Lenders’ tax consequences of foreclosure

Recent economic conditions have caused headwinds for lenders and borrowers alike. With U.S. interest rates at their highest level in decades,¹ many borrowers are struggling to meet their payment obligations on debt. This is especially true in the commercial real estate secured financing space, where property owners face continuing challenges because of a nearly 20% office vacancy rate nationwide.² In some instances, nonperforming debt may be worked out and modified for the betterment of both parties.³ However, in scenarios when it cannot be, often the next steps result in either an amicable deed-in-lieu of foreclosure (deed-in-lieu) or a foreclosure.

A tremendous amount has been published on the tax consequences of both a deed-in-lieu and foreclosure from a borrower’s perspective. However, much less has been written on the tax consequences to commercial lenders as creditors. This article seeks to shed light on the tax effects of deeds-in-lieu and foreclosures from the perspective of the lender, providing practical examples.⁴

Before discussing the tax consequences to the lender, it is important to understand the similarities and differences between a deed-in-lieu and a foreclosure. While there may be nuances among the states, generally, the overarching principles remain the same.

Deed-in-lieu and foreclosures

A deed-in-lieu is generally the last step a delinquent borrower may take after exhausting all other options. The mechanics of a deed-in-lieu are relatively straightforward: The borrower, in exchange for relief of liability on the outstanding loan, deeds the underlying property to the lender. Should there be a remaining balance on the loan after the deed-in-lieu has taken place (also known as a “deficiency”), this may be forgiven if agreed to by both parties. A deficiency generally occurs if the value of the underlying property is less than the principal balance of the note outstanding and accrued interest not paid; i.e., the property is “underwater.”

Foreclosures are by nature a more intensive process and, depending on the state, may take two forms: a judicial foreclosure or a nonjudicial foreclosure. In general, judicial foreclosures are a longer process, as the lender must go through the judicial system to obtain permission to foreclose. This contrasts with a nonjudicial foreclosure, where the lender typically does not need to go to court unless, as discussed below, it wishes to sue the borrower to collect a deficiency left after the foreclosure sale.⁵

As a result of the foreclosure process, typically, the borrower is forced to sell the underlying property at an auction. The lender is allowed to bid at the auction and generally can apply the balance owed to it as a bid price (known as “credit bidding”). If the lender does not bid, the sales proceeds the borrower receives from the auction are paid to the lender up to the amount owed. Whether the lender is successful at the auction and wins the property or is paid proceeds from the sale to a third party, there may be a deficiency remaining due to the value of the underlying property not meeting or exceeding the amount owed on the loan. If that is the case, the lender, depending on state law and the language of the loan agreement, may obtain a “deficiency judgment” from a court to pursue the borrower for the remaining balance.

The tax consequences to the lender of either a foreclosure or a deed-in-lieu depend on two determinations: (1) the amount the lender realizes, if any, and (2) the character of any gain or loss. The remainder of this article focuses on these issues.

Tax implications — realization

As a result of a deed-in-lieu or foreclosure, a lender may realize taxable gain or loss. The calculation of taxable gain or loss in a deed-in-lieu transaction is a simpler process, so that will be discussed first.

Recall that a deed-in-lieu is a more amicable process than a foreclosure, and, if agreed upon by the lender and borrower, any unpaid balance remaining after the borrower deeds the property to the lender is forgiven. The calculation of the amount realized by the lender would occur as of the date the property is deeded. Generally, the difference between the fair market value (FMV) of the property deeded and the lender’s basis in the loan is taxable gain if the FMV of the property is greater than the basis of the loan. If the FMV is less than the basis, the loss results in a bad debt deduction under Sec. 166.⁶ The lender will then take a basis in the property equal to its FMV.

Example 1: AB Partnership, an accrual-basis taxpayer, originates a $95 note with a principal balance of $100 to CD, secured by real property, on Jan. 1, year 1. The note requires quarterly interest payments of $2.⁷ The $5 difference between the amount lent and the principal balance is treated by AB as original issue discount (OID).⁸ By Dec. 31, year 3, AB included in taxable income $2 of accreted OID. Additionally, CD has missed $4 of interest payments, which AB has included in taxable income. On Jan. 1, year 4, when the underlying real property has an FMV of $93, AB and CD agree to a deed-in-lieu.

AB’s tax basis in the note on Jan. 1, year 4, is $101 ($95 originally lent, plus $2 OID, plus $4 accrued interest income not paid). Thus, AB has a taxable loss of $8 ($93 property received, less $101 basis).

