This article reviews how a seller may write off his cost basis in a note that was carried back on the sale of rental or investment real estate and is now uncollectible.
Writing off an exhausted bad debt
A seller of real estate carries back a note executed by the buyer as payment for part of the sales price. The note is secured by a second trust deed on the real estate sold, junior to a first trust deed lien. The seller reports the sale on the installment method, deferring the payment of profit taxes until principal is paid on the note.
After the year of sale, the buyer defaults on the first trust deed loan. The first trust deed lender forecloses and, in the process, extinguishes the seller’s security interest in the property under his second trust deed lien. The unpaid carryback note is now unsecured.
The dollar amount the first trust deed lender bid to acquire the property at the foreclosure sale was the total amount of the principal remaining on the first trust deed. Thus, no sales proceeds remain to be distributed to the seller for payment on his carryback note.
The buyer is unwilling to pay off the note and the seller is unable to judicially enforce collection for the balance due on the now unsecured note. The buyer is not personally liable since the carryback note he signed evidences a nonrecourse debt, also called purchase money paper. Thus, the seller’s now unsecured carryback note is uncollectible. [Calif. Code of Civil Procedure §580b]
Can the seller write off any part of the uncollectible note on his federal income tax return?
Yes! The property sold was a rental or investment property, not the seller’s principal residence or property used in the seller’s business. The amount the seller can write off is the remaining dollar amount of the property’s cost basis that was allocated to the carryback note for installment sale reporting. The remaining, unrecovered basis that is written off is classified as a short-term capital loss by the IRS. [Internal Revenue Code §166(d)]
However, he cannot write off the untaxed profit remaining in the note’s principal balance.
On the other hand, if the carryback seller reported and paid taxes on all of the profit in the year of the installment sale, as he may elect to do, he is entitled to write off the entire remaining principal balance of the now worthless note. The profit, when taxed at the time of sale, is added to the basis carried forward to the note. Thus, the profit became part of the note’s basis and the entire basis is written off as a short-term capital loss when the note becomes worthless. [Phillips v. Commissioner (1927) 9 BTA 1016]
The unsecured carryback is worthless debt
A carryback note held by a seller of investment real estate is a debt since it represents a valid obligation of the buyer to pay the seller a fixed sum of money, even though:
· enforcement is limited to the value of the property sold; and
· the buyer cannot be held personally liable if the seller’s security interest is wiped out. [Rev. Regs. §1.166-1(c); CCP §580b]
The debt evidenced by the note carried back by the seller must be a nonbusiness debt. It qualifies as such if the real estate sold is:
· a residential or nonresidential rental or an investment property, such as land; and
· not used in the seller’s trade or business or as the seller’s principal residence. [IRC §166(d)(2)]
A nonbusiness debt becomes worthless when no means exist to collect the debt. [Rev. Regs. §1.166-2(b)]
California’s anti-deficiency laws bar a seller from collecting the balance due from the buyer on a wiped out carryback note. [CCP §580b]
A carryback note that has become unsecured due to the loss of its security interest is a worthless debt since there is no way to collect the amount due. Thus, the seller, directly as an individual or individually as a member of a tenancy in common, partnership or LLC holding the note, can write off the amount of the property’s basis allocated to the note as a short-term capital loss. [Revenue Regulations §1.166-6(a)(1)]
The basis is the bad debt write-off
A seller whose carryback note is worthless can write off only the capital investment (his basis) remaining in the unpaid note. [Rev. Regs. §1.166-6(a)(1)]
The profit in a carryback note is gain from a sale. If the seller reports on the installment method, he has not yet paid capital gains taxes on the profit. The amount of the property basis that is allocated to the carryback note represents the seller’s remaining unrecovered capital investment in the property sold. [See Chapter 20]
The amount of basis a seller can write off on a worthless carryback note is calculated as:
· the face amount of the note;
· minus the total amount of profit allocated to the note under the contract ratio established for the sale [See Chapter 20];
· minus the untaxed portion of any principal that has been paid on the note. [Rev. Regs. §1.453-9(b)(2)]
Again, the portion of a wiped out note that can be written off as a short-term capital loss is limited to the note’s basis. The seller is reporting the loss of his remaining, unrecovered capital investment — the amount of the property’s basis that has been allocated to the note, minus the amount of principal paid on the note and reported as a recovery of basis.
Surplus sales proceeds
Consider a seller who carries back a note and second trust deed on the sale of his property. The seller elects to report and pay taxes in the year of sale on the profit taken on the sale.
Thus, the entire principal balance of the note becomes basis since the profit on the sale is reported and taxed. When taxed, the profit allocated to the note is added to the basis carried forward to the note.
Later, the seller’s trust deed securing the carryback note is wiped out by the foreclosure sale under the senior trust deed. The successful bid at the trustee’s sale is an amount greater than the amount of money due the foreclosing lender, a situation called an overbid, which produces surplus funds.
The surplus sales proceeds are distributed to the seller and are applied to the now unsecured carryback note, leaving an unpaid balance which is due and uncollectible.
Here, the unpaid principal remaining on the debt after credit for the surplus foreclosure sales proceeds can be written off by the seller as a short-term capital loss. The principal amount of the note is all basis — after-tax dollars — as a result of the seller’s prior election to report and pay taxes in the year of the sale. [Phillips, supra]