How the IRS Categorizes Rentals
When a rental home is foreclosed upon by a lender, there are actually two tax implications. The first is the original loss that a bank or mortgage lender is stuck with. The second is the amount of cancelled debt that a homeowner is often stuck with if money was still owed on the investment home mortgage.
The IRS will view any foreclosure as a sale and the net income or loss must be reported. Taxpayers who use form 1040 are generally required to include form 1099-C in the tax year that a foreclosure is complete. A property owner who has an LLC or corporate business formation typically uses form 4797 to report the sale of business property to the IRS.
Recourse or Non-Recourse Mortgage
Every state has laws that determine what type of loans are underwritten by lenders. Some states enforce a recourse loan which means that a property owner will usually be liable for any debt that is not repaid on a mortgage. Other states enforce a non-recourse loan that specifies that a property owner can be relieved from owning the remaining balance on an outstanding loan.
Some lenders have the ability to sue for outstanding debts. Knowing what type of loan was underwritten and what the current state legislation is where a rental home is positioned can be helpful when navigating the rental home taxation process.
Fair Market Value Realization
Many laws support a fair market value when determining the actual value recognized for taxation. Because many loans are recourse types, a gain or loss will usually be calculated on a personal or business tax return. Lenders will generally foreclose on the fair market value of a home instead of the amount that is remaining on the unpaid mortgage.
Starker Exchange and Foreclosure
A gain is most often recognized when a 1031 or starker exchange is used for a rental property purchase. Some investors have been successful in using an exchange agreement with a qualified provider in order to avoid foreclosure on a rental.
By performing another 1031 before a short sale or other legal maneuver, a rental home could be eliminated from the process and some forms of taxation. Buyers and fractional buyers of real estate do have more than one option for avoiding complicated foreclosures and tax liabilities in some cases.