The tax consequences of the statutory right of redemption in property foreclosures.

• Author: Pasquini, C. Barrett

TABLE OF CONTENTS INTRODUCTION I. THE HOUSING AND FORECLOSURE BOOM II. FUNDAMENTALS OF PROPERTY OWNERSHIP A. Mortgages 1. Recourse Lending 2. Nonrecourse Lending B. Foreclosures C. Statutory Right of Redemption III. INCOME AND THE STATUTORY RIGHT OF REDEMPTION A. Income B. Basis and Debt C. Statutory Redemption's Effect on Income 1. Recourse Scenarios 2. Nonrecourse Scenarios 3. Income Recognition IV. DEPRECIATION AND THE STATUTORY RIGHT OF REDEMPTION A. "Breaking the Chain" B. "Bridging the Gap". C. Bridging the Gap over Breaking the Chain CONCLUSION INTRODUCTION

In November of 2001, the National Bureau of Economic Research officially declared the U.S. economy in recession. (1) To counter this lull and restore strength to a struggling economy, the Federal Reserve began a series of interest rate reductions (2) that would lead to the lowest mortgage lending rates in forty years. (3) Almost immediately, the housing market responded. From 2002 to 2005, the U.S. economy moved from recession to expansion, sustained primarily with the aid of a housing boom. (4)

It is no secret that market conditions over the past five years have made it easier than ever to own a home. (5) What is not so well known is that these same conditions have also compounded the problem of foreclosures. In recent years, foreclosure rates have increased dramatically. (6) But, should the housing market contract, or in other words, should the proverbial housing bubble burst, (7) foreclosures could reach record levels. (8)

With foreclosures come statutory redemptions. The statutory right of redemption allows a borrower who lost her home at foreclosure to buy back her home within an allotted period of time, which ranges from thirty days to two years depending on the state redemption statute. (9) Because conditions are primed for a foreclosure boom, the need to address statutory redemptions is both relevant and timely.

This Note looks at one unaddressed aspect of statutory redemptions, namely the tax consequences and treatment of property redeemed after foreclosure. More specifically, this Note focuses on statutory redemption's effect on income, income recognition, and depreciation.

Part I will begin by discussing the housing market and the factors that have contributed to the current state of foreclosures. Part II will then provide a background of those principles relevant to property ownership and taxation, including mortgages, foreclosures, and the statutory right of redemption. Part III will discuss the effect of the statutory right of redemption on income as it applies to taxation. Part III will also address the element of income recognition, focusing on when income arising from the discharge of indebtedness as a result of statutory redemption should be recognized. Part IV will then analyze the effect of the statutory right of redemption on property depreciation. Part IV's analysis will first address the arguments for "breaking the chain" of depreciation in statutory redemptions, then address the arguments for "bridging the gap" in such depreciation, and finally conclude that "bridging the gap" should be preferred over "breaking the chain."

To help illustrate the principles discussed herein, this Note will use the following hypothetical as a reference throughout the text: Borrower (B) buys a house from Seller (S) for $100,000; and B finances the purchase through Lender (L) who loans B $90,000, with B using her own money to pay the remaining $10,000. (10)

1. THE HOUSING AND FORECLOSURE BOOM

   Low interest rates over the past five years have resulted in a boom in both the housing and lending industries. (11) Borrowers have taken advantage of low rates by purchasing homes at record pace, by refinancing, by taking out home equity loans, and by purchasing additional properties as investments. (12) Lenders have also sought to capitalize on low rates by offering a variety of new loan products (13) and by lowering the requirements for obtaining loans. (14) The result is an increasingly large population of borrowers with an increasingly large amount of debt. (15) When these two conditions meet, foreclosures abound. (16)

   For the past twenty years, property foreclosures have been steadily escalating. (17) Although part of this escalation may be attributed to factors such as an increasing number of homeowners, the primary cause of this rise in foreclosures is the degree to which borrowers are financially extended. (18) Yet this is only half the story. With every ebb in the cycle of interest rates comes a corresponding flow. As the trend has demonstrated over the past year and a half, rates are again on the rise. (19)

