Real property foreclosures can produce unexpected tax consequences depending on the type of debt that is involved. Most tax practitioners assume that when a foreclosure occurs, the taxpayer can use the generous exceptions to the recognition of debt discharge income included in section 108 of the Internal Revenue Code. However, the debt discharge rules do not apply if the discharged debt is nonrecourse with respect to the taxpayer. This treatment may be detrimental for bankrupt or insolvent taxpayers who can exclude debt discharge income (as opposed to gain on a deemed sale) from taxable gross income.
Recourse and Nonrecourse Debt Generate Different Tax Consequences
Recourse debt is debt that allows the lender to collect from the debtor and the debtor's assets in the case of default. In other words, the lender can pursue the individual borrower for the balance due on a debt in addition to foreclosing on the property. On the other hand, nonrecourse debt is debt that is secured solely by the property that is pledged as collateral. When property is foreclosed, the tax results differ depending on whether the debt is recourse or nonrecourse. It is impossible to determine the tax consequences of the abandonment, foreclosure or deed in lieu of foreclosure until the type of debt is determined and in most cases, the FMV of the property is known.
Foreclosures Involving Nonrecourse Debt
When a foreclosure of nonrecourse debt occurs, the transaction is treated as a deemed sale of the underlying property in an amount equal to the face amount of the nonrecourse debt. In Commissioner v. Tufts, 103 S. CT. 1826, 5/2/1983, the Supreme Court held that a partner who sold an interest in a partnership that operated an apartment complex realized an amount equal to the outstanding balance of the nonrecourse mortgage even though the balance of the nonrecourse mortgage exceeded the fair market value (FMV) of complex. Since the amount realized on the deemed sale is the full amount of the indebtedness, there is no “forgiveness” of indebtedness.
Deemed sale treatment cannot be avoided by abandoning the property. The abandonment of property encumbered by nonrecourse financing is treated as a foreclosure resulting in a deemed sale of the property. See Freeland, 74 TC 970 and Middleton, 693 F. 2d 124, 12/6/1982.
In Allan, 856 F.2d 1169, 9/16/1988, the Eighth Circuit Court of Appeals held that 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.
The theory that the amount realized from a deemed sale equals the full face amount of nonrecourse debt means there can be no debt discharge income due to an abandonment, foreclosure or deed in lieu of transaction involving only nonrecourse debt. Unlike the treatment of foreclosures involving recourse debt (discussed below), the FMV of the property is irrelevant. Moreover, the insolvent or bankrupt status of the taxpayer does not affect the results.
Foreclosures Involving Recourse Debt
The taking of property by the lender in satisfaction of a recourse debt is treated as a deemed sale of the underlying property with the proceeds equal to the lesser of the property's FMV at the time of foreclosure or the amount of secured debt. If the amount of debt exceeds FMV, the difference is treated as debt discharge income if it is forgiven. See Treasury Regulation §1.1001-2(c), Example 8, and Rev. Rul. 90-16, 1990-1 CB 12. As a result, 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) debt discharge income because the secured debt is in excess of the property's FMV.
The amount credited or received in a foreclosure sale determines the sales proceeds for computing gain or loss. See Aizawa, 74 AFTR 2d 94-5493 (1994, CA 9) and Webb, TC Memo 1995-486. The character of the gain or loss depends on the character of the property subject to the foreclosure. Rev. Rul. 92-92 1992-2 CB 103, provides that to the extent the underlying debt discharged is allocated to a passive activity, the debt discharge income is treated as arising from a passive activity. Alternatively, to the extent the underlying debt is attributable to a nonpassive activity the debt discharge income is nonpassive.
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. See Treasury Regulation § 1.166-6(b)(2). In Fraiser, 111 TC 243 (1998), the Tax Court acknowledged that the amount bid by a lender may be arbitrary; as a result, 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 debt discharge income.
Debt discharge 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, debt discharge 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 debt discharge income will occur when the state law for enforcing the debt expires.
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 debt discharge income. If the property is used in a trade or business or rental activity, gain from the sale generally is treated as a capital gain under §1231 (some of which may be subject to the 25% rate applicable to unrecaptured 1250 gain). On the other hand, debt discharge income is ordinary income to the borrower.
A foreclosure of real property is generally deemed to be a sale or exchange that produces tax consequences to the borrower at the time of foreclosure. However, if state or local laws grant the borrower a right to redeem (repurchase) the property within a stated period following a foreclosure, the gain or loss from the deemed sale is not recognized until the redemption right expires. See Hawkins, 19 AFTR 116 and R. O’Dell & Sons, 37 AFTR 173.
Planning Considerations
If the borrower is insolvent at the time of the foreclosure (or could qualify for one or more of the exclusions from gross income included in §108), it may be beneficial 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 debt discharge income, which can be fully or partially excluded from income under §108. Alternatively, if the borrower is solvent at the time of the foreclosure (or could not qualify for one or more of the exclusions from gross income included in §108), it is usually beneficial to value the property as high as possible. This may maximize gain that may be eligible for preferential capital gain treatment and minimize the amount of ordinary income from debt discharge.
Fair market value is a subjective measure and arguably can vary within a reasonable range of amounts. As a result, borrowers may be able to 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.
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. The 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 negotiation, the borrower may be “surprised” by the items reported on the Form 1099-A.
Because §108(a) provides insolvent taxpayers relief only for COD income (and not gain on the deemed sale of the property), the timing of foreclosures may be critical when a taxpayer has multiple properties being foreclosed upon, some securing recourse debt and some securing nonrecourse debt. Foreclosures involving nonrecourse debts often result in taxable gains while those involving recourse debts generate COD income. Insolvent taxpayers who exclude COD income under §108 must reduce the amount of certain tax attributes (NOLs, credit and other loss carryovers, and tax basis in depreciable assets) by the amount of the excluded COD income.
Insolvent taxpayers with NOLs and other tax attributes subject to reduction under §108 will generally benefit by timing foreclosures so that those involving nonrecourse debts occur in a tax year before those involving recourse debts. This strategy enables the taxpayer to use NOLs and other loss carryovers to offset gain realized from the foreclosure of the nonrecourse debt before those attributes are reduced by COD income excluded in connection with the recourse debt. In addition, the taxpayer can depreciate or amortize the full tax basis of property in computing taxable income for the year of discharge (before reducing tax basis because of excludable debt discharge income). In effect, the attribute reductions occur on the first day of the tax year after the debt discharge occurs (which means the taxpayer gets “one last bite at the apple”).