Q: In Feb. 2006 I bought a condo for my personal residence for $175k and put $35k down. I lived there until Nov. 2008 when I purchased a home here and moved. From Nov. 2008 until Sept. 2012 I rented the condo out at market rate. I short sold the condo in Sept. 2012 for $52k with the mortgage balance at $120k. There was a write off amount on the mortgage which I plan to counter by demonstrating insolvency. Am I able to write off any of my capital loss on the condo?
A: First, you may have converted the condo from a residence to a rental in November 2008. This has a number of significant implications.
Before discussing the nature of your gain or loss, you have to know what type of mortgage you had on the condo that you sold and what your " adjusted tax basis" is in it. These factors will have a direct impact on the computation of gain or loss from the sale. If your sales price exceeds your adjusted tax basis, you have a gain. If your adjusted tax basis exceeds the sales price, you have a loss.
If the debt was nonrecourse, that is the lender could only go to the property to obtain repayment, then the portion of the debt that was discharged in the short sale is treated as part of the sales price of the property. If the debt was recourse, meaning the lender can look to your other assets for repayment, you get a different result. Your loan may be recourse if you refinanced the original purchase loan. Only the portion of the debt up to the fair market value of the property is counted as part of the sales price. Debt forgiven in excess of the property's fair market value is cancellation of debt income (CODI). CODI is ordinary income and is not accounted for as part of the sale. Only CODI is subject to the insolvency exclusion.
Your initial tax basis in the condo for purposes of calculating depreciation and gain or loss from the sale is the lesser of your cost plus improvements or the fair market value as of the date you converted it to a rental, November 2008. In other words, to the extent that the value decreased between your purchase in early 2006 and the property's conversion to a rental in late 2008, the loss is not deductible since it was a personal residence.
This rule was enacted to prevent a taxpayer from changing an otherwise nondeductible personal loss into a deductible loss by converting a residence into a rental for a short period of time prior to selling it.
In order to calculate the adjusted tax basis you must reduce the initial tax basis by depreciation allowed or allowable from the time you started renting the property until the sale. That has the effect of increasing gain or reducing loss. If you have a gain, to the extent that the gain is attributable to depreciation, it is taxable at a special 25% rate. Beyond that it is taxable as a long-term capital gain.
If you have a loss on the sale it would not be a capital loss, it would be a "Section 1231 loss," which may be ordinary in character, and not subject to the limits that apply to capital losses.
You may have a situation where you have a nondeductible loss to the extent of a decrease in value between 2006 and 2008 and a gain from the sale if the loan is nonrecourse, none of which could be excluded from income.