Discharge of Indebtedness on Principal Residences and Business Real Property

by John C. Zimmerman, CPA, MST, J.D.

EXECUTIVE SUMMARY

* Discharge of indebtedness income generally must be included in income. However, under Sec. 108(a)(1)(E), qualified principal residence indebtedness that is discharged is excluded from income.

* Qualified principal residence indebtedness is acquisition indebtedness up to $2 million. Principal residence for these purposes has the same meaning as it does for the Sec. 121 exclusion for gain on the sale of a principal residence.

* The tax consequences of a discharge of qualified principal residence indebtedness depends on whether the debt is recourse or nonrecourse.

* 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.

The meltdown in real estate values in recent years has led to numerous debtor defaults and to creditors’ lowering the carrying values of mortgages. This article discusses the differing tax consequences under Sec. 108(a)(1)(E) of a borrower’s default and/or indebtedness discharge on recourse versus nonrecourse loans on principal residences. It then addresses the unresolved issue of what constitutes business indebtedness for purposes of the Sec. 108(a)(1)(D) exclusion from taxation for discharge of qualified real property business indebtedness. Planning opportunities are presented in each section.

Principal Residence Indebtedness

Sec. 61(a)(12) provides that gross income includes income from the discharge of indebtedness. However, as introduced by the Mortgage Forgiveness Debt Relief Act of 20071 and extended by the Emergency Economic Stabilization Act of 2008,2 Sec. 108(a)(1)(E) excludes from gross income qualified principal residence indebtedness discharged after 2006 and before January 1, 2013. Sec. 108(h)(2) states that qualified principal residence indebtedness is “acquisition indebtedness” as defined in Sec. 163(h)(3)(B), except that the total indebtedness excluded for purposes of Sec. 108 is $2 million, not the $1 million mentioned in Sec. 163(h)(3)
(B)(ii).

Sec. 163(h)(3)(B)(i) defines acquisition indebtedness as indebtedness that is incurred in acquiring, constructing, or substantially improving any qualified residence and is secured by the residence. The term also includes refinancing indebtedness as long as the refinanced loan does not exceed the original indebtedness. However, if the refinanced indebtedness in excess of the original acquisition indebtedness is used to substantially improve the principal residence, it will also be considered acquisition indebtedness. The above definition of acquisition indebtedness excludes home equity indebtedness unless the taxpayer uses the equity debt to make improvements to the principal residence. Hence, absent finding some other provision that would exclude discharged home equity indebtedness from income (i.e., title 11 bankruptcy under Sec. 108(a)(1)(A)) or insolvency under Sec. 108(a)(1)(B), such discharge will result in income recognition.

Sec. 108(h)(5) defines a principal residence as having the same meaning as used in Sec. 121. Sec. 121(a) provides that for a residence to qualify as a principal residence, the taxpayer must own and use the residence for two of the five years preceding the sale by the taxpayer. The ownership and use tests need not be concurrent. The exclusion is limited to $250,000 in the case of an individual and $500,000 in the case of a married couple filing jointly. Sec. 121(a)(2)(A) provides that for a married couple, both spouses must meet the use requirement but only one spouse must meet the ownership requirement.

When a creditor reduces a loan balance on the principal residence, Sec. 108(h)(1) provides that the basis of the residence shall be reduced (but not below zero) by the amount of the discharge. However, Sec. 108(h)(3) states that the general rule of nontaxability will not apply if the reason for the discharge is services performed by the debtor for the lender or any other factor not related to the decline of the property’s value or the taxpayer’s financial condition.

