Editor: Michael D. Koppel, CPA, PFS
The tax ramifications of a foreclosure, from a debtor’s perspective, can best be understood by first exploring the general approach to determining the tax treatment of any particular debt forgiveness event. This approach begins with a two-step process. The first step is to divide the debt into two components: (1) discharged principal and (2) discharged, but previously deducted, accrued unpaid interest (if any). The first step is necessary because the tax treatment applicable to the discharge of principal is generally not the same as the treatment applicable to previously deducted accrued unpaid interest.
Discharged principal must be included in gross income under the “general rule” of Sec. 61(a)(12) and as such is taxed as ordinary income (referred to as cancellation of debt (COD) income). There are two exceptions to the general rule, and they are discussed below in connection with the second step.
Discharged principal may, in part or in whole, be excluded from gross income under the exclusion rules of Sec. 108. As a price to be paid for the exclusion, the taxpayer may be required to reduce certain enumerated tax attributes, including certain loss and tax credit carryforwards and basis in certain property (Secs. 108 and 1017). The exclusion and tax attribute reduction rules are beyond the scope of this item. To the extent debt proceeds (from the canceled debt) are allocated to a passive activity at the time the debt is canceled, the COD income is characterized as income from a passive activity (the allocation can be determined by using the methodology available under the interest tracing rules of Temp. Regs. Sec. 1.163- 8T (see Rev. Rul. 92-92)).
Discharged accrued interest (that the borrower previously deducted) is generally included in gross income under the “tax benefit rule” (Sec. 1341). Consequently, the exclusion and tax attribute rules do not apply to accrued interest.
The second step concerns the discharge of principal and determining whether either of the two exceptions (discussed below) apply. As previously stated, the requirement to include discharged principal in gross income (as COD) is a general rule under Sec. 61(a)(12). The two exceptions to the general rule are (1) the purchase price adjustment exception and (2) the foreclosure exception. These exceptions are mutually exclusive.
Under the purchase price adjustment exception, the debtor does not report COD income. Instead, the debtor reduces the adjusted basis of the purchased property (Sec. 108(e)(5)). Where depreciable property is concerned, this has the effect of reducing depreciation deductions over the property’s remaining recovery life. The purchase price adjustment applies only to seller-financing transactions (i.e., installment sales) in which the creditor is the property’s original seller (i.e., seller financing), the debtor is the property’s original purchaser, and the debt arose from the property’s purchase. Certain other criteria must also be satisfied.
The foreclosure exception applies to transactions involving the surrender of collateralized property in full satisfaction of mortgage debt. Under Regs. Sec. 1.1001-2, cancellation of indebtedness arising from the involuntary (i.e., foreclosure), or in exchange for the voluntary (i.e., deed in lieu of foreclosure), disposition of property is treated as a sale or exchange of such property. As a result, the discharged principal, and under certain circumstances previously deducted accrued unpaid interest (see below), may be includible in the amount realized for purposes of determining gain or loss.
A foreclosure is the legal process by which the lender takes collateral property to satisfy an outstanding debt. A deed in lieu of foreclosure (i.e., conveyance) is a transaction in which the borrower merely transfers title to the lender in full satisfaction of the debt. Both transactions are treated as a sale or exchange of property for tax purposes. In either case, the tax treatment depends largely on the type of debt involved (i.e., nonrecourse or recourse). The basic tax consequences associated with foreclosures are discussed in detail below, but for quick reference, Exhibit 1 summarizes the rules, and Exhibit 2 on p. 824 illustrates how those rules work.
Nonrecourse debt: In the case of a foreclosure involving nonrecourse debt, the entire amount of canceled principal debt is included in the amount realized (Regs. Sec. 1.1001-2). Gain or loss from a foreclosure, or the transfer of a deed in lieu of foreclosure, is generally characterized as either Sec. 1231 or capital gain. Sec. 1231 or capital gains do not constitute income includible in gross income under Sec. 61(a)(12)—the general rule. Consequently, borrowers can never exclude such gains from gross income under Sec. 108. Sec. 1231 or capital gains will generally be taxed at lower capital gains rates (Sec. 1(h)), subject to the depreciation recapture rules under Sec. 1250 and the five-year lookback rule under Sec. 1231. The amount of gain or loss is the difference between the full amount of the nonrecourse debt and the surrendered property’s adjusted tax basis (Tufts, 461 U.S. 300 (1983), and Regs. Sec. 1.1001-2). The amount realized can never be lower than the outstanding principal amount at the time of foreclosure, even where the fair market value (FMV) of surrendered property is lower than the outstanding nonrecourse principal balance (Sec. 7701(g)).
Recourse debt: In the case of a foreclosure involving recourse debt, the rules applicable to nonrecourse debt also apply to recourse debt except where the recourse debt exceeds the FMV of the surrendered property. In this instance, two unrelated events are deemed to occur: (1) a COD income recognition transaction to which the Sec. 61(a)(12) general rule will apply and (2) a sale or exchange transaction resulting in gain or loss under Sec. 1001 (Regs. Sec. 1.1001-2; Rev. Rul. 90-16; Aizawa, 29 F.3d 630 (9th Cir. 1994)). With respect to the former, the taxpayer has COD income to the extent the canceled debt exceeds the FMV of the property at the time of the discharge. In all cases, COD income is subject to the general rule (including the exclusion and tax attribute reduction rules) mentioned above.
