Many people have questions regarding the tax consequences of debt forgiveness on rental or investment real estate. During the real estate boom many investors made significant investments in real estate only to find themselves losing them through foreclosure or short sales. There can be significant tax consequences for many of these investors. Dealing with tax issues associated with rental or investment property can be challenging. Taxpayers need to make sure that they seek the assistance of a CPA or other qualified tax professional.
Whether or not there is forgiveness of debt income first depends on whether the mortgage debt is recourse or nonrecourse. Debt is recourse if you are personally liable for the debt. Debt is nonrecourse if the property itself is the only collateral for the debt instrument and the lender may not pursue a deficiency against the owner. For nonrecourse debt, since the lender can only take the property itself in satisfaction of the debt, there is no debt forgiveness. For recourse debt, once the property is sold or foreclosed and the lender agrees to forgive the remaining balance of debt, income from debt forgiveness must be addressed.
For a rental property, the tax accounting can get complex. When a rental property is foreclosed or sold through a short sale the owner must address both the debt forgiveness and the gain or loss on the sale of the property.
If the debt is nonrecourse debt, the amount of the outstanding debt is used as the sales price and the basis is then subtracted. The basis is normally the purchase price less the allowable depreciation (but may include other adjustments). Since the mortgage is nonrecourse there is no debt forgiveness income. Accordingly, the loss is the only transaction that is reported on the tax return.
If the debt is recourse debt, the calculation is a little different. Let’s assume that upon foreclosure of the property the lender forgives the remaining debt balance. You must first calculate the gain or loss on the disposition of the property and then calculate any taxable debt forgiveness income. Since it is recourse debt, the sales price is the fair market value of the property and then you subtract the basis. Since the lender forgave the remaining debt balance (difference between the outstanding debt balance less the property’s fair market value), this amount will be taxable income (unless another exclusion applies).