This article reviews the presumption a lender receives no reportable profit when acquiring property by foreclosure, and the carryback seller’s exemption on foreclosure.
A tax-free, note-for-property exchange
A borrower defaults on a real estate loan with a remaining balance of $500,000. The lender holding the note and trust deed calls the note due and commences a trustee’s foreclosure to enforce collection of the $500,000 loan amount.
At the trustee’s sale, the lender submits a credit bid of $400,000. No other bidders appear and the lender is the successful bidder, taking title by a trustee’s deed.
However, the lender’s collection of the unpaid $100,000 balance remaining due from the borrower following the $400,000 bid, is barred by anti-deficiency laws since the lender foreclosed by a trustee’s sale. [Calif. Code of Civil Procedure §580d]
The property’s fair market value at the time of the trustee’s sale was $550,000.
The lender reports a bad debt loss for the $100,000 unpaid balance on the note, the amount due and uncollectible from the borrower.
Can the lender properly write off the $100,000 note balance which is unpaid and uncollectible as a bad debt loss on his investment due to his underbid?
Yes! The debt owed on the note has become uncollectible from the borrower by way of a money judgment and is fully deductible at the option of the lender. [CCP §5806]
However, the lender concurrently received a profit, which must also be reported.
On acquiring the property at the trustee’s sale for the amount of his credit bid, the lender actually exchanged a portion of the amount owed on the note for the ownership of real estate. This exchange of a portion ($400,000) of the balance due on the note for the property is a taxable transaction. [IRC §1001(c)]
Thus, the lender also receives a reportable profit since the value of the real estate ($550,000) was the consideration the lender received in exchange for his $400,000 bid, using as credit a portion of his note.
As a result, the foreclosing lender received a $150,000 profit on the note-for-property exchange ($550,000 value minus $400,000 bid).
Having reported the $100,000 loss on the note due to the underbid, the lender must now report the $150,000 profit from his exchange — a net reportable investment profit of $50,000 on the transaction. [Helvering v. Midland Mut. Life Ins. Co. (1937) 300 US 216]
However, this profit reporting could have been avoided under the Internal Revenue Service (IRS) bid-equals-value presumption.
When a lender forecloses and acquires the secured property on a credit bid at the foreclosure sale, the Internal Revenue Service (IRS) simultaneously treats the lender as:
· a creditor holding paper; and
· a seller of that paper (by an exchange).
Consequently, the lender must calculate his profit or loss at foreclosure in a dual status, as follows:
1. As a creditor, the lender computes the amount of loss, if any, on the loan, by deducting the bid price using the remaining principal balance on the loan as credit. When the loan’s remaining principal balance exceeds the successful bid, the money lender has a bad debt loss for the unsatisfied amount, which he may choose not to report. [IRC §166]
2. As a seller, if the lender’s credit bid to acquire the property exceeds the unpaid principal and foreclosure costs/advances, the bid includes reportable income in the amount of the excess. Typically, credit bids that exceed principal and cash advances occur when unpaid accrued interest, prepayment penalties, etc. is added to set the amount of the bid.
However, when a lender bids in an amount not greater than the remaining principal, costs and advances, the IRS presumes the lender received no reportable profit or income on the note.
The money lender may properly open bidding at or below the amount of the loan’s remaining principal balance plus foreclosure costs and advances. If cash bidders overbid, it is prudent then for the lender to consider increasing his credit bid up to an amount that covers the accrued interest, accrued late charges and any prepayment penalty due and unpaid.
A lender 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 lender is willing to add cash to become the owner of the property.
“Bidding in” is buying property
Consider a foreclosing lender who is the highest (or only) bidder at his trustee’s sale. Through the foreclosure process, the lender acquires ownership of the secured property as satisfaction for all or part of the trust deed note.
The lender does not receive cash for cancellation of the note, but instead receives the secured property itself. Thus, the lender has “exchanged” the note and trust deed for the property.
Any profit or loss received by the lender on the exchange is reportable. There are no tax provisions that exempt any profit from taxation on the conversion of a note to real estate. Initially, the lender must declare a profit for any value received in excess of his loan basis and pay the tax on it. [IRC §1001]
If the lender has received a profit of $150,000 on an underbid at a trustee’s sale (a $550,000 value received minus a $400,000 credit on the note), the underbid constitutes a tax loss for the lender on the note of $100,000 ($500,000 loan balance minus $400,000 bid).
But because he underbid and reported a loss, he is exposed to taxes on the profit resulting from the exchange of his paper for the real estate’s equity.
Consider this below market value scenario:
A lender forecloses on a loan with an outstanding balance of $400,000. The lender’s successful bid at the trustee’s sale is $350,000, but the property’s cash value is only $320,000.
As a creditor, the lender takes a $50,000 loss on his loan ($400,000 balance minus the $350,000 bid).
