Not sure how to handle the foreclosure and cancellation of debt for rental that was vacant for over a year.

[bookish29]

I have a complicated situation that I can't seem to find the answers for in IRS publications or articles online.  We had a rental that was formerly my husband's primary residence.  It was converted to a rental 1/1/2015.  Due to multiple lease cancellations and unapproved repairs by the management company, we could no longer make mortgage payments (11/2017.)  We continued to rent it out until 6/2018, when the lender began the foreclosure process and the management company would no longer rent it out.  We advertised on our own, but it remained vacant.  Then our city was hit by Hurricane Michael in 10/2018.  The rental sustained damage making it unlivable.  As the property was still in the foreclosure process, and we were fighting it out with our insurance company, it remained vacant and unrepaired.  The lender finally foreclosed 3/6/2020.  We received a 1099-C for cancellation of debt (it was a recourse loan.)

Beginning in 2015, I reported the rental on Schedule E.  We had losses every year, so we had several years of accumulated passive losses.  When I filed our 2019 taxes (with Turbo Tax Online,)  we had no income and no expenses, so I checked "I did not rent, nor attempt to rent, this property at all in 2019," which deleted the rental.  Therefore, no depreciation was taken for 2019.  But even if we had taken it, it would have been added to our passive loss carryover. 

I am using the Turbo Tax Premier download for 2020.  I thought I had figured out how to report all of this, but now I'm having second thoughts.  Here's what I've done so far:

• I used the canceled debt worksheet to calculate the income from cancellation of debt, and the foreclosure sale. I linked the CODI to Schedule E.  The loss from foreclosure went to 4797.
• Schedule E: I entered 0 rental days and 0 personal days.  CODI is listed as rental income.  I entered mortgage interest from the 1098 received from the lender for 2020.  It is significantly higher than usual, since the 2018 and 2019 1098's were $0.  
• Because I entered 100% business use for 2020, there is depreciation for 2020 (until the date of sale.)
• I entered all prior passive losses, which are now deductible. 
• I have a gain on Sch. E and a loss on Form 4794.

Things I am uncertain about:

1. When I deleted the rental for 2019, in IRS's eyes, did I convert it to personal use? If so, is amending 2019 necessary?
2. Was accidentally converting it to "personal use" actually correct, even though we attempted to rent it out, and then were unable to due to hurricane damage?  If so, how are passive losses and CODI handled? Do I convert it back somehow to have the CODI go to the Sch. E? ? Do I handle the foreclosure sale differently than the way I explained earlier?
3. If I should NOT have converted it to personal use,  does it matter that I did not claim depreciation for 2019 (since it would have been cancelled out by becoming a passive loss)?  Would I use my 2018 prior depreciation and passive losses, or include the 2019 depreciation and passive loss (even though they were never claimed)?  I can amend 2019 if necessary (it would be a Sch. E with $4000 depreciation, which would add $4000 to my passive loss carryover on Form 8582.)  
4. Is it correct to use the total mortgage interest from the 2020 1098 as an expense on Sch. E? Should I use only a percentage? None at all?

I know this is a lot of information and I tried to explain the best I could.  Any advice would be greatly appreciated.

[DaveF1006]

Yes, that was quite a change of events over the years. let me answer your questions one by one.

