I own a rental property in Arizona, and I live in DE. I will either short sale the condo, or it will be foreclosed, this year. The debt is non-recourse under applicable Arizona statute. Given that it is non-recourse, I will not need to pay cancellation of debt income on the property. However, I understand that I will need to pay capital gain tax on the disposition of the property, equal to the difference of the value of the loan and the fair market value of the property. The current value of the loan is approximately $215,000, and the most recent appraisal of the property was for $140,000. What actions can I take to minimize capital gain tax on this disposition, and what expenses are included to calculate the basis of the property, other than its FMV (i.e. depreciation, repairs, etc.)?
The rental property will not qualify for capital gains tax exclusion under the Mortgage Cancellation Tax Relief Act, which is scheduled to expire at the end of 2012 and which applies only to one's principal residence. Therefore, the figures you state suggest a maximum capital gain of $75,000. Of course, that potential gain amount will be reduced by any closing costs, appraisals fees, attorney fees, real estate fees, and other costs associated with any short-sale or preparing the property for short sale. Don't forget to increase your basis for any improvements over the time you had the property. One obvious strategy to reduce the capital gain tax would be to sell any marketable securities that might generate a capital loss prior to the closing. Do you have an investment portfolio that might be able to generate a capital loss? Any loss realized would of course be an offset to the capital gain from the rental property. Do you have any loss carryforwards from prior years? Don't forget that there may very well be an additional issue involving recaptured depreciation. Can't tell from the facts but I suspect you have taken depreciation deductions on prior returns. A final thought is to turn the property into your principal residence ,if you can hold the bank at bay that long.
You will have a capital gain equal to the revenue received on the property, less its tax basis as adjusted for depreciation allowed or allowable, an adjustment to basis for debt forgiven, and less any commissions and closing costs. If you made any improvements to the property this will add to the basis. You can use other capital losses you had during the year to offset these capital gains.
Any individual seeking legal advice for their own situation should retain their own legal counsel as this response provides information that is general in nature and not specific to any person's unique situation. Circular 230 Disclaimer - Advice given in this response cannot be used to eliminate penalties with the IRS or any other governmental agency.