When and how to avoid sec. 1038 relief when reacquiring real property.

• Author: Frankel, George

When a lender receives a conveyance of mortgaged property in satisfaction of debt, gain or loss is realized even if the borrower returns the property voluntarily. However, the lender can elect under Sec. 1038 to limit the gain recognized to the cash and property (other than the repossessed property) previously received from the buyer; a loss cannot be recognized. While in certain cases, Sec. 1038 relief maybe welcome, there may be instances in which the lender wants to avoid the provision altogether. This article explains the law and suggests when and ways to avoid Sec. 1038's application.

When a borrower defaults on a loan secured by real property, the lender may foreclose or repossess. If the lender receives a conveyance of mortgaged property in satisfaction of debt, gain or loss is realized on the transaction, even if the borrower voluntarily returns the property.

Sec 1038 provides special rides for computing gain when a secured seller repossesses real property in satisfaction of debt, and provides for loss nonrecognition. Prior to the enactment of Sec. 1038, a repossession of real property was viewed as a taxable exchange by the seller, requiring gain or loss recognition. Congress enacted Sec. 1038 so that the repossession is treated not as a taxable transaction, but as a nullification of the original sale. According to the Senate Report,(1) such treatment is appropriate because (1) the seller is in no better position than before he made the sale (except to the extent of any additional cash or other property received after the sale); (2) valuation at the time of the repossession is difficult; (3) the seller would be taxed on gain not yet realized, so that funds to pay the taxes might not be available.

Sec. 1038 is generally beneficial to a seller, because it limits the gain recognized to the cash and property (other than the repossessed property) previously received from the buyer. However, in limited circumstances the seller may wish to avoid its application.

When Does Sec. 1038 Apply?

Sec. 1038 is mandatory if it applies, but applies only if four conditions under Regs. Sec. 1.1038-1(a) are met:

1. The repossession is of real property.

2. The debt was received in the original sale of the real property and is secured by the property. (Regs. Sec. 1.1038-1(a)(2)(ii) provides that debt is secured by real property if the seller has the right to take tide to or possession of the property on default.)

3. The repossession is made in full or partial satisfaction of such debt (i.e., the reacquisition is made in furtherance of the security interest).

4. The seller does not pay any additional consideration on the reacquisition; or, if such consideration is paid, it was provided for in the original sales contract or default has occurred or is imminent.

For this purpose, "additional consideration" is defined in Regs. Sec. 1.1038-1(a)(3)(i) to include any amount the seller pays in addition to discharging the debt arising from the original sale and secured by the real property, such as money and other property, and the seller's assumption or reacquisition of the property subject to debt that arose after the original sale. Debt that arose prior to or out of the original sale is not additional consideration.

According to Regs. Sec. 1.1038-1(a)(3)(ii), the manner of reacquisition is immaterial for Sec. 1038 purposes. The seller may reacquire ownership in the property through agreement (e.g., voluntary conveyance, abandonment) or by process of law (including foreclosure proceedings by judicial sale or by power of sale in the loan agreement, strict foreclosure, foreclosure by entry and possession, by writ of entry, or by publication of notice).

Sec. 1038(f) provides that the special rules do not apply to organizations described in Sec. 593(a), such as mutual savings banks, domestic building and loan associations and cooperative banks.

Tax Consequences to Mortgagee

When Sec. 1038 Does Not Apply

When a repossession of real property does not trigger Sec. 1038, the tax consequences are the same as on a reacquisition of personal property. The mortgagee must compute gain or loss on the repossession of the real estate; in certain...