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WHEN AN INVESTMENT PROJECT GOES BAD

June 06, 2008

So you bought a fixer-upper with your spouse. It seemed like a sure thing. Real estate prices seemed to only go up. You bought it with borrowed money, so the risk was all the bank's, but the profits were all yours. Then things got complicated:

The couple borrowed $256,000 for the purchase of the property, only to realize shortly thereafter that not only did they not like each other, but they also could not make the payments. Rather than falling into foreclosure and ruining their credit, they entered into a short-sale agreement with the lender and, in 2003, found a buyer willing to purchase the property for $200,000.

In short, the bank forgave the $56,000 difference, plus the costs of sale and accrued interest. The bank sent 1099-C forms to the no-longer-happy spouses, as the tax law required. But the taxpayers didn't report the debt forgiveness as income.

WHEN REAL ESTATE DEBT CAN BE FORGIVEN TAX-FREE

The tax law generally requires you to report any forgiven debts as taxable income. There are exceptions for insolvent taxpayers and taxpayers in bankruptcy. There are also two specialized exceptions for real estate indebtedness.

First, debt for "qualified real property business indebtedness" can be forgiven tax-free, unless you are a C corporation. This is debt that is incurred to purchase or improve real property used in a trade or business, including the business of operating or managing real property. The taxpayer has to elect this treatment for it to apply.

Second, home mortgage debts up to $2 million can be forgiven tax-free through 2009 if it is related to the decline in value of the house.

Unfortunately for the star-crossed couple, the property wasn't a principal residence, they didn't elect the qualified real property business debt exclusion (and it may not have applied in the first place), and they apparently weren't bankrupt or insolvent.

So how was this taxed? They had debt forgiveness income - according to the Tax Court, the actual number came out to over $70,000 They had a capital loss of about that much, but you can only deduct those to the extent of your capital gains, plus $3,000. Bottom line? The Tax Court says tax is due.

Cite: Stevens, T.C. Summary Opinion 2008-61

Tags: debt forgiveness.mitchell port.