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Foreclosure ATG - Chapter 2 - Type of Debt

Publication Date - February 2015

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.


Nonrecourse and Recourse Debt

As defined earlier, a loan is nonrecourse if the taxpayer is not personally liable and the bank cannot pursue the taxpayer for any outstanding balance after the property is foreclosed. The loan is recourse if the taxpayer was personally liable for repayment of the loan and the bank has the right to pursue collection of all or part of the outstanding balance after the foreclosure. The lender may have indicated on Form 1099 whether the taxpayer was personally liable or not. Consultation with local Counsel regarding state law may assist in identification of the type of loan. Each loan type has different tax consequences. Although, a taxpayer no longer owns their foreclosed property, a reportable gain or taxable CODI from the disposition could result because foreclosures, short sales, and deeds in lieu of foreclosure are treated as taxable dispositions. 

Gain and Loss Computation and Cancellation of Debt Income

The computation of gain or loss from the sale or other disposition of property is located in IRC §1001. The gain is the excess of the amount realized over the adjusted basis. The loss is the excess of the adjusted basis over the amount realized. 

The amount realized is defined in IRC §1001(b) as money received plus the fair market value of the property received (other than money). As discussed later, the amount realized for nonrecourse notes is the greater of the fair market value (FMV) of the property or the outstanding loan amount. The amount realized for recourse notes is the lesser of the fair market value of the property or the outstanding loan amount. Treas. Reg. §1.1001-2 discusses the gain or loss when there is a discharge of liabilities. Examples of dispositions for nonrecourse and recourse notes are under Treas. Reg. §1.1001-2(c). 

Confusion exists as to the year that the disposition should be reported when the lender repossesses property and then sells it in a subsequent year. If the note that secured the property was nonrecourse, the disposition is reported in the year of repossession. If the note that secured the property was recourse, the disposition is reported in the year of the foreclosure sale. 

Diagram 1, Debt Flowchart (PDF), displays the taxable consequences of nonrecourse and recourse debt. Each consequence is explained in detail.

Nonrecourse debt

A loan is nonrecourse if the taxpayer is not personally liable and the bank cannot pursue the taxpayer for any outstanding balance after the property is foreclosed. The borrower is not personally liable and repossession of the mortgaged property, for example, will generally satisfy the outstanding debt. Generally, there is no CODI from foreclosure of property with nonrecourse debt. However, situations may exist where a taxpayer will have CODI from nonrecourse debt. Refer to Example 5, which is an example of CODI from nonrecourse debt. 

As displayed in Diagram 1, discussed earlier, nonrecourse debt generally has one tax consequence to consider and that is whether a recognized gain or loss from the disposition exists.  The gain/loss calculation is the amount realized less the adjusted basis.  For nonrecourse debt, the amount realized is the greater of the outstanding debt of all loans immediately before the foreclosure or fair market value of the property plus the proceeds received from the foreclosure (e.g., relocation payment from the lender). The adjusted basis immediately before the foreclosure is subtracted from the amount realized to determine the gain or loss.

IRC §7701(g) states that the sales price is the greater of the FMV or the outstanding loan balance for nonrecourse loans to determine the gain or loss.

In Commissioner v. Tufts, 461 U.S. 300 (1983), the Supreme Court held that when a taxpayer "sells or disposes of property encumbered by a nonrecourse obligation exceeding the fair market value of the property sold, as in this case, the Commissioner may require him to include in the "amount realized" the outstanding amount of the obligation; the fair market value of the property is irrelevant to this calculation." The Court reasoned that because a nonrecourse note is treated as a true debt upon inception (so that the loan proceeds are not taken into income at that time), a taxpayer is bound to treat the nonrecourse note as a true debt when the taxpayer is discharged from the liability upon disposition of the collateral, in spite of the lesser fair market value of the collateral. 

Example 1. Maxine paid $200,000 for her second home. She put $15,000 down and borrowed the remaining $185,000 from a bank. Maxine is not personally liable for the loan, but pledges the house as security. The bank foreclosed on the mortgage because Maxine stopped making payments. When the bank foreclosed on the loan, the balance due was $180,000, the fair market value of the house was $170,000, and Maxine's adjusted basis was $175,000 due to a casualty loss she had deducted. Maxine has a gain of $5,000 ($180,000 outstanding debt minus $175,000 adjusted basis) from the foreclosure.

