Congressman Don Edwards Inns of Court
May 19, 2010
Steven J. Sibley
Jay Crom, CPA
THEN: house or property fair market value (FMV) more than secured debt. Sale of appreciated property resulted in cash and Capital gain.
NOW - Personal residence or other property FMV is less than amount of secured debt against the property.
I. Facts Needed Key factors in determining the amount of gain or income realized from a foreclosure or short sale:
- (1) total amount of the secured debt.
- (2) type of debt - nonrecourse (purchase money), or - recourse (refinanced debt),
If recourse (refinanced) debt involving a personal residence, need to know the amount of the original debt when the property was purchased.
- (3) the adjusted tax basis in the property; and
- (4) the fair market value of the property (usually the short-sale price or amount bid at foreclosure sale).
II. General Rules: Short Sales or foreclosures involving recourse debt can result in cancellation of indebtedness income. Short Sales or foreclosures involving either recourse or nonrecourse debt can result in capital gains.
- A. Nonrecourse Debt. - generally, purchase money.
If property subject to a nonrecourse liability is foreclosed upon or voluntarily conveyed by the debtor, such debtor will recognize gain or loss equal to the difference between (1) the amount of the liability (plus the amount of cash and the fair market value of any other property paid to the debtor) and (2) the debtor=s adjusted tax basis in the property immediately before disposition.
- No portion of the debtor=s gain will constitute COD income.
EXAMPLE 1. Frank T. has total nonrecourse debt of $2 million on House. Frank T.=s adjusted basis in House is $1 million. House is nonjudicially foreclosed by Bank, with a credit bid of $2 million. At the time of the nonjudicial foreclosure, House is worth $1.5 million. What are the capital gain and cancellation of debt income consequences to Frank T as a result of the nonjudicial foreclosure?
Capital gain:Amt. Realized (total nonrecourse debt)$ 2,000,000Less - adjusted basis1,000,000LCapital Gain$ 1,000,000No COD income.
- B. Recourse Debt - refinanced debt, or not the original debt when property was acquired.
If property subject to a recourse liability is foreclosed upon by, or voluntarily conveyed to, a creditor, the transfer is analyzed as two transactions: (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 liability of the debtor to the creditor or a discharge by the creditor of the remainder of the liability that was not satisfied by the conveyance of the property. The debtor must recognize gain or loss equal to the difference between the fair market value of the property and the debtor=s adjusted tax basis immediately prior to the disposition. If the remainder of the debt is forgiven as part of the transaction, the amount forgiven will constitute COD income that, unless one of the exceptions provided by I.R.C. ' 108 is applicable, must be included in the debtor=s gross income.
EXAMPLE 2. Frank T. has total recourse debt of $2 million on House. Frank T.=s adjusted basis in House is $1 million. House is nonjudicially foreclosed by Bank, with a credit bid of $2 million. At the time of the nonjudicial foreclosure, House is worth $1.5 million. Bank waives deficiency claim. What are the capital gain and cancellation of debt income consequences to Frank T as a result of the nonjudicial foreclosure?
Capital gain:Amt. Realized (FMV)$1,500,000Less - adjusted basis$1,000,000Capital Gain$ 500,000
COD Income:Recourse debt$2,000,000Less FMV$1,500,000Cancellation of Debt Income$ 500,000
III. Exclusions to Recognition of Income or Gain.
- Exclusions from Income under I.R.C. ' 108
Section 108 contains a number of special rules for COD income exclusion that debtors may use to avoid recognition of COD income that they have realized.
- 1. Bankruptcy
COD income is excluded from gross income if the discharge occurs in a title 11 case.
Example 3: Same facts as Example 2, except that the foreclosure occurs while taxpayer is a debtor in Chapter 7 bankruptcy. I.R.C. ' 108 excludes from recognition (taxation) the $500,000 of COD income. However, the $500,000 capital gain is not excluded from recognition.
- 2. Insolvency
COD income is excluded from gross income to the extent the debtor is insolvent. Indebtedness means that the debtor is liable or the property is subject to the liability. Section 108 makes no distinction between recourse and nonrecourse indebtedness. However, contingent liability does not constitute indebtedness of the debtor for purposes of section 108.Landreth v. Commissioner, 50 T.C. 803, 812-813 (1968).
If the discharge occurs in a title 11 case and the debtor is insolvent at such time, the discharge is deemed to occur in the title 11 case. I.R.C. ' 108(a)(2)(A). As a result of this priority, a debtor who is solvent following a discharge in a bankruptcy case will avoid recognizing COD income since the discharge is deemed to occur in the bankruptcy case.
- 3. Reduction of Tax Attributes under I.R.C. ' 108(b).
Section 108(b) exacts a toll charge from bankrupt and insolvent taxpayers who exclude COD income from gross income under Section 108(a) by requiring such taxpayers to reduce certain of their tax attributes by the amount of debt discharged.