Further, the lender has an additional $30,000 reportable loss as the lender received only a $320,000 value on his exchange of paper for equity at the foreclosure sale ($350,000 bid minus $320,000 fair market value). Thus, the lender’s total losses amount to $80,000 [Nichols v. Commissioner (6th Cir. 1944) 141 F2d 870]
To justify the loss deduction on the exchange, the lender must show the IRS that the property’s cash value is below his successful bid.
Thus, before the date of the trustee’s sale, the lender should have determined the property’s value and bid up to that amount at the trustee’s sale. A lower bid limited to the property’s market value would have avoided the need for reporting a further capital loss.
IRS presumptions and appraisals
When a lender acquires property at a foreclosure sale, the IRS initially presumes the price bid is the property’s fair market value (FMV) when establishing the lender’s reportable loss incurred at the price bid. [Revenue Regulations §1.166-6(b)(2)]
However, the IRS can rebut the FMV presumption that sets the value received based on the bid price, if the property’s cash value was actually higher than the bid. [Rev. Regs. §1.166-6(b)(2)]
The IRS may independently establish the property’s value at the time of the trustee’s sale. If the IRS can demonstrate through appraisals that the property’s FMV was higher than the bid price at the foreclosure sale, the lender will have to either reduce the reported loss or report income as the difference between the FMV and the lender’s basis in the loan.
For example, a lender forecloses by trustee’s sale on a number of loans and declares a loss based on the difference between his underbids and his cost basis in the loans.
The reporting of his losses triggers an audit. The IRS appraises the properties’ values retrospectively to the time of the foreclosure sales. The IRS discovers the property values were much higher than the bid prices.
The lender claims:
· the bid prices set the properties’ fair market values under state law, as all of the trustee’s sales were advertised auctions properly conducted under California foreclosure law [Calif. Civil Code §§2924 et seq.];
· a trustee’s foreclosure sale blocks a deficiency judgment in California [CCP §580d]; and
· the IRS presumes the bid price at a properly conducted trustee’s sale to be the fair market value.
Is the IRS bound by the California fair value limitations on foreclosures or any other borrower defenses?
No! Federal tax law is wholly separate and preempts any state law to the contrary. The state anti-deficiency laws are designed primarily to protect borrowers after foreclosure, not lenders. The federal tax law, on the other hand, is designed to measure a lender’s income and profits (or losses) on a foreclosure since it is a taxable exchange, priced at the amount bid. [Community Bank v. Commissioner (9th Cir. 1987) 819 F2d 940]
The two analyses are entirely separate and serve quite different purposes.
Thus, the IRS can independently appraise the property to calculate the money lender’s profit on the note-for-property exchange that occurred. By establishing a higher value to the property than the price bid, the IRS rebuts their presumption that the foreclosure bid is the property’s value.
Deed-in-lieu of foreclosure
A lender acquiring property through a deed-in-lieu of foreclosure must report any income, profit or loss on the receipt of real estate received in exchange for cancellation of a note.
By taking a deed-in-lieu, the lender acquires the property immediately, rather than waiting to bid for it at the foreclosure sale. Thus, they can reduce their potential losses.
If the property’s value, when conveyed by a deed-in-lieu, exceeds the total of the loan’s remaining balance, costs and advances, the lender will have interest income, and possibly profit, to report. Unpaid interest constitutes income and excess value in the real estate constitutes profit.
On the other hand, if the property’s value is less than the unpaid loan balance, the lender has a reportable loss on the conversion.
For a deed-in-lieu to be insurable by a title company, the deed must state the conveyance is freely and fairly made, and fully satisfies the debt. [See first tuesday Form 406]
Before insuring title, some title companies further require an estoppel affidavit or additional statement in the deed that confirms the lender’s consideration for the deed equals the value of the property’s equity. However, the lender must be cautious reporting a loss while at the same time agreeing to a full satisfaction declaration when accepting a deed-in-lieu.
Guidelines for a foreclosing lender
A foreclosing lender should appraise property before its foreclosure sale to:
· ascertain whether the property’s value exceeds the debt owed; and
· plan a bidding strategy to avoid reportable income or profit on the foreclosure.
Ordinarily, lenders do not want to acquire secured property at a foreclosure sale. However, a foreclosing lender is usually the successful bidder at a trustee’s sale. Trustee’s sales are typically not competitive bidding events, except during the transitions from a seller’s market to a buyer’s market.
Before initiating the foreclosure sale, the lender must initially determine the amount of his opening bid. Competitive bidding will cause the foreclosing lender to increase his bid — but only up to the limit of his credit bid amount (principal, costs, advances, interest and other loan-related charges).
Debt versus value bid calculations
A foreclosing lender must first determine the secured property’s value in relation to the debt.
Taxwise, three possible debt-to-value scenarios exist for the lender:
· the debt owed exceeds the property’s value, called debt-over-value;
· the property’s value exceeds the debt owed, called value-over-debt; or
· the property’s value equals the debt, called debt- equals-value.
