The following excerpt is from the current edition of Tax Benefits of Ownership, which gives an overview and explanation of the foreclosing mortgage holder’s taxes on repossession.
Planning the tax-free, note-for-property exchange
Consider a property owner who defaults on a mortgage with a remaining balance of $500,000. The mortgage holder calls the note due and commences a trustee’s foreclosure to enforce collection of the amounts due under the mortgage note and trust deed.
At the trustee’s sale, the mortgage holder submits an opening credit bid of $400,000. No other bidders appear. The mortgage holder as the high bidder acquires title to the property in exchange for partial satisfaction of the debt owed. Based on the amount of bid and the debt owed, the mortgage holder suffers a loss of $100,000.
On analysis, note that the maximum amount of any mortgage holder’s credit bid equals the total debt owed to the mortgage holder under the note and trust deed, including:
- the principal remaining due on the note;
- any cash advances made under the trust deed;
- foreclosure costs and attorney fees for any litigation;
- interest accrued and unpaid;
- late charges; and
- prepayment penalties.
Contrary to the amount of the credit bid, the fair market value (FMV) of the property received in exchange for satisfaction of debt was $550,000 on the date of the trustee’s sale. Thus, a $150,000 profit is realized on the exchange.
May the mortgage holder write off the unpaid, uncollectible balance remaining on the note as a loss on their mortgage investment based on the amount of their underbid and acquisition of the property?
Yes, with a flipside. Here, the remaining debt owed on the note has become uncollectible. Anti-deficiency laws bar the mortgage holder from collecting the $100,000 balance remaining unpaid on the note. The lender foreclosed by completing a trustee’s sale, not a judicial sale of the property. [Calif. Code of Civil Procedure §580d]
Here, at the option of the mortgage holder, the $100,000 underbid loss taken at the foreclosure sale is fully deductible.
Financially, however, the mortgage holder received a profit on the exchange at the trustee’s sale. This profit too is taxed if not offset by losses. The exchange transaction of a foreclosure and acquisition of real estate is not exempt from taxation.
The economic function of a foreclosure sale in an exchange by the mortgage holder:
- satisfaction of all or a portion of the mortgage debt as consideration given in exchange for
- acquiring ownership of real estate which was security for the debt.
In our example, the exchange of principal remaining due on the note, even a portion of that principal, for ownership of the secured property is a taxable transaction. [Internal Revenue Code §1001(c)]
Thus, the mortgage holder receives a profit on their credit bid acquisition of the property. The FMV of the property ($550,000) was the value received in exchange for satisfaction of a $400,000 portion of the mortgage debt.
As a result, the foreclosing mortgage holder realizes a $150,000 profit on the note-for-property exchange transaction, taxable in the year of the foreclosure transaction.
The mortgage holder concurrently suffered a $100,000 loss on the note due to the underbid and bar against collection and enjoyed a $150,000 profit on their exchange — a net profit of $50,000 on the entire exchange-by-foreclosure transaction. [Helvering v. Midland Mut. Life Ins. Co. (1937) 300 US 216]
Now the flipside. The mortgage holder may avoid reporting the profit taken due to the greater value received in the foreclosed property by applying the Internal Revenue Service (IRS) bid-equals-value presumption.
Mortgage holder forecloses and buys – a forced purchase
A mortgage holder acts as a creditor at a foreclosure sale by limiting its bid to include only the amount of the remaining principal, advances and costs. Classified as a creditor, the IRS presumes the amount of the credit bid is equal to the property’s FMV. Thus, the mortgage holder receives no reportable income in the form of interest and penalties added to the bid. Importantly, the profit on the greater value in the property acquired at the foreclosure sale is not reported — the result of the bid-equals-value presumption. [Revenue Regulations §1.166-6(b)(2)]
The mortgage holder properly opens bidding at or below the amount of the remaining principal balance plus advances and foreclosure costs. And when cash bidders overbid, it is prudent for the mortgage holder to consider increasing their credit bid, limited to the amount that covers the accrued interest, earned late charges and any prepayment penalty due and unpaid.
