Tax Aspects of Real Estate: Foreclosures and Insolvency

By Sandler, John | The National Public Accountant, December 2001 | Go to article overview

Tax Aspects of Real Estate: Foreclosures and Insolvency


Sandler, John, The National Public Accountant


Many individuals and businesses have overextended them selves within the last two years and face the prospect of foreclosure. Foreclosures are no-win situations. Not only does the owner lose his investment and equity in the property, but the foreclosure can result in taxable income to the owner when the property is encumbered by a mortgage. IRC Sec 61 requires that "except as otherwise provided gross income means all income from whatever sources derived." Discharge of indebtedness income is specifically included in gross income by IRC Sec 61(a)(12). However, IRC Sec 108 provides various exceptions to IRC Sec 61. IRC Sec 108 specifies situations in which discharge of indebtedness income is excluded from gross income, and is not taxable. Also, the Revenue Reconciliation Act of 1993 (RRA' 93) adds to the tax relief offered by IRC Sec 108.

Taxable Event

In a typical foreclosure situation the fair market value of the property is lower than the outstanding obligations: mortgage, taxes and other assessments. The mortgagor either voluntarily or involuntarily reconveys the property to someone else (mortgagee), or the mortgagor abandons the property and the mortgagee exercises its lien and repossesses the property. In either situation, title to the property is transferred from the mortgagor to another party and the mortgagor receives nothing from the transaction, but is relieved of property with a lien on it.

The courts have held that such transactions constitute a sale or exchange under the Internal Revenue Code and thus are a taxable event to the mortgagor. The amount realized under IRC Sec 1001(b) is equal to the amount of debt forgiven. Gains determined under Sections 1001(a) and 61 (a)(3) are equal to the excess of the amount realized over the adjusted basis of the property. Losses result when the adjusted basis of the property exceeds the amount realized. They may be fully deductible as ordinary losses under IRC Sec 1231, if the property is depreciable real property used in a trade or business, or may be subject to the limitation of Sec 1211(b) if the property is not used in a trade or business.

Exclusion of Gains: IRC SEC 108

IRC Sec 108 provides three exceptions to the general rule. The first exception is provided by IRC Sec 108(1)(a). This section excludes cancellation of indebtedness income if the taxpayer declared bankruptcy under Title 11 of the bankruptcy code. This exclusion applies only if the taxpayer is under the jurisdiction of the court and the discharge of indebtedness is by the court or pursuant to a plan approved by the court.

A second exception is provided by IRC Sec 108(a)(1)(c). If the debt discharged is qualified farm debt, discharge of indebtedness income is excluded to the extent the taxpayer can offset the income by reducing the basis of the properties, reducing NOL and capital loss carry-overs, and reducing foreign tax credits and general business credit carry-overs. A debt is considered qualified farm debt if such debt is incurred directly in connection with the operation of a farm, and if 50 percent or more of the taxpayer's gross revenues for the preceding three years are attributable to farming.

A third exception provided by IRC Sec 108(a)(1)(b) excludes cancellation of indebtedness income in situations in which the debtor is insolvent. Taxpayers who do not declare bankruptcy, but are technically insolvent, are not subject to taxation on their cancellation of indebtedness income.

Unlike bankruptcy, insolvency is much more difficult to determine. Insolvency is defined as the excess of liabilities over the fair market value of assets. For example, if a taxpayer owns assets with a fair market value of $100,000 and has liabilities of $150,000, the amount by which he is insolvent is $50,000. Therefore, if the liabilities were discharged, only $50,000 can be excluded from gross income.

Determination of insolvency must be made on the basis of the taxpayer's assets and liabilities immediately before the discharge. …

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