Owner-occupied, underwater homes may have been thrown a lifesaver with the extension of the Mortgage Forgiveness Debt Relief Act, but investors struggling to make it to shore are left to just keep swimming.
The debt forgiveness income exclusion applies only to debt used to purchase, construct or improve a primary residence, said Wayne Mushet, CPA at Brodshatzer, Wallace, Spoon & Yip.
Shanna Welsh, attorney and real estate broker at Southern California Realty Law, agreed that the Mortgage Forgiveness Debt Relief Act (MFDRA) applies only to principal residences.
“However, the definition of principal residence for the purposes of the IRS tax code is a home that the taxpayer lived in for at least two of the last five years,” Welsh said.
Alan Nevin, principal at The London Group, said if the property was purchased as an investment and the investor has lost money, he or she can take a loss as if it were any other kind of business.
“The act helps to level the playing field between homeowners and investors,” Mushet said.
For investors who are looking to short sell a property, Mushet provided this advice in an email:
“The answer starts with the character of the debt. Is the debt recourse or non-recourse?" he wrote. "A recourse lender has the option to sue the investor for the difference between the market value of the property and the balance owed on the loan, or to forgive the unpaid portion of the debt. A non-recourse lender cannot sue for the deficiency.
“Investors with recourse debt loans who are short selling a rental property are required to divide the tax reporting into two parts.
"Part one requires comparing the market value of the property to its tax basis (cost less tax depreciation) to calculate the taxable gain or loss. If the result is a gain, it is taxed as a capital gain. If the result is a loss, it’s taxed as an ordinary loss.
"Part two requires the investor to report the difference between the loan balance and the market value of the property as debt forgiveness income. This is the loan amount forgiven by the lender in a short sale.
"Debt forgiveness income is taxable ordinary income with two exceptions. If the investor has filed for bankruptcy the income is excluded. If the investor is insolvent, defined as total liabilities greater than total assets, the income is excluded. If the forgiveness makes the investor solvent, then a portion of the income may be taxable.
“Non-recourse investor reporting is simpler; the full amount of the debt is treated as the sale price in the gain/loss calculation. There will not be debt forgiveness income to report when the debt is non-recourse.
“Real estate rental investors do not have the same tax problems homeowners have because the loss in part one of the calculation above will generally be larger than the income computed in part two.
"The loss offsets the debt forgiveness income. A homeowner is not allowed to deduct the loss from the sale of their personal residence, hence there is nothing to offset the forgiveness income in a short sale.
"The Mortgage Debt Relief Act helped to resolve the issue. The Act helps to level the playing field between homeowners and investors.”