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Bad debt question

Some time ago, I made a real estate loan investment, with the loan being secured by the deed of the property involved. The idea was that the debtor would use the money to purchase a run-down property and fix it up over a period of months, paying monthly interest-only payments to me during that time (which I of course reported as interest income), then eventually sell the improved property at a profit and use those proceeds to pay off the loan. I've done a few such loans, but it's certainly not my trade or business. I'm a full-time engineer, that's how I make my living and for me, the real estate loans have genuinely been just a side way of generating some extra income, akin to owning bonds or dividend-paying stocks, but just with a higher yield than those. As such, if I understand things correctly, this does not constitute a "business debt" for tax purposes.

In the case of this loan, things went badly and at the end 2010, the debtor defaulted and I assumed ownership of the property. However, with the drop in real estate prices that had occurred in that location, the current value of the property is actually about 15% less than the outstanding loan balance. From a tax perspective, is this default effectively like I purchased the property, with the original loan amount becoming my cost basis? For example, if I were to close out the whole deal by selling the place tomorrow, does that then become reported as a capital loss of 15% for 2011? Or could it even be a capital loss of 15% in 2010, with my cost basis going forward from that time becoming that now lowered property value, rather than the original loan amount? Or does the fact that the deal originated as a loan mean that it would be reported in some other manner altogether?

Reply to
Michael Welch
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Normally lenders that make these kind of loans (generally called construction loans) have an agreement for a total loan amount, but give the money in installments, as the construction is done. Often the payments are made directly to the contractors. You might consider something like that in the future if you evern want to make the same kind of loan.

Do you put the interest on a Schedule C?

How did that happen? Normally lenders don't simply assume ownership of property securing their loans. Normally they have to foreclose, which includes an auction where the property is sold to the highest bidder. The lender, bidding in the amount of the loan, is usually the highest bidder.

If you purchased the property at the foreclosure sale, then that's exactly what you did.

Reply to
Stuart A. Bronstein

Thank you, Mr. Bronstein for taking the time out to read my question and offer thoughtful and considered reply. Please know that I am genuinely appreciative.

For simplicity and brevity in asking the question, I left out some of the details of the situation. From your questions, I see that I really should have been more precise, so allow me to apologize for that. The salient details are as follows:

1) These loans are brokered by a third-party financial firm that indeed makes a business of the process. That firm actually makes the original loan to the debtor, then sells the loan (sometimes partial interest therein; other times, including this one, the entire loan as a whole) to individual investors like myself, with the firm remaining on as servicer of the loan. The firm collects the interest payments from the debtor, retains from it their servicing fee (and any interest due them in the event they kept any ownership interest in the loan), disperses the remaining amount to the loan's investor(s) monthly, and provides a 1099-INT to the investors at the end of the year. 2) I have reported that interest as interest income on Schedule *B*, not on Schedule C, since, as I mentioned, I am not making a business of this. I just invest the initial money and collect the interest until the loan is paid off, much like I would if I'd bought a bond. I've participated in maybe four of five such loans over the course of about three years, and this instance about which I'm asking is the first time a loan in which I was involved had a default and thus is the first time that there's been anything more to it than that. 3) There was no foreclosure because the agreement with the debtor included a Deed In Lieu of Foreclosure agreement. So ownership was indeed transferred without a foreclosure auction being involved.
Reply to
Michael Welch

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