Tax Laws for Abandoned Real Estate Projects
Sunk costs are a fact of doing business. Recognizing sunk costs helps businesses decide whether to continue pursuing a project when costs escalate and forecasts fall. Even though it means accepting sunk costs as lost, abandoning a real estate project that’s gone off budget or unlikely to turn a profit can curtail further losses involved in seeing the project through to completion. Abandoning a real estate project can have a number of tax implications.
As your property appreciates, you don’t have to pay taxes on the increase, even though you might be able to benefit from the increased value of the property, because federal income tax laws recognize gain and loss on real estate projects when the project is disposed. Tax laws regard abandonment -- giving up your rights to property without transferring it to anyone else -- as a form of disposition. When you abandon property, you must report it on your federal income taxes.
Mortgages on real estate might require the borrower to take personal responsibility for any unpaid debt after foreclosure. This is called recourse debt. The tax rules for recognizing income from abandoning a real estate project delay calculating gain or loss from the abandoned project until the property is sold at foreclosure. When your lender cancels any debt after foreclosure, you typically would report that amount as ordinary income; however, if your abandoned project is part of your real estate business, you can exclude canceled debt on recourse loans.
Some lenders offer nonrecourse loans, which are secured only by an interest in the real estate project. If you default on a nonrecourse mortgage, the only way for the lender to recover its loan is by selling off the property at foreclosure. Any shortfall between the outstanding loan and the sale of the property is the bank’s loss and your gain for tax purposes.
Abandoned real estate projects might result in either ordinary or capital gains income. Any gain recognized from the cancellation of debt, such as when you abandon a nonrecourse mortgage because the outstanding debt is greater than the fair market value of the property, is ordinary income. If the project sells for more than your adjusted basis at foreclosure, that gain is taxed at the preferential capital gains rate.