Many taxpayers in the current economy have had trouble paying mortgages, car notes and other debts. Some are forced to abandon property, go through foreclosures or have property repossessed. While such measures may alleviate the financial burden on these taxpayers, the tax consequences often are overlooked.
When property that secures a debt is abandoned by voluntary or involuntary action, the tax consequence depends, among other things, on whether the taxpayer was personally liable for the debt and whether the abandoned property was personal use.
PROPERTY SECURED BY RECOURSE DEBT
If the debtor
is personally liable for the loan on the property being abandoned, the
loan is a recourse debt, and until foreclosure or repossession
procedures are completed, there are no tax consequences, whether the
property is personal use or business use. The foreclosure or
repossession is treated as a sale, and the debtor may realize a gain
or loss on the deemed sale. The amount realized is the lower of the
asset’s fair market value on the date of abandonment or the
outstanding debt immediately before the transfer, reduced by any
amount for which the taxpayer remains personally liable after the
transfer. The amount realized also includes any proceeds the debtor
received from the foreclosure sale. The amount realized is compared
with the debtor’s basis in the property to determine gain or loss.
Gain from a foreclosure sale of abandoned property is includible in gross income whether or not the taxpayer used the property for business purposes. However, losses from personal-use property are nondeductible. If the property is a business-use asset, the gain or loss on disposition is either a capital or an ordinary gain or loss, depending on the character and nature of the asset. After the foreclosure has been completed, if the financial institution or creditor forgives the debtor any part of the debt, the forgiven portion is cancellation of debt (COD) income and may be includible in the debtor’s gross income. It is reported separately from any gain or loss realized from the sale.
PROPERTY SECURED BY NONRECOURSE DEBT
If the
debtor is not personally liable for the debt (nonrecourse debt) and
abandons personal-use property, such as a home or an automobile, the
abandonment is treated as a sale in the year of abandonment. The
amount realized on the sale—the outstanding loan balance—is compared
with the taxpayer’s adjusted basis in the property to determine gain
or loss. Any loss is a nondeductible personal expense. If the property
abandoned is business or investment property, the amount of gain or
loss is determined in the same way. However, a loss is deductible. The
character of the loss depends on the character of the property.
Generally, no COD income arises from these types of transactions because the debtor is not personally liable for the debt. However, if the debtor retains the collateral and accepts a discount from the creditor for the early payment of the debt, or agrees to a loan modification that reduces its principal balance, the amount of the discount or principal reduction is considered COD income, even if the debtor is not personally liable for the debt.
CANCELLATION OF DEBT INCOME
Generally, if a
creditor forgives or cancels a taxpayer’s recourse debt, the amount
forgiven or canceled is ordinary income to the taxpayer. The taxpayer
may be able to exclude canceled debt from gross income if the debt
cancellation was a gift, or in some cases if the canceled debt was a
student loan, deductible debt or a price reduction after the original
purchase of the property. Sec. 108 also may exclude canceled debt from
gross income if the taxpayer was bankrupt or insolvent immediately
before the debt cancellation or if the debt is qualified farm
indebtedness, qualified real property business indebtedness or
qualified principal residence indebtedness.
This is an overview of some of the principles that are likely to be involved for CPAs’ clients in these situations. Facts and circumstances may indicate a variety of options and considerations regarding these issues. CPAs can guide clients through such determinations and help them avoid undesirable tax consequences when they must relinquish property securing their debts.
By Curtis Webley, CPA, Ph.D., ( cwebley@webleysaccountingservices.com ) founder of Webley’s Accounting Services PC in Chicago. He lectures at Chicago-area colleges, conducts financial seminars and has written extensively on accounting and taxation topics.
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