Cited: ABA Journal
Every day, debt saps the strength of millions of families and businesses around the country even with rumors that the recession may be easing its grip on the country. The worst symptom of this is home foreclosures. According to RealityTrac, foreclosure filings were reported in over 358,000 properties in August alone. That is one in every 358 homes in the country. Even though filings were down 1% in July there were 18% more in August 2008, which is not much good news.
Meanwhile, August consumer bankruptcy filings totaled 119,874, an increase of 24% over the number of filings in August 2008, according to the American Bankruptcy Institute, a nonpartisan organization that analyzes issues relating to insolvency. Here, too, there was a little bit of good news: The number of bankruptcy filings in August 2009 fell by 5% from July.
In the face of these numbers—and the very real personal turmoil they represent—more attention is being given to how lenders can cooperate with borrowers to reduce their debt, modify their mortgages and other obligations, and, in some cases, even cancel their indebtedness. For borrowers, such loan workouts represent another chance, while lenders improve their odds of receiving at least some repayment on loans.
A reduction, modification or cancellation of indebtedness can have significant consequences under federal tax law. Too often, however, debtors fail to take tax considerations into account when they restructure debt, especially as many of them try to navigate their way through the process without legal counsel.
This article gives an overview of the federal tax rules that apply to debt workouts, with a primary focus on how individual debtors are affected. (In many cases, additional rules apply to debt workouts for business entities.)
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Restructuring Debt
The essential tax rule that applies to cancellation of debt is fairly straightforward. Under section 61(a)(12) of the Internal Revenue Code of 1986, as amended, a taxpayer generally must recognize canceled debt as gross income. In most cases, income from cancellation of debt—called COD in tax shorthand—is taxed as ordinary income. (The creditor, meanwhile, is generally permitted to claim a corresponding bad-debt deduction under IRC section 166.)
There are a number of statutory exclusions for COD income set forth in IRC section 108 (discussed below). But the debtor pays a price for those exclusions in the form of reductions in debtor “tax attributes” (such as basis of assets and specified tax credits). These reductions can offset some benefits of excluding COD income from gross income.
Foreclosures and Repossessions
Most debt workouts, however, don’t involve simple cancellation of debt. A creditor may agree to accept a voluntary conveyance of the loan collateral in complete satisfaction of the debt—say, a house in the case of a mortgage—or the creditor can foreclose on or repossess the collateral.
Either of these actions, in effect, amounts to a sale of the property, so the debtor will have some mix of cancellation of debt income and capital gain under IRC section 1001. The mix of COD income and sale or exchange gain depends on whether the debt is recourse or nonrecourse.
In the case of a recourse debt—which allows the creditor to recover other debtor assets in addition to the original collateral—the conveyance of or foreclosure on the collateral is split between COD income and capital gain.
First, the transaction results in a capital gain or loss, which depends on the difference between the fair market value of the property and the debtor’s adjusted basis (original cost of the property reduced by depreciation and increased by capital improvements). Generally, the tax rate on capital gain is 15 percent.
If the fair market value of the property exceeds the amount of the debt, there is no COD income. If, however, the fair market value is less than the debt, then the debtor may realize COD income in the amount that the canceled debt exceeds the fair market value—in addition to any capital gain or loss. The debtor can avoid COD income if the creditor accepts a deficiency note to cover any shortfall between the value of the property conveyed and the amount of the debt.
If there is an auction or foreclosure proceeding, the bid price is presumed to equal the fair market value of the property in the absence of clear and convincing proof to the contrary. But a debtor should be wary of this presumption if a distressed sale yields very little, and should be prepared to rebut the presumption with an appraisal.
Example: A debtor’s house is subject to a $200,000 recourse mortgage, but the distressed sale yields only $25,000. If the debtor’s basis in the house exceeds $25,000, then the debtor realizes a nondeductible capital loss on the foreclosure, but has $175,000 of ordinary COD income. Any appraisal over $25,000 would reduce the amount of COD income. (Note, however, that the debtor may prefer COD income to sale or exchange gain if the debtor qualifies for one of the COD exclusions, discussed in more detail below.)
In the case of a nonrecourse debt—which bars a creditor from attaching assets of a debtor beyond the original collateral—cancellation of debt income is removed from the tax equation.
A voluntary conveyance or foreclosure of property in satisfaction of a nonrecourse debt is treated as a sale or exchange of the transferred property. The debtor simply realizes a capital gain or loss equal to the difference between the principal amount of the debt and the adjusted basis of the property.
Example: Let’s say a debtor has debt of $1 million secured by a house—a capital asset—with a fair market value of $800,000, and that the debtor’s adjusted basis in the property is $700,000. If the debt is nonrecourse, the foreclosure or voluntary conveyance is treated this way for debtor’s taxes:
- Amount realized – $1,000,000
- Taxpayer’s basis – 700,000
- Capital gain – 300,000
If the debt is recourse, the foreclosure or voluntary conveyance is treated this way for debtor’s taxes:
- Amount realized – $800,000
- Taxpayer’s basis – 700,000
- Capital gain – 100,000
- COD income – $200,000 (remainder of debt)
Recourse debt might actually be preferable if a debtor can exclude the COD income through a bankruptcy or insolvency exclusions under the IRC section 108 rule.
Continued in “The Frustration of Bad Debt Part 2”
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My Take: You need to be an accountant to understand this! However, I did work as a payroll accounting clerk so I can get an idea of what is meant. I just hope I’m able to understand the rest of the parts as I post them. I do understand that if you have Grandview NY properties, there are certain things you need to do to avoid foreclosure. The same thing goes for property management companies if they own property; they need to help finance avoid foreclosure.
The process of purchasing Piermont real estate and selling it are two different things when foreclosure is involved. The seller usually loses money and the buyer gets a good deal. However, if the seller is economical and makes improvements to the property they could still make a little extra money. They could easily put bifold interior doors in the home, which would raise the price. But the one that really brings the price up in a home are the beautiful exterior wood doors that make it look beautiful.
I do know that a property management company Louisville MN with homes for rent Maple Grove MN would be able to help a client if they were having problems with a mortgage. It is their job to know those kinds of things. Other kinds of debts can easily be avoided by getting rid of all of your credit cards. Pay cash for everything!
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