10/26/2024
THIS IS NAUSEATING . BUT HOW MANY FORECLOSURE CASES FORGOT TO INCLUDE THE FOLLOWING !
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 in a foreclosure sale determines the sales proceeds for computing gain or loss (Aizawa,29 F.3d 630 (9th Cir. 1994); Webb,T.C. Memo. 1995-486). The character of the gain or loss depends on the character of the property subject to the foreclosure.
Observation: To the extent the underlying debt discharged is allocated to a passive activity, the COD income is treated as arising from a passive activity. Conversely, to the extent the underlying debt is attributable to a nonpassive activity, the COD income is nonpassive (Rev. Rul. 92-92).
Note: The bid price in a foreclosure sale is presumed to be the property's FMV unless there is clear and convincing proof to the contrary (Regs. Sec. 1.166-6(b)(2); Community Bank, 819 F.2d 940 (9th Cir. 1987)).
The Tax Court has acknowledged that the amount bid by a lender may be arbitrary, so if the taxpayer presents clear and convincing proof (e.g., an appraisal) of a more accurate FMV, the FMV amount rather than the bid price is used in determining the sales proceeds from the transaction and any related COD income (Frazier, 111 T.C. 243 (1998)).
COD income will occur in a foreclosure transaction only if the lender discharges part or all of any deficiency (excess of indebtedness over the property's FMV) upon taking the property. If the lender continues to pursue the borrower for the deficiency, COD income will not occur until that deficiency is discharged for less than full value. If the lender fails to pursue the borrower or to discharge all the indebtedness, the COD income will occur when the state law for enforcing the debt expires.
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