Academic journal article Journal of Accountancy

Recognizing Income on Foreclosures

Academic journal article Journal of Accountancy

Recognizing Income on Foreclosures

Article excerpt

How much income does a taxpayer realize if he or she is insolvent and a creditor forecloses on property secured by recourse debt? Can the taxpayer exclude any of the income as forgiveness-of-indebtedness income?

Taxpayers are required to recognize income from all sources, unless specifically excluded. Forgiveness-of-indebtedness income is specifically excluded under IRC section 108 if the taxpayer is insolvent both before and after the "forgiveness." As a general rule, gain from the sale or exchange of property is not forgiveness-of-indebtedness income. But, when a creditor forecloses, does the taxpayer then recognize forgiveness-of-indebtedness income or gain from a sale or exchange?

It is generally accepted that a foreclosure is a sale. However, the regulations under IRC section 1001 provide a unique rule for foreclosures of recourse debt. In such cases, the regulations bifurcate the transaction. They treat the difference between the value of the foreclosed property and the taxpayer's basis as a sale and the difference between the forgiven debt and the value of the property as forgiveness-of-indebtedness income. It is not, however, clear how the property's value is measured.

Richard Frazier owned property with an adjusted basis of $495,000 and a recourse debt of $586,000. Because Frazier was insolvent, the lender foreclosed. At the foreclosure sale, the lender made the sole bid--$571,000. At the time of the foreclosure, however, Frazier had had the property appraised at $375,000.

According to the IRS, the property value is always the price obtained at the foreclosure sale. In this case, the sale price of $571,000 would generate a taxable gain of $76,000 for Frazier ($571,000-$495,000). …

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