The lender's foreclosure on property secured by nonrecourse debt that is greater than the FMV of the property does not result in cancellation of debt income. The entire amount of the nonrecourse debt is treated as the amount realized. As such, Maxine recognized no CODI upon the foreclosure, but realized $180,000, the outstanding debt balance immediately before the foreclosure. Her gain is the difference between the loan balance of $180,000 and the adjusted basis of $175,000. Maxine has a $5,000 recognized gain from the foreclosure of her second home. The disposition is reported on Form 8949, Sales and Other Dispositions of Capital Assets and Schedule D, Capital Gains and Losses

Generally, there is no cancellation of debt income from foreclosure of property when nonrecourse debt secures the property, because repossession of the mortgaged property will satisfy the outstanding debt. The lender's foreclosure on property secured by nonrecourse debt that is greater than the FMV of the property does not result in cancellation of debt income. The entire amount of the nonrecourse debt is treated as the amount realized. 

However, in certain situations, the discharge of nonrecourse debt will result in CODI. Revenue Ruling 91-31, 1991-1 C.B. 19 provides that the reduction of the principal amount of an undersecured nonrecourse debt (nonrecourse debt greater than the fair market value of the property) results in CODI. For example, a reduction in the loan balance through a loan modification will result in CODI when nonrecourse debt exceeds fair market value of the property. 

Confusion exists as to the year that the disposition should be reported when the lender repossesses property and then sells it in a subsequent year. If the note that secured the property was nonrecourse, the disposition is reported in the year of repossession. 

Example 2. Walter paid $580,250 for his second home. He paid $30,000 down and borrowed the remaining $550,250 from a bank. Walter is not personally liable for the loan, but pledges the house as security. When the fair market value of the property dropped to $400,000 and the loan balance was $535,698, the bank agreed to modify his loan and reduced the principal balance by $52,435. 

Walter did not qualify to exclude the cancellation of debt income from gross income under IRC §108. Therefore, Walter would report $52,435 as other income on Form 1040, line 21, for the discharged nonrecourse debt. 

Recourse debt

The loan is recourse if the taxpayer was personally liable for repayment of the loan and the bank has the right to pursue collection of all or part of the outstanding balance after the foreclosure. As displayed in Diagram 1, Debt Flowchart, discussed earlier, recourse debt has three different potential tax consequences which are (1) CODI, (2) gain/loss from the disposition, and (3) the reduction of tax attributes if CODI is excluded from income. The first calculation is to determine the amount of cancellation of debt income. Cancellation of debt income is determined by the outstanding debt balance immediately before the foreclosure (minus debt liable after the foreclosure) minus the fair market value of the property equals the cancellation of debt income.

Cancellation of debt income may be excluded if the taxpayer qualifies under IRC §108. Form 982 is used to report the exclusion and any reduction of certain tax attributes

Taxable cancellation of debt income is reported as:

  • Non-business Debt – Form 1040 as other income.
  • Sole Proprietorship – Schedule C or F as other income, if the debt is related to a sole proprietorship nonfarm or farm business.
  • Non-Farm Rental Activity – Schedule E as other rental income, if the debt is related to a nonfarm rental of real property.
  • Farm Rental Activity – Form 4835 to report rental income based on crops or livestock produced by a tenant.

In general, if taxable income (including CODI) is derived from a trade or business and is reported on a Schedule C or F, then it is self-employment income and it will be subject to self-employment tax. If an exception applies to exclude CODI from gross income, the CODI is also not self-employment income subject to self-employment tax. Self-employment income means the "net earnings from self-employment derived by an individual" IRC §1402(b). Net earnings from self-employment is defined as "the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in IRC §702(a)(8) from any trade or business carried on by a partnership of which he is a member" IRC §1402(a) and Treas. Reg. §1.1402(a)-1.

The second tax consequence for a recourse note is the calculation of the gain or loss from the foreclosure sale.  The gain or loss is calculated as the amount realized plus any proceeds received from the foreclosure (e.g., relocation payment from the lender) minus the adjusted basis of the property immediately before the foreclosure sale.  The amount realized is the lesser of the fair market value of the property or outstanding debt balance.

The fair market value of a property may be in question during an examination. That is because the sales price of the property is generally determined to be the fair market value of the property. This amount may be different from the amount reported on Form 1099-A. In Frazier v. Commissioner 111 T.C. 243, 246 (1998) the court stated, "Absent clear and convincing proof to the contrary, the sale price of property at a foreclosure sale is presumed to be its fair market value." See Community Bank v. Commissioner, 79 T.C. 789, 792 (1982), affd. 819 F.2d 940 (9th Cir.1987).

