What Are the Tax Implications of a Typical Foreclosure Action?

June 17, 2020

In the wake of the COVID-19 pandemic and the resulting economic downturn, millions are out of work and individuals and companies are finding it difficult or impossible to make their mortgage payments. As income and revenues decline due to unprecedented job losses and financial hardship, what can taxpayers do to reduce or defer taxable income in foreclosures? This article will discuss the tax implications of a typical foreclosure transaction and the exclusions taxpayers may be able to leverage. 

Exclusion of Income

Taxpayers may realize two types of income or loss when restructuring debt. The first is a gain or loss on the sale of the property and the second is a discharge of indebtedness income, also known as cancellation of debt (COD) income.

Generally, the amount by which taxpayers can benefit from the discharge of indebtedness is included in their gross income. However, under certain circumstances pursuant to Internal Revenue Code (IRC) Section 108, taxpayers can exclude the amount of discharged indebtedness from their gross income.

This generally occurs when a property owner can no longer make the required mortgage payments and the lender discharges the principal of the outstanding liability.  Taxpayers must include in gross income their COD income.  Again, COD income may be excluded from gross income under certain exclusion provisions, subject to a limited set of circumstances.  Any income (besides COD income) recognized from a foreclosure transaction may be taxed at lower capital gains rates.  

Foreclosures 

A foreclosure is the legal process by which the lender takes collateralized property to satisfy its outstanding debt balance.  A deed in lieu of foreclosure (i.e., voluntary conveyance) is a transaction in which the borrower merely transfers title to the bank in full satisfaction of the outstanding debt.  (Those of you who have seen the movie Larry Crowne may remember that this is what Tom Hanks’ character does when he falls on hard times and is about to lose his house.) Both transactions are treated as taxable sales or exchanges of property for income tax purposes.  In either case, the tax treatment depends largely on the type of debt involved, nonrecourse or recourse.  A partnership liability is nonrecourse to the extent that no partner (or related party through the complex tax attribution rules) bears the economic risk of loss associated with such liability.  Conversely, a recourse liability occurs to the extent that any partner (or related party through the complex tax attribution rules) bears the economic risk of loss associated with such liability.   

In the case of a foreclosure involving nonrecourse debt, the entire amount of the outstanding principal debt balance canceled is included in the amount realized.  Gain or loss from a foreclosure or the voluntary transfer of a deed in lieu of foreclosure is characterized as either a Section 1231 gain in the case of business property or a capital gain in the case of investment property.  The gain may also be subject to the depreciation recapture rules under Section 1250.  The amount realized can never be less than the outstanding principal amount at the time of foreclosure even where the fair market value of the foreclosed (or surrendered) property is lower than the outstanding nonrecourse debt balance.

In the case of a foreclosure involving recourse debt, the same rules discussed above related to nonrecourse debt are applicable to recourse debt except when the recourse debt exceeds the fair market value (FMV) of the surrendered property. In this case, the foreclosure transaction is deemed to be bifurcated into two unrelated transactions wherein the taxpayer may be required to recognize ordinary income and capital gain or loss. First, the taxpayer will recognize COD income to the extent the canceled debt exceeds the FMV of the property at the time of the foreclosure.  Second, a sale or exchange is deemed to occur, and gain or loss (either Section 1231 gain or loss or capital gain or loss) will be determined by reference to the difference between the amount realized (the canceled debt less the portion treated as COD income) and the adjusted tax basis in the property.  In situations where the property’s FMV is less than its adjusted tax basis, a taxpayer may realize a capital loss (ordinary loss if the underlying collateral was Section 1231 property) and COD income on the same transaction with the net effect resulting in the same total gain or loss as if the property had been secured by nonrecourse debt.

If the discharge occurs in a Title 11 case, where the taxpayer is insolvent (insolvency is a simple test meaning one’s liabilities exceed its assets) or where the indebtedness is qualified farm indebtedness or qualified real property business indebtedness, gross income does not include any amount that otherwise would be includible in gross income by reason of that discharge (in whole or in part) of the taxpayer’s indebtedness.

Reduction of Tax Attributes

Although IRC Section 108(a) excludes COD income from gross income under those circumstances, IRC Section 108(b) requires the taxpayer to reduce certain tax attributes in an amount that reflects the amount excluded from gross income, thereby generally deferring (rather than permanently eliminating) - the inclusion of COD income.

The reduction of the taxpayer’s tax attributes is done in the following order:

• net operating losses;

• general business credits;

• minimum tax credits;

• capital loss carryovers;

• adjusted basis of property;

• passive activity losses and credit carryovers; and

• foreign tax credit carryovers.

IRC Section 108(b)(4)(A) provides that the reductions are made after the determination of the tax imposed for the taxable year of the discharge.  Further, Section108(b)(4)(B) provides that the reductions of net operating losses and capital loss carryovers are made first for the loss in the taxable year of the discharge and then in the carryovers to such taxable year in the order of the taxable years from which each such carryover arose.  If the excluded COD income exceeds the sum of the taxpayer’s tax attributes, the excess is disregarded (eliminated) and does not result in income or have other tax consequences.

Taxpayers must file Federal Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) with their income tax return for a year a discharge of indebtedness is excluded from their gross income to report the exclusion and the reduction of certain tax attributes.

Instead of reducing tax attributes, a taxpayer may elect to reduce first the adjusted bases of its depreciable property to the extent of the excluded COD income.  The amount to which the election applies is limited to the aggregate adjusted tax basis of the depreciable property held by the taxpayer as of the beginning of the taxable year following the taxable year in which the discharge occurs.  If the adjusted tax bases of depreciable property are insufficient to offset the entire amount of excluded COD income, the taxpayer must then reduce any remaining tax attributes in the order set forth above.

COD income is a typical example of phantom income–an occurrence in which a taxpayer incurs a tax even though no cash is received from the capital transaction.  As such, Congress intended the reduction of tax attributes and the election to reduce the depreciable tax basis of taxpayers’ properties to allow them, including insolvent taxpayers and debtors in bankruptcy, to account for a debt discharge amount in a manner that is most favorable to their respective tax situations.

Conclusion

There is a long list of repercussions associated with foreclosures, but few taxpayers consider the tax implications—until they must file their tax return. A foreclosure is treated the same as the sale of a property, which can trigger a capital gain. In some cases, the taxpayer may also owe income tax on the amount of any part of the mortgage debt that has been forgiven or canceled. However, an exception or exclusion may save you from having to pay taxes on canceled mortgage debt.

As you can see, the tax consequences of a foreclosure are complex. Marks Paneth remains available to provide you with more clarity on these unfortunate types of transactions and the tax nuances as it relates to foreclosures and tax attribute reductions. Let’s keep the discussion going...