Case — Loss on Foreclosure

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TL Case Summ

THE QUESTION

Does a mortgage foreclosure lead to an ordinary loss attributable to abandonment or a capital gain attributable to a sale or exchange?

THE DISPUTE

Taxpayer Says: She had an ordinary loss from abandonment of her home because she lost the value of the residence at a time when the debt obligation exceeded that value.

Internal Revenue Service Says: The taxpayer had a long-term capital gain resulting from the foreclosure of a mortgage loan securing the residence because the foreclosure resulted in a sale or exchange where the taxpayer’s indebtedness exceeded her adjusted basis in the residence.

THE LAW

From Federal Tax Regulation 1.1001-2(a)(1): In general. Except as provided in paragraph (a) (2) and (3) of this section, the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition.

From Crane v. Commissioner, 331 U.S. 1 (1947): In Crane, the taxpayer inherited real property that was encumbered by a mortgage that had not been assumed by the taxpayer. For tax purposes the taxpayer claimed depreciation using the value of the property. When the taxpayer subsequently sold the property, the value of the property and the mortgage balance were approximately equal and she received a net amount of $2,500 which she treated as the gain from the sale. The Commissioner, on the other hand, treated the value of the property less depreciation as the taxpayer’s basis and the outstanding balance of the mortgage plus the $2,500 as the sale price, thereby resulting in a larger gain and an increased tax burden. The Supreme Court, holding for the Commissioner, decided that the amount of the unassumed mortgage is to be considered part of the proceeds of sale.

From Commissioner v. Tufts, 461 U.S. 300 (1983): Where the unpaid amount of a nonrecourse mortgage exceeded the fair market value of the property sold, it was held that the taxpayer, although required to include the outstanding mortgage obligation as proceeds of sale, was not entitled to a loss to the extent that the mortgage exceeded the fair market value of the property.

From Yarbro v. Commissioner, 737 F.2d 479 (5th Cir. 1984), aff’g T.C. Memo. 1982-675: An abandonment of real property subject to a nonrecourse debt is a “sale or exchange” for purposes of determining whether a loss is a capital loss. The case involved the question of whether an individual taxpayer’s loss resulting from the abandonment of unimproved real estate subject to a nonrecourse mortgage exceeding the fair market value is an ordinary loss or a capital loss.

THE CAUSE OF THE DISPUTE

When you abandon property, you may be able to claim an ordinary loss even if the property is a capital asset. To do so, the loss must have been from your business or a transaction you entered into for profit, or the result of a casualty or theft, and you have to abandon the property instead of selling or exchanging it. Generally that means you have to provide written notice to creditors that you intend to abandon the property, and stop making mortgage or real estate tax payments. The loss is equal to your adjusted basis in the property.

In this case, the taxpayer purchased a home in 2005 for $333,239. She lived there until 2006. During 2007 she rented out the home, reported the income from the rental, and claimed $12,118 of depreciation. Later in 2007, when the fair market value of the home was less than the outstanding mortgage, she was unable to find a renter.

She stopped making mortgage payments and in effect abandoned the residence. She took no formal steps to transfer title or to provide her lender with notice of her intention to abandon the residence.

In 2008, the lender foreclosed and sold the home for $278,315. The lender sent a 2008 Form 1099-A, Acquisition or Abandonment of Secured Property, showing the outstanding balance of the mortgage as $325,855. The Form 1099-A also showed the fair market value of the home to be the sale price.

The taxpayer says she has an abandonment loss of $313,737 because she lost the value of the home at a time when the debt exceeded that value.

The IRS says the taxpayer has a capital gain of $4,734 (the amount of the sale less her adjusted basis) resulting from the foreclosure because the foreclosure was a sale or exchange.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 40KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

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!
For the IRS. The taxpayer purchased the property, depreciated it, and, after her inability to rent it, walked away when her mortgage obligation was in excess of the value of the property and also in excess of her adjusted basis in the property. Even though she walked away from the property with the intention of no longer making payments on the mortgage, the subsequent foreclosure of the mortgage loan securing the property constituted a sale or exchange. She is not entitled to an ordinary loss due to abandonment equal to the value of the property because that would ignore the fact that she held a capital asset subject to a mortgage.
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