With respect to the deemed sale or exchange event, gain or loss (whether it be Sec. 1231 or capital) is determined by reference to the difference between the amount realized (usually the total canceled debt less the portion treated as COD income) and the adjusted tax basis in the property (Sec. 1001).
Timing of income recognition: A debtor (i.e., mortgagor) realizes taxable gain or loss in the year that the foreclosure sale becomes final. In states that provide for a right of redemption in the debtor/ mortgagor, the sale remains open until the expiration of the redemption period (Rev. Rul. 70-63; Letter Ruling 9540006).
Accrued unpaid interest—accrual method
borrower: The treatment of accrued
previously deducted unpaid interest that is discharged in
connection with a foreclosure (or deed in lieu
transaction) is governed by the holding in Allan,
856 F.2d 1169 (8th Cir. 1988). According to
Allan, if the lender treats the unpaid accrued
interest as an addition to principal (and the accrued
interest is secured by the property), an accrual-method
borrower must include the discharged interest in the total
amount realized for purposes of computing Sec. 1001 gain
or loss on foreclosure or the transfer of a deed in lieu
Allan did not address the tax treatment of accrued interest associated with a loan for which accrued unpaid interest is not required to be added to principal. There is virtually no guidance available for this particular scenario. However, there is one viable approach: The tax consequences of a hypothetical sale of the property, followed by an immediate paydown of the entire debt, can be used as a guideline. For instance, accrued interest should be included in the amount realized, but only to the extent that the property’s FMV exceeds the discharged principal. The rationale for this conclusion is based on the reality that the amount realized from an actual sale of the property would have been equal to the discharged principal plus the excess of the property’s FMV over the discharged principal. Any remaining accrued interest (that was previously deducted) would be reported as ordinary income under the tax benefit rule (1180 East 63rd St. Building Corp., 12 T.C. 43 (1949)). The IRS also endorses this approach in Letter Ruling 8041017, although the letter ruling does not specifically state that the borrower was not required to add unpaid interest to the mortgage principal.
Accrued unpaid interest—cash basis borrower: With respect to a cash basis borrower, the treatment of accrued but unpaid interest will also depend on the property’s FMV. The question that arises in connection with a cash basis borrower is whether the borrower would be entitled to a deduction for interest paid in a foreclosure. It appears that no deduction will be allowed if the value of the property is equal to, or less than, the outstanding principal. However, if the value of the property exceeds the principal, the borrower will be allowed a deduction for interest to that extent.
Exhibit 1: Tax consequences to debtor
|Type of debt||Amount realized||Basis||Sec. 1001
|Sec. 61(a) (12) COD income|
|FMV of property exceeds debt||Recourse||Principal debt||Tax basis in property||Amount realized > basis||None|
|FMV of property exceeds debt||Nonrecourse||Principal debt (may include accrued interest under certain circumstances)||Tax basis in property||Amount realized > basis||None|
|Debt exceeds FMV of property||Recourse||FMV of property||Tax basis in property||Amount realized > basis||FMV of property|
|Debt exceeds FMV of property||Nonrecourse||Principal debt (may include accrued interest under certain circumstances)||Tax basis in property||Amount realized > basis||None|
Exhibit 2: Property transferred to lender—tax
consequences to debtor:
Example (assume a non-interest-bearing loan)
|Property||FMV||Tax basis||Debt||Principal balance||Sec.
|Sec. 61(a)(12) |
- The income would be active or passive depending upon the characterization of the activity.
- Since the tax basis equals FMV and the debt is recourse, the transfer results in COD income.
- For purposes of determining gain with respect to property subject to nonrecourse debt, Sec. 7701(g) provides that the FMV of such property shall be treated as not less than the amount of the nonrecourse debt.
- Since the tax basis is less than the FMV of the property, gain is recognized to that extent. The balance is COD income.
- Since the tax basis is greater than the FMV, a loss is recognized to that extent. Since the property is treated as having been sold for its FMV, the difference between the FMV and the debt is COD income.
- COD income may be excludible under Sec. 108.
Caution: The determination of whether debt is recourse or nonrecourse for purposes of applying the above rules may differ from its classification for other purposes. For example, the classification of debt for purposes of determining the tax basis of a partnership interest would not be dispositive for purposes of determining its character in analyzing the tax consequences of a foreclosure or deed in lieu of foreclosure at the partnership level. A determination is required as to whether the debt is recourse or nonrecourse at the partnership level—for instance, whether the creditors’ rights of recovery are limited to the asset securing the liability (nonrecourse) or can extend to all the assets of the partnership (recourse).
Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.
For additional information about these items, contact Mr. Koppel at (781) 407-0300, or email@example.com.