Business Foreclosures or Short Sales
October 2009 - In our July 2009 Tax News, we addressed some of the questions we had been receiving related to a foreclosure or a short sale of a personal residence. The other question we have received asks, “What if the foreclosure is on my rental property?”
Generally, when there is either a foreclosure or a short sale, a taxpayer will receive a federal Form 1099-A, Acquisition or Abandonment of Secured Property, and a Form 1099-C, Cancellation of Debt, (in some cases the lender may issue just a Form 1099-C)from the lender which contains information to compute gain or loss, including whether the taxpayer was personally liable for the debt.
The Form 1099A,Acquisition or Abandonment of Secured Property, is issued when a borrower abandons secured property, or when a lender acquires property in full or partial satisfaction of a debt and the property was used as security for the debt.
The 1099C, Cancellation of Debt, is issued once the creditor abandons their right to collect a balance due from the debtor of $600 or more, and there is an identifiable event.
If both occur in the same calendar year, the creditor can file just the Form 1099-C, Cancellation of Debt.
If a borrower abandons secured property, or a lender forecloses on the property, the abandonment or lender foreclosure is treated as a disposition of property. The effect of the disposition will depend on the type of property (business or personal), the type of loan (recourse or non-recourse), the loan balance, the taxpayer’s adjusted basis in the property, and the fair market value (FMV) of the property foreclosed.
Depending on the type of loan, you use the taxpayer's adjusted basis or the loan balance at the date of foreclosure and the FMV of the property.
If the loan on the rental property is a recourse loan, then depending on the facts, you may have cancellation of debt (COD) income, and potentially a reportable gain, in which case you would want to determine if one of the provisions in IRC 108 would apply, allowing the COD income from the discharge of indebtedness to be excluded.
If the foreclosure occurred outside of bankruptcy, the taxpayer is determined to be solvent, and is not a C corporation; they may elect to exclude cancellation of Qualified Real Property Business Indebtedness (QRPBI) income if certain requirements are met (IRC section 108(c)). Under California law, if a taxpayer makes an election for federal income tax purposes that election is binding for California income tax purposes and no separate California election is allowed.
If you make an election to exclude canceled qualified real property business debt from income, you must reduce the basis of your depreciable real property (but not below zero) by the amount of canceled qualified real property business debt excluded from income. The basis reduction is made at the beginning of the year. However, if you dispose of your depreciable real property before the beginning of the year, you must reduce the basis of the depreciable real property (but not below zero) immediately before the disposition.
The Internal Revenue Service has issued several informative articles and publications on foreclosures/short-sales available at irs.gov you may want to refer to.