A recent article in The Tax Adviser discussed the tax consequences of discharge of business real property indebtedness (see Zimmerman, “Discharge of Indebtedness on Principal Residences and Business Real Property,” 42 The Tax Adviser 602 (September 2011)). But the article did not address another situation that often arises in today’s economic climate: a short sale of real property held for investment, not for rental, secured by a recourse note.
Example: Taxpayer T buys investment land and a building for $1 million. She puts no money down and assumes a recourse note for the full amount. She does not attempt to rent the property but instead holds it with the intention that it will appreciate in value over time. When the property’s value declines to $600,000, T enters into a short sale for the property’s fair market value. T has made no principal payments on the note. She has cancellation of indebtedness (COD) income of $400,000 and a capital loss of $400,000.
If the note is nonrecourse, T will be treated as selling the property for $1 million with no COD income. Hence, there will be no tax consequences with a nonrecourse note.
There are no relief provisions for recourse debt in these circumstances unless T is in title 11 bankruptcy (Sec. 108(a)(1)(A)) or insolvent (Sec. 108(a)(1)(B)). Note that if she had attempted to rent the property, it could qualify as business real property and thus would be eligible for the exclusion of Sec. 108(a)(1)(D).
Under Sec. 108(a)(1)(D), a taxpayer other than a C corporation may exclude a discharge of qualified real property business indebtedness from income. For purposes of this exclusion, courts have held that the rental of a single property may qualify as a trade or business if the taxpayer is actively involved in the rental of the property.
Note that this result could possibly be achieved even if T was unable to actually rent the property. The Seventh Circuit ruled in Cabintaxi , 63 F.3d 614 (7th Cir. 1995), that it is not necessary to have any gross receipts to be in a trade or business as long as there are a bona fide business motive and sincere efforts to engage in a business.
A number of taxpayers currently find themselves in the unfortunate circumstance of holding investment real property, purchased with a recourse note, that is sold short. Perhaps Congress could extend the provisions of Sec. 108(a)(1)(D) to investors who hold the property with the sole intention of having it increase in value. Thus, property held for the production of income, as defined in Sec. 212, would qualify for the exclusion. Alternatively, Congress could enact a provision that would allow taxpayers in these circumstances to show the loss as ordinary. Thus, the COD income would be offset by an ordinary loss.
A taxpayer who currently holds property for the production of income that has decreased in value below its adjusted basis can convert it to a rental property and have it classified under Sec. 1231 as property used in a trade or business. Provided that the conversion is truly for the intent of rental, a subsequent short sale will qualify for the exclusion under Sec. 108(a)(1)(D). Moreover, the taxpayer will not be required to reduce the property’s depreciable basis upon conversion. The requirement that a property’s basis for depreciation be reduced to its fair market value when lower than the adjusted basis upon conversion applies only to personal use property. Regs. Sec. 1.167(g)-1 makes clear that the basis reduction does not apply to property held for the production of income that is converted to business use. Similarly, the corresponding loss recognition provision in Regs. Sec. 1.165-7(a)(5) that restricts losses on the sale of personal use property converted to property used in a trade or business does not apply to property held for the production of income that is converted to business use.
Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.