Income tax consequences of real estate foreclosures.

When the economy falters, real estate foreclosures and related actions (voluntary reconveyances,
abandonments) become facts of life. CPAs with clients who are parties to such traumatic events,
either as mortgagors or mortgagees, often find them preoccupied with the circumstances preceding
or following the events rather than with the events themselves. The mortgagor's thoughts usually
are consumed by the economic circumstances preceding the foreclosure--a job loss or a real estate
and homes for sale business failure-- while the mortgagee typically focuses on the potential loss of
goodwill or its lack of expertise in managing and marketing the repossessed or foreclosed property.
But equally important to both parties-- and within the CPA's domain--are the foreclosure's tax
consequences. The tax law generally is so unforgiving that both parties may find a loan workout
more economically beneficial.
This article reviews the tax provisions of voluntary reconveyances, foreclosures and abandonments
of property as well as the tax consequences of the most common loan workout types. These
provisions also apply if the financing instrument is a deed of trust rather than a mortgage. Because
of the tax law's prohibition against deducting personal losses, much of the discussion from the
mortgagor's standpoint assumes the property reconveyed, foreclosed or abandoned is income-
producing.
TAXABLE EVENTS FOR THE MORTGAGOR
The threshold issue in a voluntary reconveyance, foreclosure or abandonment is determining
whether a taxable event has occurred. The courts have long held all three taxpayer actions
constitute sales or exchanges under the Internal Revenue Code and thus are taxable events to the
mortgagor.
Voluntary reconveyance and foreclosure. The courts treat these events in the same way--as a sale or
exchange--because of their similarity and a lack of congressional intent to differentiate between a
forced sale and a voluntary one. In both cases, the mortgagor's interest in the property is
terminated, title to the property is transferred to someone else and the mortgagor receives nothing
from the transaction. In both instances the mortgagor is relieved of property with a lien on it and the
obligation to pay taxes and assessments.
Abandonment. A taxpayer who abandons property subject to nonrecourse debt is relieved of the debt
obligation when he or she gives up legal title to the property. In fact, the prospect of debt relief is
the impetus for the abandonment. It is advantageous for the taxpayer to relinquish title to the
property only because its market value is less than the related debt obligation. In many cases the
mortgage agreement itself effectively treats the property and the debt as being equivalent in value.
Thus, the courts have held an abandonment involves giving something so as to receive something
else in return, which fits the ordinary meaning of a sale or exchange under the IRC.
TAX CONSEQUENCES FOR THE MORTGAGOR WHEN OUTSTANDING DEBT EXCEEDS BASIS
In most voluntary reconveyances, foreclosures and abandonments involving income-producing
property, the outstanding debt exceeds the mortgagor's tax basis in the property. The tax
consequences depend on the mortgagor's solvency and whether or not the mortgagor is personally
liable for the debt.
Solvent and personally liable. When the mortgagor is solvent and personally liable, the outstanding
debt is considered realized to the extent of the property's fair market value at the reconveyance,
foreclosure or abandonment date. The gain on the transaction, as determined under IRC section
1001, is the difference between the amount realized on the disposition and the properry's adjusted
basis. In addition, any excess of the outstanding debt over the property's fair market value is
ordinary income to the mortgagor under IRC section 61(a)(12).
Insolvent and personally liable. When the mortgagor is insolvent and personally liable, the
outstanding debt is treated as an amount realized to the same extent it is when the mortgagor is
solvent--that is, to the extent of the property's fair market value. Accordingly, the mortgagor
recognizes gain equal to the excess of the amount realized over the property's adjusted basis.
If the outstanding debt exceeds the property's fair market value, the excess is treated as debt
forgiveness income. Since the borrower is insolvent, however, this income is excluded under IRC
section IOS(a)(3).
Not personally liable. When the mortgagor is not personally liable for debt repayment, the full
amount outstanding--even if it exceeds the property's fair market value-is considered realized when
the property is voluntarily reconveyed, foreclosed or abandoned. Under sections 1001(c) and
61(a)(3), the mortgagor recognizes gain to the extent the amount realized exceeds the mortgagor's
basis in the property. The mortgagor's solvency has no effect on the income recognized in this
situation and there is no debt forgiveness income.
Exhibit 1, page 47, compares the tax consequences of voluntary reconveyances, foreclosures and
abandonments in terms of the mortgagor's solvency and personal liability. As the example shows, the
mortgagor's total income is the same under the various permutations, but the character of that
income changes.