Section 108(b)(2) mandates that the bankrupt or insolvent taxpayer reduce his tax attributes in the following order: (1) net operating losses; (2) general business tax credits; (3) the minimum business tax credit; (4) net capital losses; (5) basis in depreciable property; (6) passive activity loss or credit carryovers; and (7) foreign tax credit carryovers. Taxpayers should report the reduction of their tax attributes due to a discharge of debt on IRS Form 982.
- B. Exclusion from Gain for Residence under I.R.C. & 121.
An unmarried individual may exclude from income up to $250,000 of gain realized on the sale or exchange of a residence. The amount of excludable gain is increased to $500,000 for married individuals filing jointly. The taxpayer must have owned and occupied the residence as a principal residence for an aggregate of at least two of the five years before the sale or exchange.
- Seller-Financed Sale of Property I.R.C. ' 108(e)(5).
When there is a debt reduction by virtue of a direct agreement between the original buyer and the original seller, the reduction in indebtedness will be deemed a purchase price adjustment rather than COD income. Section 108(e)(5) is not elective; thus, debt reductions described therein will automatically be treated as purchase price adjustments. In addition, section 108(e)(5) does not apply if the debt reduction occurs in a bankruptcy case or when the taxpayer is insolvent.
- D. The Mortgage Forgiveness Debt Relief Act of 2007 (H.R. 3648)
Under the Mortgage Forgiveness Debt Relief Act of 2007, enacted December 20, 2007, Debt Relief Act taxpayers may exclude from recognition as COD income the debt forgiven on their principal residence. Principal reason for the Act stems from all-to-common situation of a taxpayer purchasing a primary residence, with a cash downpayment, losing the property to foreclosure, which results in the loss of their downpayment and (without the Act=s provisions) cancellation of debt income.
- 1. Relief under the Debt Relief Act is subject to the following rules:
- - The debt must have been discharged by the lender in 2007, 2008, 2009 through 2011.
- - The balance of the loan was less than $2 million ($1 million if filing married-separate).
- - Forgiveness of debt on vacation homes, second homes and investment property doesn=t qualify.
- - The exclusion can be used only if the loan was taken out to acquire, build or substantially improve a principal residence. Debt used to refinance qualifying debt is also eligible for the exclusion, but only up to the amount of the old mortgage principal, just before the refinancing. Non-qualifying debt is treated as discharged first and does not qualify for the exclusion.
Example 4 Portion of Non-Qualifying Debt: Taxpayer=s principal residence is secured by a recourse debt of $1 million, of which $800,000 is qualified principal residence indebtedness. If the residence is sold or lost to foreclosure for $700,000 and $300,000 of debt is discharged, only $100,000 of the debt discharged may be excluded ($300,000 discharged - $200,000 nonqualified debt). The remaining $200,000 of nonqualified debt may qualify in whole or in part for one of the other exclusions (e.g., insolvency).
- 2. Issues arising from the Debt Relief Act:
- a. possible election out of Principal Residence Exclusion if insolvent to preserve tax basis.
- b. timing of debt discharge-if multiple properties, best in same year, pre- vs. post-petition events, impact of property being abandoned by trustee.
- c. potentially offsetting deductions and losses.
- d. Non-deductible loss on primary residence vs. 1231 loss on rental/business property.
- e. Use of IRC ' 121 capital gain exclusion limited if property used as rental or business property (if property used as a rental 20%, then only 80% of gain excluded) and partial exclusion of gain for residence held less than two years due to job loss\change, divorce.
E. IRC Section 1398 Splitting Taxable Years for Individual Chapter 7 and 11 Debtors.
Internal Revenue Code section 1398 allows individual taxpayer filing ch. 7 or 11 to elect to split taxable year into two years; the first from Jan. 1 to the day before the petition date, the second taxable year from the petition date to December 31st.
Why do this? Splitting the taxable years can allow payment from the bankruptcy estate of a tax liability incurred in the same tax year prior to the bankruptcy filing. Without the 1398 election, all the tax liability will follow debtor\taxpayer outside of bankruptcy.
Example 5 Same Facts as Example 2, except House foreclosure happens June 30, 2010, and Frank T has non-exempt property of $80,000. Making the 1398 election would allow payment from the estate of the capital gains tax liability. Without election, funds would go to other creditors.
- Fee Agreement Provisions Re: Tax Provisions
While bankruptcy attorneys do not generally provide tax advice, it is likely the scope of an attorney's services to a potential debtor would include, at least, notice to the client of the possible tax consequences of a foreclosure, short-sale or the 1398 election, particularly when the foreclosure or short sale occurs in the same year as the bankruptcy filing. An example of an Attorney Fee provision:
The scope of this representation does not include providing tax advice to CLIENT. CLIENT should seek the advice of a qualified tax professional to determine the tax consequences of a foreclosure or short-sale involving any real property owned by CLIENT and whether to split a taxable year pursuant to Internal Revenue Code ' 1398.