Tax on Lenders of Foreclosures, Repossessions, Voluntary Conveyances, and Bad Debts

Foreclosures, repossessions, voluntary conveyances, and bad debts have tax consequences for lenders, sellers accepting installment payments, and borrowers. With a default, the lender or installment seller may foreclose or repossess the property, restructure the loan, or treat the default as a bad debt, resulting in a realized gain or loss. The restructuring of a loan means changing its terms to lessen the financial stress to the borrower, usually by either canceling some of the debt or disposing of the property. Both may have tax consequences. Canceled debt may be taxable income to the borrower, lessened by the debtor's insolvency. This article discusses the tax consequences of defaults for lenders and installment sellers; how foreclosures, restructured or canceled debt affects the borrower is discussed in Taxation of Canceled Debt.

Figuring Gain or Loss on Repossession of Personal Property Sold as Installments

If you repossess personal property, you may have a gain, loss, or bad debt. Figuring the gain or loss and the basis in the repossessed property depends on whether the original sale was reported as an installment sale or if the entire gain was reported in the year of the sale, even though the buyer was paying on the installment method. Payments include not only actual payments but also payments treated as being received. Payments are treated as being received if the buyer assumes or pays any debts or expenses of the seller.

To better understand how gain or loss is calculated when repossessing personal property, remember how gain or loss is calculated on a property sale, equal to the sale price minus your tax basis in the property. On a repossession, the sale price is the fair market value (FMV) of the repossessed property and your basis in the property equals a portion of your original basis, which is calculated differently depending on whether the entire gain is reported in the sale year or the gain was reported over several years under the installment method.

If you claim the entire gain in the sale year instead of using the installment method, then:

Installment Obligation Basis

Gain or Loss on Repossessed Property

Example: Figuring Gain or Loss on Repossessed Personal Property

You sell a piano for $1000 and received $400 of payments + some interest before the default, and the fair market value of the piano was $900 when repossessed at a cost of $100, then:

Installment obligation basis

Gain or loss

Your basis in the piano will be the fair market price of $900.

Repossession of Personal Property Reported under the Installment Method

Calculating gain or loss for a property sale reported under the installment method is more complicated but follows the above method, except that the installment obligation basis is calculated differently. This can best be explained by an example:

Example: Repossession of Personal Property Reported under the Installment Method
Sale Price $1,600
Adjusted Tax Basis $1,000
Selling Expenses $100
Buyer Payments
Down payment $300
Month 1 payment $100
Month 2 payment $100
Month 3 payment $100
Month 4 payment $100
Buyer defaults after 4th monthly payment.
Fair market value of repossessed property $1,300
Unpaid balance of the installment obligation $900 = Sale PriceDown Payment − Monthly Payments
Gross profit percentage 38% = (Sale PriceTax Basis) ÷ Sale Price
Unrealized profit $338 = Unpaid Balance × Gross Profit Percentage
Basis of obligation $563 = Unpaid BalanceUnrealized Profit
Repossession costs $75
Gain or loss $663 = Property FMVBasis of ObligationRepossession Costs

Adjusted Basis for Installment Sale

  • = Adjusted Basis of Property
  • + Selling Expenses
  • + Recaptured Depreciation

Seller's Repossession After Buyer's Default

If a buyer defaults on a loan from the seller, the seller may realize a capital gain or loss when repossessing the property from the defaulting buyer:

Taxable Gain

To determine taxable gain when the property is resold later, the seller must calculate the new tax basis of the repossessed property:

Basis of Repossessed Property

Example: Calculating Capital Gain after Repossession

You sell land on an installment basis, but your buyer defaults in the 3rd year. Capital gain is calculated in the table below. The interest earned on the mortgage is reported as ordinary income, so it is not a factor in calculating the capital gain.

1: Calculate the Capital Gain from Received Installment Payments
Land Sale Price $60,000
Adjusted Basis of Property $45,000
Down Payment $15,000
Mortgage Amount $45,000
Installment Sale Term in Years 4
Annual Principal Repayment
= Mortgage Amount / Installment Sale Term =
$11,250
Repossession Costs $500
Gross Profit Percentage
= Adjusted Basis of Property / Land Sale Price =
25%
1st Year Reportable Income
= Down Payment × Gross Profit Percentage =
$3,750
2nd Year Reportable Income
= Annual Principal Repayment × Gross Profit Percentage =
$2,813
Total Received
= Down Payment + 2nd Year Principal Installment =
$26,250
Taxable Gain Claimed in Prior Years
= 1st + 2nd Year Reported Income =
$6,563
Taxable Capital Gain
= Land Sale PriceAdjusted BasisGain Already ClaimedRepossession Costs =
$7,938
2: Calculate Adjusted Basis of Repossessed Property
Remaining Debt
= Mortgage Amount − 2nd Year Payment of $11,250 =
$33,750
Unreported Profit on Remaining Debt
= Remaining Debt × Gross Profit Percentage =
$8,438
Adjusted Basis of Installment Obligation on Repossession
= Remaining Debt Unreported Profit on Remaining Debt =
$25,313
Adjusted Basis of Repossessed Property
= Adjusted Basis of Installment Obligation + Taxable Capital Gain + Repossession Costs =
$33,750

Foreclosure on a Nonpurchase Money Mortgage

A purchase money mortgage is a mortgage used to buy the underlying real estate. A nonpurchase money mortgage is a mortgage secured by real estate but was not used to purchase it.

