FOR TAX PROFESSIONALS
Prior newsletters have attempted a broad look at a narrow topic, staying within the expertise of the tax professional. The topics selected have primarily been based on calls received by the TAX ANSWER HOTLINE. Due to the number of inquiries, this newsletter takes a narrow look at the complex area of home foreclosure. It is intended to be a starting point from which to ask the proper questions by providing an introductory look at some of the key tax authorities, with the understanding that material tax consequences should be discussed with real estate tax counsel familiar with the property laws of the state involved.
Two rulings are prominent in this area - Tufts v. Comr. 651 F.2d 1058 (5th Cir. 1981) and Revenue Ruling 90-16, 1990-1 CB 12. Tufts established that nonrecourse debt constitutes selling price, not cancellation of debt income upon foreclosure or other transfer of the property even if the debt exceeds the value of the property. Rev Rul 90-16 deals with foreclosure where there is recourse debt, and splits the debt into selling price (to the extent of the fair market value of the security) and cancellation of debt (the excess of debt over the fair market value).
In some states, foreclosures on refinancing of owner-occupied detached residences and foreclosures of secured debt on certain income properties provide the right to recover a deficiency judgment against the debtor. It is a poorly kept secret that many limited partnerships with secured debt documentation from which the right to a deficiency judgment has not been removed are often erroneously categorizing the debt as nonrecourse debt allocable to limited partners, allowing them basis against which to currently deduct losses. The government must administer the federal income tax law in many jurisdictions, and this distinction is often overlooked on examination of the partnership and partners' returns. It is important, however, to properly classify debt as recourse or nonrecourse before evaluating the tax consequences of foreclosure.
What happens when the lender must choose between pursuing the debtor via a judicial foreclosure sale (thereby maintaining its rights to recover a deficiency judgment), or instituting a nonjudicial foreclosure proceeding (thereby giving up its rights to a deficiency judgment)? Rev Rul 90-16, after illustrating the principle that recourse debt is bifurcated into selling price and cancellation of debt when there is a voluntary conveyance of the property in satisfaction of the debt, adds the following wording:
"... If the (property) had been transferred to the bank as a result of a foreclosure proceeding in which the ... debt was discharged (rather than having been transferred pursuant to the settlement agreement), the result would be the same ...".
One commentator interprets the above to mean that the debt retains recourse treatment upon foreclosure for tax purposes, even if the right to a deficiency judgment is relinquished in the proceeding.
Note that a reduction in (or elimination of) nonrecourse debt was held to constitute part of the selling price when part of a sale or exchange. Reduction in recourse or nonrecourse debt may produce cancellation of indebtedness income if it occurs other than as part of a sale or exchange.
Regulation 1.1274-5(b) states:
" ... if ... property is taken subject to a debt ..., in connection with a sale ... , the terms of the debt ... are modified as part of the sale ... and the modification triggers an exchange under section 1001, the modification is treated as a separate transaction taking place ... before the sale... and is attributed to the seller ... (if) the seller ... had reason to know about the modification. (Emphasis added)
Could this mean that there is no sale or exchange at the time of modification, thus resulting in cancellation of debt income even if nonrecourse debt? Keep in mind that these regulations were written for purposes of guidance with respect to the "original issue discount" rules.
One leading tax editorial service, while discussing a "recourse" case (Michaels v. Comr., 87 T.C. 1412 (1986)), after noting that prepayment of indebtedness at a discount during a simultaneous sale of the property was held to be cancellation income because it was a transaction separate from the sale, then adds " ... the IRS might attempt to apply the same principle to a nonrecourse mortgage".
The recognition of taxable gain is at the time the foreclosure sale becomes final. In jurisdictions which provide a right of redemption, this has been interpreted to mean the expiration of the redemption period, unless the homeowner releases the right of redemption at an earlier date. You will find variations on the above where the right of redemption is worthless or the foreclosure is contested. (See Derby Realty Corp. v. Comr., 35 BTA 335; Hill v. Comr, 40 BTA 376; O'Dell & Sons Co, R. v. Comr., 169 F2d 247; Abelson v. Comr., 44 BTA 98.)
The general rule for payments on debt is that interest is deemed paid first, with any remaining amount applied to principal (by both debtor and creditor). However, Newhouse v. Comr., 59 T.C. 783 (1973), after citing prior authority, states:
"... that rule does not appear to be applicable in the case of an involuntary foreclosure of mortgaged property, particularly where the debtor is insolvent ..." (emphasis added).
The case further discusses the debtor's insolvency, however the highlighted portion appears to refer to a factual situation where the debtor is solvent but the value of the property does not exceed the debt principal. If the debtor is insolvent, but the value of the property exceeds the principal balance of nonrecourse debt, at least one tax editorial service conjectures that the amount realized on "sale" includes accrued interest up to the value of the property, with a corresponding interest deduction. (See Malmstedt v. Comr., TC Memo 1976-46.)
In a recent memorandum case dealing with foreclosure on nonrecourse debt (Catalano T.C. Memo 2000-82) the Court appears to conclude that the amount realized on the deemed "sale" includes the entire principal AND ACCRUED INTEREST, irrespective of the value of the property. The opinion cites the Tufts case for the proposition that the full PRINCIPAL amount of the nonrecourse debt constitutes realized gain, thus constructive payment of the interest to that extent. With respect to the accrued interest, the opinion cites Allan, 856 F.2d 1169 (8th Cir. 1988) and Harris v. Comr., TC Memo 1975-125. Inspection of those cases reveals that: 1) the taxpayer in Allan was an accrual method taxpayer, which had accrued and deducted the unpaid interest; and 2) in Harris, the second trust deed lien holder had paid the outstanding interest and taxes to the holder of the first trust deed. Thus, the Court in Catalano found no need to determine the fair market value of the property (see Catalano at footnote 7). This writer has significant reservations concerning applicability of the Tufts, Harris or Allan cases to the accrued interest portion in Catalano under the facts of that case to the extent it exceeded the value of the property. Your comments are invited.
With respect to cancellation income attributable to recourse debt, IRC §108(e)(2) provides that " ... no income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction."
The above is intended to be a starting point for evaluating the risks of alternative positions when reporting a foreclosure of a cash basis taxpayer's personal residence. Not all case law and rulings are consistent in this area, nor do they cover all factual combinations (solvency vs. insolvency, recourse vs. nonrecourse, fair market value vs. bid price, etc.) Material tax consequences should be discussed with the client's real estate tax counsel - his or her expertise in local property laws and the interplay with federal income tax law is essential. It is hoped that you will be in a better position to discuss the issues by having available the above summary of some of the key cases and rulings.
RICHARD A. LAVINE, CPA You DO have a
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