Category: Sales & Exchanges
Subject: Installment Sales
Title: Foreclosure by Superior Lienholder as Disposition of Junior Installment
IRC Sections: 453B
Date Produced: 08/94
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Taxpayer (TP) sold a 44-unit apartment complex to an unrelated purchaser
in 1985. TP received A) cash of approximately $930,000 (resulting from the
purchaser's first mortgage financing with a lending institution); and B)
a second mortgage in the amount of $345,000. TP reported the transaction
on the installment method for tax purposes. A summary of the relevant facts
Selling price $1,275,000
Cost basis 504,113
Selling costs 80,905
Gross profit 859,041
Gross profit % 67.38%
TP received payments of only $25,000 on the second mortgage, and the
first mortgage holder foreclosed on the property in 1993.
The issue is how to treat TP's loss on the installment note.
Subject to verification of the legal issue described below, the transaction
set forth above is a deemed disposition of the installment note giving rise
to gain or loss to the extent of the difference between the fair market
value of TP's installment note (presumably zero) and TP's basis in that
note. In addition, the character of the resulting gain or loss is the same
as the character of the gain recognized from the initial disposition of
the property which gave rise to the installment note.
Internal Revenue Code §453B(f) provides if an installment obligation
is canceled or otherwise becomes unenforceable, the obligation is treated
as if it were disposed of. Gain or loss is recognized equal to the difference
in the fair market value of the obligation as compared to its basis. §453B(b)
provides that the basis of an installment obligation is its face less any
unrecognized installment gain. §453B(f) also provides that any gain
or loss resulting from the disposition of the installment obligation shall
be considered as resulting from the sale or exchange of the property in
respect of which the installment obligation was received.
Based on the language of the statute, if TP's installment note became
unenforceable under local law as a result of the foreclosure by the first
mortgage holder, the installment note is deemed disposed of for tax purposes.
Based on the information provided, the basis of the obligation is $104,438
computed as follows.
Face of the obligation $320,000
Unrecognized gain 215,562 (A)
Basis of obligation 104,438
(A): Gross profit of $859,041 less collections of $955,000 times the
gross profit percentage of 67.38%.
Since the installment note presumably has no value as a result of the
foreclosure, the entire basis of $104,438 would be recognized as a loss.
Presumably the original sale of the property gave rise to §1231 gain;
accordingly, under §453B(b) the disposition would give rise to §1231
loss as well.
The only matter left for consideration is the legal status of the second
mortgage in TP's hands as a result of the foreclosure by the first mortgage
holder. The issue is whether the foreclosure renders the second mortgage
unenforceable. I am not an attorney, and this is a question that must be
resolved by a qualified attorney based on the laws of your state. Resolution
is essential to the tax consequences set forth above. If the second mortgage
is not extinguished as a result of the foreclosure, §453B(f) will not
come into play and there would be no basis on which to claim a loss. This
matter should be carefully considered with the assistance of a qualified
attorney. It seems to me that if the second mortgage were recourse, the
foreclosure might not extinguish the second mortgage holder's rights. In
that case, it might be necessary to formally cancel the second mortgage
note in order to claim benefits under §453B(f). There may well be other
scenarios as well in which the second mortgage survives the foreclosure.
Again, this is a matter for a qualified attorney.
Finally, you raise the issue of return disclosure. There is no guidance
regarding how to disclose this type of transaction. Here are my thoughts
on the matter.
1. The transaction should be reported of Form 4797 since the character
of the loss is controlled by the character of the original sale.
2. Assuming the fair market value of the installment obligation is really
zero, proceeds from the sale should be zero.
3. The basis of the note, assuming what I have done above takes into
account all the facts of which you are aware, should be $104,438. There
is no accumulated depreciation to show.
4. It seems to me the description for the asset sold should be something
like: "Installment note disposition under §453B(f) see note attached".
5. It seems to me the date of acquisition should be the date the property
was acquired (the 44-unit complex). The disposition date should be the foreclosure
date assuming the foreclosure really does extinguish the second note under
local law. If not, the disposition date should be the date on which the
note is canceled under local law.
5. It seems to me that a supporting schedule should explain the transaction
in roughly the following manner.
Disposition of Installment Obligation
The taxpayer was the holder of an installment note resulting from the
1985 sale of a 44-unit apartment complex. The taxpayer's note was junior
to another mortgage on the property, and the senior lien-holder foreclosed
during the tax year. Under Florida law, the foreclosure extinguished the
taxpayer's note. (If this is really true.)
Under §453B(f), if an installment note is canceled or becomes unenforceable,
the note is deemed disposed of and gain or loss is recognized on the disposition
based on the difference between the fair market value of the obligation
and the taxpayer's basis in the obligation. Also, the character of the gain
or loss is the same as the character of the gain resulting from the transaction
that gave rise to the installment obligation.
The fair market value of the taxpayer's installment obligation is zero
after the foreclosure. The taxpayer's basis is $104, 438, and the original
sale which gave rise to the installment obligation produced §1231 gain.
Accordingly, $104,438 of §1231 loss is reported on Form 4797 for the