If the lender of a nonpurchase money mortgage bids on the foreclosed property, and the property is either sold to the secured lender or to a 3rd party, the foreclosure sale may have 2 tax consequences:

  1. bad debt deduction: If the net bid price, equal to the bid price minus sales expenses, is less than the mortgage, the lender will have a bad debt deduction equal to the difference if the lender can show that the remaining debt is uncollectable.
  2. capital gain or loss: The foreclosure is treated as an exchange of the mortgage for the foreclosed property, so a capital gain or loss = the difference between the fair market value (FMV) of the property and the mortgage amount.

Whether the lender has a capital gain or loss on the property is determined by comparing the matching bid price against the FMV of the property. The lender has a capital loss if the bid price exceeds the FMV; a capital gain if the bid price is less than the FMV.

Net Bid Price

Bad Debt Deduction

Capital Gain or Loss

Example: Calculating Capital Gain or Bad Debt Losses on a Nonpurchase Money Mortgage
Case #1
Mortgage Debt on Property $60,000
Fair Market Value $35,000
Foreclosure Sale Bid Price $47,000
Sale Expenses $3,000
Net Bid Price = Bid PriceSales Expenses = $44,000
Bad Debt Deduction = Mortgage on PropertyNet Bid Price = $16,000
Capital Loss = FMVNet Bid Price = ($9,000)
Case #2, Same as Case #1, except:
Bid Price = $38,000
Net Bid Price = Bid PriceSales Expenses = $35,000
Bad Debt Deduction = MortgageNet Bid Price = $25,000
Capital Gain = FMVNet Bid Price = $10,000
Case #3, Same as Case #1, except:
Bid Price = $58,000
Net Bid Price = Bid PriceSales Expenses = $55,000
Bad Debt Deduction = MortgageNet Bid Price = $5,000
Capital Loss = FMVNet Bid Price = ($20,000)

Voluntary Conveyance

In a voluntary conveyance, the borrower (aka mortgagor) voluntarily conveys the property to the lender in exchange for canceling the mortgage, in which case, the lender can claim a loss equal to the mortgage debt + the accrued interest minus the FMV of the property. However, the lender realizes a taxable gain if the FMV exceeds the debt + the accrued interest, which is reported for the tax year when the lender receives the property.

If FMV > Mortgage Debt + Accrued Interest + Sales Expense

Then

Else:

The property's basis is the FMV when it is received. If the bid price covered any unreported accrued interest, the lender must report the interest as ordinary income.

Foreclosure Sale to a Third-Party

If a third-party buys a foreclosed property, the lender receives the amount to apply against the debt. If the received amount is less than the debt, the lender can sue the borrower to get a deficiency judgment for the difference. Foreclosure expenses reduce the foreclosure proceeds, which increases the bad debt deduction.

Tax law distinguishes between 2 types of deductible bad debts:

  1. A business bad debt arises during the course of business and is fully deductible if the amount loaned was previously reported as income; otherwise, the loan amount would simply not be reported as income.
  2. A nonbusiness bad debt is one not connected with the creditor's trade or business activities but can also include loans between related parties (IRC §166).

A nonbusiness bad debt is deductible as a short term capital loss that can only be used to offset capital gains. A partially worthless business bad debt is deductible, but a nonbusiness bad debt is only deductible if the entire debt is shown to be worthless, such as when the borrower declares bankruptcy.

Example: Foreclosure Sale to 3rd Party
Mortgage Debt $50,000
Foreclosure Sale Price $37,000
Foreclosure Expenses $3,000
Bad Debt Deduction = Mortgage DebtForeclosure Sale PriceForeclosure Expenses = $16,000

Reporting Foreclosures and Repossessions

When property is acquired in a foreclosure or repossession or if it is abandoned, and the lender acquires legal title to the property, the lender uses Form 1099-A, Acquisition or Abandonment of Secured Property to notify the IRS of the foreclosure sale price, amount, and whether the loan was recourse or nonrecourse. Canceled debt exceeding $600 may be reported on Form 1099-C, Cancellation of Debt with information about the foreclosure or repossession. Form 1099-A is sent both to the IRS and to the borrower when mortgage property is foreclosed or repossessed and the title transfers back to the lender. The sale of real estate held for personal or business purposes is reported on Form 8949, Sales and Other Dispositions of Capital Assets and Schedule D, Capital Gains and Losses.

If the property is a principal residence, excludable under the home sale exclusion rules, the foreclosure or voluntary conveyance need not be reported if the gain is less than the home sale exclusion. Foreclosures and reconveyances of business property are reported on Form 4797, Sales of Business Property. If the debt on business real estate is restructured, a solvent taxpayer may delay taxes on the restructuring by electing to reduce the basis of the depreciable property by the amount of the debt discharge. This election is made on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness.