Karrie L. Bercik, JD, LLM

It is well settled that a voluntary disposition of property through a deed in lieu of foreclosure or an involuntary disposition of property through foreclosure constitutes a sale or exchange for federal income tax purposes. 1 Section 1001(a) provides that gain or loss recognized to a taxpayer in connection with the sale or disposition of property is measured by the difference between the amount realized and the adjusted basis of the property. Section 1001(b) defines the amount realized from the sale or other disposition of property as the sum of any money received plus the fair market value of other property received. The amount realized on a foreclosure or deed in lieu of foreclosure depends upon several factors, the most important of which are (1) whether the debt encumbering the property constitutes recourse or nonrecourse debt, and (2) the current fair market value of the property.

The amount realized upon the disposition of property subject to a nonrecourse debt will always be at least equal to the amount of the nonrecourse liability .2 Thus, if property subject to a nonrecourse debt is conveyed to the creditor, the debtor will recognize gain or loss equal to the difference between the amount of the liability discharged (plus the amount of cash and fair market value of any property paid to the debtor) and the debtor's adjusted tax basis in the property immediately before the disposition. No portion of the debtor's gain is treated as cancellation of indebtedness income ("COD"). Further, the property's fair market value is irrelevant to the transaction.

If property subject to a recourse debt is conveyed to a creditor, the transaction is split into two parts 3 consisting of (1) a taxable disposition of the property, and (2) to the extent the value of the property is less than the recourse liability, either a continuing debt obligation to the creditor or a discharge of the remainder of the liability. Under this approach, the taxpayer recognizes gain or loss equal to the difference between the fair market value of the property and the taxpayer's adjusted tax basis therein immediately prior to the disposition. If the remainder of the debt is forgiven, the amount forgiven will constitute COD income that, unless excepted under Section 108, will be included in the taxpayer's ordinary gross income. 4

Occasionally, a debt may be recourse on its face, but because of some other provision of law it becomes in fact nonrecourse. The most common example is an anti-deficiency statute. There is no clear guidance whether anti-deficiency statutes cause a recourse debt to become nonrecourse. In a 1991 private letter ruling dealing with Alaska law, the Service proclaimed that despite an anti-deficiency statute, a debt remained recourse for purpose of a foreclosure. Arguably, all of the facts and circumstances should be considered in determining whether a debt is nonrecourse, including whether an anti-deficiency statute precludes the creditor from satisfying the debt from the debtor's personal assets.

Gain from a foreclosure of a personal residence is treated the same as gain from voluntary sales of residences. If the sale occurred prior to May 6,1997, under Section 1034 the debtor could rollover some or all of the gain by purchasing another residence within two years. After May 6, under new Section 121, the debtor can exclude $250,000 of income from the sale of a residence from his gross income. A married debtor is entitled to a $500,000 exclusion. This exclusion is available every two years and repeals the prior rule that was a one-time exclusion $125,000 for taxpayers over 55.

Generally, because of the new Section 121 exclusion, a debtor is better off taking the position that the mortgage on his personal residence is nonrecourse if, under state law, including any anti-deficiency statute, the creditor's only source of payment is the residence. Generally, a nonrecourse debt would result in a capital gain (that will be excludable under Section 121) rather than COD income. Although the COD income may be excludable under Section 108 if the taxpayer is insolvent, the taxpayer will have to make offsetting reductions in tax attributes including NOLs, capital losses, passive activity losses, and basis in assets. Prior to the enactment of Section 121, taxpayers generally preferred COD income to capital gains if the taxpayer was in bankruptcy or insolvent. However, if the insolvent taxpayer's gain exceeds the $250,000 or $500,000 limit of Section 121, the taxpayer would be better off arguing that the debt is recourse creating part capital gain and part COD income. In such case, the insolvent taxpayer could use both Section 121 and Section 108 to exclude the income from his gross income. With careful planning, a foreclosure may no longer be a devastating taxable event for some taxpayers.

FOOTNOTES

1 See Helvering v. Hammel, 311 U.S. 504 (1941); Tres. Reg. § 1.1001-2(a)(1).return to text

2 See Commissioner v. Tufts, 461 U.S. 300 (1983); Crane v. Commissioner, 331 U.S. 1 (1947).return to text

3 See Bressi v. Commissioner, 62 T.C.M. 1668 (1991); Treas. Reg. §§ 1.1001-2(a)(2), 1.1001-2(c), Example (8).return to text

4 Some cases have not followed the bifurcation approach of the regulations. See Chilingirian v. Commissioner, 52 T.C.M. 606 (1986), aff'd, 90-2 U.S.T.C. ¶ 50569 (6th Cir. 1990); Aizawa v. Commissioner, 99 T.C. 197 (1992). The Internal Revenue Service (the "Service") has taken the position that a disposition of property secured by a recourse liability must be analyzed in accordance with the bifurcation method of the regulations. Rev. Rul. 90-16, 1990-1 C.B.12; G.C.M. 39814 (March 30, 1990); T.A.M. 8504010 (October 26, 1985).return to text

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Last updated April 3, 1998

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