Discussion:Shortsale: Personal residence converted to Rental

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Discussion Forum Index --> Advanced Tax Questions --> Shortsale: Personal residence converted to Rental


Discussion Forum Index --> Tax Questions --> Shortsale: Personal residence converted to Rental

Adam13 (talk|edits) said:

11 May 2010

To preface, I spent several hours sifting through posts here at TaxAlmanac related to this topic. I will say that what I have gleaned from the posts here has been much more valuable than all the source documents from the IRS, and other websites I found via Google, and even my limited RIA subscription.

A special thanks to Dave Fogel, for his contributions and his two excellent articles, which can be found here:
http://fogelcpa.com/Documents/FogelForeclosuresCSEA-2.pdf
http://fogelcpa.com/Documents/FogelRentalForeclCSEA.pdf

Before you post a follow-up question or even your post, you would do us all a favor by reading these articles first. I have drafted a couple in-house memos on the handling of a deed-in-lieu foreclosure in a partnership setting, and I can tell you, it was quite a struggle to figure out where to start and how to end. Dave's articles are top notch and very easy to understand.

I digress, here is my issue, and I thought I'd throw it up here for further clarification, and hopefully for the benefit of others with a similar issue: We have a client who purchased a home in California back in late 2005 for 400,000. He moved during the first part of 2007, and proceeded to rent his former residence starting the late summer of 2007. He has been renting it (or trying to) since that time, and has found that he can't come close to covering his payments. He has taken ~25,000 in depreciation, has an outstanding mortgage of 320,000, and believes he can sell his home for 240,000.

He has asked us what will happen in a short-sale, and here is where I need to cement my understanding (also, want to throw it out to see if any laws, Fed/State) may have changed since many of the previous posts were written. As I understand it, he would qualify for the QRPBI (Qualified Real Property Business Indebtedness §108(a)(1)(D)) exclusion. And his workout would be as follows:

QRPBI = Loan - Proceeds from Sale = 320,000 - 240,000 = 80,000

Image:ShortSaleLoss.png

One caveat I'm not sure about, when you convert a personal home to a rental property, does your cost basis transfer? Or are you required to take the FMV at the date placed into service? Does this result in a non-deductible loss if the FMV decreases? If so, I think the result would be very different, probably resulting in a capital gain (yuck).

Image:ShortSaleGain.png

Thanks!

Tkelly911 (talk|edits) said:

11 May 2010
Can you confirm this is a refinanced loan, and not a purchase money mortgage?

Adam13 (talk|edits) said:

11 May 2010
This actually is a PMM, and not a refi. No seconds or home-equity lines.

I know my example assumes a recourse loan, but that does not hinge on the loan being a refi, but the fact that he holds the property has a rental now.

Tkelly911 (talk|edits) said:

11 May 2010
If it qualified as a non-recourse deed of trust at purchase, it is still a non-recourse loan. The rental status is immaterial. In California, the nature of a purchase money mortgage is fixed at the time it is executed.

Adam13 (talk|edits) said:

11 May 2010
If that is the case, then what follows is that since the loan is non-recourse, there is no forgiveness of debt income, and it is just treated as a sale of investment property?

My final question still remains, is the basis in the rental property the cost or the FMV at the date of conversion?

DaveFogel (talk|edits) said:

12 May 2010
TKelly911 is right. As you may know, section 580b of the California Code of Civil Procedure essentially provides that a loan obtained to purchase real property that is owner-occupied is nonrecourse because the lender cannot pursue the borrower for a deficiency judgment. Several real estate lawyers have told me that if you have property that comes within this section, and you subsequently convert the property into a rental, you are still protected by this section. As a result, the $320,000 loan is nonrecourse, there is no COD income and therefore, no need to consider the QRPBI exclusion.

