Category: Sales and Exchanges/Real
Estate Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Background Taxpayer, a partnership, sold real property for $4.1 million taking back a recourse note secured by the property in the amount of $3.5 million. The maker of the note was a partnership. The taxpayer properly elected out of installment sale treatment and recognized the entire gain on the transaction in the year of sale. In 1997, the property was foreclosed. At the time, the principal balance of the note was $3.28 million, and a concurrent appraisal put the value of the property at $2.4 million. Buyer and seller stipulated to that value. Under local law the buyer's obligation to the seller was satisfied to the extent of the $2.4 million stipulated value. Later in 1997, the property was sold for $2.25 million. During the period between the foreclosure and the subsequent sale, the taxpayer received rents of $100,000 and paid related expenses of $50,000. Issues 1. What is the basis of the property after the foreclosure? 2. What is the gain or loss on the subsequent resale? 3. If the subsequent disposition results in a loss, is this loss the result of a property sale or a bad debt? 4. What is the proper treatment of the rental income and related expenses?
1. The basis of the property in the hands of the foreclosing taxpayer is $3.28 million plus any expenses associated with the foreclosure (e.g., legal fees). 2. The loss on the subsequent disposition of the property is $1.03 million. 3. The disposition loss is not a bad debt but rather a loss on the sale of the property. 4. The rental income and expenses during the taxpayer's period of ownership are currently taxed. Discussion Section 1038 controls the much of this transaction. In general, Section 1038(a) provides that no gain or loss is recognized as a result of the foreclosure of seller financed property provided the property is secured by the seller financing. Section 1038 only applies if the seller financing is satisfied in whole or in part by the foreclosure. An exception to the general rule of Section 1038(a) exists. Gain must be recognized to the extent cash and other property received by the seller prior to the foreclosure exceed the amount of gain reported by the seller from the sale transaction in periods prior to the foreclosure. Section 1038(b)(1). Since the taxpayer reported far more gain than the amount of cash received, there is no gain to recognize under this provision at the time of foreclosure. Section 1038(c) provides that the basis of reacquired property shall be the adjusted basis of the indebtedness as of the date of the reacquisition plus any gain recognized under Section 1038(b) plus any expenses or other amounts paid by the seller in connection with the reacquisition. Section 1038(c) also provides if any indebtedness to the seller secured by the property is not discharged on reacquisition of the property, the basis of such indebtedness shall be zero. As I understand it, the seller financing in question is secured by the property and the seller has recourse against the personal assets of the buyer. You have represented that the foreclosure discharged the buyer's indebtedness to the extent of the stipulated value, $2.4 million. The difference between the note balance and the stipulated value ($3.28 million minus $2.4 million = $880,000) represents indebtedness not satisfied by the foreclosure. Thus, the $880,000 is not discharged by the foreclosure. Under Section 1038(c), this $880,000 takes on a zero basis in the taxpayer's hands. I can find nothing in the literature that requires the loss on subsequent disposition of the property to be treated as a bad debt loss or anything that prevents this loss from being treated as a loss from the sale of the property. Reg. Section 1.1038-1(g)(3) provides that the seller's holding period for the reacquired property includes the period of time the seller held the property prior to the original sale. I see nothing to prevent this property from Section 1231 treatment in this case. The theoretical underpinning of Section 1038 is to place the seller (as nearly as possible) in the same position as if the sale had not occurred. If the sale had not occurred and the property in question were just now being sold for the price received on resale (plus the prior down payment and the note collections), then the gain or loss realized should be equal to the original gain less the current loss. In fact, recognizing a loss of $1,030,000 on the subsequent disposition against the $950,000 original gain nets out to an $80,000 loss. If the property were sold now for the resale price of $2.25 million plus the $600,000 down payment plus the $220,000 note payments against its original $3.15 adjusted basis, an $80,000 loss would be produced. You have suggested that it is necessary or appropriate to capitalize rents collected and expenses paid during the period the seller owned the property between the foreclosure and the subsequent sale. I see nothing to support that theory. I feel that these items are clearly taxable on a current basis. See Murray v. Comr., 21 TC 1049 (1954), aff'd. 232 F2d 742 (Oth Cir. 1956). |