Further, under Sec. 108(a)(2)(A) the general exclusion rule on principal residence indebtedness discharge will not apply if the discharge occurs in a title 11 bankruptcy case. Rather, the exclusion under Sec. 108(a)(1)(A) will apply. However, Sec. 108(a)(2)(C) provides that the principal residence exclusion rule will take precedence over the insolvency exclusion rule listed in Sec. 108(a)(1)(B) unless the taxpayer elects otherwise. A taxpayer who uses any of the income exclusion provisions under Sec. 108 must file with the tax return Form 982, Reduction of Tax Attributes due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

As noted above, the total amount of principal residence indebtedness that qualifies for relief is $2 million. However, there will be no limit on the amount of relief if the debt is a purchase money mortgage as described in Sec. 108(e)(5). This means that the property’s seller is carrying the mortgage. This is not an unusual occurrence for very large mortgages where a third party may not be willing to extend credit. Debtors who have purchase money mortgages simply reduce their basis in the property by the amount of the indebtedness discharge. It should be emphasized that the provisions of Sec. 108(e)(5) apply to all property, not only principal residences. However, the exclusion will not apply in a title 11 case or when the purchaser is insolvent.

Recourse and Nonrecourse Debt

The tax consequences of principal residence acquisition indebtedness discharge can have differing impacts depending upon whether the debt is recourse or nonrecourse. Recourse debt means that the debtor can be held personally liable in the event of default. Thus, if the fair market value (FMV) of the property that secures a loan is not sufficient to cover the outstanding principal of the loan in the event of default, a creditor can attach other property owned by the debtor to cover the loan balance. Nonrecourse debt means that the creditor can seize only the property that secures the loan, even if the FMV of that property is not sufficient to cover the loan balance. For example, principal residences are sold in California on a nonrecourse basis. Hence, homeowners can walk away from their loans without fear of being pursued by the creditors.

The regulations provide that relief of a nonrecourse loan will be sufficient consideration received for property that is in default.3

Example 1: Taxpayer T defaults on a nonrecourse mortgage loan of $300,000. The principal residence basis is $320,000, and the FMV is $250,000. The property is considered to be sold for $300,000, and its FMV is irrelevant for purposes of determining liability relief.4 T has an unrecognized $20,000 loss because the property is personal use property. However, there are no further tax consequences as a result of the default.

The taxpayer can simply walk away from the loan. The lender issues the taxpayer Form 1099-A, Acquisition or Abandonment of Secured Property. The taxpayer does not file a Form 982 because there has been no discharge of indebtedness. The taxpayer reports the sale on a Form 1040, Schedule D, Capital Gains and Losses. Since a loss cannot be recognized, the sale price (i.e., the balance of the nonrecourse loan) and property’s basis will be the same: $300,000.

However, if the nonrecourse lender cancels part of the debt for $600 or more under the repossession (e.g., a lender cancels part of the debt and then later in the year forecloses), the lender must file Form 1099-C, Cancellation of Debt. In that case, it can report the repossession information in boxes 4, 5, and 7 of Form 1099-C instead of filing Form 1099-A.5 The taxpayer files Form 982 and Schedule D.

In the above example, if the lender has recourse against the taxpayer for property other than the property securing the loan, the treatment changes.6 The borrower automatically has discharge of indebtedness income of $50,000, the difference between the property’s FMV ($250,000) and the loan balance on the property ($300,000). The property is then considered sold for the remaining $250,000 debt securing the property. This results in a $70,000 loss that the taxpayer cannot recognize for tax purposes because the principal residence is personal use property. However, the taxpayer is allowed to treat the indebtedness discharge under the general rule of Sec. 108(a)(1)(E). The taxpayer files Form 982 showing the amount of the discharge excluded from income and also files Form 1040, Schedule D, showing a sale for $250,000 and a basis of $250,000.

Many recourse lenders are allowing taxpayers to sell their principal residences in what is referred to as a short sale.

Example 2: Taxpayer V sells her principal residence property for less than the mortgage that secures it. The lender issues Form 1099-C to V. Box 5 on the form asks whether the taxpayer is personally liable (recourse liability). If V is personally liable, she either must recognize income from the discharge of indebtedness or is allowed the exclusion from the discharge if the requirements of Sec. 108(a)(1)(E) are met.

In the above illustrations there are effectively no differences for tax purposes between the nonrecourse and recourse notes securing the property. The only difference, as noted, is how the transactions are reported when the taxpayer loses the principal residence. This situation changes if the loan balance discharged exceeds $2 million, because that is the maximum amount eligible for relief.

