurred from the property.
Charlie is required to reduce tax attributes owned on January 1, 2013 by $20,000, in the order identified in IRC §108(b) under the insolvency exclusion. By excluding CODI, Charlie has essentially deferred any tax associated with the excluded CODI amount by reducing any tax attributes. Under IRC §108(b)(4)(A) attributes are reduced after taxable income is determined.
Tax attributes owned on January 1, 2013 are an NOL carryover for 2012 of $5,000, a 2011 NOL carryover of $3,000, and a 2012 capital loss carryover of $12,000. The tax attribute reductions are shown in the following table.
Note: The following presentation of tax attribute reduction is not meant to imply that CODI is reduced, but only used to demonstrate the amount of tax attributes reduced. Under IRC §108(b)(1) the amount excluded from gross income shall be applied to reduce tax attributes.
|Minus 2012 NOL carryover (2012 F. 982 line 6)||5,000|
|Minus 2011 NOL carryover (2012 F. 982 line 6)||3,000|
|Minus 2012 Capital loss carryover
(2012 F. 982 line 9)
In summary, CODI excluded from 2012 rental income under the insolvency exclusion is $20,000 and the January 2, 2013 tax attribute balances are zero ($5,000 2012 NOL minus $5,000 NOL tax attribute reduction), zero 2011 NOL ($3,000 2011 NOL minus $3,000 tax attribute reduction), and zero 2012 capital loss carryover ($12,000 capital loss carryover minus $12,000 tax attribute reduction).
Because the facts and circumstances of each taxpayer may be unique, the passive rules could be applied slightly differently in every examination. Refer to the Passive Activity Loss Audit Technique Guide for a complete discussion on passive activity loss activities or contact a Passive Activity Loss Technical Advisor.
Rental Audit Strategies
- When CODI, Form 4797 gain/loss or Schedule D gain/loss, and Schedule E gain/loss for all years are netted, you arrive at an overall gain or loss. If this is a loss, ask yourself whether the taxpayer is "poorer" by that amount. If the taxpayer could not afford to sustain that loss then how were the losses funded (e.g., other debt, current year income, other assets)?
- Sometimes taxpayers attempt to convert their principal residence into rental real estate property right before it forecloses and deduct losses. A temporary conversion may not be a true rental activity and loss from the foreclosure would be a non-deductible personal loss. In addition, expenses (e.g., property insurance) would generally be non-deductible personal expenses. It is important to ascertain the facts and circumstances surrounding the reasons for converting the residence to a rental to determine if it was a principal residence, second home or rental property. In MaDan v. Commissioner, (T.C. Memo. 1986-7), the petitioners listed their vacant home with three different realtors as "For Sale or Rent.". The court ruled, "even if exclusively for rent would not be sufficient to establish a profit motive". Whereas, in Sherlock v. Commissioner, (T.C. Memo. 1972-97), the court held that a bona fide intention to rent the vacant residence was converted for the production of income even though, it was never rented. One factor the court relied upon was the taxpayer's willingness to accept low rent.
- What efforts did the taxpayer make to rent the property? Has the taxpayer provided any documentation of the time spent attempting to the rent the property? Has the taxpayer provided copies of advertisements, listing agreements or other evidence that the property was in fact held out for rent?
- Insurance policies. This should reflect if the property is a rental, personal residence, vacant investment, etc.
- If applicable, how was the property taxed? For real estate property taxes, what is the taxpayer telling the local assessor as to the use of the property? Rental? Vacant? Personal?
- Non-issuance of a Form 1099-C does not relieve a taxpayer of their responsibility to include CODI in income. Identify all loans on the property through internal records and/or property records. All loans should be considered in the CODI and gain/loss calculations. Review internal records from one or two years prior to the foreclosure to identify other debt associated with the foreclosed property. The taxpayer may not have a Form 1098 issued for interest paid in the year of foreclosure, because they made no payments.
- Consider state foreclosure laws of where the property is located. State laws govern foreclosure actions by the lender which will determine the date of sale.