Taxing Lessons From Court Decisions

Decisions – An island of debt

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When you borrow money to buy property and then fail to repay the loan, the lender can foreclose, or take back, the property. Under current tax law, you figure and report gain or loss from the foreclosure as if it was a sale. As a general rule, that means you have a gain if the amount you realize is greater than your adjusted basis in the property, and a loss if the amount you realize is less than your adjusted basis.

In T.C. Memo. 2019-59, (Breland), the question was how much long-term capital loss the taxpayers could claim due to the foreclosure of a mortgage.

The taxpayer, a real estate developer, purchased two lots on a barrier island. He paid $322,720 in cash, took out a mortgage of $6,720,000 and satisfied liabilities of $1,105,200 on the purchase of Lot 1.

He paid $5,613,287 for Lot 2, and took out a recourse mortgage of $11,200,000 (the proceeds included the refinancing of Lot 1 so that the loan was secured by both lots).

The taxpayer failed to repay the mortgage. The balance on the date of default was $10,764,262. The tax court determined that the balance of the recourse loan survived the foreclosure sale (meaning the taxpayer had no immediate cancellation of debt income).

The bank foreclosed on the mortgage, held a foreclosure sale, was the highest bidder, and purchased the lots for $7,203,750. Neither the taxpayer nor the bank obtained an objective appraisal of the properties in connection with the foreclosure sale.

Two days later, the taxpayer filed for chapter 11 bankruptcy protection and the bank filed a proof of claim for $6,254,478.

Here’s the relevant tax law

From internal revenue code section 1001(b): The amount realized from the sale or disposition of property equals the amount of money plus the fair market value of property received.

From income tax regulation section 1.1001-2(a)(1): Ordinarily, the amount a taxpayer realizes from the sale or disposition of property includes the amount of any liabilities from which the taxpayer is relieved as a result of that transaction.

From income tax regulation section 1.1001-2(a)(2): “[t]he amount realized on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness under section 61(a)(12).” In addition, the amount realized from the transfer of the property in the case of recourse debt is the fair market value of the property.

From income tax regulation section 1.166-6(b)(2): In the case of mortgaged property sold at a foreclosure sale, we presume fair market value to be the bid price, absent clear and convincing evidence to the contrary.

1

Based on the above information, what is the sale price of the two lots for purposes of computing the realized gain or loss?

or

2

Based on the above information, for purposes of computing the realized gain or loss, does the taxpayer’s basis in Lot 1 include the satisfied liabilities of $1,105,200?

or

3

For extra credit (because you’ll need a calculator), what is the taxpayer’s total basis in the two lots?

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions and IRS documents. The full documentation may include facts and issues not presented here. Please use the link provided in the post to read the entire document.

This information should not be considered legal, investment, or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment, or tax advice. Always consult your legal, investment, and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
✓ Right answer!

The court said that in the absence of an appraisal or other reliable evidence of fair market value, no clear and convincing proof overrides the presumption that the bank's bid price was the fair market value. Therefore, the court concluded that the fair market value at the time of the foreclosure sale was the $7,203,750 bid price.
✓ Right answer!

The taxpayer's basis in Lot 1 is $5,937,520, consisting of the cash spent and the indebtedness incurred in purchasing the property, less the liabilities satisfied as part of the transaction.
Sorry, wrong answer :(


$4,347,057.

The taxpayer's basis in Lot 1 is $5,937,520, consisting of the cash spent and the indebtedness incurred in purchasing the property, less the liabilities satisfied as part of the transaction.

Along with the $5,613,287 basis in Lot 2, the aggregate basis in the Island properties at the time of the foreclosure sale was $11,550,807.

Because the taxpayer realized $7,203,750 from the sale of the properties at foreclosure and the basis in the properties was $11,550,807, the court concluded that the taxpayer's resulting long-term capital loss is $4,347,057.
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