Debits & credits

By Douglas Schultz and Craig Schmitt

While there has been a great deal written about the soundness of the nation’s mortgage portfolios and the impact defaults could ultimately have on the economy, the other, more individual side of the problem from the property owner’s perspective has received little attention. If a property owner finds herself (or himself) looking at the prospect of defaulting on a mortgage, the options one can take to deal with the default can result in the recognition of income, either as Cancellation of Debt Income (CODI) or gain from the sale of property.

The tax issues accompanying the available options are very complex and very fact driven. The situations discussed below deal with general issues related to a specific set of facts. Any questions you have should be discussed with your tax advisor before taking any steps involving distressed properties.

Q. I have a four-unit building with an adjustable rate mortgage. The rate has gone up substantially and the rental income no longer covers the payments. I may not be able to continue making the payments. What are my options?

A. Most lenders will not deal with a hypothetical situation, so they may not be willing to discuss options or negotiate until the borrower actually misses a payment. Once a payment has been missed, however, and a loan is in default there are generally four possible options: foreclosure, short sale, sale or workout with the lender. There are different tax consequences for each of these options.

A foreclosure, deed in lieu of foreclosure and a short sale are all transfers of properties that are sales for tax purposes that will result in gain or loss on the sale. The nature of the property may have a significant impact on how much taxable income will be realized. A short sale can result in both gain and CODI. A workout with the lender that reduces the loan principal may result in the recognition of CODI.

Q. Does it make a difference if one of the units is my residence?

A. If the property secured by the loan is a residence, California law presumes that the loan to acquire the property was nonrecourse. The computation of gain on a foreclosure of a property subject to a nonrecourse loan is different from the computation of the gain on a foreclosure of a property subject to a recourse loan. Whether a loan is nonrecourse or recourse will have an impact on whether a reduction in principal associated with a sale will result in CODI. Further, if the property is the owner’s principal residence, there may be additional consequences related to the sale.

A loan is nonrecourse if the lender’s rights to collection extend only to the property securing the loan and not to any other assets of the mortgagee. A foreclosure involving a nonrecourse loan is a sale for the amount of the loan still outstanding with no other proceeds. The value of the property has no bearing on the gain or loss or the recognition of any other income.

As an example, say the four-unit building was originally purchased for $1,000,000, subject to a first mortgage of $800,000 and a second mortgage of $100,000. All four units are equal and the owner computed depreciation on the three units that were rented. If the property were foreclosed upon two-and a-half years later, the principal balance of $900,000 (interest only) would be the proceeds realized from the transaction. The gain or loss is computed separately for the rental portion and the residence portion. In this example, there is a loss on the rental portion of $5,000 (proceeds of $675,000 less the original basis of $750,000 reduced by depreciation of $70,000). There is also a loss on the residence portion of $25,000 (proceeds of $225,000 less the original cost of $250,000). Since the rental of property is a trade or business, the $5,000 loss on the sale is deductible. The loss on the residence, however, is nondeductible since it is a loss related to the sale of a personal asset. If the sale of the residence had resulted in a gain, the owner could utilize the homeowner exclusion (up to $250,000, or $500,000 on a joint return).

Q. What if I refinanced my original loan and used some of the refinance proceeds for something other than refinancing my original loan?

A. Refinancing the original purchase money mortgage can make a significant difference in the tax consequences. California Civil Code of Procedure §580b generally confers nonrecourse status to mortgage loans on residences (not necessarily a principal residence). It does not permit any deficiency judgment in excess of the amount of the balance of the loan contract where the property is under a deed of trust or mortgage for a dwelling of not more than four families that is “occupied entirely or in part, by the purchaser.” This section, however, does not apply to a new loan that refinances a purchase money mortgage. A new loan that refinances the original converts the home mortgage to a recourse loan: a loan where the lender’s rights to collect extend beyond the property secured by the loan to other assets of the mortgagee for satisfaction of the obligation.

A recourse loan changes the rules for computing income recognized on the transfer of a property. If property subject to a recourse loan is transferred to the lender to satisfy the remaining balance on the obligation, the amount of the debt and the fair value of the property both figure in the computation of the income recognized. First, income from CODI is recognized to the extent the amount of the obligation exceeds the fair market value of the property and then gain is recognized on the transfer of the property equal to the fair value of the property minus the adjusted basis.

In our previous example, the debt was nonrecourse and so the entire transaction resulted in a loss on the sale of the property. If the loan was refinanced for $950,000 and the property owner took cash out, the loan is now considered a recourse loan. Fair market value now becomes part of the computation. Let’s say that, as a result of market conditions, the value of the property declined to $800,000. The fair market value is now treated as the proceeds of the sale. The difference between the amount of the outstanding loan of $950,000 and the fair market value is CODI. The loss on the rental portion of the property is now $80,000 (proceeds of $600,000 less basis of $680,000) and the loss on the residence is $50,000 (proceeds of $200,000 less the original cost of $250,000). Since the rental loss is deductible, it can offset $80,000 of the $150,000 of CODI. The economic gain is $20,000 (debt relief of $950,000 less basis of $930,000), but the owner ends up with a net taxable income of $70,000 as a result of the nondeductible loss on the residence.

However, if the lender does not accept the property in full settlement, the borrower recognizes CODI only to the amount forgiven by the lender. Another negative consequence of the sale of a principal residence is that the homeowner exclusion can only exclude gain on the sale; it cannot be used to exclude CODI.

Q. My broker recommends a short sale to protect my credit. Are the tax consequences the same as a foreclosure?

A. The benefit of the short sale over foreclosure is that the borrower’s credit is protected since the credit report includes a statement “paid as agreed” with the lender. The consequences, however, are very similar to the example above where the debt is recourse. On the surface, a short sale looks very much like a foreclosure involving nonrecourse debt since the bank accepts a reduced purchase price as satisfaction of the entire obligation. However, while the obligation is satisfied from the lender’s perspective, it does not matter if the obligation is nonrecourse since the reduction of the obligation is treated as a separate transaction from the sale. (The sale takes place with a third party.) The lender accepts a voluntary reduction of the obligation that results in CODI. The second part of the transaction is the sale.

Q. If I can get the lender to modify the terms of my loan, without requiring a sale of the property, can I avoid recognizing CODI?

A. Possibly. The first thing to remember is that any reduction of principal with no property transfer will create CODI regardless of whether the debt is recourse or nonrecourse. However, if you can convert an adjustable rate mortgage to a fixed mortgage with a lower payment, you may solve the cash crunch and avoid income recognition. A word of caution goes with this option. Changes in terms that greatly change the rights of the lender may still result in an exchange of one debt obligation for another and result in gain on the exchange.

Q. If I end up with CODI on a Form 1099-C from exercising one of my options, how can I avoid recognizing taxable income, especially since I have no funds from the sale to pay the tax?

A. The Internal Revenue Code provides exceptions for bankruptcy, insolvency, qualified farm indebtedness and qualified real property business indebtedness. Taxpayers who meet these exceptions can exclude part or all of the CODI they realize. Unfortunately, these exceptions are too complex to cover in the context of this article. CODI may be unavoidable, so it should always be part of the discussion of your options with your tax advisor.

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The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. Douglas Schultz is a CPA and partner in the tax practice in the San Francisco office of Burr, Pilger & Mayer, LLP. Craig Schmitt is a CPA and senior tax manager in the San Francisco office of Burr, Pilger & Mayer, LLP. Both can be contacted at 415-421-5757. Copyright © 2008 by SF Apartment Magazine. All rights reserved.