Tax Treatment of Investment Property Sold at a Loss via Land Contract

[Kevin Suksi]

Thanks in advance for any insight on this item.

I am preparing a tax return for another investor who converted her tenant to land contract.

This property was purchased in 2005 for $106,000. The investor is tired of landlording, and wanted out despite the decline in value. The tenant came up with some EMD money and is paying a higher land contract amount than they were paying in rent, so the investor feels that in the short term the deal has improved for her. The amount on the land contract is $60,000. The improvements she's made on the property happen to amount to about the same amount of depreciation which has been taken, so the basis is materially the same as it was when the property was placed in service. It's a $46K loss!

So the IRS basically says that with installment sales, with a gain, you realize it over the life of the contract; with a loss, you must recognize it all at once:

http://www.irs.gov/publications/p537/ar02.html

She actively manages the property. At this point we're taking the whole chunk to line 14 and wiping out $46K in taxable income.

It seems really aggressive to me given the nature of land contracts but I don't see how else to report it. Our plan at this point is to report it this way and see if the IRS challenges it. If the land contract fails and she takes the house back, then I expect that a pro-rata of the loss would be picked back up as income.

Any insight would be appreciated from anyone who has encountered this situation.