Example 3: Taxpayer W has a basis in her principal residence of $9 million, an FMV of $5 million, and a loan balance of $8 million. W defaults, and the property is repossessed by the lender. There are no tax consequences if this is a nonrecourse mortgage; it is simply treated as a sale of the property for $8 million. However, if the note is recourse and the lender allows W to enter into a short sale, she will have $3 million of discharge of indebtedness income, the difference between the mortgage on the property and its FMV. W has $1 million of income recognition, since she can exclude only $2 million under the general rule. The remaining $5 million is treated as consideration paid for the property. The basis of the property is reduced by the $2 million, leaving W with an unrecognized loss of $2 million ($5 million remaining loan less $7 million remaining basis).

Complications also arise if the taxpayer has borrowed against the increased value of the property during times when real estate values were high. Equity borrowing was quite common before the real estate meltdown. The relief afforded under Sec. 108(a)(1)(E) does not apply to equity borrowing.

Example 4: Taxpayer X has a nonrecourse acquisition note and a nonrecourse equity note on his property. The equity loan proceeds are not used for improvements to the principal residence. X’s basis is $500,000 (original acquisition cost), FMV is $350,000, principal acquisition residence indebtedness is $450,000, and equity debt is $150,000. Third-party holders of the debts cancel $50,000 of the acquisition indebtedness and $100,000 of the equity debt. X keeps the home and recognizes $100,000 discharge of indebtedness income on the equity debt.

Each debt discharge will be reported to X on a Form 1099-C. However, X can exclude the $50,000 of acquisition indebtedness under the general rule. In this example, the results are the same if the debt is recourse because X has not disposed of the principal residence.

However, the results change if the taxpayer gives up the principal residence either through foreclosure (nonrecourse mortgage) or a short sale (recourse mortgage). If both loans are nonrecourse and the creditors foreclose, he will have $100,000 of capital gain ($600,000 of debt relief on a principal residence with a basis of $500,000). If he meets the criteria of Sec. 121 for exclusion of gain on the sale of a principal residence, he will not have to recognize any of the gain. Even if he must recognize the gain, the taxpayer has the advantage of the long-term capital gain rates instead of the ordinary income rates on $100,000 that he would have to recognize as discharge of indebtedness income if he keeps the principal residence.

If the debts are recourse, the taxpayer will not have the benefit of capital gain recognition and Sec. 121 exclusion. If the creditors allow him to engage in a short sale for $350,000, the home’s FMV, he will have $150,000 of ordinary income on the equity debt discharge and $100,000 ordinary income on the acquisition debt discharge. He will be allowed the benefit of the Sec. 108(a)(1)(E) exclusion only on the $100,000 of acquisition debt. Thus, if the debts are nonrecourse, the taxpayer has $100,000 of capital gain potentially eligible for the Sec. 121 exclusion. If they are recourse, there is $250,000 of ordinary income of which the taxpayer can exclude only $100,000 from recognition.

Planning Opportunities

As the above examples illustrate, there are far more planning opportunities with nonrecourse as opposed to recourse mortgages. In some instances with a nonrecourse mortgage, the tax consequences of default can be more favorable than the consequences of keeping the home. This will be the case if there is a nonrecourse equity loan that will not qualify for the Sec. 108(a)(1)(E) exclusion.

Example 5: Taxpayer Y purchases a house for $550,000. At present, there is no acquisition indebtedness. Y borrows $500,000 on the house’s equity when it is worth $650,000. The house’s present value is $400,000. If the nonrecourse equity lender agrees to discharge $100,000 of the loan so that Y will owe only the house’s FMV, there will be $100,000 of discharge of indebtedness income. However, there are no tax consequences if Y defaults and the house is repossessed. Y is considered to have sold the house with a tax basis of $550,000 for the amount of the $500,000 debt relief. If the debt is recourse and there is a short sale for $400,000, there will be $100,000 of ordinary income and a $150,000 loss that cannot be recognized for tax purposes ($550,000 of tax basis less the remaining $400,000 debt relief on the sale).

