When taxpayers encounter unusual nonrecurring events, the work of a tax professional with Enrolled Agent training reaches its highest value. An ideal example is the individual who loses a home to foreclosure. Most individuals expect that they cannot possibly have a tax liability due to a foreclosure because they are losing something rather than receiving income. Unfortunately, this is not always the case.
A foreclosure removes the property from the owner’s list of assets and cancels the mortgage from the owner’s liabilities. The difference is a taxable gain or loss. Gains are the result of a debt removal that’s greater than the asset value. The key component of this calculation is that the value used for the property is the owner’s book value. An Enrolled Agent course gives directions to identifying this basis that the taxpayer holds in the property.
Basis is the book value as if the taxpayer had maintained accounting records like a business. Not many individuals conduct their bookkeeping in such a complete manner. This explains the importance of Enrolled Agent tax work to untangle the details. Starting with the original price – including acquisition costs – basis is increased by the cost of subsequent improvements. Next, basis is reduced by any cost already written off as depreciation on tax returns.
People who incur foreclosures on property they have maintained as their primary residences for two of the past five years are currently entitled to a tax break. They can exclude a portion of gain just like people who sell their homesteads. The story is a little different for rental properties – even houses that people convert to rental after residing in them. California resident Drucella Malonzo recently discovered the impact of this situation in Tax Court.
Malonzo represented herself rather than relying upon an expert with an EA license to unwind complications of basis and taxable gain. She purchased a home in Sacramento during 2005, but moved to San Francisco in 2006. The house was rented for a portion of 2007 and Malonzo claimed $12,118 of depreciation on her tax return for that year. When she could no longer find a tenant, she abandoned the home. After not having payments on the mortgage, the lender foreclosed in 2008 when the market value was $278,314.84. This is the amount stated as market value on the Form 1099-A that the lender issued.
The outstanding balance of indebtedness indicated on the 1099-A was $325,855. Malonzo decided she had lost $313,737 after subtracting her depreciation from the mortgage amount. A California Enrolled Agent could have shown her the correct formula. She had a gain of $4,734. That exactly what the IRS determined by first identifying the taxpayer’s basis. The purchase price for the residence was $333,239 in 2005. Subtracting the depreciation arrives at a basis of $321,121. That figure is $4,734 less than the cancelled mortgage debt. Naturally, the Tax Court sided with the IRS accounting methodology.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.
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