Silver Lining for Owner of Income Property Is Having a Loss to Report to Uncle Sam

Q. Last year we were forced into foreclosure on a piece of income property for which we had paid $150,000 and on which we still owed $127,000. The bank says that the property is worth just $62,000 and that it forgave us $65,000 in debt. The bank has not sold the property, and I believe that the value it has placed on it is far too low. Meanwhile, we have received a 1099 for the $65,000 and realize that the Internal Revenue Service will expect us to report that as income and pay taxes on it. We cannot afford to pay taxes on that amount. What are our choices?

--M.H.L.

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A. You’re fortunate your property was an investment and not your home, because even after declaring the $65,000 debt forgiveness as business income, you will have a loss to report to Uncle Sam.

Here’s how to figure it out. We’ll assume for the purposes of these calculations that you did not transfer untaxed gains from a previous investment to this property through a tax-deferred exchange. We’ll also not take into account any depreciation you took on the property, which would reduce your tax basis in it. That said, here’s how it works:

You paid $150,000 for the property, which we’ll say is your tax basis. You “sold” the property back to the lender for $62,000. (Actually, the lender took it back and gave it a value of $62,000, but that doesn’t matter here.) You have a loss of $88,000. From that loss you deduct $65,000, which is the amount of the loan that was forgiven. This gives you a loss, deductible as a business expense, of $23,000.

Another way to look at this is that you paid $150,000 for the property and took out a $127,000 loan, presumably adding from your own pocket the remaining $23,000 as a down payment. You’ve lost this $23,000 and are claiming it as a business deduction.

Let’s expand the scope of this exercise by applying the same figures to a property that is your residence rather than an income investment. What would happen then?

It would all hinge on the type of mortgage you were walking away from--that is, whether it was a recourse or non-recourse loan. A recourse loan is secured by the property being purchased as well as the borrower’s general assets, and it allows the lender to seek “recourse,” or repayment, from the lender’s assets when the note is due. Non-recourse loans are secured only by the property being purchased, and the lender is restricted to attaching only the property for loan repayment.

In California, loans secured for the purchase of a property, so-called purchase money loans, typically are non-recourse. However, second mortgages and mortgage refinancings are recourse loans, leaving the borrower’s full assets open to attachment for repayment of the note.

If your loan was a purchase money, or non-recourse loan, you do have to declare the full amount of the mortgage ($127,000) that was relieved as “sale proceeds” since you have given back to the lender the only asset it could attach for the note. However, the “sale proceeds” will be offset by the $150,000 cost basis in the property, resulting in a loss of $23,000 that is not deductible because losses on a personal residence are not deductible.

If, however, the loan had been refinanced or was another type of recourse note, you would be required to report the “sale” of the residence, showing the sale price equal to the fair market value of $62,000 that was offset by the $150,000 cost, resulting in a loss of $88,000 that is not deductible because we are again talking about a personal residence.

In addition, you would be required to declare as ordinary income the $65,000 the bank forgave as debt forgiveness income. The only way to avoid paying taxes on the $65,000 would be to declare yourselves completely insolvent at the time the bank repossesses the property.

She Can’t Claim 100% Benefits Until Age 65

Q. I am a widow with Social Security earnings greater than those of my late husband’s. I would like to retire at age 60 and claim widow’s benefits on his account and then, at age 65, switch to receiving benefits on my own account. Will I be able to receive 100% of my Social Security benefits if I follow that strategy? I cannot find an answer to this question on the official literature, and I have received conflicting answers.

--M.R.

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A. According to our sources at Social Security, you and other taxpayers born after Jan. 2, 1928, may receive widow’s benefits at age 60 and still be eligible for full benefits on your own account at age 65. However, at age 60, widow’s benefits are just 71.5% of what the wage earner--in this case, your deceased husband--was entitled to receive at age 65. You cannot claim the full 100% widow’s benefits until you turn 65.

The good news is that you are entitled to receive them at age 60, and may continue receiving them on your late husband’s account until switching over to full benefits on your own account at 65. This strategy makes sense only when the surviving spouse has higher Social Security earnings than the deceased’s.

Taxpayers born before Jan. 2, 1928 had to wait to age 62 to be treated similarly.

Carla Lazzareschi can be reached by writing to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053. Or send e-mail to carla.lazza reschi@latimes.com