Property which is pledged as collateral on a debt will
sometimes be surrendered to the creditor if the debtor is
unable to make payments. The rise in incidents of
foreclosure of homeowner mortgages across the nation is but
one aspect of this. Repossessions of cars and mobile homes
are also common occurrences in the current economic
environment. This article explores the income tax
consequences to the borrower which may ensue from
surrendering property to satisfy a debt. In general there
are two tax aspects to consider: (1) recognition of gain or
loss on the transaction and (2) recognition of cancellation
of indebtedness (COD) income.
Gain or loss on sale.
Section 1001 of the Internal Revenue Code provides that upon
a sale or exchange of property, the amount of gain
recognized is the excess of the “amount realized” on the
sale over the taxpayer's adjusted basis in the property, and
the amount of loss realized is the excess of the adjusted
basis over the amount realized. In tax law, when a
transaction occurs it is said to be “realized.” When the
transaction affects taxable income by resulting in a taxable
gain or deductible loss, it is said to be “recognized.”
Whether the gain or loss is recognized depends on the type
of property involved.
Principal Residence.
A person may have several residences but can have only one
“principal” residence at a time. In general, in the case of
property which has been used as the principal residence of a
taxpayer for two of the past five years and has no period of
“nonqualified use” gain may be excluded from income up to a
maximum of $250,000 for a single taxpayer and $500,000 for a
married couple. IRC 121. “Nonqualified use” means any
period preceding the time the property was last used
as the principal residence of the taxpayer and occurring
after January 1, 2009. Any gain allocable to “nonqualified
use” will not be eligible for the exclusion. Any gain not
excluded is taxable as a capital gain (except for
depreciation recapture if the property had been used as
rental property and depreciation claimed. Loss on the sale
is not deductible and cannot be used to offset capital
gains.
Business and Investment Property.
Property, whether real or personal, used in a trade or
business is accorded special tax treatment. Gains are
treated as capital gains (except for depreciation recapture)
and losses are treated as ordinary, fully deductible
losses. Real estate held for rental is generally not
considered used in a trade or business. Gains and losses
from such property are capital in nature.
Personal Use Property.
Gains from sale of property held for personal use – as a
vacation or second home, a personal car, etc. – is capital
gain. Losses are not recognized.
Recourse vs. Nonrecourse Debt.
Where property is transferred for underlying indebtedness,
the amount realized depends on whether the debt is recourse
or nonrecourse to the property owner. If the debt is
nonrecourse, the amount realized will include the full
amount of the debt. Code section 7701(g) provides that the
fair market value of such property shall be treated as being
not less than the amount of any nonrecourse indebtedness to
which such property is subject. Where the debt is recourse
to the property owner, Treas. Regulation § 1.1001-2 provides
that the amount realized is the fair market value of the
property.
Whether debt is recourse or nonrecourse is generally
determined by the terms of the note evidencing the debt. If
the note provides that the borrower is not personally liable
for repayment and the lender agrees to look only to the
collateral, it is nonrecourse. If the borrower is
personally liable for repayment it is recourse. In the case
of real estate, Arizona has two anti-deficiency statutes:
one dealing with mortgage foreclosures and one dealing with
trustee sales under a deed of trust. Under these statutes,
the lender is generally barred from suing the borrower on a
deficiency where the foreclosed or sold property fails to
repay the lender for the full amount of the note. These
statutes only apply to property used for residential
purposes, of two and one-half acres or less, upon which is a
one or two family structure and in the case of the mortgage
foreclosure statute, only to acquisition indebtedness.
Where the lender is barred from suing under these statutes,
the debt would presumably be treated as nonrecourse for tax
purposes, despite its terms, but surprisingly there is no
direct authority for this in the Internal Revenue Code or
regulations. Note that the anti-deficiency statutes do not
apply to business property, apartment complexes, or any
situation other than a foreclosure or trustee sale. Also
they do not apply to mobile homes or other personal
property. In addition, if funds are borrowed against a home
and used for non-home purposes, the lender under a deed of
trust may elect to forego the trustee sale and foreclose
judicially, which would make this debt recourse debt.
Calculation of Gain or Loss.
Where the gain or loss is recognized under the above rules
it is calculated by subtracting the property’s tax basis
(generally, its cost, including improvements) from the
“amount realized.” In the case of foreclosures or similar
transactions where the lender takes back the property, in
cases where the debt is recourse debt, the amount
realized is the lower of (1) the amount of debt on
the property less any amount for which the taxpayer remains
personally liable, or (2) the fair market value of the
property. When property is sold at a foreclosure sale, it
is normally auctioned to the highest bidder. When that
bidder turns out to be the debt holder, any amount bid at or
below the outstanding loan amount will not require an
exchange of cash. Therefore, to determine the amount
realized, the usual practice is to look at the amount bid.
