Recognizing Income on Foreclosures

How much income does a taxpayer realize if he or she is insolvent and a creditor forecloses on property secured by recourse debt? Can the taxpayer exclude any of the income as forgiveness-of-indebtedness income?

Taxpayers are required to recognize income from all sources, unless specifically excluded. Forgiveness-of-indebtedness income is specifically excluded under IRC section 108 if the taxpayer is insolvent both before and after the “forgiveness.” As a general rule, gain from the sale or exchange of property is not forgiveness-of-indebtedness income. But, when a creditor forecloses, does the taxpayer then recognize forgiveness-of-indebtedness income or gain from a sale or exchange?

It is generally accepted that a foreclosure is a sale. However, the regulations under IRC section 1001 provide a unique rule for foreclosures of recourse debt. In such cases, the regulations bifurcate the transaction. They treat the difference between the value of the foreclosed property and the taxpayer’s basis as a sale and the difference between the forgiven debt and the value of the property as forgiveness-of-indebtedness income. It is not, however, clear how the property’s value is measured.

Richard Frazier owned property with an adjusted basis of $495,000 and a recourse debt of $586,000. Because Frazier was insolvent, the lender foreclosed. At the foreclosure sale, the lender made the sole bid —$571,000. At the time of the foreclosure, however, Frazier had had the property appraised at $375,000.

According to the IRS, the property value is always the price obtained at the foreclosure sale. In this case, the sale price of $571,000 would generate a taxable gain of $76,000 for Frazier ($571,000 — $495,000). Frazier, however, argued that the amount bid should not be used as the sale price, but rather the appraised value of the property.

Result. For the taxpayer. The Tax Court said that, normally, the foreclosure price is the property’s value and would be the amount used to calculate gain or loss. However, a foreclosure sale may not necessarily be a sale between a willing buyer and a willing seller. Or, the lender might set a bid price that differed from the actual value of the property for a number of reasons, including not wanting to recognize a current loss. As a result, the bid price may not be a true measure of value. If the taxpayer, as in this case, can prove a lower value, then that value is the proper “sale price” to use under the section 1001 regulations. If the $375,000 appraisal value is used, Frazier has a $120,000 deductible capital loss ($495,000 — $375,000) and $211,000 of forgiveness-of-indebtedness income ($586,000 — $375,000). The forgiveness-of-indebtedness income will be taxable or nontaxable based on the rules in section 108.

Taxpayers faced with a foreclosure sale should not assume the bid price will equal the property’s actual value. To limit the amount of gain or even recognize a loss, they should obtain qualified outside appraisals. In the future, taxpayers may find it easier to prove a reduced sale price, given the current burden-of-proof rules that shift the burden to the government in factual issues.

• Richard Frazier, 111 TC no. 11.

Prepared by Edward J. Schnee, CPA, PhD,
Joe Lane Professor of Accounting and director,
MTA program, Culverhouse School of Accountancy,
University of Alabama, Tuscaloosa.