Client wants to take the position that the following facts give rise to a foreclosure loss which should be treated as a deductible capital loss (limited to $3k annually). I think this may be the case but i would be grateful for a second opinion (or third…and any views to the contrary : )
Taxpayer received a 1099-A for 2018 with the following:
Box 1 - date: February 2018
Box 2 - principal balance: $600
Box 3 - blank
Box 4 - fair market value: $1000
Box 5 - recourse debt: NOT checked
Taxpayer acquired the property as a personal residence in 2005 for $1100, taking out a mortgage loan for $900 (first mortgage) and a home equity line of credit for $100 ("HELOC") and supplying the balance as equity.
Treating the foreclosure as a disposition, and ignoring the HELOC for a moment as this will be dealt with below, one would calculate the foreclosure loss as nonrecourse debt relief of $600 less basis of $1100 or $500.
(1) Would you agree?
But wait …there's more? Taxpayer rented the property to tenants during the years 2013 through 2015.
In 2015, things started to unravel. Taxpayer filed for bankruptcy protection resulting in the discharge of the HELOC in its entirety (assume $100). In addition, the first mortgagee initialed the foreclosure proceedings that culminated in the issuance of the 1099-A. This debt not discharged in bankruptcy because it was nonrecourse debt to begin with. (Not sure why, but let's assume the taxpayer and "box 5" are right).
To calculate the foreclosure loss under the additional facts, we would need to take into account:
(i) attribute reduction (in effect basis reduction) under 108(b)(2)(E) as a result of the discharge of the HELOC in bankruptcy—subtract $100 from basis (reduce basis of all assets pro rata?), and
(ii) depreciation, allowed or allowable, as a result of the rental use of the property.
(2) Would you agree that the basis reduction should take into account depreciation “allowable” even if taxpayer took none?
(3) Would you agree that basis reduction should take into account depreciation for the period 2016 through 2018 during the period the property was in foreclosure even though the property was not actually rented during that time?
The recomputed basis for purposes of computing foreclosure loss therefore is $1100 original basis less $100 basis reduction under sec 108 less $70 further basis reduction by the depreciation allowed or allowable from 2013 to 2018, so $930.
(4) Does that sound right?
The foreclosure loss under the additional facts is nonrecourse debt relief of $600 less basis of $930 or $330. This is treated as a capital loss because the property was converted to rental use starting in 2013.
(5) Does THAT should right?
(6) And finally, just for fun, if you were to file an otherwise unremarkable 1040 that reflected the above positions and the TPT’s combined learning, would you charge extra?
Many thanks!