The third potential tax consequence of a recourse note is the reduction of tax attributes when cancellation of debt income is excluded from gross income. Generally, tax attributes are reduced by the amount of CODI excluded from income. Reduction of tax attributes is discussed later under Reduction of Tax Attributes in Chapter 4.

Confusion exists as to the year that the disposition should be reported when the lender repossesses property and then sells it in a subsequent year. If the note that secured the property was recourse, the disposition is reported in the year of the foreclosure sale. 

Property which secures a taxpayer's recourse obligation is not worthless prior to foreclosure. Commissioner v. Green, 126 F. 2d 70, 72 ( 3d Cir. 1942) ("where, as here, the taxpayer is liable for the debt, interest and taxes by virtue of the mortgage or the bond thereby secured, the property continues, until foreclosure sale, to have some value which, when determined by the sale, bears directly upon the extent of the owner's liability for a deficiency judgment."). Likewise, property which secures a taxpayer's recourse obligation may not be considered abandoned for purposes of a loss deduction prior to foreclosure. Daily v. Commissioner, 81 T.C. 161 (1983) (an attempt to abandon property subject to recourse debt does not result in a deductible loss), aff'd, Daily v C.I.R., 742 F.2d 1461 (9th Cir. 1984). Once the year of disposition is identified and the type of debt is identified that secured the real estate property, the computation of the gain or loss and any CODI can be made. 

Example 3. Marcus bought his second home for $400,000 in 2003. He paid $30,000 down and borrowed the remaining $370,000 from a bank. Marcus is personally liable for the loan and the house is pledged as security for the loan. Marcus lost his job in January 2010 and the bank declined his requests for a loan modification. Although, Marcus found another job in October 2010, he earned less and was unable to make the mortgage payments and the bank ultimately foreclosed on the home in 2012. Marcus moved out of the home in 2012. 

The recourse debt balance before the foreclosure was $350,000. The bank sold the property for $250,000 to a third party. After the foreclosure sale, the bank forgave $60,000 of the $100,000 debt in excess of the FMV ($350,000 minus $250,000) and Marcus remained liable for the $40,000 balance. He did not qualify for any of the exclusions in IRC §108(a)(1).

Marcus has cancellation of debt income of $60,000 ($350,000 debt balance immediately before the foreclosure minus $40,000 amount personally liable immediately after the foreclosure sale minus $250,000 FMV of the property). Under the circumstances, Marcus has other income of $60,000 from the canceled debt. His nondeductible loss is $150,000 ($250,000 FMV of the property minus $400,000 adjusted basis of the property).        

Marcus would file Form 982 to report the CODI exclusion and complete Part I for discharge of qualified principal residence indebtedness. Marcus should also report the foreclosure on Form 8949, Sales and Other Dispositions of Capital Assets as a nondeductible loss. For more details, see Nondeductible Losses in the instructions to Schedule D, Capital Gains and Losses. 

Example 4. Jimmy took out a recourse loan for $700,000 to purchase an office building to expand his sole proprietorship realty business. Three years later, through a loan modification, the bank forgave $78,000 of the loan balance when the FMV of the property was $600,000. Jimmy would report $78,000 on Schedule C as other income if he did not qualify to exclude some or the entire amount of CODI under IRC §108.  

Analysis of Disposition of Property Secured by Nonrecourse or Recourse Debt

The primary difference between nonrecourse and recourse debt is the timing and amount of any potential taxable income from the disposition and cancellation of debt income demonstrated in the following table. For this analysis, the outstanding loan balance is $300,000, the fair market value of the property is $265,000, and the adjusted basis is $280,000. The cancellation of debt income is $35,000 ($300,000 outstanding loan balance minus $265,000)   

Analysis of Disposition of Property
Description Nonrecourse Recourse
Amount realized $300,000 $265,000
Minus adjusted basis 280,000 280,000
Equals gain/(loss) $20,000 (15,000)
Add cancellation of debt income   35,000
Equals net gain on disposition   $20,000

The nonrecourse note results in a gain of $20,000 ($300,000 amount realized minus $280,000 adjusted basis). Whereas, the recourse note results in a disposition loss of $15,000 ($265,000 amount realized minus $280,000 adjusted basis) plus $35,000 of cancellation of debt income resulting in a net gain of $20,000. The overall tax consequence for both notes is a gain of $20,000.  However, the $35,000 cancellation of debt income can be deferred through the reduction of tax attributes if the taxpayer qualifies to exclude the cancellation of debt income under IRC §108.


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