Hidden Tax Consequences of Real Estate Foreclosures

• June 6, 2023
• Courtney DeVane

Since the recovery from the financial crisis of 2008, the real estate industry has, overall, fared well and values have appreciated.  Due to the positive conditions in the market, we have not as often encountered property foreclosures.  In this article, we discuss the tax consequences of real property foreclosures, or “deed in lieu of foreclosure”. 

A deed in lieu is a mutual agreement between the borrower and the lender and is a method that can be used to avoid a having foreclosure on record.  Alternatively, with a foreclosure, the lender involuntarily repossesses the property after a period of nonpayment by the borrower.  Both produce the same tax result.

Real property foreclosures can result in various tax consequences, largely dependent on the type of debt involved (recourse or nonrecourse).  A recourse debt holds the borrower personally liable and enables the lender to pursue the individual borrower for the balance due on the debt, even after the foreclosure of the property.  A nonrecourse debt is secured solely by the real property, shielding the individual borrower from personal liability.

Recourse debt

A lender’s acquisition of a property in satisfaction for a recourse debt is treated as a deemed sale with proceeds equal to the lesser of the fair market value (“FMV”) of the property at the time of foreclosure, or the amount of the secured debt.  If the amount of secured debt exceeds the FMV, the excess is treated as cancellation of debt (“COD”) income if it is forgiven.  These rules often result in a bifurcated transaction, where is it possible to have both (1) a gain or loss from the deemed sale of the property because the property’s FMV is more or less than the basis, and (2) COD income because the secured debt exceeds the property’s FMV.

COD income will occur in a foreclosure transaction only if the lender discharges part, or all of, the deficiency upon taking the property.  If the lender chooses to pursue the borrower for the deficiency, the COD income will not occur until that deficiency is discharged for less than full value.  If the lender does not either pursue the borrower or discharge the indebtedness, the COD income will occur when the state law for enforcing the debt expires. 

Internal Revenue Code (“IRC”) Section 108 provides a special mandatory relief provisions for COD income of certain bankrupt or insolvent taxpayers.  IRC Section 108(a)(1)(B) generally excludes COD income from a taxpayer’s gross income if the discharge occurs when the taxpayer is insolvent.

Therefore, if a taxpayer is insolvent at the time of the foreclosure, it can be beneficial for the FMV assigned to the property to be as low as possible.  This minimizes the gain from the deemed sale, and maximizes COD income (which may be excluded from income). 

On the other hand, if a taxpayer is solvent at the time of the foreclosure, it is typically beneficial for the FMV assigned to the property to be as high as possible.  This maximizes the gain from the deemed sale which may be eligible for preferential capital gain treatment, and minimizes COD income, which is ordinary income. 

Nonrecourse debt

Where nonrecourse debt is forgiven in a deed in lieu of foreclosure, the transaction is treated as a deemed sale of the property by the borrower to the lender with proceeds equal to the amount of the nonrecourse debt.  The gain or loss from the deemed sale is the difference between the amount of the outstanding nonrecourse debt and the adjusted basis in the property.

In a deed in lieu of foreclosure transaction involving only nonrecourse debt, there can be no COD income.  Also, unlike foreclosures involving recourse debt, both the FMV of the property and the taxpayer’s insolvent or bankrupt status is irrelevant.  This can be unfavorable for bankrupt or insolvent taxpayers who could otherwise exclude the COD income from gross taxable income.

The following examples illustrate the tax treatment of foreclosures involving recourse and nonrecourse debt, and the related character of income (or loss) realized on each transaction.

	Recourse Debt	Recourse Debt	Recourse Debt	Nonrecourse Debt	Nonrecourse Debt
Outstanding Debt	500,000	500,000	500,000	500,000	500,000
Property FMV *	450,000	450,000	550,000	450,000	450,000
Adjusted Tax Basis	300,000	600,000	300,000	300,000	600,000
Gain / (Loss) on Deemed Sale	150,000	(150,000)	200,000	200,000	(100,000)
COD Income **	50,000	50,000	0	N/A	N/A

With careful planning, taxpayers who find themselves in a potential foreclosure scenario can be proactive in minimizing the tax consequences. 

Sources: IRS.gov, Thompson Reuters

Tags: Real Estate, Federal and state taxation, including proposed regulations, Industry best practices, Industry trends/analysis | Comments Off on Hidden Tax Consequences of Real Estate Foreclosures