TAX CONSEQUENCES FOR THE MORTGAGOR WHEN BASIS EXCEEDS OUTSTANDING DEBT
Income-producing property not subject to basis-reducing depreciation (for example, undeveloped
land) may have an adjusted tax basis that exceeds the dc real estate for sale outstanding debt at the
reconveyance, foreclosure or abandonment date. In such situations the mortgagor's loss is a capital
loss--and thus of limited utility because of limitations on the deductibility of capital losses under
section 1211(b)--unless the property is held for use in a trade or business, in which case the loss is
ordinary.
TAX CONSEQUENCES FOR THE MORTGAGEE
Upon receipt of property through voluntary reconveyance, foreclosure or abandonment, the
mortgagee neither recognizes a gain or loss nor considers the debt worthless or partially worthless
under the bad debt provisions of IRC section 166. Instead, the gain or loss is recognized on the
property's final disposition. Exhibit 2, page 48, shows how this gain or loss is calculated and
incorporated in the mortgagee's taxable income.
Basis of property received. The mortgagee's basis in property received through voluntary
reconveyance, foreclosure or abandonment is the adjusted basis of the indebtedness for which the
property served as security, determined as of the acquisition date, plus acquisition costs. The
adjusted basis of the indebtedness includes any unpaid interest on the indebtedness to the extent it
was included in the mortgagee's gross income. The acquisition date is the date the security property
is legally reduced to mortgagee ownership or possession through voluntary reconveyance,
foreclosure or abandonment. Acquisition costs include all expenditures directly related to obtaining
the property through reconveyance, foreclosure or abandonment, including fees for an attorney,
master, trustee, auctioneer, publication, title acquisition, lien clearance, filing and recording and
court costs.
The IRC considers property acquired by the mortgagee to have the same characteristics as the
indebtedness for which the property was security. Thus, the mortgagee is not allowed a deduction
for the acquired property's exhaustion, wear and tear, obsolescence, amortization or depletion.
However, if at any time the property's adjusted basis exceeds its fair market value and the
mortgagee can establish any portion of the excess will not be collected from the mortgagor, the
excess can be treated as a worthless debt under section 166 and the property's basis reduced
accordingly.
Minor capital improvements. The mortgagee may add the cost of minor capital improvements to the
basis of property received through voluntary reconveyance, foreclosure or abandonment, if all such
improvements made to a particular property are treated in the same manner. An improvement is
minor if its cost does not exceed $3,000. To substantiate the treatment of these improvements, the
mortgagee must maintain records clearly reflecting the cost of each improvement and whether all
minor capital improvements to a particular property were treated as additions to the property's
basis.
Capital improvements exceeding $3,000 are not included in the acquired property's basis.
Consequently, the mortgagee is allowed a deduction for exhaustion, wear and tear, obsolescence,
amortization or depletion of such improvements to the extent otherwise allowed. When the property
is sold, the amount realized is prorated between the acquired property and the capital improvements
on the basis of fair market values. The amount allocated to capital improvements is treated
according to the normal provisions governing the sale or disposition of such property.
Maintenance expenses. Costs to prepare real estate for resale--for example, painting or repairing
walls, doors or roofs--are maintenance expenses and are added to the basis of the property received
by the mortgagor. Accordingly, these expenses cannot be deducted for exhaustion, wear and tear,
obsolescence, amortization or depletion.
Amount realized. In computing the mortgagee's gain or loss on disposition, the amount realized
represents a recovery of capital, such as proceeds from the sale or other disposition of the property,
payments on the original indebtedness made by or on behalf of the mortgagor and any collections on
a deficiency judgment obtained against the mortgagor. Any expenses incurred to dispose of the
acquired property are not deductible as business expenses but are taken into account in computing
the gain or loss on the property's disposition.
Treatment of gain or loss. The mortgagee's treatment of the gain or loss on disposition of property
received in a voluntary reconveyance, foreclosure or abandonment depends on (1) whether a gain or
loss exists and (2) the mortgagee's method of accounting for bad debts. If a loss exists-- the amount
realized is insufficient to restore to the mortgagee the property's adjusted basis--it is treated as a
bad debt subject to section 166.
Section 166 (and related IRC sections 585 and 593) allow mortgagees using the reserve method of
accounting for bad debts to charge the loss to the reserve for losses on qualifying real property
loans. Mortgagees using the specific deduction method of accounting for bad debts, on the other
hand, may deduct the loss currently. Thereafter, any amount received by the mortgagee for the
original indebtedness or the acquired property is treated as a bad debt recovery.
