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Tax Implications for Lenders of Foreclosures, Repossessions & Bad Debts

Tax Implications for Lenders of Foreclosures, Repossessions & Bad Debts

Foreclosures, repossessions, voluntary conveyance, and bad debts have tax consequences for both the creditor and the debtor. In the event of default, the lender may seize or restructure the loan, treat the default as a bad debt, or repossess the property, resulting in a realized gain or loss. In general, restructuring a loan means changing its terms to reduce the financial stress of the loan for the borrower. This often results in part of the debt being written off or the property being disposed of, which can have tax consequences. Any debt relief may result in taxable income for the borrower but will be reduced by the debtor's insolvency.

How to calculate the profit or loss on repossession of personal property sold as installments

If you have repossessed personal property, you may have a profit, loss, or bad debt. The calculation of the profit or loss and the basis for the repossession will depend on whether the original sale was recorded as a forward sale or the full gain was recorded in the year of the sale, even if the buyer paid in installments. Payments include actual payments and also payments considered received. Payments are considered received if the buyer assumes or pays the seller's debts or expenses.

To better understand how the capital gain or loss on the repossession of personal property is calculated, it is worth remembering how the capital gain or loss on the sale of a property is calculated, which is equal to the sale price minus the taxable income of the property. On a repossession, the sale price is the asset repossessed of the fair market value (FVM). Its basis in the asset is equal to a portion of its original basis, which is calculated depending on whether the entire gain is reported in the year of the sale or the profit was reported over several years under the installment method.

If you are reporting the total income of the sale instead of using the installment method, then:

  • Installment obligation basis = sale price - all principal payments

  • Profit or loss = Property FMV − Cost of Repossession− Installment Obligation Basis

Repossession of personal assets declared using the installment method

Suppose the sale of the property was reported using the installment method. In that case, the calculation of profit or loss is more complex but follows the above method, except that the basis for the installment obligation is calculated differently.

Seller's repossession after buyer's default

If a buyer defaults on the seller's loan, the seller may get a capital gain or loss by repossessing the defaulting buyer's property:

Taxable income = Payments received on the initial sales contract until collection + payments made to third parties for the benefit of the seller - taxable income previously declared before collection – repossession costs.

To determine the taxable capital gain on the subsequent resale of the property, the seller must calculate the new tax base of the repossessed property:

Basis of repossessed property = adjusted debt base secured by property + taxable gain on recovery + repossession costs.

Foreclosure on a non purchase money mortgage

A cash purchase mortgage is a mortgage used to purchase the underlying property. A nonpurchase mortgage is a mortgage secured by property but not used to purchase it.

Suppose the non purchase mortgage lender makes an offer on the foreclosed assets, and the property is sold to the secured creditor or a third party. In that case, the foreclosure sale can have two tax consequences:

  1. Bad Debt Deduction: If the net offer price, equal to the offer price, less selling costs, is less than the mortgage, the lender will take a bad debt deduction equal to the difference if the creditor can prove that the outstanding debt is irrecoverable.

  2. A capital gain or loss: A foreclosure is treated as an exchange of the mortgage on the foreclosed property, so a gain or loss will be equal to the difference between the FMV (fair market value) value of the property and the value of the mortgage.

Whether the lender has a capital gain or loss is determined by comparing the equivalent offering price to the property's fair market value.

If the bid price exceeds FMV, the lender will incur a loss of principal; if the offer price is lower than the property's fair market value, the lender will realize a capital gain.

Reporting Foreclosures and Repossessions 

When the property is acquired by repossession or foreclosure or if it is abandoned and the lender acquires legal title to the property, the lender uses Form 1099-A to notify the IRS of the sale price of the foreclosure, the amount, and whether the loan was a recourse or nonrecourse. A Form 1099-A is filed with the IRS and the borrower when the mortgaged property is seized or repossessed, and the title passes to the lender. If the canceled debt exceeds $600, it can be reported on Form 1099-C. Real estate held for personal or business purposes is disclosed on Form 8949, Sales and Other Dispositions of Capital Assets, and on Schedule D.

If the property is a principal residence and is eligible for foreclosure under the home sales foreclosure rules, you do not need to report foreclosure. Foreclosure of business property is reported on Form 4797, Sales of Business Property. If commercial real estate debt is restructured, a creditworthy taxpayer may defer taxes on the restructuring by electing to reduce the depreciable base of the real estate by the amount of the debt reduction. This election is made on Form 982.



Dennis Jao
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