There can be no Sec. 108(a)(1)(E) relief since there is no principal residence acquisition indebtedness remaining on the loan. Hence, with nonrecourse mortgages it may be advantageous for tax purposes to simply walk away from the house and allow the lender(s) to repossess it.

Qualified Real Property Business Indebtedness

General Provisions

Sec. 108(a)(1)(D) excludes from income recognition for a taxpayer, other than a C corporation, a discharge of qualified real property business indebtedness. Sec. 108(a)(2)(A) provides that the exclusion is not available if the discharge occurs in a title 11 bankruptcy case. Sec. 108(a)(2)(B) provides that the exclusion will not apply to the extent that the taxpayer is insolvent. In that case, the insolvency provisions of Sec. 108(a)(1)(B) will apply. Secs. 108(c)(1) and (2) explain the rules for the maximum amount eligible for the exclusion and the basis reductions to depreciable real property when the exclusion is used. Essentially, the maximum exclusion allowed is the amount by which the qualified acquisition indebtedness (discussed below) exceeds the property’s FMV. However, the exclusion cannot exceed the property’s adjusted basis.

Sec. 108(c)(3) defines qualified real property business indebtedness as indebtedness:

* That is incurred or assumed by the taxpayer in connection with real property used in a trade or business that is secured by the real property;

* That is incurred or assumed before January 1, 1993, or if incurred or assumed after this date is qualified acquisition indebtedness (this includes refinanced indebtedness only to the extent it does not exceed the debt being refinanced); and

* With respect to which the taxpayer elects to have the exclusion applied.

The term does not apply to qualified farm indebtedness (covered under Sec. 108(a)(1)(C)).

Sec. 108(c)(4) provides that qualified acquisition indebtedness means indebtedness incurred to acquire, construct, reconstruct, or substantially improve real property used in a trade or business. Therefore, equity debt used for purposes other than capital improvements to the property on which the borrowing is made will not qualify. The taxpayer must make the election to use the provisions on a timely filed return (including extensions) for the tax year in which the discharge occurs. The taxpayer makes the election on a Form 982.7

In the case of a partnership, the determination of whether the debt is qualified real property business indebtedness is made at the partnership level. However, the election to apply the provision is made at the partner level.8 Hence, different partners may treat the discharge differently.

One of the problems with Sec. 108(a)(1)(D) is the lack of definition of what constitutes a trade or business for the section’s purposes. For example, if a taxpayer owns a rental property on which debt is discharged due to a decline in market value, can the rental be considered a trade or business for purposes of the section? Unfortunately, there is no definitive answer. Nevertheless, looking to Sec. 469, which deals with passive losses, can give some idea of how trade or business should be interpreted in light of Sec. 108(a)(1)(D). There is precedent for looking at another Code section when attempting to ascertain the meaning of a term. For example, the Third Circuit looked to the Sec. 108 meaning of indebtedness when trying to define the term “indebtedness” for purposes of Sec. 61(a)(12).9 In another case, the Supreme Court looked to obsolete cases to define “differing materially” as used in Regs. Sec. 1.1001-1. The cases had been decided long before the regulation’s enactment.10

Passive Loss Guidance

Sec. 469 deals with the rules for the passive loss limitations. Sec. 469(c)(7) provides “special rules for taxpayers in real property business.” Sec. 469(c)(7)(B) states that a taxpayer in a real property business is one who (1) spends more than one-half his or her personal service time performed in all trades or businesses in real property trades or businesses in which he or she materially participates and (2) performs more than 750 hours of services during the tax year in real property trades or business in which he or she materially participates. The problem is that many taxpayers will not be able to meet these requirements. In addition, if a taxpayer owns multiple real estate rentals, Sec. 469(c)(7)(A) applies the above rules to each rental separately, effectively meaning that it could be impossible to meet the test.

