Like any business, cash flow is imperative for real estate ownership to operate. Without the ability to collect rent on tenant leases, the real estate lessor is in danger of borrower default on its debt obligations and potential foreclosure or debt restructuring on its properties.   The following will discuss the tax implications of foreclosure and debt restructuring and potential exclusions taxpayers may be able to utilize.

Tax Implications of Foreclosure

Foreclosure is the process of taking possession of a mortgaged property when the borrower fails to keep up its mortgage payments. For tax purposes, a foreclosure is recognized as a taxable sale or exchange with the type of debt involved (recourse or nonrecourse) determining the specific tax treatment.

Debt is considered to be nonrecourse to the extent no borrower bears the economic risk of loss linked with such liability. Recourse debt occurs when a borrower does bear the economic risk attached with such liability.

When recourse debt is cancelled in foreclosure, the tax results are split. In the case where the debt exceeds the fair market value (FMV) of the property, a gain from sale or exchange is recognized to the extent the FMV of the property exceeds the property tax basis, and then cancellation of debt (COD) income is recognized to the extent the forgiven debt exceeds the property fair market value.

Specific to a foreclosure involving nonrecourse debt, there is no split. The entire amount of the debt is treated as an amount realized on sale or exchange of the property and no income from cancellation of debt occurs. The amount realized will never be less than the outstanding debt amount at the time of foreclosure even where the fair market value of the foreclosed property is less than the outstanding nonrecourse debt.

The type of debt that is preferable depends on the debtor’s circumstances.  If the debt is cancelled and the debtor is insolvent, bankrupt or subject to other COD income exclusions, nonrecourse debt is generally preferable.  The debtor will have no COD income, and the gain if any will be long-term capital gain if the asset was held for more than one year.

Exclusion of Income and Interaction with Bankruptcy and Insolvency Provisions

Taxpayers can realize two types of income in foreclosure or debt restructuring.  Gain or loss may be realized on the sale of the property and, depending on the type of debt discharged, there may be cancellation of debt (COD) income.

Amounts by which taxpayers benefit from the discharge of indebtedness is generally included in their gross income.  However, IRC Sec. 108(a)(1) indicates that when a debtor is bankrupt or insolvent, discharge of indebtedness is excluded from income. Accordingly, if the debtor is bankrupt or insolvent, the benefits of recourse vs. nonrecourse debt may flip. Recourse debt may be more beneficial when the assets have declined dramatically in value as realized COD income would be excludable. If the bankrupt debtor had nonrecourse debt, the result would be treated as non-excludable gain on sale.

The result from cancellation of recourse debt held by insolvent debtors is similar to that for bankrupt debtors with the exception that the exclusion could be limited. The amount of COD excluded from income is limited to the amount by which the taxpayer is insolvent. Insolvency is defined in IRC Sec. 108(d)(3) as the excess of liabilities over the FMV of assets, determined prior to discharge.

The exclusion of COD from income does come with a cost. As specified in IRC Sec. 108(b), the amount excluded from income must reduce tax attributes, thereby generally deferring (rather than permanently excluding) the inclusion of COD income.

IRC Sec. 108(b) notes tax attribute reductions are made after the determination of tax imposed for the year of discharge. Reductions of net operating losses and capital loss carryovers are made first for losses in the taxable year of the discharge and second to  the carryovers to such taxable year in the order of the taxable years from which each carryover arose.  COD excluded in excess of the taxpayer’s tax attributes is disregarded with no resulting tax consequences. As an alternative to reducing tax attributes, a taxpayer may elect to reduce first the adjusted basis of their depreciable property to the extent of the excluded COD.

Summary

A foreclosure is treated the same as a sale of property. Capital gain or loss may be triggered upon such sale and, in certain instances, taxpayers may also realize income from forgiveness on certain debt.   Exclusions of income created in a foreclosure may be available to taxpayers in certain circumstances.