A caller asked me whether imputed income after a foreclosure on an investment home when the owner had taken the home off the rental market for a year before the foreclosure. I’ve written previously on this about the income tax effect of foreclosure and 1099 debt forgiveness on rental properties. I’ve stated that my own accountant, Mr. Lonnie Young of Lake Mary, Fl, told me that 1099 income on rental property can be offset by investment losses so that foreclosure and debt forgiveness usually will not increase income taxes. This caller was concerned that his removal of the property from the rental market and subsequent vacancy, would disqualify the property as a "rental property."
I posed this question to Mr. Young. Here is a summary of his explanation of the general income tax rules for mortgage foreclosure and his answer to the caller's question. Assume one real estate investor (I’ll call him "Moe") purchases non-income producing property, such as vacant land, and his friend (I’ll call him "Larry") invests in income producing rental property, such as vacant land.. Assume that both Moe and Larry lose their properties at foreclosure sales, that both properties are "upside down" and that both taxpayers receive a 1099 income form from their respective lenders representing imputed income for debt forgiveness.
Mr. Young explained that Moe’s investment in non-income producing property is a capital investment for future appreciation. Moe’s losses in his real estate investment is a "capital loss" which can offset his capital gains for that year, but Moe’s capital loss greater than his capital gain for same year can offset only a small amount ($3,000) of other income in that year, with the balance carried forward to future years.
Larry’s investment in his rental property is a business for production of income; this investment is similar for taxes to other typical small businesses such as a landscape business or flower shop. Any losses Larry incurs in his business may offset any other income Larry earns that year. Therefore, Larry can offset his 1099 income from the foreclosure sale with the full loss he incurred which is at least the difference between his adjusted tax basis and the lower fair market value at time of foreclosure sale.
If, after foreclosure, the mortgage company did not issue a 1099 statement Larry might still claim a loss against his other income that year, but if in later years the mortgage company did issue a 1099 then Larry would realize imputed income without an offsetting loss having previously deducted the loss. Mr. Young said that regardless of whether Larry’s lender issues a 1099 Larry can recognize the imputed income and offsetting loss in the year of the foreclosure sale.
If, as in the case of the caller mentioned above, Larry removed the house from the rental market because he could not find a suitable tenant, or if management and maintenance expenses exceeded market rents, for example, Mr. Young believes Larry’s property would still be business rental property in most cases. If Larry originally purchased the property to produce rental income the property would retain its "business nature" even if market conditions led to operating losses.
This is all I know about the income tax effect of foreclosure on upside down investment property. Please don’t ask me any more questions. If you have any questions you should call your CPA, or if you don’t have a smart CPA, then call Lonnie Young. 407 936-2500.