The taxpayer can elect to treat all interests in rental real estate as one property for purposes of the two tests. Taxpayers will generally make this election when they want to avoid the limitations for deducting passive losses. However, because of the operation of the passive loss rules, making such an election would mean that all properties covered under the election would have to be disposed of before any suspended passive losses could be deducted. Secs. 469(d) and (g) provide that a taxpayer can deduct suspended passive losses only when the taxpayer has sufficient passive income to offset such losses, disposes of his or her complete interest in the property that has generated suspended passive losses, or dies.

However, under Sec. 469(c)(6), to the extent provided in the regulations, “trade or business” means:

* Any activity in connection with a trade or business; or
* Any activity for which expenses are allowable under Sec. 212.

Sec. 212 allows expenses for activities conducted for the production of income. This could include expenses for real estate rentals in certain circumstances.11 Regs. Sec. 1.469-9(b)(1) states that “[a] trade or business is any trade or business determined by treating the types of activities in §1.469-4(b)(1) as if they involved the conduct of a trade or business, and any interest in rental real estate, including any interest in rental real estate that gives rise to deductions under section 212” (emphasis added).

Case Guidance

Court cases and IRS rulings have been ambiguous as to whether renting property constitutes a trade or business. Cases dating back to the 1940s have held that renting even a single property may constitute a trade or business. In Hazard,12 the taxpayer sold for a loss a single rental property that he had converted from a principal residence. The IRS argued that the loss was capital. However, the Tax Court looked to the then equivalent of current Sec. 1231(b), which defines “property used in the trade or business” as property “of a character which is subject to the allowance for depreciation.” On this basis, the court held that the loss was ordinary, and the IRS acquiesced. Courts also have decided subsequent cases in favor of taxpayers who sought to have losses on improved real estate rental properties treated as being from a trade or business.13 Where rental property used for sharecropping was unimproved, a district court held that the rental activity did not constitute a trade or business.14 Similarly, the Tax Court disallowed unimproved rental realty from being classified as a trade or business.15

In Grier,16 a district court case affirmed by the Second Circuit, a taxpayer’s ownership of property rented for 14 years was held not to constitute a trade or business. However, in that case it was the taxpayer who said that the rental did not constitute a trade or business, while the IRS argued that it did. The court looked to the taxpayer’s minimal efforts in managing the property and noted that there was a lack of “regular and continuous activity of management.” The Tax Court cited Grier in a case where a taxpayer held inherited rental property for only three months before its sale.17 In denying a classification of the property as being held in a trade or business, the court noted that the taxpayer’s “activities with respect to the premises as rental property were almost non-existent” and that no evidence was presented that she attempted to remedy any of the problems with the property.

The IRS indicated in Letter Ruling 835000818 that it would look to a taxpayer’s efforts in managing a rental property to determine whether the rental activity constituted a trade or business. The taxpayer leased property that required the lessee to be responsible for all tax assessments, maintenance, and repairs, and “all claims and liabilities arising out of or in connection with” the rental property. Such rental agreements are known as net leases. Based on these facts, the ruling held that the rental did not constitute a trade or business because “[t]he Taxpayer-lessor engaged in little or no activity with respect to the property.”

The IRS addressed the applicability of Sec. 108(a)(1)(D) to real estate rentals in Letter Ruling 9840026.19 The taxpayer, a partnership, rented residential apartments. The partnership was actively involved in managing the rental property. This included setting the rents, arranging for necessary repairs, hiring maintenance personnel, purchasing supplies, keeping books, and collecting rents. The IRS held that the taxpayer was in a trade or business. Significantly, the IRS stated that “[t]he rental of even a single property may constitute a trade or business under various provisions of the Code.” The ruling emphasized that net leases will not qualify as a trade or business, and cited an earlier case20 and revenue ruling21 to this effect.

The substance of the cases and rulings on whether a real estate rental will constitute a trade or business is that the taxpayer must be actively involved in the rental. There is no guidance on what exactly constitutes such involvement. However, the IRS’s interpretation of Sec. 469(i), which provides a limited exception to the passive loss rules for certain rental real estate for an individual who actively participates in the rental, may provide some guidance. The IRS has defined such active participation as making “management decisions in a significant and bona fide sense.”22 This includes “approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.”

