After losing a property to foreclosure, many taxpayers learn that they may owe additional taxes on the canceled debt. The following is part three of a series on tips for reducing foreclosuretax consequences and securing the most favorable tax position in a foreclosure.
When faced with the prospect of foreclosure on property other than a principal residence, a taxpayer should determine if one of the four exemptions apply to exclude cancellation of debt income from gross income. The exemptions are applicable in the following circumstances:
(A) the discharge of debt occurs in a title 11 bankruptcy case,
(B) the discharge occurs when the taxpayer is insolvent,
(C) the indebtedness is qualified farm indebtedness, or
(D) in the case of taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness. We will discuss in more detail the exemptions for bankruptcy, insolvency, and qualified real property business indebtedness.
It should be noted that there is a hierarchy for applying the exemptions to exclude cancellation of debt income from gross income. The bankruptcy exemption is at the top of the pyramid and trumps the other exemptions. When cancellation of debt income occurs in bankruptcy, the cancellation of debt income will be excluded by virtue of the bankruptcy exemption even if the other exemptions apply. The taxpayer should elect to use the bankruptcy exemption on Form 982.
When a taxpayer is not in bankruptcy, but is insolvent (liabilities are in excess of the fair market value of assets) prior to foreclosure the taxpayer can elect to utilize the insolvency exception to exclude cancellation of debt income from gross income. When a taxpayer uses the insolvency exception the amount excluded cannot exceed the amount by which the taxpayer is insolvent. A taxpayer’s insolvency should be documented to support the amount of cancellation of debt income to be excluded from income. When a taxpayer elects to utilize the insolvency exception, the taxpayer should be certain to make the election on Form 982.
When a taxpayer takes advantage of the insolvency exclusion, the taxpayer must reduce their tax attributes in the following order: (1) net operating loss (NOL), (2) general business credit, (3) minimum tax credit, (4) capital loss carryover, (5) basis reduction – basis of the property of the taxpayer, (6) passive activity loss and credit carryovers, (7) foreign tax credit carryovers.
A third exemption to exclude cancellation of debt income from gross income is for qualified real property business indebtedness. Qualified real property business indebtedness is debt (1) that was incurred or assumed in connection with real property used in a business and that is secured by that real property, (2) that is qualified acquisition indebtedness, which is indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve property, and (3) for which the taxpayer elected treatment as qualified real property business indebtedness. When electing to use this exception, a basis reduction is required to the real property. The taxpayer should be certain to complete Form 982 and elect the qualified real property business indebtedness exemption.
To conclude knowing and planning for losses can be as or more important than planning for gains. By proper planning most taxpayers can end up saving taxes on these types of property transfers when it counts the most.