The Mess Left Behind: Taxation of Post-death Foreclosures

• Publication year: 2009
• Author: By James P. Lamping, Esq.

THE MESS LEFT BEHIND: TAXATION OF POST-DEATH FORECLOSURES

By James P. Lamping, Esq.^*

"A man who pays his bills on time is soon forgotten." - Oscar Wilde

I. INTRODUCTION

The foreclosure of real property raises a number of income tax issues. These issues may become more complicated when they arise during the administration of a decedent's estate.¹ Personal representatives who think they may simply walk away from real property secured by a mortgage may be in for a rude surprise when the tax bill arrives. It therefore is imperative that the attorney recognize and advise the personal representative on the tax implications of a foreclosure, so that the fiduciary charged with administering the estate can make educated decisions.

This article begins with an analysis of the tax issues arising from foreclosures generally, and then turns to the operation of the applicable tax laws in the post-death administration context. Finally, there is a discussion regarding the rules pertaining to the priority for payment of creditors, illustrating why it may make sense to undertake the administration of an insolvent estate holding property subject to foreclosure. The discussion focuses on residential property, although many of the same tax rules (but not the special homeowner relief provisions) apply to investment property as well.

II. TAX CONSIDERATIONS GENERALLY

A. Overview: Capital Gains or Ordinary Income

The tax law pertaining to foreclosures was developed mostly with the living individual in mind. The extension of the rules developed in this context to the post-death administration are not always clear. This article therefore provides some background regarding the law in this area generally, before turning to a discussion of foreclosure in a post-death administration.

The starting point is to ascertain whether the lender has recourse against the debtor personally, or whether the lender is limited to taking possession of the real property. In addition to defining the extent to which the debtor's other assets are exposed for the debt, this distinction also may determine whether the foreclosure will generate capital gains, ordinary income, or both, for income tax purposes. Since the exclusions from income relating to capital gains and ordinary income are different, this is a critical branch in the analysis.

B. Nonrecourse Debt

1. Purchase Money Rule

California law generally provides that debt used to purchase a personal residence will be non-recourse, whether the financing is provided by the seller or by another lender. The Code of Civil Procedure provides:

No deficiency judgment shall lie in any event after a sale of real property or an estate for years therein for failure of the purchaser to complete his or her contract of sale, or under a deed of trust or mortgage given to the vendor to secure payment of the balance of the purchase price of that real property or estate for years therein, or under a deed of trust or mortgage on a dwelling for not more than four families given to a lender to secure repayment of a loan which was in fact used to pay all or part of the purchase price of that dwelling occupied, entirely or in part, by the purchaser.
Where both a chattel mortgage and a deed of trust or mortgage have been given to secure payment of the balance of the combined purchase price of both real and personal property, no deficiency judgment shall lie at any time under any one thereof if no deficiency judgment would lie under the deed of trust or mortgage on the real property or estate for years therein.²

The protection offered by a purchase money loan generally cannot be waived at the time the debt is created or renewed.³ However it may be waived if it is not raised in litigation, because it is an affirmative defense.⁴ While a refinancing by a third party lender will remove the purchase money protection,⁵ this protection may remain following a refinancing or loan modification by the original lender.⁶

2. Capital Gains

The relinquishment of real property subject to a nonrecourse debt through foreclosure or a deed in lieu of foreclosure is treated as a sale or exchange for capital gains tax purposes.⁷ In explaining the rationale for this principle, the court in Yarbro v. Commissioner stated:

The term "exchange," in its most common, ordinary meaning implies an act of giving one thing in return for another thing regarded as an equivalent. Webster's New International Dictionary (2d ed. 1954). Thus, three things are required: a giving, a receipt, and a causal connection between the two. In the case of abandonment of property subject to nonrecourse debt, the owner gives up legal title to the property. The mortgagee, who has a legal interest in the property, is the beneficiary of this gift, because the mortgagee's interest is no longer subject to the abandoning owner's rights.
In Middleton, as in this case, the taxpayer argued that, because the debt was nonrecourse and he therefore had no personal liability for the debt, he received nothing in exchange for his relinquishment

