Owners of real property sometimes encounter difficult financial times due to an overall decline in the economy or events that adversely affect their particular area of the country. These conditions may produce situations where an owner does not have sufficient cash flow from a property to meet the debt requirements, or the property declines to a value that is less than the outstanding debt. In either case, foreclosure of the property by the lender is often the final outcome.
Real property foreclosures can produce various tax consequences depending on the type of debt (recourse or nonrecourse), the taxpayer's adjusted basis in the property, and the taxpayer's financial condition at the time of the foreclosure. Proper planning both before and after a foreclosure can help minimize the tax consequences of these transactions.
Note: There are special tax provisions (not covered in this column) for cancellation-of-debt (COD) income on principal residences.
Recourse and nonrecourse debt often produce different tax results
A recourse debt enables the lender to pursue the individual borrower for the balance due on a debt in addition to foreclosing on the property. Conversely, a nonrecourse debt is secured solely by the real property, thus shielding the individual borrower from personal liability. When property is foreclosed, the tax results differ depending on whether the debt is recourse or nonrecourse. Understanding the differences is a key factor in proper planning for the foreclosure.
A foreclosure, or a deed in lieu of foreclosure, transaction may result in COD income to the borrower when recourse debt is involved. The taking of property by the lender in satisfaction of a recourse debt is treated as a deemed sale with proceeds equal to the lesser of the property's fair market value (FMV) at the time of foreclosure or the amount of secured debt. If the amount of debt exceeds FMV, the difference is treated as COD income if it is forgiven (Regs. Sec. 1.1001-2(c), Example 8, and Rev. Rul. 90-16). (Note that Sec. 108 provides special mandatory relief provisions for COD income of certain bankrupt or insolvent taxpayers.)
As a result of these rules, it is possible for a foreclosure transaction involving recourse debt to result in both (1) a gain or loss from the sale of the property because the property's FMV is more or less than basis and (2) COD income because the secured debt exceeds the property's FMV. The amount credited or received in a foreclosure sale determines the sales proceeds for computing gain or loss (Aizawa,29 F.3d 630 (9th Cir. 1994); Webb,T.C. Memo. 1995-486). The character of the gain or loss depends on the character of the property subject to the foreclosure.
Observation: To the extent the underlying debt discharged is allocated to a passive activity, the COD income is treated as arising from a passive activity. Conversely, to the extent the underlying debt is attributable to a nonpassive activity, the COD income is nonpassive (Rev. Rul. 92-92).
Note: The bid price in a foreclosure sale is presumed to be the property's FMV unless there is clear and convincing proof to the contrary (Regs. Sec. 1.166-6(b)(2); Community Bank, 819 F.2d 940 (9th Cir. 1987)). The Tax Court has acknowledged that the amount bid by a lender may be arbitrary, so if the taxpayer presents clear and convincing proof (e.g., an appraisal) of a more accurate FMV, the FMV amount rather than the bid price is used in determining the sales proceeds from the transaction and any related COD income (Frazier, 111 T.C. 243 (1998)).
COD income will occur in a foreclosure transaction only if the lender discharges part or all of any deficiency (excess of indebtedness over the property's FMV) upon taking the property. If the lender continues to pursue the borrower for the deficiency, COD income will not occur until that deficiency is discharged for less than full value. If the lender fails to pursue the borrower or to discharge all the indebtedness, the COD income will occur when the state law for enforcing the debt expires.
Example 1. Property foreclosure involving recourse debt: M bought a commercial building on Jan. 1, 20X1, for $5,000,000. He put $500,000 down and financed the balance with a $4,500,000 recourse debt. The purchase price was allocated $500,000 to land and $4,500,000 to the building.
In 20X3, M started to experience financial difficulties from the property due to falling rents and the loss of a major tenant. Finally, when he was unable to make further payments on the debt, he deeded the property to the bank in lieu of foreclosure on Nov. 30, 20X4.
When the property was deeded back to the bank, the outstanding balance on the debt was $4,325,000. M's adjusted basis after depreciation in the property was $4,052,500 — $3,552,500 in building and $500,000 in land. The FMV of the property at the time of foreclosure was $4,150,000.