A mortgage holder will rarely bid an amount in excess of the total amount owed on the debt unless competitive bidding drives up the bid amount and the mortgage holder is willing to add cash in an exchange to become the owner of the property.
“Bidding in” is buying property
Consider a mortgage holder who forecloses on a mortgage with an outstanding balance of $400,000. The mortgage holder’s successful bid at the trustee’s sale is $350,000, but the property’s FMV is only $320,000.
The mortgage holder takes a $50,000 loss on their mortgage. Further, the mortgage holder has an additional $30,000 reportable loss. They received only $320,000 in FMV on their exchange of the portion of the mortgage debt they canceled for property ownership at the foreclosure sale. Thus, the mortgage holder’s total losses amount to $80,000 [Nichols v. Commissioner (6th Cir. 1944) 141 F2d 870]
To substantiate the loss on the exchange, the mortgage holder presents evidence to the IRS, such as an opinion of value or appraisal, demonstrating the property’s FMV is below their successful bid.
IRS presumptions and appraisals
The bid-equals-value presumption for reporting the exchange is rebuttal by the IRS. Thus, the IRS may independently establish the property’s value at the time of the trustee’s sale when a loss is reported by the mortgage holder. When the IRS demonstrates through appraisals that the property’s FMV was higher than the bid price at the foreclosure sale, the mortgage holder either reduces the reported loss or reports income for the difference between the property’s FMV and the mortgage holder’s basis in the mortgage.
For example, consider a mortgage holder who forecloses by trustee’s sale on several mortgages. Losses are declared based on the difference between their underbidding and their cost basis in the mortgages.
Reporting their losses triggers an audit. The IRS appraises the properties to determine their values at the time of the foreclosure sales. The IRS discovers the FMV of the properties was much higher than the bid prices and disallows the losses and assesses taxes on the profits.
The mortgage holder claims:
- the bid prices set the FMV of the properties under state law, as all the trustee’s sales were publicly advertised auctions properly conducted under California foreclosure law [Calif. Civil Code §§2924 et seq.];
- a trustee’s foreclosure sale bars any deficiency judgment and collection of remaining debt in California [CCP §580d]; and
- the IRS presumes the underbid price at a properly conducted trustee’s sale to be the FMV.
Is the IRS bound by the California limitations on foreclosures or any other borrower defenses?
No! The state anti-deficiency laws are designed with the purposes of protecting borrowers after foreclosure, not mortgage holders. Federal tax law, on the other hand, is designed to measure a mortgage holder’s income, profits or losses on a foreclosure since a foreclosure sale concluding with the lender taking title to the property is a taxable exchange. [Community Bank v. Commissioner (9th Cir. 1987) 819 F2d 940]
Here, the IRS may independently appraise the property to calculate the mortgage holder’s profit on the note-for-property exchange that occurred. When establishing a higher value for the property than the price bid, the IRS rebuts their own bid-to-value presumption. Moral: do not do loss reporting that will trigger an audit if you are foreclosing at a profit.
Deed-in-lieu of foreclosure as an exchange
By taking a deed-in-lieu of foreclosure, a mortgage holder acquires the property immediately, rather than waiting for a foreclosure sale to be noticed and processed. Thus, they reduce one risk of further loss.
When the value of a property conveyed to the mortgage lender by a deed-in-lieu is greater than the remaining balance, costs and advances, the mortgage holder will have interest income, and possibly profit, to report. Unpaid interest when received constitutes a creditor’s income, while excess value in the real estate acquired (as the seller exchanging a mortgage) produces profit.
On the other hand, when the property’s value is less than the unpaid mortgage balance, the mortgage holder has a reportable loss on the cancellation of mortgage debt in exchange for ownership of the property.
For a deed-in-lieu to be insurable by a title company, the deed needs to state the conveyance is freely and fairly made as granted in full satisfaction of the debt. [See RPI Form 406]
Some title companies further require an estoppel affidavit or additional statement in the deed that confirms the mortgage holder’s consideration for the deed equals the value of the interest conveyed in the property. However, the mortgage holder needs to avoid reporting a loss when they accept a full satisfaction declaration in a deed-in-lieu.
