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Foreclosure, Deeds in Lieu, Short Sales, and Taxes

When the owner of real estate defaults on a real estate loan and the lender asserts its rights in the collateral (the real estate) by suit to foreclose or trustee’s sale, or where the debtor proposes to convey the property to the lender by deed in lieu of foreclosure or to sell the property in a short sale for less than is owed, the consummation of any of these transactions can have significant income tax consequences for the owner/debtor.

The nature and severity of these consequences depends in part on whether the loan is a “recourse” loan or a “non-recourse” loan. A recourse loan is one on which the lender has the right to sue the debtor for a “deficiency,” the difference between the loan balance and the value of the property at the time of a foreclosure or trustee’s sale. A non-recourse loan does not give the lender such right, thus limiting the lender to recovering the value of the property.

The tax treatment on a recourse loan requires calculation of the amount of debt forgiven which is treated as cancellation of debt (“COD”) income.  Such income is reported as “other income” and is taxed as ordinary income; i.e., same as wages, interest, etc. By contrast, non-recourse loans do not give rise to COD income.  Instead, the value of the property is ignored and instead, the property is treated as being sold for the amount owed to the lender, and capital gain (or loss) is reported on the difference between that amount and the owner’s cost basis. In most situations cost basis will be the amount of the purchase price (unless acquired in a tax-free exchange), adjusted for depreciation taken, improvements made, etc. This difference is often a loss, rather than a gain in a default situation.

On a given set of facts, the tax difference between recourse and non-recourse financing can be very large. For example, assume property purchased for $200,000 with $25,000 down, cost basis is $200,000 with no adjustments, loan amount of $175,000 and current value of $150,000. If the loan is recourse and the property is foreclosed, the owner would have $25,000 of COD income ($175,000 - $150,000 = $25,000). However, if the loan is non-recourse and is foreclosed, the owner would have a $50,000 capital loss ($200,000 - $150,000 = $50,000).

Whether a loan is recourse or non-recourse depends on the language of the loan documents, but for certain kinds of property, state law supersedes the language of the loan documents. Arizona and some other states have so-called “anti-deficiency statutes” which prevent a lender from suing for a deficiency on certain kinds of property. The effect of these statutes is to make all loans on such properties non-recourse. In Arizona the property to which the anti-deficiency statutes applies is parcels of 2½ acres or less limited to and utilized for either a single one family or a single two family dwelling. Although the property must be used as a residence, it is not necessary that it be a principal residence or even owner-occupied; therefore, investment properties can qualify.

A person’s principal residence is treated more specifically under the tax laws. The Internal Revenue Code provides that even if the debt is recourse (in states without anti-deficiency statutes), resulting in COD income, that income is excluded if the debt is qualified principal residence indebtedness.

This post is for general information only.  The applicable tax law, state laws and the documents governing loan transactions are complex and require the assistance of a professional.

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