Because the amount of a credit bid is limited to the dollar amount of debt owed to the lender under the note and trust deed, for bidding purposes that amount includes:
· the remaining principal and any cash advances made under the trust deed;
· foreclosure costs and attorney fees for any litigation; and
· accrued but unpaid interest, late charges and prepayment penalties.
Again, the property’s value for tax reporting is its fair market value at the time of the trustee’s sale, not the bid.
Debt-over-value bid calculations
When the amount of unpaid debt is greater than the property’s fair market value, the lender’s opening bid should be at or below the property’s value, called an underbid. Thus, the lender does not create reportable income on receipt of the property at the foreclosure sale.
Taxwise, the lender acquiring over-financed property on an underbid will:
· declare no income on the unpaid accrued interest;
· declare no profit on the note-for-property exchange;
· declare a reportable capital loss on the note; and
· delay taking any profit until a future resale if the resale price of the property exceeds the bid.
The lender receives no income or profit on the exchange because:
· accrued interest income is not included in the bid; and
· the property value roughly equals the price set by the bid.
The loss reported on the note is proper since the total unpaid principal due on the note is an amount that exceeds the property’s value.
Of course, the lender who first underbids may find it convenient and proper to increase the credit bid to include the entire debt. When confronted with a competitive cash bidding situation, the lender should consider overbidding the prior cash bids. Again, the lender’s total credit for bidding is limited to the debt owed.
Value-over-debt bid calculations
When the property’s value is greater than the amount of the debt (and no waste or insured loss has occurred), the lender’s opening bid should be limited to:
· the unpaid principal on the note and advances made under the trust deed;
· the foreclosure costs; and
· attorney fees for any litigation.
Thus, the credit bid does not include any interest or penalty income that would have to be reported. If the bid is accepted, the lender applies the IRS “bid-equals-value” presumption to avoid declaring a profit.
Having received the property on a bid equal only to the funds invested in principal plus the costs of collecting the debt and preserving the security, the lender will then:
· report no capital loss on the note;
· report no ordinary income on the interest accrued (since it remains unpaid); and
· delay until resale reporting the profit taken for having received a property value greater than the amount of the debt canceled.
Lenders should not get greedy when competitive bidding fails to occur by deliberately underbidding to incur a reportable capital loss when they know the value far exceeds the bid.
The IRS “bid-equals-value” presumption that allows a lender to avoid reporting profit on an exchange of debt for the property works to the lender’s advantage. However, a lender who abuses the presumption by declaring a loss when in reality a foreclosure was profitable, runs the risk of triggering an audit and a reversal of fortunes due to a penalty tax on the unreported profit.
When a lender relies on the value presumption and acquires property with a bid that is close to the property’s value, the lender’s reported loss on an underbid will most likely withstand an audit.
Debt-equals-value bid calculations
When the amount of the debt equals the property’s value, the lender’s opening bid should equal the principal, advances, costs and attorney fees the lender has invested in the note and trust deed. These items are the out-of-pocket sums that constitute the lender’s basis in the note.
If this “cost basis” bid is the successful bid, the lender avoids reportable income on accrued and unpaid interest, late charges and prepayment penalties. These sources of income were not included in the bid. Taxwise, these items are not a reportable loss since they merely accrued and went unpaid.
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 lenders who do the same thing.
Sellers who carry back a trust deed note help the buyer in financing the purchase of the property by simply extending credit, not by making a loan as a lender does.
Occasionally, a seller who extends credit by carrying back a note and trust deed is forced to reacquire the property, and is able to do so by negotiating a deed-in-lieu of foreclosure when the default occurs. Like a foreclosing lender, the foreclosing carryback seller who reacquires the property by a deed-in-lieu of foreclosure does so in exchange for his cancellation of the note and trust deed, and must report any profit in the note unless it is exempt from taxes. [IRC §1001]
Unlike lenders, however, carryback sellers are exempt from reporting any income or profit received when they reacquire property on a full credit bid for all sums owed them, including interest, late charges and prepayment penalties.
Accordingly, the reacquisition of property sold on an installment sale plan involves no reportable income or profit — regardless if the value of the seller’s securities interest in the property under his trust deed is higher or lower than the entire debt owed the seller. Likewise, the carryback seller cannot take a loss if the property has decreased in value to below the principal amount of debt remaining unpaid, which is typically the reason for the default that leads to the foreclosure or deed-in-lieu. [IRC §1038]
The carryback seller who forecloses and reacquires the property reports no profit or loss until the property is resold. Only on the resale can the seller report any profit or loss.
However, a foreclosure or deed-in-lieu completed by the carryback seller does trigger a reanalysis of the tax reporting on the original sale in which the carryback paper was created. On reacquiring the property, the seller must report and pay profit taxes on that portion of the principal he received on his original sale that was not previously reported as profit and was included in the down payment or installments he received on the note.