Investors who have multiple rental properties and experience a debt cancellation relating to a rental property might be missing an important tax break.
Tax return preparers and individuals who use tax return preparation software or (God forbid!) prepare their income tax returns by hand usually report taxable cancellation of debt for a rental property as “other income” at line 21 of Form 1040.
According to Revenue Ruling 92-92 and page 3 of IRS Publication 4681, cancellation of debt attributable to passive activity expenditures, such as purchase of the rental property, is passive activity income. For a rental property, the debt cancellation income should be included on line 3 of Schedule E as “rental income” for the property.
If some of the cancellation of debt income is attributable to funds used for a personal purpose, such as cash received from refinancing a property used to pay for a personal car or vacation, that portion does not qualify as passive activity income and still must be reported as “other income” on line 21 of Form 1040.
Reporting the cancellation of debt income as passive activity income will enable the taxpayer to not only use any unused passive activity losses for the foreclosed or short sold property as an offsetting deduction, but also unused passive activity losses from other properties or passive investments.
Be sure to watch for this when reporting cancellation of debt income for a rental property in 2009, and check whether an amended income tax return should be filed to correct errors on tax returns already filed.