The calculation of taxable gain or loss is more complex when a foreclosure occurs. This is largely due to both credit bidding and potential deficiency judgments. In the case of a foreclosure and subsequent bidding process where the lender does not partake in credit bidding, the lender may recognize taxable gain or loss on the difference between the proceeds received from the sale and the lender’s basis in the note. However, a taxable loss is taken as a Sec. 166 bad debt deduction and will only be deductible once the deficiency becomes wholly or partially uncollectible.⁹ If the lender decides to pursue the borrower for any deficiency, a loss cannot be taken until it is determined that all or a part of the deficiency is never to be recovered.¹⁰ This is possible, for example, in cases of bankruptcy.

Example 2: Assume the same facts as Example 1, except that on Jan. 1, year 4, AB successfully was granted a court-ordered credit bidding process as a part of a foreclosure. The property was sold to a third party for $93, which was paid to AB. AB is seeking a deficiency judgment for the remaining balance owed.

The principal balance of the loan to be repaid is $100, and there is $4 of accrued but unpaid interest. Thus, $104 owed less $93 received is a remaining economic deficiency of $11. From a tax perspective, however, the total potential loss is the same as in Example 1: $8. Additionally, AB cannot deduct all or a part of the $8 tax loss until the deficiency claim attempts have failed totally or partially.

Alternatively, the lender might decide to partake in credit bidding. In this case, should the lender’s credit bid be the winning one, taxable loss or gain is recognized as the difference between the amount of the obligation applied to the credit bid price and the FMV.¹¹ The FMV of the property is presumed to be the amount bid by the lender unless there is clear proof otherwise.¹²

Example 3: Assume the same facts as Example 1, except that on Jan. 1, year 4, AB successfully was granted a court-ordered credit bidding process as a part of a foreclosure. AB also bid $90 of the amount owed to it at auction and won rights to the property, even though the FMV was proven to be $93. AB is seeking a deficiency judgment for the remaining balance owed.

Under Regs. Secs. 1.166-6(b)(1) and (2) , AB has incurred a taxable gain of $3. This is the difference between what was bid and the proven FMV. Recall AB’s basis in the loan is $101 immediately before the credit bid. Thus, in addition to the $3 gain, under Regs. Sec. 1. 166-6(a), AB has a potential tax loss (deductible as a bad debt deduction) of $11. As a bad debt deduction, the loss will be totally or partially deductible, depending on the success of the deficiency claim.¹³ AB’s tax basis in the property purchased is equal to the FMV on the date of acquisition, or $93.¹⁴ Finally, AB has in theory assigned $90 of the total $101 tax basis in the loan to the property during the credit bid and thus had a $3 gain to be recognized. As a result, the remaining $11 is assigned to the deficiency claim, and if the deficiency claim is eventually paid in part or in full, the amount received will be a return of capital. If the deficiency claim is entirely unsuccessful, AB will have an $11 tax deficiency, which, when netted with the $3 tax gain, results in an $8 loss. Uncoincidentally, this is equal to the difference between the FMV of property received at the credit bid and the basis AB had in the loan.

Tax implications — character of the loss or gain

If, after a foreclosure or a deed-in-lieu, the lender realizes a net taxable loss, the character of the loss needs to be determined, i.e., whether the loss is ordinary in nature or capital. Taxpayers typically benefit dramatically more from ordinary losses, as there is generally no limitation on their deductibility.

The character of a loss from a foreclosure or deed-in-lieu is governed by Sec. 166. Defaulted business debts, also known as business bad debts, are allowed as ordinary deductions.¹⁵ Defaulted nonbusiness debts, also known as nonbusiness bad debts, are allowed as short-term capital losses,¹⁶ which first may be used to offset short-term capital gains and then long-term gains thereafter (if there is an excess net short-term capital loss after the netting, taxpayers other than corporations may use only up to $3,000 ($1,500 if a married individual filing a separate return) of the net short-term loss to offset ordinary income).¹⁷

Further, business bad debts can be recognized when wholly worthless or partially worthless, so that in the event of a partially worthless business bad debt, the taxpayer may claim a deduction for the portion of the bad debt deemed “charged off ” during the tax year.¹⁸ Nonbusiness bad debts, however, must be wholly worthless.

Business debts are generally defined as those that were acquired in a taxpayer’s trade or business. Nonbusiness debts are those that were not. The question of what rises to the level of a trade or business involves a facts-and-circumstances test. As outlined in Groetzinger,¹⁹ to be engaged in a trade or business, “the taxpayer must be involved in the activity with continuity and regularity and … the taxpayer’s primary purpose for engaging in the activity must be for income or profit.” From specifically a lending perspective, some factors outlined in Owens²⁰ that can be looked to include: (1) the total number of loans made; (2) the time period over which the loans were made; (3) the adequacy of the taxpayer’s records; and (4) whether the loan activities were kept separate from the taxpayer’s other activities.²¹ Other factors outlined in Owens are “whether the taxpayer sought out the lending business; the amount of time and effort expended in the lending activity; and the relationship between the taxpayer and his debtors.”²²

Example 4: Assume the same facts as Example 3. Furthermore, assume AB extends loans regularly throughout the year and has no other significant business activities. AB has sufficient records of each loan and its terms.

