Category: Bankruptcy, Insolvency & Debt Discharge; Real Estate
Subject: Foreclosure Against Recourse Debt, Discharge in Bankruptcy
Title: Effect of Foreclosure and Subsequent Discharge
IRC Sections: 61(a)(12), 108
Filename: 1381.html
Date Produced: 04/98

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
I refer to your memorandum of March 31, 1998 and the associated Forms 1099-A and 1099-C. These items are incorporated by reference into this memorandum. As I understand it, the taxpayer owned a single family residence with an adjusted basis of $127,487. The property was encumbered by recourse indebtedness. The lender foreclosed on the property when the property was worth $60,522 and the outstanding balance of the mortgage was $135,592. The remainder of the outstanding indebtedness not satisfied by the foreclosure was discharged in bankruptcy.

The Foreclosure Transaction
As you know, a foreclosure of encumbered property is considered a sale or exchange of the property. Helvering v. Himmel, 311 U.S. 504 (1941). If the debt is nonrecourse, the amount realized from the foreclosure sale is the entire amount of outstanding indebtedness. Tufts, John v. Com., (1978) 70 TC 756, revd(1981, CA5) 48 AFTR 2d 81-5660, 651 F2d 1058, 81-2 USTC ¶9574, revd(1983, S Ct) 51 AFTR 2d 83-1132, 461 US 300, 75 L Ed 2d 863, 83-1 USTC ¶9328, affd on remand(1983, CA5) 52 AFTR 2d 83-5759, 712 F2d 199, 83-2 USTC ¶9674. If the debt is recourse, the transaction is part sale part and part debt discharge. See Revenue Ruling 90-16, 1990-1 CB 121, attached.

In this case the debt is recourse. The foreclosure is treated as a sale of the property for an amount equal to the fair market value of the property at the time of the foreclosure. In this case, you should show a sale for $60,522 against the $127,487 adjusted basis of the property. I assume the property in question was rental property and the taxpayer was not a real estate dealer. In that case, the transaction should be reported on Form 4797. This takes case of Form 1099-A.

The taxpayer satisfied $60,522 of his outstanding debt via the foreclosure. The remaining portion--$68,495 according to Form 1099-C--was discharged in bankruptcy. This amount flows to Form 982.

I recognize that the numbers do not exactly add up here. One would think if the $135,592 mortgage balance at the date of foreclosure is correct, the debt discharge amount would have been $75,070 instead of $68,495. I cannot explain this difference. Perhaps $135,592 includes accrued and unpaid interest and the principal outstanding at the time of the foreclosure was $60,522 + $68,495 = $129,017. I suggest looking at the taxpayer's mortgage statement. Note that discharged amounts which if paid would give rise to a deduction do not constitute COD income. IRC Section 108(e)(2).

Attribute Reduction
The debt discharged would normally create taxable income under Section 61(a)(12). In this case since the debt was discharged while the taxpayer was in bankruptcy, cancellation of debt (COD) income is excluded by reason of Section 108(a). This gives rise to the obligation to reduce the tax attributes set forth at Section 108(b). You have pointed out that the taxpayer has very little in the way of tax loss and credit carryovers. After elimination of these minor amounts, the issue is whether the taxpayer must reduce the basis of his personal residence by the remaining COD amount. As I understand it the taxpayer's residence was treated as exempt property in the bankruptcy. You have suggested that because this property was exempt, attribute reduction is not required. That is exactly correct. Internal Revenue Code Section 1017(c)(1) provides as follows.

In the case of an amount excluded from gross income under section 108(a)(1)(A), no reduction in basis shall be made under this section in the basis of property which the debtor treats as exempt property under section 522 of title 11 of the United States Code.

As a practical matter, I suggest attaching a white-paper schedule to Form 982 reciting that the basis of the taxpayer's residence was not reduced by reason of Section 1017(c)(1) and there are no other assets or attributes.