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Taxation of Short Sales, Deeds-in-Lieu and Foreclosures: One More Technique | By: John Hyre

Cancellation of Debt (COD)

Taxation of Short Sales, Deeds-in-Lieu and Foreclosures: One More Technique

By John Hyre, Tax Attorney, Accountant, Real Estate Investor

In our ongoing discussions on reducing taxes we examined several ways to avoid or reduce taxable income from Cancellation of Debt, also known as “COD Income”.

COD income is generally an issue when a lender explicitly forgives all or part of a debt (such as occurs during a short sale, for example) or implicitly does the same (in a foreclosure where no “deficiency judgment” is obtained, for example). I omitted one big exception to COD income for investors who sell short, give a deed in lieu or face foreclosure: The exception for “Qualified Real Property Business Indebtedness”.

Here’s how it works:

1. Internal Revenue Code Section 108(a)(1)(D) provides that COD Income can be forgiven in whole or in part for taxpayers (except C-corporations) if the debt in question is “Qualified Real Property Business Indebtedness”. That name is a real mouthful, so we will call it QRPB Debt for the rest of this article.

2. Assumed or Incurred in Connection with a Trade or Business: To be excluded from income (In other words, “not taxed”), QRPB Debt must have been incurred or assumed in connection with real property used in a “trade or business”.

a. Trade or Business Need Not Be An Real estate Business:

Note that this rule does not require that the debt have been assumed in connection with a real estate trade or business. Rather, the requirement is that the debt on the RE was incurred in connection with any trade or business. For example, debt on an office purchased by a doctor for his practice would likely be considered as having been acquired with respect to a trade or business.

b. Rental Activity Does Not Always Rise to Level of a “Trade or Business”: The term “trade or business” is what lawyers call a “term of art”. In English, it is a blurry concept without a sharp definition, the sort that “you’ll know when you see it”. In general, for rentals to qualify as a “trade or business”, the landlord needs to be quite “hands on” (e.g., deal with tenants directly, do some maintenance directly, have enough rentals that running managers and contractors takes significant direct involvement, etc.). The decision whether a landlord is “hands on enough” is quite grey and normally requires some analysis by tax advisors familiar with real estate.

c. Timing: Whether a debt on a property was incurred or assumed “in connection with” a property used in a trade or business is determined at the time a debt was incurred or assumed. Generally, if a debt is secured by a property, then the debt was incurred or assumed in connection with that property.

3. Secured by Real Property Used in Trade or Business: At the time the debt is forgiven, it must be secured by real property used in a trade or business.

4. Qualified Acquisition Indebtedness: If incurred or assumed after 1992, the debt must be “qualified acquisition indebtedness”, which is debt used to acquire, construct, reconstruct or substantially improve the property used in the trade or business.

5. Make Election: This loophole does not automatically take effect; the taxpayer must elect to use it on the tax return for the year that the COD income arises.

6. Limit on COD Income Forgiven: The amount of COD income forgiven cannot exceed the balance on the loan forgiven (just before the forgiveness) minus the FMV of the property just before the forgiveness. The FMV of the property is reduced by the amount of any other loans that would qualify for QRPD debt and are secured by the same property.

7. Additional Limit on COD Income Forgiven: The amount of COD Income forgiven cannot exceed the adjusted bases (amount invested for tax purposes, less total depreciation taken) of depreciable real property held by the taxpayer just before the forgiveness of the debt.

8. Reduce Basis In Exchange for Debt Forgiveness: If a taxpayer uses this exception to avoid COD Income, the taxpayer’s other depreciable property must be reduced in basis by the same amount as the debt forgiven.

a. For Example: If the taxpayer used this election to avoid taxation of $50,000 of COD Income from a property he purchased in Greenville, SC, then the taxpayer must reduce the basis of other depreciable real property by $50,000. That reduction in basis will reduce the depreciation deductions generated by the property and increase the gain on sale if the property is later sold. HINT: Do not sell such property OR use a tax-free exchange to sell such a property!

John Hyre

This article is brought to you by the Upstate Carolina Real Estate Investors Association. (UCREIA)
Information about UCREIA’s Educational programs can be obtained off this website or by contacting the club’s Dir. of Education, Karla Kuhn

For more information on this topic, contact the author John Hyre;  Tax Attorney, Accountant and Real Estate Investor

Reprinted with Permission

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