Tax ramifications of a foreclosure: a debtor's perspective.

• Author: Barranca, Steven C.

The tax ramifications of a foreclosure, from a debtor's perspective, can best be understood by first exploring the general approach to determining the tax treatment of any particular debt forgiveness event. This approach begins with a two-step process. The first step is to divide the debt into two components: (1) discharged principal and (2) discharged, but previously deducted, accrued unpaid interest (if any). The first step is necessary because the tax treatment applicable to the discharge of principal is generally not the same as the treatment applicable to previously deducted accrued unpaid interest.

Discharged Principal

Discharged principal must be included in gross income under the "general rule" of Sec. 61(a)(12) and as such is taxed as ordinary income (referred to as cancellation of debt (COD) income). There are two exceptions to the general rule, and they are discussed below in connection with the second step.

Discharged principal may, in part or in whole, be excluded from gross income under the exclusion rules of Sec. 108. As a price to be paid for the exclusion, the taxpayer may be required to reduce certain enumerated tax attributes, including certain loss and tax credit carry-forwards and basis in certain property (Secs. 108 and 1017). The exclusion and tax attribute reduction rules are beyond the scope of this item. To the extent debt proceeds (from the canceled debt) are allocated to a passive activity at the time the debt is canceled, the COD income is characterized as income from a passive activity (the allocation can be determined by using the methodology available under the interest tracing rules of Temp. Regs. Sec. 1.1638T (see Rev. Rul. 92-92)).

Discharged accrued interest (that the borrower previously deducted) is generally included in gross income under the "tax benefit rule" (Sec. 1341). Consequently, the exclusion and tax attribute rules do not apply to accrued interest.

The second step concerns the discharge of principal and determining whether either of the two exceptions (discussed below) apply. As previously stated, the requirement to include discharged principal in gross income (as COD) is a general rule under Sec. 61(a)(12). The two exceptions to the general rule are (1) the purchase price adjustment exception and (2) the foreclosure exception. These exceptions are mutually exclusive.

Under the purchase price adjustment exception, the debtor does not report COD income. Instead, the debtor reduces the adjusted basis of the purchased property (Sec. 108(e)(5)). Where depreciable...