Taxing Lessons From Court Decisions

Decisions — The keys to success

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Image source: Evan-Amos (Own work) [Public domain], via Wikimedia Commons
Image source: Evan-Amos (Own work) [Public domain], via Wikimedia Commons

Sometimes you no sooner find the keys to success than the locks get changed. In “cash for keys” programs, mortgage lenders pay borrowers to voluntarily return the keys and leave a home that would otherwise go through foreclosure. But is the amount received ordinary income, or reported as part of the overall foreclosure capital loss?

That was the question in T.C. Summary Opinion 2016-74 (Bobo). The taxpayer entered into a deed in lieu of foreclosure agreement with their home mortgage lender that would cancel an outstanding mortgage of $716,426.

The taxpayer also entered into a keys for cash payment agreement with the lender. Under the keys for cash terms, the taxpayer agreed to move out within a specified time period, and leave the home in good condition. The lender would inspect the home to confirm that it was vacant and in good shape, and then pay the taxpayer $20,500.

The taxpayer moved out of the home in May 2012 per the agreement terms, and the lender forgave the debt and paid the $20,500. The lender issued two Forms 1099. One, the Form 1099-A, reported the cancellation of debt income. The other, Form 1099-MISC, reported the cash for keys $20,500 payment as nonemployee compensation (Note: the taxpayer did not work for the lender).

The taxpayer filed an individual income tax return for 2012, and reported a capital loss of $113,074 from the cancellation of debt. The taxpayer included the $20,500 payment as part of the debt forgiveness transaction.

The IRS says the cash for keys payment was an incentive that the taxpayer would only receive for fulfilling the conditions the lender established. Instead of including the $20,500 as part of the amount received, the transaction is separate from the deed in lieu of foreclosure agreement, and the cash should be treated as ordinary income.

The taxpayer says the cash for keys payment is merely a part of the entire deed in lieu of foreclosure process, and the payment was treated correctly on the tax return.

 

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

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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Right answer!
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For the taxpayer.

It is “well settled” that the transfer of property by deed in lieu of foreclosure constitutes a “sale or exchange” for federal income tax purposes. The gain or loss recognized on this “sale or exchange” is the difference between the amount realized from the disposition and the property owner’s adjusted basis.

The amount realized from the disposition is the sum of any money received in the transfer plus the fair market value of property (other than money) received. When a taxpayer’s obligation to repay a nonrecourse mortgage is extinguished, the amount of the extinguished debt is included in the amount realized. The taxpayer’s adjusted basis is generally a cost basis.

The court looks to the substance of the transaction when determining how a deed in lieu of foreclosure or a similar exchange is taxed. On the basis of this record we are satisfied that the deed in lieu of foreclosure and the cash for keys incentive are the results of a single transaction.

The taxpayer had two agreements with the lender stemming from the exchange of property: the deed in lieu of foreclosure agreement and the cash for keys agreement. Looking at the substance of the transaction the two agreements are inseparable; the lender would not have issued the cash for keys payment but for the taxpayer agreeing to sign over the deed to the property. Thus, the cash for keys payment should be treated as part of the deed in lieu of foreclosure transaction and included in the amount realized on the house.

It is clear from the record that the lender did not hire the taxpayer for services or have another reason to issue the cash for keys payment. Rather, the cash for keys payment was part of a single transaction, the property sale or exchange; the lender paid the taxpayer $20,500 to avoid the lengthy and expensive legal process of foreclosure as part of the deed in lieu of foreclosure process.

The two agreements are inextricably linked, and there is no basis for treating them separately.

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