Recent residential and commercial real estate market declines have resulted in many homeowners and business owners being “upside down” on their real estate holdings and the related debt or unable to make their mortgage payments due to unemployment and business slowdowns. In an effort to provide relief to these real estate holders, the federal government enacted legislation to assist taxpayers in alleviating their debt burden when they can no longer maintain their properties, without having to pay tax on the debt relief.
In general, if you settle a debt with a creditor for less than the full amount, or a creditor writes off the debt you owe, the IRS treats the forgiven debt as taxable income. Certain kinds of debt forgiveness, however, qualify for exclusions from income.
Principal Residence Indebtedness
Under the Mortgage Forgiveness Debt Relief Act of 2007, debt discharged during the years 2007 through 2012 on a principal residence, such as mortgage debt, is exempt from taxation within certain limitations. If the loan was secured by your principal residence and was used to purchase, construct or substantially improve the qualified residence, you may exclude up to $2 million of debt. However, this exclusion does not apply to a mortgage securing a vacation home or a home equity loan which is not used for improvements of your principal residence.
The tax consequences of a discharge of qualified principal residence debt can depend on whether the debt is recourse or nonrecourse debt. Recourse debt means the debtor can be held personally liable in the event of default. If the fair market value of the property that secures the loan is not sufficient to cover the outstanding debt balance, the creditor may seek other property owned by the debtor to cover the loan balance. Nonrecourse debt means the creditor can only seize the property that secures the loan.
In a nonrecourse loan, the debtor can simply give up the property and walk away from the loan without being pursued by the creditor, and the property is considered to have been sold for a price equal to the loan balance. In a recourse loan, if the fair market value of the property that secures the loan is less than the loan balance, the borrower may have discharge of indebtedness income. This income, however, is excluded under the tax law as discharge of indebtedness on a qualified principal residence. Unless the debt discharged is greater than $2 million, or gain on the sale of the residence exceeds the gain exclusion (see below), there is no income to recognize in either situation. In most cases, the only difference is how it is reported on your tax return.
If taxpayers are able to keep their principal residence, a discharge of indebtedness on the property will have the same impact for nonrecourse and recourse debt. In both cases, the taxpayer must reduce the basis of the principal residence by the amount of the debt discharge income excluded (up to $2 million). With the taxpayer’s basis in the principal residence now reduced, the question then becomes, what happens when that principal residence is sold? The basis reduction will increase the gain on a sale of that residence, but the tax law excludes up to $250,000 ($500,000 on a joint return) of gain on the sale of a principal residence. A gain greater than those allowances would be recognized as income.
Qualified Real Property Business Indebtedness
A discharge of qualified real property business indebtedness may also be excluded from income for a business taxpayer. This exclusion exists for taxpayers other than C-corporations. The IRS defines qualified real property business indebtedness as indebtedness that is incurred or assumed by the taxpayer in connection with real property used in a trade or business and that is secured by the real property.
To be considered qualified acquisition indebtedness, the debt must have been incurred to acquire, construct, reconstruct, or substantially improve real property in a trade or business. Discharge of other types of debt, other than qualified real business indebtedness, will not qualify for this income exclusion.
The maximum exclusion allowed is the amount by which the qualified acquisition indebtedness exceeds the property’s fair market value. The exclusion cannot, however, exceed the property’s adjusted basis.
The exclusion is not automatic. It must be elected by the business taxpayer on a timely filed tax return (including extensions) for the year in which the discharge occurs.
An issue in the use of this income exclusion for non-C corporation businesses is: Is rental real estate considered a trade or business? The answer is, it depends. The tax law gives us no clear cut definition. The substance of the law on whether the rental of real estate constitutes a trade or business depends on how actively involved the taxpayer is in the rental activity.
The IRS has defined active participation as making “management decisions in a significant and bona fide sense.” This would include the approval of new tenants, deciding on rental terms, approving expenditures, etc. It is clear, however, that in cases where the lessee is responsible for management and expenditures of the property, the related debt will not qualify for the income exclusion.
If you are in a situation where debt on your principal residence or business real estate property is going to be discharged, consult your tax advisor to help you determine whether a discharge of debt, short sale, and/or outright default on your principal residence indebtedness or qualified real property business indebtedness would trigger any adverse tax consequences. Tax consequences can vary greatly depending on the nature of the debt and the actions taken.
As can sometimes be the case, a little planning and communication with your accountant could be the difference between paying more or less when it comes time to file your tax return.
Content contributed by Sam Leder, CPA, Partner with Potter & Company, P.A., a locally based certified public accounting firm offering core services of professional accounting, business consulting, and financial analysis. For more information, contact him at 704-786-8189or visit www.gotopotter.com.