Basis when purchasing subject-to

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@Steven Hamilton II and @Dmitriy Fomichenko

I read some threads recently where the info on basis when purchasing sub2 seemed conflicting.  2 years ago I bought a property subject-to the existing liens of $250K.  Then four months later negotiated a payoff on the liens (as the owner, so not a short sale) for $80K.  I rehabbed it and sold it a few months later for $165K.  I treated it as inventory on my Schedule C that year.

If I had kept the property for longer, what would the basis be?  I've read the purchase price plus any debt should be the basis, so in this case $251K.  But that seems like such a windfall, as I would have a reportable loss when that property was totally profitable.  Since the debt wasn't mine, I didn't receive a 1099 on the forgiveness.

Is that just a perk of sub2 purchase?  

[Nathaniel Busch]

@K. Marie, 

This is a fascinating scenario you put forward. 

Here is my take on it...

Your basis is initially $250,000. 

Four months later, you incur $170,000 of cancellation of debt income as the amount you are required to pay instantly drops by that amount, to $80,000.

When you sell the property for $165,000 you would have a loss of $85,000. 

The cancellation of debt rules require that you report the income in a matter consistent with the nature of the underlying transaction. So, the COD income would also be reported on Schedule C in addition to the loss of $85,000.

The result is a net Schedule C gain of $85,000.

Interestingly, this is the same exact result had you just ran with basis of $80,000 (the updated debt amount four months following the subject 2). 

I know this seems like additional steps, but it's the technically correct answer.

The root of this answer falls in the tax court case "Denver & Rio Grande Western Railroad Co v. U.S., (1974, Ct Cl)".

Basically, the courts determined that your initial basis at purchase is the total agreed upon amount of mortgage debt to be taken over by the buyer on behalf of the seller. Interestingly, it also states that basis in a property cannot be achieved through an encumbered debt if the payment of that debt is contingent. However, these rules are only important if you plan on renting the property versus selling it in the short term, so I won't tread down that path too much. 

Since the courts state that your initial basis is established in whatever amount you agree to pay for on behalf of the buyer, you need to run with that initial agreed upon amount as your basis. I think it was mentioned above that cancellation of debt income ONLY falls back on the seller because the mortgage is in their name. That is not entirely true. Cancellation of debt income is not limited to just mortgages - it extends to any debts where there is an agreed upon liability between two parties where the obligation or responsibility to pay is altered at the benefit of the responsible party. 

Fortunately, it really makes no difference in your case as the buy and sell of the transaction was completed in the same tax year. 

Had the sale been completed in a second year, that would have created an interesting scenario as well. Fortunately, there are rules that would have permitted you to avoid the tax trap of a large gain in one year, follow by a large loss. Check with a qualified real estate CPA to see what those rules and opportunities would have been to escape taxation. 

On a side note - must you report this on Schedule C and subject it to FICA? There could be opportunity to report on Schedule D even if the property was held under a year. I think these are the crucial questions you should be asking. 

If you need any further help with your transaction, I'm happy to lend a hand.