Tax Consequences for the Lender of Foreclosures, Repossessions, Voluntary Conveyances, and Bad Debts
Foreclosures, repossessions, voluntary conveyances, and bad debts have tax consequences to both the lender and the borrower. With a default, the lender may foreclose or repossess the property, restructure the loan, or treat the default as a bad debt, resulting in a realized gain or loss. Generally, a restructuring of a loan means to change its terms to lessen the financial stress of the loan to the borrower. This usually results in either canceling some of the debt or disposing of the property, both of which may have tax consequences. Any cancellation of debt may result in taxable income to the borrower, but it will be lessened by the debtor's insolvency. This article discusses the tax consequences of defaults for the lender; 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 repossessed personal property, then you may have a gain or loss, or bad debt. Figuring the gain or loss and the basis in the repossessed property will depend 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, it helps to remember how gain or loss calculated on the sale of property, which is 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 is equal to a portion of your original basis, which is calculated differently depending on whether the entire gain is reported in the year the sale or the gain was reported over several years under the installment method.
If you claim the entire gain in the year of the sale instead of using the installment method to report the original sale, then:
Installment Obligation Basis = Sale Price – All Payments of Principal
Gain or Loss = Property FMV – Repossession Costs – Installment Obligation Basis
Example: Figuring Gain or Loss on Repossessing Personal Property
So if you sell the piano for $1000 and received $400 of payments before the default, and the fair market value of the piano was $900 at the time of the repossession, with repossession costs of $100, then:
Installment obligation basis = sale price – principal repayments = $1000 – $400 = $600
Gain or loss = FMV – repossession costs – installment obligation basis = $900 – $100 – $600 = $200
Your basis in the piano will be the fair market price of $900.
Repossession of Personal Property Reported under the Installment Method
If the property sale was reported under the installment method, then calculating gain or loss is more complicated, but similar to the above method, except that the installment obligation basis is calculated differently. This can best be explained by an example:
|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 Price – Down Payment – Monthly Payments|
|Gross profit percentage||40%||= (Sale Price – Tax Basis) ÷ Sale Price|
|Unrealized profit||360||= Unpaid Balance × Gross Profit Percentage|
|Basis of obligation||480||= Unpaid Balance – Unrealized Profit|
|Gain or loss||$745||= Property FMV – Basis of Obligation – Repossession Costs|
Seller's Repossession After Buyer's Default
If a buyer defaults on a loan from the seller, then the seller may realize a capital gain or loss when repossessing the property from the defaulting buyer:
Taxable Gain = Payments Received In The Original Sales Contract Up To The Repossession + Payments Made To 3rd Parties For The Seller's Benefit – Taxable Gain Previously Reported Before The Repossession – Repossession Costs
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 = Adjusted Basis of Debt Secured by the Property + Taxable Gain on Repossession + Repossession Costs
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|
|Installment Sale Term||4|
|Annual Principal Repayment = Mortgage Amount / Installment Sale Term =||$11,250|
|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 + Second Year Principal Installment =||$26,250|
|Taxable Gain Claimed in Prior Years = 1st + 2nd Year Reported Income =||$6,563|
|Taxable Capital Gain = Land Sale Price – Adjusted Basis – Gain Already Claimed – Repossession 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 that is used to buy the underlying real estate. A nonpurchase money mortgage is a mortgage that is 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, then the foreclosure sale may have 2 tax consequences:
- bad debt deduction: If the net bid price, equal to the bid price minus sales expenses, is less than the mortgage, then the lender will have a bad debt deduction equal to the difference, if the lender can show that the remaining debt is uncollectable.
- capital gain or loss: The foreclosure is treated as an exchange of the mortgage for the foreclosed property, so a capital gain or loss will equal 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 fair market value of the property. If the bid price is greater than the FMV, then the lender has a capital loss; if the bid price is less than the fair market value of the property, then the lender has a capital gain.
- Bad Debt Deduction = Mortgage Debt – Net Bid Price
- Capital Gain or Loss = FMV – Net Bid Price
|Mortgage Debt on Property||$60,000|
|Fair Market Value||$35,000|
|Foreclosure Sale Bid Price||$47,000|
|Net Bid Price = Bid Price – Sales Expenses =||$44,000|
|Bad Debt Deduction = Mortgage on Property – Net Bid Price =||$16,000|
|Capital Loss = FMV – Net Bid Price =||$9,000|
|Case #2, Same as Case #1, except:|
|Bid Price =||$38,000|
|Net Bid Price = Bid Price – Sales Expenses =||$35,000|
|Bad Debt Deduction = Mortgage – Net Bid Price =||$22,000|
|Capital Gain or Loss = FMV – Net Bid Price =||$0|
|Case #3, Same as Case #1, except:|
|Bid Price =||$58,000|
|Net Bid Price = Bid Price – Sales Expenses =||$55,000|
|Bad Debt Deduction = Mortgage – Net Bid Price =||$5,000|
|Capital Loss = FMV – Net Bid Price =||$20,000|
In a voluntary conveyance, the borrower, otherwise known as the 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 plus the accrued interest minus the fair market value of the property. However, if the FMV is greater than the debt plus the accrued interest, then the lender realizes a taxable gain, which is reported for the tax year when the lender receives the property.
- If FMV > Mortgage Debt + Accrued Interest + Sales Expense then
- Bad Debt = Mortgage Debt + Accrued Interest + Sales Expense – FMV
- Taxable Capital Gain = FMV – Mortgage Debt – Accrued Interest – Sales Expense
The property's basis is the FMV when it is received. If the bid price contains any unreported accrued interest, then the lender must report the interest as ordinary income.
Foreclosure Sale to a Third-Party
If a third-party buys a foreclosed property, then the lender receives the amount to apply against the debt. If the amount is less than that, then the lender can proceed against the borrower for the difference, which is known as a deficiency judgment. Foreclosure expenses reduce the amount of the foreclosure proceeds, which increases the bad debt deduction.
The tax law distinguishes between 2 types of bad debts: both are deductible. A business bad debt is one that arises during the course of business and is fully deductible if it was previously reported as income. (Otherwise, it would simply not be reported.) A nonbusiness bad debt is one that is 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 completely worthless, such as when the borrower declares bankruptcy.
|Foreclosure Sale Price||$37,000|
|Bad Debt Deduction = Mortgage Debt – Foreclosure Sale Price + Foreclosure 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, then 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. If the canceled debt exceeds $600, then it may be reported on Form 1099-C, Cancellation of Debt with information about the foreclosure or repossession. A 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. Real estate that was 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, and if it can be excluded under the home sale exclusion rules, then the foreclosure or voluntary conveyance does not have to be reported. Foreclosures and reconveyances of business property are reported on Form 4797, Sales of Business Property. If the debt on business real estate is restructured, then 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.