   What, then, does this mean for borrowers? For those with fixed-rate loans, rising interest rates mean nothing. (20) But for those with adjustable-rate or interest-only loans, which both have vastly increased in popularity, (21) this trend means that the low rates, which enticed or allowed them to borrow money in the first place, will also begin to rise. (22) Because rate increases exert financial pressure on the borrower, (23) it is fair to assume that residential foreclosures will at least continue at their current elevated rates, or possibly rise to unprecedented levels. (24)

   The cycle of rising foreclosures could extend to commercial property as well. The Federal Reserve Board noted in a summary of reports from businesses and other contacts that a "[r]ising demand for commercial mortgages was reported in New York, Cleveland, Richmond, and Kansas City." (25) As the demand for commercial mortgages increases and is met, the number of commercial borrowers--and the number of potential commercial defaulters--also increases. This cycle may in fact be underway in places like Dallas, which is already experiencing an increase in commercial foreclosures. (26)

2. FUNDAMENTALS OF PROPERTY OWNERSHIP

   1. Mortgages

      A mortgage is an agreement between a borrower and lender that creates a legal right for the lender to recover the loan amount from the assets of the borrower should the borrower default or fail to make the required payments. (27) When a borrower defaults, the loan amount is usually recovered from the property for which the loan was originally given. (28) The loan can also be recovered, however, from the borrower's personal assets. (29) Mortgages thus act as security instruments by which lenders can recover some, if not all, of the original loan amount in the event the buyer defaults. (30)

      1. Recourse Lending

      As mentioned above, there are two ways a lender can recover the loan amount from the borrower in the case of default. (31) The first way is for the lender to recover the loan amount from the total assets of the borrower, including the property purchased with the loan as well as any other of the borrower's assets that may legally be used to pay off the debt. (32) This is known as recourse lending, and the specific debt instrument is known as a recourse loan. (33)

      Recourse lending is most commonly employed in residential lending, with recourse loans securing the vast majority of homes in this country. (34) In practice, a recourse loan ensures that the borrower is liable for the full loan amount. (35) If the proceeds from the sale of property secured by a mortgage are not sufficient to satisfy the original loan amount, then the recourse lender can look to the personal assets of the borrower to fulfill the debt.

      For example, in the hypothetical, if B defaults on the mortgage with L, and the loan was a recourse loan, then B is liable for the full $90,000 to L. (36) So if L recovers only $80,000 from the sale of the property, then L can seek a deficiency judgment to recover the remaining $10,000 from B's personal assets. (37)

      2. Nonrecourse Lending

      The second way a lender can recover a defaulted loan is to look solely to the property secured by the loan. This is known as nonrecourse lending, and the debt instrument is known as a nonrecourse loan. (38) Nonrecourse loans are most commonly employed in commercial lending. (39)

      For practical purposes, in a nonrecourse loan the borrower is not liable for any portion of the loan that exceeds the amount recovered from the sale or disposition of the property securing the loan. (40) Referring back to the hypothetical, if B defaults on the mortgage with L, and the loan is a nonrecourse loan, then B is liable solely for the amount received from the sale or disposition of the property secured by the mortgage. (41) If L recovers only $80,000 from the sale of the property, then B is no longer liable for the remaining $10,000. L has, in effect, lost this money. (42)

   2. Foreclosures

      When a borrower fails to make payments on a loan, the lender has the legal right to recover the loan amount from the borrower. (43) The lender exercises this right by taking over the secured property through foreclosure. (44)

      The process of foreclosure by way of judicial sale takes place as follows: The lender first notifies the borrower that the loan is in default and files a foreclosure complaint with the court. (45) If the loan continues in default, the lender then serves the complaint on the borrower. (46) A judicial hearing is ordered, the foreclosure decreed, and notice posted that a foreclosure sale is pending. (47) The property is then sold at a foreclosure auction open to the public and conducted by a local court officer. (48)

      The amount paid at auction is used to pay off the original loan amount. (49) As a result, lenders will normally bid up to the amount they have invested in the property to ensure that they are either paid in full or that they end up with the property itself. (50)

      Returning to the hypothetical, if L ordered a sale of B's property at foreclosure, L would likely bid at least $90,000, an amount equal to the remaining balance. That way, L either gets the property for $90,000, (51) an amount that L already has invested in the property, or, if someone bids higher than L, the proceeds from the sale will...