Some landlords find themselves in a precarious situation when their rental properties consistently generate losses, leading to financial strain. In dire circumstances, this strain can escalate to foreclosure proceedings due to the inability to meet mortgage payments. But what are the tax implications of such a situation? According to the IRS Office of Chief Counsel, a foreclosure on a rental property does indeed constitute a fully taxable disposition, potentially releasing previously suspended rental losses for deduction.
Consider a scenario where a landlord purchases a property for $1 million, financed entirely through a mortgage. Over three years, the rental property accumulates $100,000 in net passive losses, which remain suspended due to the absence of passive income to offset them. Fast forward four years, and the landlord defaults on the mortgage, leading to foreclosure. At the time of foreclosure, the property’s value has depreciated below its initial purchase price. Consequently, the lender cancels $75,000 of the landlord’s debt.
The IRS Chief Counsel provides guidance on this situation. The foreclosure constitutes a taxable disposition of a large portion of the landlord’s property interest. As a result, the landlord can now treat the previously suspended $100,000 in passive losses as losses from nonpassive activities. This allows them to deduct the losses from their other non passive income, even though the lender cancelled $75,000 of the debt. Notably, the landlord is able to exclude the cancelled debt from income due to insolvency at the time of foreclosure. checkout this IRS publication to learn more: https://www.irs.gov/pub/irs-wd/1415002.pdf