Passive Loss Definition vs. Case Definition

Recall that the passive loss definition for a rental real estate business envisages property held for the production of income as defined in Sec. 212. The cases and rulings discussed above, though not saying so directly, mean a trade or business as defined in Sec. 162, concerning “ordinary and necessary” deductions for a trade or business. In Curphey,23 the taxpayer, who was a medical doctor, took a home office deduction under Sec. 280A for managing his six rental properties. Sec. 280A(c)(1)(A) allows the deduction when the home office is the taxpayer’s “principal place of business.” His efforts included “personal efforts to manage the six units in seeking new tenants, in supplying furnishings, and in cleaning and otherwise preparing the units for new tenants. These activities were sufficiently systematic and continuous to place him in the business of real estate rental.”24

However, the court emphasized that it was allowing the expense deductions under Sec. 162, not Sec. 212. The court stated that it disallowed the deduction under Sec. 212 because that section concerned expenses for the production of income. The court did not believe that such expenditures would rise to the level of a trade or business. It stated that there is no deduction under Sec. 280A for “use of a home in connection with an activity which is merely for the production of income within the meaning of section 212 but is not a ‘trade or business’ under section 162.”25 A production of income example could be where a taxpayer used his or her principal residence to manage a stock portfolio.

Curphey and the other aforementioned cases were decided before the enactment of the passive loss rules’ definition of a trade or business as coming within the scope of Sec. 212. Hence, the courts have not decided whether Sec. 469 could create a lower threshold for purposes of a trade or business. Most likely the approach taken in Letter Ruling 9840026 and the cases it cites, discussed above, will continue to govern the definition of a trade or business for purposes of defining qualified real property business indebtedness. Moreover, it could even be argued that the test is the same whether for purposes of Sec. 162 or Sec. 212. The regulations under Sec. 212 state that “ordinary and necessary expenses paid or incurred in connection with the management, conservation, or maintenance of property held by the taxpayer as rental property are deductible.”26 Hence, there are situations when the same level of effort could be required under both sections for real estate rentals.
Differences Between Discharges for a Principal Residence and Property Used in Business

The issues surrounding qualified real property business indebtedness from the perspective of recourse and nonrecourse liabilities will be the same in some instances as those for a principal residence. Thus, a nonrecourse holder of such property will be able to default and have the reacquisition of the property by the lender treated as a sale or exchange. This result does not change when part or all of the debt on the property is equity debt. It simply will be treated as consideration for the sale of the property. However, in this instance, unlike with a principal residence, the taxpayer can recognize a Sec. 1231 ordinary loss in certain circumstances.

Example 6: Taxpayer Y borrows $400,000 on real estate rental property with a basis of $500,000. The property’s value drops to $350,000. There is no other debt on the property. Y defaults and the property is repossessed. Y recognizes a $100,000 ordinary loss. The property is treated as if it has been sold for $400,000. Y cannot recognize a loss if the property is a principal residence.

The same result occurs if the loan in the above example is recourse and the lender allows the taxpayer to engage in a short sale. In this instance, the taxpayer will have ordinary discharge of indebtedness income of $50,000, the difference between the equity debt ($400,000) and the property’s FMV ($350,000). However, the taxpayer would then recognize an ordinary loss under Sec. 1231 for $150,000, the difference between the basis ($500,000) and the remaining debt ($350,000). Thus, the taxpayer has effectively neutralized the discharge of indebtedness income. If the property was a principal residence, the taxpayer would recognize $50,000 of ordinary income but could not recognize any loss on the sale because it is personal use property.
Conclusion

The exceptions to income recognition for discharge of indebtedness income for a principal residence can have differing tax impacts depending upon whether the debt is nonrecourse or recourse. Obviously, there are situations in which a taxpayer will be in a more advantageous position when the debt is nonrecourse, because the property’s FMV fluctuations will not affect the tax considerations in the event of a default. The total debt, both acquisition and equity, will be treated as consideration for the sale. However, the taxpayer will have discharge of indebtedness income on equity debt relief when the loan is recourse and the lender allows a short sale. In this instance, any loss on the sale cannot be used to offset the income because the principal residence is personal use property.

