Tax consequences of real property foreclosures.

• Author: Young, Patrick L.

Owners of real property sometimes encounter difficult financial times due to an overall decline in the economy or events that adversely affect their particular area of the country. These conditions may produce situations where an owner does not have sufficient cash flow from a property to meet the debt requirements, or the property declines to a value that is less than the outstanding debt. In either case, foreclosure of the property by the lender is often the final outcome.

Real property foreclosures can produce various tax consequences depending on the type of debt (recourse or nonrecourse), the taxpayer's adjusted basis in the property, and the taxpayer's financial condition at the time of the foreclosure. Proper planning both before and after a foreclosure can help minimize the tax consequences of these transactions.

Note: There are special tax provisions (not covered in this column) for cancellation-of-debt (COD) income on principal residences.

Recourse and nonrecourse debt often produce different tax results

A recourse debt enables the lender to pursue the individual borrower for the balance due on a debt in addition to foreclosing on the property. Conversely, a nonrecourse debt is secured solely by the real property, thus shielding the individual borrower from personal liability. When property is foreclosed, the tax results differ depending on whether the debt is recourse or nonrecourse. Understanding the differences is a key factor in proper planning for the foreclosure.

Recourse debt

A foreclosure, or a deed in lieu of foreclosure, transaction may result in COD income to the borrower when recourse debt is involved. The taking of property by the lender in satisfaction of a recourse debt is treated as a deemed sale with proceeds equal to the lesser of the property's fair market value (FMV) at the time of foreclosure or the amount of secured debt. If the amount of debt exceeds FMV, the difference is treated as COD income if it is forgiven (Regs. Sec. 1.1001-2(c), Example 8, and Rev. Rul. 90-16). (Note that Sec. 108 provides special mandatory relief provisions for COD income of certain bankrupt or insolvent taxpayers.)

As a result of these rules, it is possible for a foreclosure transaction involving recourse debt to result in both (1) a gain or loss from the sale of the property because the property's FMV is more or less than basis and (2) COD income because the secured debt exceeds the property's FMV. The amount credited or received...