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Debt relief for rental property?

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POSTED December 20, 2013 6:37 p.m.

Q:   I am hoping you can clarify debt relief as it applies to rental property.

My sister has a single family residence that she rents out and is now letting the house follow the path to foreclosure.  She received info from a real estate attorney that didn’t make sense to me nor could I find any information that substantiated the info. He indicated that she would not have to pay any tax if the house sold at a foreclosure sale for less than the mortgage. It would be great if that was correct but I want to be sure my sister gets accurate information;  otherwise she could have a huge tax bite in the near future.

I can only find information about not having to pay tax (or relief of tax debt) if the property is your primary residence.  I can’t find any information that applies this to a rental property. Patty.

A:  Dear Patty.  I cannot provide specific legal advice in my column so I narrowed your question to the one issue: does the mortgage forgiveness law apply to investment properties? And the answer is no. I suggest that you consider finding another attorney.

Oversimplified, if you have a mortgage loan that is foreclosed upon, if the sale does not generate enough money to pay off the entire loan balance, you may have to pay income tax on the difference between the sales proceeds and the loan balance.  The IRS (and the tax law) calls this cancelled debt “taxable income”; I call it “phantom income”.

There are several exceptions where such cancelled debt is not taxable. If you file for bankruptcy relief, debts discharged by the bankruptcy judge are not considered taxable income. If you are insolvent when the debt is discharged, there is no tax to pay.

In 2007, when foreclosures started escalating, Congress enacted the Mortgage Debt Relief Act. This new law excludes from income any loan modification, or any deficiency created when the house is foreclosed.

Although the law initially was to expire at the end of 2012, Congress extended the deadline to the end of 2013.

However, the law only applies to debt that is cancelled on your principal home. So Patty, depending on how much the cancelled debt will be, your sister may want to find another approach. She can do a short sale which most likely will trigger some phantom income, but hopefully such a sale will generate more revenue than a foreclosure. She can also consider filing for bankruptcy relief.

The IRS has a publication that is fairly helpful. (Publication 4681, “Canceled Debts, Foreclosures, Repossessions, and Abandonments”, available free of charge on IRS.gov/publications. 

Q:   My daughter went through a deed-in-lieu during 2013 with her lender  for her condo in Illinois. Is it likely she will receive a form 1099 for the amount of the mortgage that was owing at the time of the foreclosure?

If so, is it possible to prevent the bank from filing and sending a 1099?

Many thanks, enjoy your columns. Dave.

A: Dave: Your question turns out to be a follow up on the question just above yours, so I also refer you to the IRS publication. If I understand your concern, you would prefer that the IRS not know of the deed-in-lieu, so that your daughter will not have to pay what I have called “phantom income”.

But I have some good news for you. If the debt cancellation is more than $600 – which I assume is the case – the lender must send out Form 1099 -C (stands for “cancellation”) by the end of January, 2014. That form will show the amount of the debt that presumably was cancelled. Your daughter will have to file form 982 with her 2013 income tax return.

But the condo was your daughter’s principal residence, then under the Mortgage Debt Relief Act, your daughter does not have to pay any tax on this “phantom income”. According to the IRS, “if you are using (form 982) only to report the exclusion of forgiveness of qualified principal residence indebtedness... you only need to complete lines 1e and 2.”

Note that I used the word “presumably” was cancelled. There is a legal question currently working its way through a number of courts, asking whether the lender – by sending in a form 1099 – really has cancelled – forgiven – the balance of the loan?

My advice to anyone engaged especially in a short sale or a deed in lieu, get a statement in writing from the lender that you will be relieved of all further obligations and that the promissory note that you initially signed when you obtained the loan will be marked “paid and cancelled” and returned to you.

Q: We have our house deed titled in our two trusts. We have our will designating our two children as beneficiaries. Could there be any problem because the deed is in our trusts? Sumitra.

A: Dear Sumitra. Yes, there is a problem. Since your house is legally owned by the trustees of your trust, then the terms in the trust document control how the property will be distributed – and not the Last Will and Testament. You need to make sure that the Trust Agreements provide for the house to be distributed to your two children.

Q: I was reading your column and you mentioned a hard money loan.  Do you know any companies that make these types of loans to homeowners?  Also, the person that wrote in mentioned how Zillow valued his home at much more than what he paid for it 16 months before.  I am in the same situation.  Do you think he could sell his home for over a hundred thousand dollars more in just 16 months? Does Zillow and Trulia give accurate estimates?  I would really appreciate your answers.  Thanks Jackie.

A: Dear Jackie. First, I do not recommend any company, or any lender. You will have to find that on your own. But if you really believe that your house has gone up significantly in value, unless your credit history is really bad, you should explore traditional lenders before going the hard-money route. There are legitimate reasons to use such a lender, but shop around for the best deal before you commit to any one.

As for the various companies that give estimates, I received the following from a reader:

“You ran a piece in which the writer said they recently purchased and shortly after the ZILLOW value was considerably higher.  Your answer was very lawyerly but you let the Zillow issue off the hook.

“I am a County tax assessor and have seen far too often where owners believe the estimates of the Zillow engine. The writer thought he had over $100K gain in this market in 16 months. We should all be so lucky.   I like to use Zillow and Trulia for information. My impression is that they generalize by geography. For instance they estimated my neighbor who was on the multiple listing at $183,000 in the low to mid 300s.  Nothing in my neighborhood is even $200,000 however the subdivision does have $300,000 homes. The estimation engine was not able to discern the value boundary.

Bob Kahman, Supervisor of Assessments    McLean County, IL

This is not in any way an indictment or criticism of those companies who assess property values; only a note to be cautious and not completely rely on those estimates. Appraising property values is not really a science but an art. The appraiser - or in Mr. Kahman’s assessments – must use a lot of data (including that from Zillow or Trulia)  to determine the value of a particular house.            Q: You often refer to the tax  basis. Exactly what is this? Penny.

A: Dear Penny. Great question. The IRS defines it as the amount of your capital investment in property for tax purposes. In real estate, it is the cost of your house. What is its’ significance? It is used to determine the amount of profit (or loss) you have made when you sell. Oversimplified, you take your sales price, less legitimate selling expenses to get what is known as the “amount realized”.

Then you take your basis, add legitimate expenditures to get “adjusted basis”. Then, you subtract that adjusted basis from the amount realized to determine your gain or loss.

As you can see, the higher the “adjusted basis” is, the less gain you will have and – assuming that you have to pay capital gains tax – there will be less tax to pay.

You can add to basis major improvements you made to your house. You can also include settlement fees and closing costs, such as owners’s title insurance, legal fees associated with the transaction, and real estate sales commissions.

For a more comprehensive analysis of basis, the IRS has two publications (both available free of charge from IRS.gov/publications). “Selling Your Home”, #523; and “Investment Income and Expenses”, #550.

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