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of title. In essence, the argument is that because the taxpayer personally had no obligation to repay the debt, the abandonment could not have relieved him of any obligation. This argument is inconsistent with several Supreme Court decisions.
The Supreme Court has held that regardless of the nonrecourse nature of the debt, the taxpayer does receive a benefit from the disposition of the property: he is relieved of his obligation to pay the debt and taxes and assessments against the property. In Crane v. Commissioner, 331 U.S. 1, 67 S. Ct. 1047, 91 L. Ed. 1301 (1947), the Supreme Court established that, in computing the amount of gain on the disposition, the outstanding debt must be included in the "amount realized" by the taxpayer, whether the debt is recourse or non-recourse.⁸

The gain or loss upon foreclosure is the difference between the adjusted basis of the property and the principal balance of the nonrecourse debt.⁹ For example, suppose that a residence encumbered by a $180,000 nonrecourse mortgage has a fair market value of $170,000 and a basis of $175,000 at the time of foreclosure. The capital gain would be $5,000 ($180,000 minus $175,000).¹⁰ It should be emphasized that the fair market value of the property is not used in this calculation. Indeed, the principal balance of the mortgage is treated as the amount realized, even where it exceeds the fair market value of the property.¹¹

3. Exclusion from Income of Capital Gains on Sale of Residence

If capital gains are realized upon the foreclosure of residential property subject to nonrecourse debt, the taxpayer must rely upon the exclusion from gain with respect to a principal residence under Internal Revenue Service (IRC) section 121 to avoid taxation.¹² The general application of this statute has been well documented and will not be analyzed at length here.¹³ Rather, it is mentioned as a precursor to a discussion of its unique application in the post-death context that is addressed below.

Other exclusions, such as the insolvency exclusion discussed below, may be available to avoid the imposition of income tax on ordinary income arising from the discharge of debt under certain circumstances. However, these exclusions do not apply to avoid the imposition of capital gains taxes upon foreclosure.¹⁴

C. Recourse Debt

1. Capital Gains and Ordinary Income

A foreclosure involving a recourse debt may result in both ordinary income and capital gains. This involves a two-step analysis. Capital gains are first calculated by comparing the fair market value of the property to the taxpayer's adjusted basis. Second, ordinary

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income results to the extent that the debt exceeds the fair market value of the property. These rules were summarized in Revenue Ruling 90-16 as follows:

Section 1.1001-2 (a)(1) of the regulations provides that, except as provided in section 1.1001-2 (a)(2) and (3), the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition. Section 1.1001-2 (a)(2) provides that the amount realized on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness under section 61(a)(12). Example (8) under section 1.1001-2(c) illustrates these rules as follows:
Example (8). In 1980, F transfers to a creditor an asset with a fair market value of $6,000 and the creditor discharges $7,500 of indebtedness for which F is personally liable. The amount realized on the disposition of the asset is its fair market value ($6,000). In addition, F has income from the discharge of indebtedness of $1,500 ($7,500 - $6,000).¹⁵

It is possible that a taxpayer will have ordinary income combined with a capital loss. For example, suppose that a residence encumbered by a $180,000 recourse mortgage has a fair market value of $170,000 and a basis of $175,000 at the time of foreclosure. The taxpayer first computes gain or loss on the foreclosure by comparing the amount realized ($170,000) with the adjusted basis ($175,000), resulting in a $5,000 capital loss. Next, the taxpayer deducts the fair market value of the residence ($170,000) from the principal balance of the mortgage ($180,000), which results in $10,000 in ordinary income from the discharge of debt.¹⁶

2. Exclusions From Income of Ordinary Income Arising from Discharge of Indebtedness

If a taxpayer realizes ordinary income from the cancellation of indebtedness, the taxpayer nonetheless will not be taxed if (1) the cancellation of indebtedness arises from a bankruptcy discharge;¹⁷ (2) the taxpayer is insolvent;¹⁸ (3) the debt is qualified farm debt;¹⁹ (4) the debt is qualified real property business debt;²⁰ (5) the debt is qualified principal residence indebtedness;²¹ or, (6) the cancellation is intended as a gift by the lender.²² Where more...