1. The rental was deleted in 2019 because of no income or expenses were being claimed. There was nothing to report. The IRS would not interpret this as converting to personal use. It was strictly a dwelling that was vacant because it was inhabitable. If you are questioned about this, this is how you would explain it.
2. No, amending is not necessary because Turbo Tax deleted this because there was activity in 2019 but if you wish to claim the $4000 depreciation, then you should amend so that it will add $4000 to your passive loss carryover..
3. Converting it to personal use is not correct. You did not move into the property or use it for recreational purposes. It was vacant and inhabitable, unfit for personal use. 
4. The cancellation of debt generated from a 1099-C would never appear as income in 2020 on a Schedule E regardless of your circumstance. The 1099-C is simply mortgage forgiveness.  It would appear as ordinary income (Or loss) on line 8 of your 1040.  In addition, if there was a a capital gains activity, It would generate a Schedule D and and report that on line 7 of the 1040. It is difficult to tell if you have a capital gains without looking at your actual tax return. 
5.  It is correct to claim mortgage interest as a 2020 deductible expense.
6. My question is, when did you indicate you converted to personal use because passive losses, including depreciation, would have ceased at that point. If in 2019, you could amend it and change the answer, then the passive losses carryovers would have continued into 2020. 
7. Lastly, you would claim depreciation each year because the depreciation would need to be recaptured this year when the property was disposed of (foreclosed). IRS says that this needs to be recaptured whether or not it was claimed in the past. This may may or may not result in a capital gains situation this year. 
8. Be sure to amend your 2019 return first to claim the depreciation. 
9. Now let's address what I think is a critical issue. I cannot say for certain if you filled out your cancellation of debt properly based on what you told me. You mentioned earlier you linked it to Schedule E but this has nothing to do with Schedule E income. The correct way to report his is to perform the following steps. in your program, go to: 

• Federal taxes>wages and income>choose what you work on
• less common income>miscellaneous income>start
• cancellation of debt (1099C) etc
• under tell us about your canceled debt indicate that you received the 1099C for another type of loan for a non-personal debt. This is a business debt and not a personal one
• The next screen will recommend you seek advice from a tax professional or reference IRS publications 4681 or 544. I assume you entered all your information on the 4797 directly but MAKE SURE you read these publications to make sure this was done correctly. 
• pub 4681             pub 544

[Edited 03-29-2021|07:00 PM PST]

[bookish29]

Thank you Dave.  I'll respond to your answers.

• 1, 2, 6, & 7

Are you saying that if I do not amend 2019 to claim depreciation (which will create a carryover,) that I will still have to reduce my basis (as if I did claim it,) and I would not be able to adjust my passive loss carryover by the same amount?  You also said I need to amend my 2019 first, but amended returns are taking months, if not longer, to be processed.  Is it ok to go ahead and e-file my 2020 even if the amended return takes 6 months? 

• 4. The cancellation of debt generated from a 1099-C would never appear as income in 2020 on a Schedule E regardless of your circumstance. The 1099-C is simply mortgage forgiveness.  It would appear as ordinary income (Or loss) on line 8 of your 1040.

According to IRS Pub. 4681 Canceled Debts, Foreclosures, Repossessions, and Abandonments, page 3:

You must report any taxable canceled debt as ordinary income on:
• Schedule 1 (Form 1040), line 8, if the debt is a nonbusiness debt;
• Schedule C (Form 1040), line 6, if the debt is related to a nonfarm sole proprietorship;
• Schedule E (Form 1040), line 3, if the debt is related to nonfarm rental of real property

Turbo Tax Premier Desktop has a Canceled Debt Worksheet that guided me through everything. I had to switch to forms view to find it.  It links the 1099-C to the Sch. E.  The worksheet instructions state that it does not support AMT differences (which doesn't apply to our rental.)  It also says: For secured debt, complete Part II, with the requested information about type, usage, and disposition of the secured property. If box 7a, 7b or 7c is checked, the property is treated as section 1250 property and the depreciation on line 12 is not recaptured. The Canceled Debt Worksheet does not support section 1250 depreciation expense recapture. (I have a loss, so this also does not apply, correct?) Perhaps this is why Turbo Tax does not handle it in the step-by-step and says to seek advice from a professional or read IRS publications (which I have EXTENSIVELY.)  Everything I have read from IRS says that the CODI goes on Sch.E for a rental.  Also, the calculations on this worksheet for figuring the gain/loss from a foreclosure are straight out of IRS Pub. 4681. 

It's possible that I could have entered something incorrectly, so if it looks off, let me know.  Everything goes to their correct forms and makes sense (at least to me.)  I did a review and TT didn't find any errors.  Here is the redacted worksheet from TT.  I can post images of the other forms in the morning, like the Sch. E and 4797.  Just posting this one has taken me hours lol, so I'm headed to bed.

Thanks again!