When a personal residence that is converted to rental property is subsequently sold, you may have one adjusted basis for computing loss and a different adjusted basis for computing gain. The adjusted basis for computing loss is the lower of the original cost or the FMV of the property on the date that it was converted to rental use (also the basis for depreciation), minus depreciation. See Treas. Reg. §1.165-9(b)(2). The adjusted basis for computing gain is the original cost of the property, minus depreciation. See Treas. Reg. §1.1012-1(a). If the selling price in the short sale is between these two numbers, then there is no gain or loss on the short sale.

Although you didn't state so, it appears that the $280,000 in your post represents the FMV of the property at the time it was converted to rental use. There would be no loss since the selling price (the $320,000 debt) minus adjusted basis for loss (FMV of $280,000 minus $25,000 depreciation) is a gain. There would be no gain since the selling price (the $320,000 debt) minus adjusted basis for gain (original cost of $400,000 minus $25,000 depreciation) is a loss.

Adam13 (talk|edits) said:

12 May 2010
Dave, I must say, that is fascinating regarding the gain/loss basis provision. Also, thank you for including the references to the Regs, I will be including such in my work papers.

And Tkelly, thank you as well, I have learned from both of you.

DaveFogel (talk|edits) said:

12 May 2010
I noticed an error in my May 12, 2010 post, so I corrected it (I struck out the words "in the short sale").

FLAcct (talk|edits) said:

14 May 2010
This thread has been extremely helpful to me. I read Dave Fogel's articles and learned a lot from them.

I have a situation very similar to Adam13's situation, with the exception that my client is a Florida resident and Florida mortgages are recourse. Therefore, there will be COD income and the possibility of a QRPBI exclusion.

In Adam13's first post (before he learned that the QRPBI exclusion does not apply in his case), he said "As I understand it, he would qualify for the QRPBI (Qualified Real Property Business Indebtedness §108(a)(1)(D)) exclusion." Is this true? This is where I am stuck.

My client has 2 residential rental properties. House A was his personal residence and became a rental when he moved into House B. House B was his personal residence and became a rental when he moved into House C. House B is the house he is considering for a foreclosure or short-sale situation. It has 1st and 2nd mortgages with the same bank and both mortgages were used to buy the property. In case it matters, my client has a W-2 job for a real estate company as a property manager for residential real estate rentals. So he knows what he's doing when it comes to rental properties, both properties are rented to non-related parties at fair market values, with proper deposits and accounting. Does my client's rental property constitute a "trade or business" which is necessary for the QRPBI exclusion? The only examples I have found where the IRS agreed a rental property did rise to a "trade or business" were for multiple unit rental properties, not single family homes.

Adam13 (talk|edits) said:

18 May 2010
One last follow-up question. Since debt will be forgiven on this transaction, I'm assuming that a 1099-C will be issued. In order to report no gain or loss on the tax return, do you simply match the adjusted basis to the amount of debt forgiven? Or does it require an attachment showing the two computations with the different bases for gain and loss calculations?

Thanks again.

Kevinh5 (talk|edits) said:

18 May 2010
we've had the §1231 discussion recently I'll find and link

Kevinh5 (talk|edits) said:

18 May 2010
Discussion:Rental Real Estate Loss Treatment

Adam13 (talk|edits) said:

18 May 2010
Thank you for your reply Kevin. I am having trouble finding the answer to my questions with that thread though.

Since I need to use a different basis for the gain than the loss calculation, how does the input work. If I understand correctly, the amount realized is the debt forgiven, as indicated on the 1099-C that will be issued.

So, it being a 1231 activity (just to make sure I'm clear, residential rental is 1245 property, correct?), I am not aware of a location where you can document this dual-basis situation on Form 4797.

DaveFogel (talk|edits) said:

18 May 2010
FLAcct, the IRS recently said that you can use the QRPBI for a residential rental property. See CCA-220170-09.

Adam13, my recommendation would be to attach a statement showing the two gain/loss calculations with the regulations citations. The amount realized is NOT just the portion of the debt that was forgiven (this is the amount shown on Form 1099-C), but rather, the entire principal amount of the debt. You might have to override some fields in your software to make it come out correctly on the Form 4797.