That bid is, however, not necessarily the same as the fair
market value. In a 1998 U.S. Tax Court case, the Court
found that the bid amount was not indicative of the value of
the property where the debt holder was the only bidder at
the foreclosure sale and that it was not an arms-length
transaction. It noted that the lender might have reasons
for submitting a bid in excess of the property’s value,
including not wanting to recognize a loss on its books.
Because the IRS could not rebut the appraisal submitted by
the taxpayer, the Court held that the appraised value, not
the amount bid at the auction, was the fair market value and
therefore the amount realized.
Forgiveness of Debt
The Internal Revenue Code specifically provides that gross
income subject to tax includes COD income. As a result,
when a debt is forgiven by the lender in whole or in part,
the forgiveness is generally subject to income tax. In the
case of a mortgage foreclosure, or more typically in
Arizona, a trustee’s sale under a deed of trust, the amount
realized by the lender on the property may be less than the
amount of the underlying debt. At this point, there are
three aspects to consider: whether a debt has been
forgiven, the amount of COD income required to be
recognized, and whether the debtor qualifies for an
exception to the COD recognition rule.
Where a debt is recourse debt, the amount forgiven by the
lender is generally taxable to the borrower, unless an
exception applies. If the debt is nonrecourse, no COD
income is recognized where the underlying debt is
extinguished. In the case of a loan modification, however,
if the lender agrees to reduce the amount of the debt, the
debt is not extinguished and the taxpayer will recognize COD
income even where the debt is nonrecourse.
Exceptions to COD income recognition
There are several exceptions to the COD income recognition
rule. These are (1) where the loan is forgiven through
bankruptcy; (2) where the taxpayer is insolvent; (3) where
the loan is “qualified farm indebtedness;” (4) where the
debt is “qualified real property business indebtedness”; or
(5) where the debt is “qualified principal residence
indebtedness.” The last exception was added by the Housing
and Economic Recovery Act to cover events occurring before
January 1, 2010 and extended three additional years by the
Emergency Economic Stabilization Act of 2008. It applies
only to a taxpayer’s principal residence and only to debt
used in the acquisition of the property. It is limited to
$2 million. In the case of a homeowner or other taxpayers,
exceptions (1) and (2) may apply; in the case of business
property, any of the above may apply. If an exception
applies to business property, an offsetting reduction in
“tax attributes” – such as net operating loss or tax basis
of property – is required. In addition to the above, if the
forgiveness of debt is of a tax-deductible item – such as
interest on a personal residence – no COD income is
recognized. Because these rules are complex, any taxpayer
receiving a 1099 reporting COD income should see a qualified
tax professional.
Examples
-
Joe, who is unmarried, purchases a house in Maricopa
County which he uses as his principal residence. Joe
paid $600,000 for the house and financed it with a deed
of trust for $540,000 and $60,000 in cash. He later
takes out a line of credit secured by a second deed of
trust on which he borrows $80,000 to invest in a
business. The line of credit, by its terms, is
nonrecourse to Joe. Joe stops making payments on both
loans in the fifth year and the house is sold in a
Trustee’s sale for $400,000. Joe is treated as having
sold the house for $620,000, because the debt is all
considered nonrecourse. He is treated as having
realized a gain of $20,000 ($620,000 debt less $600,000
basis). Joe is neither insolvent nor bankrupt. The
gain is not covered by the qualified principal residence
indebtedness exclusion because the extra $80,000 Joe
borrowed was not used to buy the house, but the gain is
still excludable from taxable income because it is less
than $250,000 and covered by the principal residence
exclusion. There is no COD income because the debt is
nonrecourse.
-
The facts are the same except the property is held for
rental and Joe never lives in it. He claimed $10,000 of
depreciation on the building. He is treated as having
realized a $30,000 capital gain ($620,000 nonrecourse
debt less basis of $590,000). Joe is neither insolvent
nor bankrupt so the gain is taxable. There is still no
COD income.
-
The facts are the same except the property is a
commercial store and the holder of the $80,000 second
deed of trust writes off the loan but Joe still owes the
$140,000 deficiency on the first loan because the debt
is recourse. Joe is treated as having sold the store
for $400,000, the lower of the debt on the property less
the amount for which he remains personally liable
($620,000 - $140,000 = $480,000) or the fair market
value of the property ($400,000). Joe has a capital
loss of $190,000 ($590,000 - $400,000). Joe also has
$80,000 of COD income, which is ordinary income. Since
Joe only leases the store it is not qualified real
property business indebtedness.
-
Sue purchases a home for $800,000, which is financed by
a first deed of trust securing an ARMS loan of
$720,000. When Sue becomes unable to afford the
payments following the adjustment, the lender agrees to
reduce the principal balance to $670,000. Sue has
$50,000 of COD income, regardless of whether the debt is
recourse or nonrecourse.
Bob Ciancola is an attorney in Scottsdale practicing in
business transactions, tax law and estate planning. He may
be reached at 480 991-0803 or by email at bob@ciancolaw.com.
