The amount realized from a sale or other property disposition includes liabilities “discharged” in the sale or disposition (Reg. §1.1001-2(a)). This rule applies to nonrecourse debt regardless of the fair market value of the property transferred.
Thus, even if the fair market value at time of transfer is less than the nonrecourse debt, it is included in the amount realized when determining the transferor’s gain or loss (Commissioner v. Tufts, 461 U.S. 300 (1983)).
Discharged Debt
If the borrower (buyer) of property does not make payments due on a loan secured by property, the lender (mortgagee or creditor) may foreclose on the mortgage or repossess the property. The foreclosure or repossession is treated as a sale or exchange from which the borrower may realize gain or loss. This is true even if the property is voluntarily conveyed to the lender.
The borrower’s gain or loss from the foreclosure or repossession is generally figured and reported in the same way as gain or loss from sales or exchanges. The gain or loss is the difference between the borrower’s adjusted basis of the transferred property and the amount realized.
Nonrecourse Indebtedness
If the underlying indebtedness is nonrecourse indebtedness, a foreclosure or other transfer of distressed property (e.g., a deed in lieu of foreclosure) is a sale or exchange of property for tax purposes. Gain or loss to the transferor is determined in the same manner as gain or loss on any other disposition – that is, the amount realized will include any debt discharged (Commissioner v. Tufts, supra & §7701(g)).
Note: The full amount of the canceled debt is included even if the property’s fair market value is less than the canceled debt.
When the amount realized exceeds the mortgagor’s adjusted basis, then the taxpayer will recognize gain. If the adjusted basis exceeds the amount realized, then a loss will be recognized.
Typically, the borrower receives no consideration from the mortgagee other than the application of the proceeds towards the amount of the debt. In such case, the amount realized by the mortgagor, will only include the amount of debt satisfied by the foreclosure.
Recourse Indebtedness
If the underlying indebtedness is recourse, Reg. §1.1001-2(a), Example 8 provides for a different result.
If the fair market value of the property transferred is less than the canceled debt, the amount realized by the owner includes the canceled debt up to the fair market value of the property. The owner is treated as receiving ordinary income from the canceled debt for that part of the canceled debt not included in the amount realized. Such income may be realized, but not recognized by reason of the §108 bankruptcy, insolvency, qualified farm debt exclusions.
The income from cancellation of debt is in addition to the gain or loss from the sale or exchange (transfer of property). This ordinary income from the cancellation of debt may arise if:
(1) The borrower is personally liable for repayment of the debt secured by the transferred property to satisfy the debt, and
(2) The fair market value (FMV) of the transferred property is less than the amount of canceled debt.
When the taxpayer-borrower is personally liable for the debt (recourse debt), the amount realized on the foreclosure or repossession does not include amounts of the canceled debts that are income to the borrower from cancellation of debt.
However, if the fair market value of the transferred property is less than the canceled debt, the amount realized by the borrower includes the canceled debt up to the fair market value of the property. The borrower is treated as receiving ordinary income from the canceled debt for that part of the debt not included in the amount realized (Reg. §1.1001-2(a)(2); Reg. 1.1001-2(c) Examples (7) and (8); §61).
Note: The excess of the amount of the debt discharge over the property’s fair market value, if any, is income from the discharge of indebtedness. This is the only amount that may be sheltered by the bankruptcy and insolvency relief provisions. Of course, there is no cancellation of indebtedness income if the borrower remains liable for the deficiency.
In essence, the transaction is treated as a sale of the transferred property followed by payment of the debt.
When the investor is insolvent or bankrupt it is important to keep the capital gain on the foreclosure low and the cancellation of indebtedness income high, since such income may end up being excluded from income under §108 and §1017. This may be done by obtaining a credible low fair market value appraisal of the surrendered property.
Reporting
The owner of property transferred through foreclosure or repossession to satisfy a debt reports gain or loss on the transfer in the same way as for a gain or loss on sales or exchanges generally (e.g., Schedule D & Form 4797).
Form 1099A
The taxpayer should receive Form 1099A, Acquisition or Abandonment of Secured Property, from the lender who acquired the property. This form will have the information needed to determine whether there is a capital gain or loss, or ordinary income from a canceled debt on the abandonment, foreclosure, or repossession.
Source: Selected Legal Issues with Tax Analysis; Danny C. Santucci, CPA
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