Kevinh5 (talk|edits) said:

18 May 2010
(and real estate used in a trade or business is generally §1250 property - I know for a time before I did taxes there was a short period when 1245 applied to real estate, but without looking it up, I couldn't say when - has to be pre-87)

Adam13 (talk|edits) said:

18 May 2010
@DaveFogel

OK, so regarding the debt forgiven, will the 1099-C have the principal amount owed net of the actual sales proceeds of the home?

Also, the actual entry on Form 4797, would you show the basis equaling the amount realized, to indicate no gain/loss, and then attach? Or is there a more appropriate way?

Kevinh5 (talk|edits) said:

18 May 2010
basis = whatever his basis was (basis for gain may be different than basis for loss, as you pointed out)

sales price = whatever the loan balance was

DaveFogel (talk|edits) said:

18 May 2010
I agree with Kevinh5. On Form 4797, I recommend that you show the sales price (loan balance) and gain as zero, and say "See Statement Attached."

I refuse to predict what the Form 1099-C will show because lenders are making too many mistakes on this form. You can usually get the principal amount of the loan from the year-end mortgage interest statement.

Adam13 (talk|edits) said:

18 May 2010
Sorry if I'm dragging this one out. I understand the amount realized portion. Are you both implying that I enter no basis...since I can't enter both? =]

Kevinh5 (talk|edits) said:

18 May 2010
no we're not implying you enter only a sales price with no basis

in my software, basis will transfer from the 4562 entry screen to the 4797 if you make the correct entries

Kevinh5 (talk|edits) said:

18 May 2010
maybe you are confusing basis with FMV?

Adam13 (talk|edits) said:

18 May 2010
OK, perhaps so. The basis of the property as a rental is the FMV they took at the time it was placed into service. So the entire Cost basis is not being depreciated.

I use ProSystem fx and it does something similar to what you describe above. Here's some numbers (ignoring depreciation).

Amount Realized: 320 Cost Basis : 400 Rental Basis (FMV): 280

Gain Calc: 320 - 400 = (80) No gain

Loss Calc: 320 - 280 = 40 No loss

I do realize that I need to figure out what portion of the FMV they apportioned to the land. It appears the past accountants failed to list that as a fixed asset. And from what I have read. If the loss calculation does result in a loss, you have to be able to substantiate the FMV of the property at the time it was converted to a rental.

Thanks again guys for staying with me =]

Kevinh5 (talk|edits) said:

18 May 2010
your 4797 should show sale for 320 with a basis of 320

Dave recommends you show your work (as you did above)

Kevinh5 (talk|edits) said:

18 May 2010
now, what about accumulated depreciation?

Adam13 (talk|edits) said:

18 May 2010
Hehe, it appears that we were talking about the same treatment while using different terminology. Sorry for being so confusing.

Regarding the Accumulated Depreciation. By the time the property is sold, it will probably have ~30,000. Does this have to be recaptured? In my situation, I'm assuming it would only come into play if the Adjusted Basis (Cost - Accumulated Depreciation), were actually below the amount realized on sale. Otherwise, decreasing the basis in the 'loss' calculation, only decreases the probability of realizing a loss.

It would play a factor though, if the land is allocated a FMV at conversion of say 70,000 (80/20). That would then yield a different calculation no? One for the land and one for the Building?

80% (Building) Amount Realized: 320 * .8 = 256 Adjusted Basis: 280-30 = 250

256 - 250 = 6 (No Loss)


20% (Land) Amount Realized: 320 * .2 = 64 Basis: 70

64 - 70 = (6) 1231 Loss


DgR (talk|edits) said:

20 August 2010
After reading the above wonder why no mention was made of amending the prior year returns for what apppears could be overstated depreciation deductions. Or would this become too complicated because of having to also change PAL carry-over, if any.

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