With this report from CNN that third-party investors are foreclosing on homes for as little as $400 in unpaid property taxes, it seems like an opportune time to review the tax consequences of a foreclosure. [Coincidentally, I will be teaching this topic at CCH's 2012 User Conference in San Diego: November 4-7. Reserve your seat now!]
First things first, the disposition of a property pursuant to a formal foreclosure proceeding, though involuntary, is nonetheless a sale of the property for federal tax purposes. (See Helvering v. Hammel]
Since a foreclosure constitutes a sale, I.R.C. § 1001 dictates that gain or loss is computed on the difference between the “amount realized” and the taxpayer’s adjusted tax basis in the property.
This begs the question: What is the amount realized on a foreclosure?
Your first reaction may be — whatever price the property fetches in the foreclosure auction — but that’s not always the case. The correct answer, as it often is in the tax world, is “it depends.”
It depends on whether the mortgage secured by the property is nonrecourse or recourse.
If the mortgage is nonrecourse, the only option the lender has should the buyer default on the loan is to seize the property and sell it at auction, applying the proceeds against the debt. Should the proceeds fail to satisfy the full balance of the nonrecourse mortgage; well, that’s the lender’s problem. For the borrower, their obligation is extinguished in full when the property is sold at auction.
Conversely, if the mortgage is recourse, the lender can not only seize and sell the property, but they can also purse the borrower for any deficiency that remains after the foreclosure sale. To illustrate, if the balance of a recourse note is $500,000 when the lender sells the property at auction for $400,000, the lender may continue to pursue the borrower for the additional $100,000 deficiency.
Now that that’s out of the way, we can determine the tax consequences in either scenario:
Foreclosure, Nonrecourse Mortgage:
Under the principles established by the Supreme Court in Crane and Tufts, upon the foreclosure of a property securing a nonrecourse mortgage, the purchase price of the property at auction is irrelevant. Instead, the borrower is treated as if they sold the property for the entire balance of the nonrecourse mortgage. Thus, gain or loss is computed on the difference between the balance of the nonrecourse mortgage and the tax basis of the property.
Because the entire amount of the nonrecourse mortgage is included in the borrower’s amount realized, there can never be cancellation of indebtedness income upon the foreclosure of a nonrecourse mortgage.
To illustrate: A buys a piece of commercial real estate for $1,000,000, putting $100,000 down and taking out a nonrecourse mortgage for the remaining $900,000. A takes $300,000 of depreciation on the property, reducing the tax basis to $700,000. When the principal balance of the nonrecourse mortgage remains $900,000, the property is foreclosed upon and sold at auction for $800,000.
Because the mortgage is nonrecourse, the purchase price of $800,000 is irrelevant. A is treated as if he sold the property for the balance of the mortgage, or $900,000. Thus, A recognizes $200,000 of gain, the difference between the $900,000 amount realized and the $700,000 tax basis. Because all of the gain relates to prior depreciation, the gain is taxed at 25% as “unrecaptured Section 1250″ gain.
Foreclosure, Recourse Mortgage:
Under the principles established by the Tax Court in Aizawa, upon the foreclosure of a property securing a recourse mortgage, the transaction must be bifurcated.
In the first part of the transaction, the borrower is treated as if they sold the property for an amount equal to its FMV. In the foreclosure setting, the FMV is presumed to be the bid price. [See Treas. Reg. §1.166-6 and Community Banks ].
The amount realized is limited to the FMV of the property because with a recourse mortgage, the lender can continue to pursue the remaining deficiency, i.e., the excess of the recourse debt over the FMV of the property
Thus, in the second part of the transaction, the borrower must wait and see whether the deficiency is pursued and paid or forgiven.
If the borrower pays the deficiency, no further gain or loss occurs. Alternatively, if the lender forgives the deficiency, the borrower recognizes cancellation of indebtedness income.
To illustrate: A buys a piece of commercial real estate for $1,000,000, putting $100,000 down and taking out a recourse mortgage for the remaining $900,000. A takes $300,000 of depreciation on the property, reducing the tax basis to $700,000. When the principal balance of the nonrecourse mortgage remains $900,000, the property is foreclosed upon and sold at auction for $800,000.
Because the mortgage is recourse, the transaction must be bifurcated.
First, A is treated as if he sold the property for the purchase price of $800,000. Thus, A recognizes $100,000 of gain, the difference between the $800,000 purchase price and the $700,000 tax basis. Because all of the gain relates to prior depreciation, the gain is taxed at 25% as “unrecaptured Section 1250″ gain.
Next, if the lender forgives the $100,000 remaining deficiency ($900,000 loan balance – $800,000 purchase price), A recognizes $100,000 of COD income.
A couple of considerations/tax planning ideas:
- Because the foreclosure of a nonrecourse mortgage only generates gain or loss, the COD exclusions of Section 108 are unavailable.
- If the property subject to a nonrecourse mortgage is the taxpayer’s primary residence, they can exclude any foreclosure gain under Section 121 if they otherwise qualify.
- On the foreclosure of a recourse mortgage, the exclusions of Section 108 will be available to reduce the COD component of the bifurcated transaction.
- A foreclosure – either of a nonrecourse or a recourse mortgage — can generate a loss. Whether it is deductible depends on whether the property was used for business (I.R.C. § 1231 loss), a capital asset (capital loss) or primary residence (nondeductible personal loss).
- A foreclosure is generally taken into account when the sale occurs, unless the borrower has a right of redemption. In that case, the transaction is not taken into account until the redemption right expires. [See Hawkins] This gives borrowers a limited ability to “control” the timing of a foreclosure if the redemption right straddles a year-end. If the borrower wants to recognize the gain in the earlier year, they can waive the redemption rights. If they want to recognize it in the later year, they can allow the redemption right to run its course.
- While the bid price is presumed to be the FMV of the property, if a borrower can establish that the bid price was not a fair representation of the FMV — for example, where the lender buys the property back at auction — the different FMV can be used.
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