Investors face a different tax landscape than your average, underwater, homeowner. While it is politically popular to support owner occupants (between tax credits and no tax on debt forgiveness), investors are left to fend for themselves. As such, investors must be much more conscious of the consequences of short sales and foreclosures.
It doesn’t matter if you are a reluctant landlord or intentional investor, you will most likely be treated the same – as a highly sophisticated, high net-worth individual, with a ready team of attorneys and accountants to help you navigate the tax code minefields. However, most real estate investors for single-family residential property don't have LA Law working on their side. So, here are a few thoughts to ponder.
Debt “forgiveness” is simply the bank’s way of saying that they are writing off your loan as a loss (short sale or foreclosure) and going to claim that to their advantage for tax purposes. You will receive a 1099-C (Cancellation of Debt) with a declaration of the difference between what you owed and what the bank actually collected. This debt cancellation is essentially considered as income to you and normally taxed as such.
You need to be concerned with both federal tax laws and your state tax laws. Naturally, tax laws, especially with respect to debt “forgiveness”, vary by state and the states do not necessarily match federal.
Under the Emergency Economic Stabilization Act, for federal tax purposes, an owner occupant (i.e., of your principal residence) can exclude the cancelled debt from their taxable income (to certain limits) providing it occurs prior to the end of 2012. In states such as California, you are still liable for state income taxes.
However, if you are dealing with income property, then these benefits do not apply and now you have not only your state income taxes, but also federal income taxes to consider.
As an example, a client came in the other day for consulting. Her real estate agent was going to help her get out from under an excess $500 / month loss on one of several investment properties. The client is looking at a short sale wherein the property is $310,000 upside-down. Although technically it is not the agent's responsibility, the agent didn’t think she needed to worry about the tax consequences – she would have all year to figure it out.
He seemed to think it inconsequential. But instead it is a rather substantial amount. Taken in isolation and ignoring all additional expenses of selling, debt cancellation of $310,000 will cost her $26,525 in California taxes and $87,443 in federal taxes, for a total of $113,968 or 36.76% of the cancelled debt. That tax obligation seems rather onerous, especially considering the client cannot afford the $500 / mo. In fact, it she could pay the taxes at a $500/mo rate, it is equivalent to a 19-year mortgage.
The only possible out is not a pretty picture. One IRS article states, “Normally, you are not required to include forgiven debts in income to the extent that you are insolvent. You are insolvent when your total liabilities exceed your total assets.”
As an investor, be sure you are fully aware of the tax consequences for your properties, and / or be sure you consult your accountant, first.
Nothing in this post should be considered tax advice. Consult your tax professional for your situation.
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