When the taxpayer keeps the principal residence, the discharge will have the same impact for nonrecourse and recourse debt. In both instances, the taxpayer can reduce the basis of the principal residence by up to $2 million of the discharge for acquisition indebtedness. In both instances, the taxpayer will also have to recognize income from any discharge of equity debt.

Taxpayers may exclude from gross income qualified real property business indebtedness, not to exceed the amount by which such indebtedness exceeds the property’s FMV. The amount is further limited to the property’s adjusted basis. Real estate rental properties can qualify as a trade or business for this purpose. A single real estate rental also may qualify as a trade or business. The only issue is how much effort a taxpayer must put into the rental properties to have the activity classified as a trade or business. Though there is no fixed rule, the substance of the cases and rulings (especially Letter Ruling 9840026) suggest that the taxpayer must be actively involved in the management decisions for the property, including setting rents, approving repairs and other expenditures, and approving tenants. It is clear that debt on a property subject to a net lease, where the lessee is responsible for the property’s management and expenditures, will not qualify for the exclusion. In this case, the lessor-owner will not have performed sufficient functions to be considered to be in a trade or business for purposes of Sec. 108(a)(1)(D).

This article should help practitioners decide when to advise clients to engage in partial debt discharge, short sales, and/or outright defaults on principal residence indebtedness and qualified real property business indebtedness. Of particular concern will be whether the property is secured by a recourse or nonrecourse note and whether the debt is acquisition or equity indebtedness. In each instance the tax consequences can vary dramatically depending upon the nature of the debt and the action to be taken.

Footnotes

1 Mortgage Forgiveness Debt Relief Act of 2007, P.L. 110-142.

2 Emergency Economic Stabilization Act of 2008, P.L. 110-343.

3 Regs. Secs. 1.1001-2(a)(1) and (a)(4)(i).

4 Regs. Sec. 1.1001-2(b).

5 Instructions for Forms 1099-A and 1099-C (2011), p. 1. See also IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments (2010), p. 12.

6 Regs. Sec. 1.1001-2(a)(2), and see Regs. Sec.1.1001-2(c), Example (8).

7 Regs. Sec. 1.108-5(b).

8 IRS Letter Ruling 9840026 (10/2/98), citing the legislative history; Sec. 108(d)(6). See also Gershkowitz, 88 T.C. 984 (1987).

9 Zarin, 916 F.2d 110 (3d Cir. 1990).

10 Cottage Savings Ass’n, 499 U.S. 554 (1991).

11 See Bolaris, 776 F.2d 1428 (9th Cir. 1985), where real estate rental deductions, including depreciation under Sec. 167, were allowed under Sec. 212. The taxpayer was allowed to show a loss for tax purposes on a temporary rental of a principal residence.

12 Hazard, 7 T.C. 372 (1946), acq., 1946-2 C.B. 3.

13 Stratton, T.C. Memo. 1958-214; Post, 26 T.C. 1055 (1956), acq., 1958-2 C.B. 7; Schwarcz, 24 T.C. 733 (1955), acq., 1956-1 C.B. 5; Gilford, 201 F.2d 735 (2d Cir. 1953).

14 Durbin v. Birmingham, 92 F. Supp. 938 (S.D. Iowa 1950).

15 Emery, 17 T.C. 308 (1951).

16 Grier, 120 F. Supp. 395 (D. Conn. 1954), aff’d without discussion, 218 F.2d 603 (2d Cir. 1955).

17 Balsamo, T.C. Memo. 1987-477.

18 IRS Letter Ruling 8350008 (12/16/83).

19 IRS Letter Ruling 9840026 (10/2/98).

20 Neill, 46 B.T.A. 197 (1942).

21 Rev. Rul. 73-522, 1973-2 C.B. 226.

22 IRS Publication 925, Passive Activity and At-Risk Rules (2010), p. 3.

23 Curphey, 73 T.C. 766 (1980).

24 Id. at 775.

25 Id. at 770.

26 Regs. Sec. 1.212-1(h).