Your rental property went down in value so much that it was worth less than your $500,000 mortgage, so you walked away from the property. Let the bank enjoy it!
You pat yourself on the back for your clever move until the following January. January is 1099 time and you get a 1099-C from the bank stating you have $500,000 of cancellation of debt (COD) income
Your cronies at the club tell you that you have to pay US and NJ income tax on the $500,000 at ordinary income tax rates, not the favorable capital gains rates. You calculate that your brilliant move will cost you $200,000.
HELP!
Don’t despair. It’s not nearly as bad as you think.
- You didn’t notice the additional information on the 1099. It says the fair market value (FMV)of your property is $350,000. The cancellation of debt income is the debt forgiven less the FMV of the property relinquished, so your COD income is only $150,000
- You have an additional item to report on your tax return, the “sale” of the property. You are deemed to have sold the property to the bank for its FMV. You have gain (loss) for FMV less basis. (Basis is purchase price, improvements, and fees at closing less cumulative depreciation taken). Let’s say you paid $600,000 for the property, put in $25,000 of improvements and $5,000 of fees. In the 10 years you owned the property you took a total of $150,000 of depreciation. Your basis is $480,000. Subtract that from the FMV of $350,000 and you have a loss of $130,000 to offset some of that COD income.
- It is very common for rental properties to generate losses. Often these losses are suspended due to the passive loss rules. In the year you dispose of the property you deduct all of the suspended losses. For example, you could easily have $100,000 of passive losses that directly offset your $150,000 of COD income.
So before you decide to listen to your all-knowing friend who majored in Political Science and jump off the nearest bridge, consult with a competent accountant to determine how much you really owe.