If you or someone you know dumped some "bad" real estate, then there might be a ticking tax bomb coming your way. It’s a Form 1099-C and it means you have a "cancellation of debt", and cancellation of debt is taxable.
So if the lender forecloses and takes your property from you, or you do a short sale, chances are the current value is less than your loan. That means the lender has to forgive part of the debt or may pursue you for the difference.
If they forgive the debt, you have a cancellation of debt. And if you have a cancellation of debt, you have a taxable event. The amount of debt that is cancelled is taxable income to you. You report it on your Form 1040 just like any other type of ordinary income. In other words, you never got a check, but you have to pay tax on it.
So, let’s go with the foreclosure or short sale scenario and assume that your lender has forgiven the debt. Just as a note though, don’t assume that the lender is forgiving all the debt. In most states, they can pursue you if you’ve refinanced the first loan or for a second mortgage. And depending on your particular state laws, they could wait years to come after you for the amount. Yikes!
Anyway, for purposes of this article, we’ll assume that the property shortfall is forgiven.
For example: You bought a property for $500,000 with a $450,000 mortgage. It’s foreclosed on and sold for $200,000. The lender forgives the debt of $450,000. You now will have to pay taxes on $250,000 ($450,000 – $200,000).
But don’t panic quite yet. If it’s a rental property, you’re going to have some taxable loss too. So, let’s keep it simple and assume that there is no depreciation.
You have effectively sold the property for $200,000. Your basis was $500,000. That means you have a loss of $300,000.
Solution: Sell it as a rental property. Taxable income of $250,000. Loss of $300,000. You end up with a net loss of $50,000 ($300,000 – $250,000).
That’s all the preamble to the big tax issue: Investment property that has not yet been put in service. If the property is just sitting there vacant, it’s a capital loss when you lose it, not an active real estate property. If you sell it as an investment property without operating it as an rental property, you will have taxable income of $250,000 and a capital loss of $3,000. You can take your capital loss against capital gains and then just $3,000 of the excess. The bottom line is you end up with taxable net income.
Solution: Put the property into service before you walk away or lose it.
If you walk away on the property too quickly, you’ll pay as much as $40,000 in extra taxes. That one little piece of advice that can save you BIG TIME!