I previously wrote about the tax impact of a short sale or foreclosure on your primary residence, but what about rental properties?  

If you aren’t insolvent, then you need to look at the new rules for possible exclusion of debt discharged from your gross income.  This is a bit more sticky than the primary residence rules, so I’ll try to make this a simple as possible.   These exclusions are available under IRC code section 108 which is not new like the primary residence exclusion. 

You must make an election on Form 982 with your federal tax return on which the debt cancellation is reported to take advantage of these exclusions. 

• The rental activity must qualify as a trade or business activity as opposed to an investment activity
• The debt must be related to real property use in business (rental properties most likely qualify if rented to an unrelated party at fair market rental value)
• These rules apply if you are solvent (meaning not bankrupt or insolvent)
• The excludible amount from any cancelation of debt on real property is limited by the lesser of
  • The excess debt over the fair market value of the property
    • For example, if you owe $500,000 and the property is worth $450,000, the most that is excluded from income is $50,000
  • Or your basis in the property (purchase price + improvements – depreciation taken)

Examples are the easiest way to show how this works, so let’s look at a few: 

Example 1:

Shannon did a short sale on her office condo which she rented to an unrelated party. Here are the numbers:         

                       Shannon’s tax basis in office condo:                      $320,000

                       Mortgage on date of short sale:                             $300,000

                       Fair market value of the office condo:                    $200,000

                       Office condo sold for:                                             $200,000 

                       Debt forgiven (COD):                                             $100,000 

Amount of COD excluded from income for tax purposes is $100,000 ($300,000-200,000) and reduces her basis by $100,000.  She also has to consider the sale effect for tax purposes: 

                       Sale price:                                                             $ 200,000

                       Less basis ($320,000-100,000):                             (220,000) 

                       Tax loss of                                                             $( 20,000) 

 Example 2: 

Sarah did a short sale on her office condo which she rented to an unrelated party. Here are the numbers:   

                        Sarah’s tax basis in office condo:                         $240,000

                        Mortgage on date of short sale:                           $300,000

                        Fair market value of the office condo:                  $250,000

                        Office condo sold for:                                           $200,000 

                        Debt forgiven (COD):                                           $100,000 

Amount of COD excluded from income for tax purposes is $50,000 ($300,000-250,000) and reduces her basis by $50,000.  The remaining $50,000 of COD is taxable income.  She also has to consider impact of the sale for tax purposes: 

                         Sale price:                                                            $200,000

                         Less basis ($240,000-50,000):                            (190,000) 

                        Taxable gain                                                          $ 10,000

 These are generic examples that may fit your situation.  You should consult with a professional if you are dealing with debt forgiveness (cancelation of debt) income.  There are several facts to take into consideration when calculating the tax impact of this event.

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