Category: Sales & Exchanges Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com 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 follows. Selling price $1,275,000 TP received payments of only $25,000 on the second mortgage, and the first mortgage holder foreclosed on the property in 1993. Issue: Answer: Discussion: 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 tax year. |