In a deed in lieu of foreclosure transaction, the transfer of the property to the recourse debt lender is treated as a sale with proceeds equal to the lesser of the FMV of the property ($4,150,000) or the amount of the outstanding debt ($4,325,000). Thus, M recognizes a Sec. 1231 gain of $97,500 ($4,150,000 FMV less adjusted basis of $4,052,500). The gain is allocated between the land and building based on the relative FMV of each.
The excess of the debt principal extinguished in the transaction ($4,325,000) over the FMV of the property ($4,150,000) results in COD income of $175,000. If the lender forgives the deficiency at the time of the transaction, M recognizes the income then. If, however, the lender pursues M for this deficiency, this part of the transaction remains open, and M does not recognize income until the lender eventually forgives it or the debt is settled for an amount less than full value.
As Example 1 illustrates, the FMV assigned to the property at foreclosure or deed in lieu of foreclosure determines the amount of the borrower's gain or loss from the deemed sale of the property and potential COD income. If the property is used in a trade or business or rental activity, a gain from the sale is often treated as a capital gain under Sec. 1231. Conversely, COD income is ordinary income to the borrower.
If the borrower is insolvent at the time of the foreclosure, it may be advantageous to get the lowest FMV possible assigned to the property. This will minimize the amount of gain from the deemed sale and maximize the amount of COD income, which can be fully or partially excluded from income under Sec. 108. In addition, a taxpayer who deeds real property to a lender and has debt discharged may be eligible to make the election for real property business debt.
Alternatively, if the borrower is solvent at the time of the foreclosure, it is usually advantageous to value the property as high as possible. This will maximize gain that may be eligible for preferential capital gain treatment and minimize the amount of ordinary income from debt discharge.
It is common for the FMV of a property to fall within a reasonable range of amounts. Thus, with proper planning prior to the foreclosure or deed in lieu of foreclosure, borrowers can often negotiate with the lender to get the most advantageous FMV assigned to the property. This is most likely to occur when the lender intends to forgive the debt deficiency rather than continue to pursue the borrower. Furthermore, a borrower may have more negotiating ability if the property is voluntarily deeded back rather than foreclosed upon.
Note: Certain lenders, generally banks, savings and loans, and other financial institutions, that foreclose on property or take property in lieu of foreclosure must issue the borrower a Form 1099-A, Acquisition or Abandonment of Secured Property, reporting the details of the foreclosure. Among other information, Form 1099-A shows the FMV of the property at the time of the transfer and whether the borrower is personally liable for repayment of the remaining loan balance. Without planning and pretransfer negotiation with the lender, the borrower may be surprised by and unable to rebut the information reported on Form 1099-A.
The Supreme Court's decision in Tufts, 461 U.S. 300 (1983), resolved the main issue of the tax treatment of a foreclosure, or deed in lieu of foreclosure, transaction involving nonrecourse debt. Such a transaction is treated as a deemed sale by the borrower to the lender with proceeds equal to the amount of nonrecourse debt. Also, an abandonment of real property encumbered by nonrecourse financing is treated like a foreclosure in that there is a deemed sale of the property (Middleton, 693 F.2d 124 (11th Cir. 1982)).
An Eighth Circuit decision, Allan, 856 F.2d 1169 (8th Cir. 1988), concluded the amount realized on the deemed sale includes the full amount of the nonrecourse debt plus any additions to principal for items, such as accrued interest, that previously generated ordinary deductions for the borrower. For a cash-basis borrower, however, the amount realized on the deemed sale would equal only the principal balance of the nonrecourse debt.
Note: The theory that the amount realized from a deemed sale equals the full amount of nonrecourse debt principal means there can be no COD income due to a foreclosure or deed in lieu of transaction involving only nonrecourse debt. Unlike the treatment of foreclosures involving recourse debt, the FMV of the property is irrelevant. Also, the insolvent or bankrupt status of the taxpayer does not affect the results.
Example 2. Property foreclosure involving nonrecourse debt: Assume the same facts as in Example 1 except M's debt is nonrecourse rather than recourse. Here, transferring the property to the lender results in a deemed sale of the property with sales proceeds equal to the balance of the nonrecourse debt. Thus, M recognizes a Sec. 1231 gain of $272,500 ($4,325,000 outstanding debt less adjusted basis of $4,052,500). There is no COD income.
|Patrick L. Young, CPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact email@example.com. This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s Sales and Exchanges topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).|