If the amount realized exceeds the acquired property's adjusted basis, a gain exists that the
mortgagee includes in gross income as ordinary income if the specific deduction method is used. If
the reserve method is used, however, the mortgagee credits the gain to the reserve for losses on
qualifying real property loans.
LOAN WORKOUT MAY BE BENEFICIAL
The negative tax consequences for the mortgagor of a voluntary reconveyance, foreclosure or
abandonment--at a time when cash flows already are strained-- make a loan workout, whereby
mortgage payments are reduced, an attractive alternative. The mortgagee traditionally has been
equally receptive to a loan workout because of the no-win situation it faces: potential loss of
customer goodwill in the community, acquisition of an asset it has no expertise in managing and
marketing for sale and negative economic consequences of reclassifying a loan as nonperforming
and supporting a property with negative cash flow. Today's more demanding bank regulatory
environment has made the mortgagee more cautious in making concessions to the mortgagor in a
loan workout; nonetheless, most mortgagees still favor a workout over repossession or foreclosure.
What's the best way to reduce payments? The mortgagor generally finds it more beneficial to
negotiate a payment reduction via a reduced interest rate or to extend the loan term. Neither of
these tactics triggers discharge of indebtedness income under IRC section 61(a).
Principal reduction usually triggers income. Unless the mortgagor obtained seller financing, a
workout involving a loan principal reduction results in discharge of indebtedness income under
section 61(a)(12). With a home mortgage, the Internal Revenue Service has ruled debt forgiveness
income results regardless of whether the loan is recourse or nonrecourse, unless the IRC section
108(a) insolvency rules apply. Exhibit 3, at left, shows a typical loan workout involving a home
mortgage principal reduction.
If the acquired property is income-producing, it probably is subject to the IRC section 469 passive
activity rules. Accordingly, the debt forgiveness income is characterized as passive activity gross
income that can be offset only by passive activity deductions.
If the mortgagor obtained the indebtedness involved in the loan workout from the seller, a loan
principal reduction does not result in income recognition under section 61(a)(12). Instead, the loan
reduction lowers the property's purchase price, thereby lowering the mortgagor's basis in the
property. This exception to income recognition applies if (1) the loan reduction does not occur in a
title 11 bankruptcy case or involve an insolvent purchaser (mortgagor) and (2) without this special
provision, the mortgagor would recognize the loan reduction as discharge of indebtedness income
under section 61(a)(12).
UNPLEASANT TASK
Parties faced with the unpleasant task of real estate foreclosure or repossession often overlook the
tax consequences. The tax law provides minor relief for the economic loss to both parties. However,
if the tax consequences are known to both the mortgagor and mortgagee, any arrangement-- short of
voluntary reconveyance, foreclosure or abandonment--may benefit both parties. CPAs should inform
their clients of these tax consequences and guide them through a loan workout if at all possible.
EXECUTIVE SUMMARY
* DESPITE A GROWING ECONOMY, foreclosures and related actions (voluntary reconveyances,
abandonments) continue to plague real estate investors.
* THE TAX CONSEQUENCES of real estate foreclosures can be as important as the foreclosures
themselves. A loan workout may be more beneficial to both the borrower and the lender.
* A VOLUNTARY reconveyance, foreclosure or abandonment is g'enerally considered a sale or
exchange under the Internal Revenue Code and thus results in a taxable event for most taxpayers.
* IN MOST REAL ESTATE foreclosures the outstanding debt exceeds the mortgagor's cost basis in
the property. The resulting tax consequences depend on the mortgagor's solvency and whether or
not the mortgagor is personally liable for the debt.
* WHEN THE MORTGAGOR'S basis exceeds the outstanding debt, the mortgagor's loss is a capital
loss and subject to limits imposed by IRC section 1211(b).
* WHEN A MORTGAGEE receives property through voluntary reconveyance, foreclosure or
abandonment, no gain or loss is recognized and the debt is not considered worthless or partially
worthless. Gain or loss is recognized on the property's final disposition.
* THE NEGATIVE TAX consequences of a foreclosure for the mortgagor make a loan workout an
attractive alternative. The mortgagee also is usually receptive to a loan workout to preserve its
image in the community and to avoid owning an asset it may be unable to sell.
COPYRIGHT 1993 American Institute of CPA's
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Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.
Very helpful - however, I can't find how to see "Exhibit 2, page 48" - thanks.