Considering the above fact pattern, it would be reasonable to consider AB engaged in a lending trade or business. Thus, the loan to CD was a bona fide business debt. If the deficiency claim is never collected in whole or in part, the loss will be considered ordinary per the business bad debt rules.

Finally, in the case above where AB purchases the property in foreclosure, the gain from the difference between the credit bid and FMV is ordinary. This gain is ordinary under the following logic: Sec. 1221(a)(4) specifically excludes from the definition of “capital assets” accounts or notes receivable acquired in the ordinary course of business for services rendered. It would follow that because AB is considered engaged in a lending trade or business, the business of AB making loans could be described as rendering services.²³ In addition, “Under tax benefit principles, if a taxpayer receives an ordinary income deduction, any offsetting gain is taxable as ordinary income.”²⁴

Closing thoughts

With steep increases in U.S. interest rates and other economic challenges, it is crucial for lenders to fully grasp the tax consequences of borrower defaults. This is especially true if the lender repossesses the underlying collateral in the process.

Footnotes

¹The Federal Funds effective rate for July 2024 was 5.33%, the highest since February 2001 (FRED Economic Data, St. Louis Federal Reserve).

²Brooks, “2024 Commercial Real Estate Outlook,” Insights (J.P. Morgan, Jan. 26, 2024).

³While outside the scope of this article, Regs. Sec. 1.1001-3 has intricate rules regarding significant modifications of debt instruments.

⁴This article does not cover reacquisitions of real property by secured sellers, where recognition of gain or loss may be subject to Sec. 1038.

⁵Borrowers can also generally contest a nonjudicial foreclosure in court.

⁶Rev. Rul. 68-523.

⁷Under Regs. Sec. 1.446-2(b), stated interest accrues ratably over the accrual period to which it is attributable and thus is included as income to AB ratably because AB is an accrual-basis taxpayer.

⁸OID is governed under Secs. 1272 through 1275. Unless an exception applies, OID must be included as taxable income to the creditor currently as accreted using the constant yield method. The accretion of OID increases the creditor’s basis in the note.

⁹Regs. Sec. 1.166-6(a).

¹⁰There are rules regarding the timing of deductions in the event of defaulted debt. These will be discussed later, and for an excellent detailed discussion, see Ellentuck, ed., “Deducting Business Bad Debts,” 47 The Tax Adviser 222 (March 2016).

¹¹Regs. Sec. 1.166-6(b)(1).

¹²Regs. Sec. 1.166-6(b)(2).

¹³See also Rev. Rul. 72-238 for a similar scenario involving a bank issuing a mortgage loan to a borrower, with the borrower subsequently defaulting.

¹⁴Regs. Sec. 1.166-6(c).

¹⁵Sec. 166(a).

¹⁶Sec. 166(d)(1)(B).

¹⁷Sec. 1211(b).

¹⁸Regs. Sec. 1.166-3(a)(2).

¹⁹Groetzinger, 480 U.S. 23 (1987).

²⁰Owens, T.C. Memo. 2017-157, at *22.

²¹Although outside the scope of this article, lending activities rising to the level of a trade or business can also have significant international tax implications. For example, interest income of a domestic partnership allocable to its foreign partner may be characterized as effectively connected income (ECI) instead of fixed, determinable, annual, or periodical (FDAP).

²²Owens, T.C. Memo. 2017-157, at *22.

²³See Rev. Rul. 72-238 for a similar fact pattern and logic.

²⁴Rev. Rul. 80-56 (citing National Bank of Commerce of Seattle, 115 F.2d 875 (9th Cir. 1940)).

Contributor

Eric Homsany, CPA, is a senior tax associate with Arena Investors LP in New York City. For more information about this article, contact thetaxadviser@aicpa.org.

AICPA & CIMA RESOURCES

Articles

Gruidl et al., “A Primer on Cancellation-of-Debt Income and Exclusions,” 54-4 The Tax Adviser 17 (April 2023)

Young, ed., “Tax Consequences of Real Property Foreclosures,” 53-7 The Tax Adviser 44 (July 2022)

Broze, “Commercial Real Estate: Debt Restructuring and Planning,” 52-8 The Tax Adviser 499 (August 2021)

Conference

AICPA & CIMA Conference on Banks & Savings Institutions, Sept. 9–11, National Harbor, Md.

For more information or to make a purchase, visit aicpa.org/cpe-learning or call 888-777-7077.