Real Estate Loan Mitigation, Foreclosure, and Mortgagor Tax Liabilities

Real Estate Loan Mitigation, Foreclosure, and Mortgagor Tax Liabilities

By Patricia Hughes Mills J.D. LL.M

Upon mortgage debt default, the mortgagee's foreclosure or mitigation of the debt yield differing tax consequences to the mortgagor. Moreover, the mortgagor's tax treatment on foreclosure depends, in part, on whether the mortgagor is personally liable on the debt (i.e., recourse mortgage) or not personally liable (i.e., nonrecourse mortgage). Mortgagor tax liabilities are also affected, albeit nominally, by National Mortgage Settlement payments.

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Debt Mitigation and Mortgagor Tax Liabilities

In lieu of foreclosing on a defaulted mortgage, the mortgagee may agree to reduce the amount outstanding. This is not treated as a sale or exchange of the mortgaged property. It will, however, result in cancellation of indebtedness income (COD income) for the mortgagor unless the taxpayer qualifies for one of the exemptions described in IRC Section 108. These exemptions may affect the taxpayer's "tax attributes" or may require a reduction in the basis of depreciable real property.

Even if IRC § 108 does not apply, the timing of the discharge may be in issue. In one case, the taxpayers received a discharge of an outstanding FmHA mortgage on their farm. In exchange they agreed to pay the FmHA a lower net recovery buyout amount, and also agreed to pay to the FmHA the amount discharged if they disposed of the farm within a 10-year period. The taxpayers conceded they had received discharge of indebtedness income, but insisted that it was not includable in income until they conveyed the land or upon the passing of 10 years. They claimed that their potential obligation to repay some part, or all, of the amount discharged precluded a finding that the debt had been forgiven. The Tax Court disagreed and found that the taxpayers received discharge of indebtedness income at the time the net buyout agreement was entered into, because at that time, the taxpayers controlled whether they would ever be required to make any further payments to FmHA. The taxpayers' potential obligation to repay the amounts discharged was too contingent to be considered a substitute for the original obligation.

Foreclosures and Mortgagor Tax Liabilities

A mortgagee's foreclosure of property used to secure a debt is treated as the taxable sale of the property to the mortgagee. If the mortgagor voluntarily issues his deed in favor of the mortgagee in satisfaction of the debt (a transfer in lieu of foreclosure), the transaction is also viewed as a sale or exchange.

The amount realized on a foreclosure sale or other transfer of property in consideration of the discharge or reduction of indebtedness depends on whether the debt is recourse or nonrecourse in nature. If the debt is nonrecourse, the amount realized includes the full amount of debt canceled. If the debt is recourse debt, the amount realized generally cannot exceed the fair market value of the mortgaged property. This limitation applies even if the amount bid at the foreclosure sale exceeds the property's fair market value.

Thus, with a nonrecourse mortgage, the amount realized on foreclosure, or a transfer in lieu of foreclosure, is never less than the outstanding debt. The debt is not treated as "canceled" and the mortgagor does not have to worry about cancellation of indebtedness (COD) income. This is, however, not necessarily unmitigated good news for the nonrecourse mortgagor. Unlike the recourse mortgagor—who only includes in the amount realized the fair market value of the property—the nonrecourse mortgagor includes the full amount of the debt in the amount realized. This typically reduces the mortgagor's loss (or increases his gain) when the mortgage exceeds the fair market value of the property. The amount realized may also include interest that had accrued as of the date of the foreclosure.

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