Category: Sales & Exchanges; Real Estate Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Taxpayer (TP) sold property in exchange for cash and an installment note. Some years later, TP accepted 35% of the original land sold in full satisfaction of the note. It has been suggested that the transaction be bifurcated as A) a foreclosure portion, and B) some other transaction to reflect the TP's loss of value. Absent a special rule, foreclosure on an installment note would give rise to gain or loss measured by the difference between the fair market value of the property taken in foreclosure and the taxpayer's basis in his installment note. Regulation Section 1.453-5(b)(2) and IRC Section 1001. Section 1038 is such a special rule. Section 1038 provides that no gain or loss is recognized on the foreclosure, and the taxpayer must adjust the basis of the property reacquired. There is an exception to the prohibition against recognition of gain. Gain must be recognized to the extent that the cash plus any other property (other than the buyer's installment note) received prior to the foreclosure exceeds the amount of gain recognized by the taxpayer prior to foreclosure. This exception effectively requires gain recognition for almost all sales reported on the installment method. Cutting through all the technical twists and turns in Section 1038, the provision in effect forces the taxpayer to take basis in the reacquired property equal to the original basis of the property sold even if the taxpayer must recognize gain to restore such original basis. In this case, the full property has not been seized through foreclosure. If the principles of Section 1038 are applied to this situation, TP would be required to recognize a significant amount of gain. This result appears illogical given that only a portion of the property has been foreclosed. However, I cannot locate any support for applying Section 1038 on a piecemeal basis, i.e., to only the portion foreclosed. In my experience, foreclosure is an all-or-nothing proposition. It is not surprising that the drafters of Section 1038 did not provide for partial reacquisitions of property. The Regulations at Section 1.1038-1(a)(3) make it clear that Section 1038 applies not only to judicially effected foreclosures but also to voluntary reconveyances of the property pursuant to an agreement between buyer and seller. Again, however, there is nothing to indicate that partial reconveyances were considered. The Regulations at Section 1.1038-1(a)(3) also provide that Section 1038 does not apply if the seller (i.e., the person reacquiring the property) pays consideration to the buyer in addition to canceling the buyer's indebtedness. It seems to me that if TP wishes to avoid the harsh consequences of Section 1038 in this instance, it would be possible to argue that allowing the buyer to retain 65% of the original property in addition to discharging the buyer's indebtedness is tantamount to payment by the seller of additional consideration on the foreclosure and therefore removes the transaction from the purview of Section 1038 by virtue of Regulation Section 1.1038-1(a)(3). In such an event, TP would then recognize gain or loss on the transaction equal to the difference between the fair market value of the 35% portion of the property reacquired as against TP's basis in the installment note immediately prior to the foreclosure. |