A prudent foreclosing mortgage holder appraises the property before the foreclosure sale to:
- ascertain whether the property’s FMV exceeds the debt owed; and
- plan a bidding strategy to avoid reportable income or profit on the foreclosure.
Ordinarily, mortgage holders do not want to acquire secured property at a foreclosure sale. However, a foreclosing mortgage holder making a full credit bid is usually the successful bidder at a trustee’s sale (the owner-in-foreclosure had no equity to sell). Typically, trustee’s sales are not competitive bidding events, except during transitions after a recession when the recovery has been acknowledged.
When the amount of remaining mortgage debt is greater than the property’s FMV, the mortgage holder’s opening bid at a foreclosure sale is often set at or below the property’s FMV, called an underbid. Thus, the mortgage holder does not create reportable income on acquiring of the property.
Here, the mortgage holder acquiring over-encumbered (underwater) property on an underbid declares:
- no income on the unpaid accrued interest;
- no profit on the note-for-property exchange; and
- a reportable capital loss on the note.
The mortgage holder receives no income or profit on the note-for-property exchange because:
- accrued interest income is not included in the bid; and
- the FMV roughly equals the price set for the underbid.
The loss reported on the note is proper, as the total unpaid principal due on the note exceeded the property’s substantiated FMV.
Value-over-debt foreclosure bidding
When the property’s FMV exceeds the debt owed (and no waste or insured casualty loss has occurred which are recoverable when a loss results from the trustee’s sale bid), the mortgage holder’s opening bid will not be greater than the amount of principal and cash advances due under the note and trust deed, including foreclosure costs and attorney fees.
Having acquiring title to the property on a bid equal to the funds invested in principal and cash advances plus the costs of enforcing collection of the debt by foreclosure and preserving the security, the mortgage holder:
- reports no capital loss on the note;
- reports no ordinary income on the interest accrued (since it remains unpaid); and
- delays until resale the reporting of profit taken on acquiring a property of greater value than the amount of the debt canceled.
Mortgage holders need to avoid overreaching to create a short-term loss by deliberately underbidding when the property FMV measurably exceeds the bid and they face no competitive bidding.
The IRS bid-equals-value presumption works to the mortgage holder’s advantage unless the holder appears to be overreaching with losses. When a foreclosure is profitable a mortgage holder who abuses the presumption by declaring a loss on an underbid runs the risk of triggering an audit resulting in disallowed losses and taxes assessed on the unreported profit taken at the time of the foreclosure sale when acquiring the property.
Carryback seller’s foreclosure exemption
Carryback sellers who foreclose on their buyer and bid in the full amount of the debt are exempt from the income and profit tax inflicted on foreclosing mortgage lenders who do the same.
Occasionally, a seller who carries back a note and trust deed is later forced by the buyer’s default to foreclose and retake ownership of the property. This recovery objective may be met by negotiating a deed-in-lieu of foreclosure conveyance from the buyer. Like a foreclosing mortgage holder, the foreclosing carryback seller reacquires the property in exchange for cancellation of the note and reconveyance of the trust deed.
Unlike mortgage holders, carryback sellers who reacquire property on a deed in lieu or a full credit bid for all sums owed them, including interest, late charges and prepayment penalties, are exempt from reporting income or profit on the exchange.
Accordingly, the reacquisition of property sold in a carryback sale triggers no reportable income or profit on the foreclosure activity. The value of the seller’s security interest in the property may be higher or lower than the entire debt owed the seller with no change in the tax consequence.
Likewise, the carryback seller has no loss when the FMV of the property has decreased below the principal amount of debt remaining unpaid, which is typically the reason for default. They have recovered the property they sold and are whole again as though they never sold – except for current market and pricing conditions. [IRC §1038]
However, the foreclosing carryback seller’s reporting of the original installment sale is reconstructed. Any net cash proceeds on the sale or principal in installment payments not taxed (it was a return of capital) are now taxed as income – the seller has ownership of the property back and holds untaxed earnings generated by the property due the installment sale.