Real estate is an integral part of many savers’ retirement portfolios, even when not part of a qualified plan (IRA, 401(k), etc.). With the recent downturn in the real estate market (I am referring primarily to residential real estate), foreclosures have become a fact of life.
The bad news is that on top of a foreclosure (or a deed-in-lieu of foreclosure, or a “short sale”), the IRS can dip their hand into your transaction to make a bad situation worse.
The key under current law is generally whether your debt is “recourse” or “nonrecourse”…states like California, for example, are nonrecourse states whiles others, like Florida, are recourse states. If you are unsure about your debt, ask an attorney.
Bottom line is that with a nonrecourse loan, a lender can only satisfy the loan from that loan’s collateral (hence the term “nonrecourse”). Conversely, a lender can pursue the debtor’s other assets with a recourse loan.
Here’s the difference in how they are taxed:
Mortgage balance: $500,000
Fair market value of the collateral property: $450,000
Basis in the property: $300,000
If the lender forecloses, or accepts a deed-in-lieu of foreclosure (a “walk-away” scenario), or accepts a short-sale arrangement (debtor sells property to third party and lender accepts sale price in full satisfaction of the debt), the IRS considers all these as “sales” by the debtor. Question is: how much is the “sale price?”
With a nonrecourse loan, the mortgage can only be satisfied by the collateral property. So, the IRS would consider the sale price to be $500,000 (the mortgage balance satisfied). With a tax basis of $300,000, the gain on the sale would be $200,000. In the case of retirement assets outside a qualified plan (i.e., not held in an IRA or 401(k), etc.), this gain is taxable, generally at 15% long term capital gains tax rates. If the property were a rental, there could be “depreciation recapture” at a 25% tax rate.
The tax picture is different, however, with recourse debt. Remember, in each scenario (foreclosure, deed-in-lieu, or short sale), the lender is agreeing to forgive a portion of the debt (i.e., the fair value of the property is less than the debt balance). Since the lender has the RIGHT to pursue the debtor personally in a recourse loan – whether or not they exercise that right – the forgiveness of debt now takes on a nasty character…
[same facts as above]
Recourse Loan Balance: $500,000
Property Fair Market Value: $450,000
= “Cancellation of Indebtedness Income”: $50,000 —-> Taxed as “ordinary income” at your highest marginal tax rate.
This is on top of the ordinary capital gains treatment you would receive if the property were simply sold at an outright sale:
[same facts as above]
Property Fair Market Value: $450,000
Tax Basis: $300,000
= Capital Gain: $150,000
You can see that whether the loan is recourse or nonrecourse, total additional taxable income is $200,000, but with the recourse loan, $50,000 of that (the forgiveness of debt) is taxed as ordinary income, rather than more preferential long term capital gain…
NOTE: If the “retirement” asset is a primary residence, the capital gain would not be taxable under Section 121 of the Internal Revenue Code ($500,000 of gain on sale of principal residence excluded for married filing jointly and was primary residence 2 of the past 5 years). However, this $50,000 of forgiveness of debt income would STILL be taxed – it does not qualify for the normal exclusion of gain rules.
What if the property had decreased in value (e.g., a recent real estate purchase)?
[new facts]
Mortgage balance: $500,000
Fair market value of the collateral property: $450,000
Basis in the property: $700,000
In this case, there is a tax loss on the property (the property has declined in value since purchase), and, as in the prior example, the tax results are different if the loan is recourse vs. nonrecourse:
Nonrecourse –
Mortgage balance: $500,000
Tax Basis: $700,000
Capital Loss: $200,000 (nondeductible, personal loss if it’s a primary residence or second/vacation home)
Recourse –
a) Recourse Loan Balance: $500,000
Property Fair Market Value: $450,000
“Cancellation of Indebtedness Income”: $50,000 —-> Taxed as “ordinary income” at your highest marginal tax rate.
b) Property Fair Market Value: $450,000
Tax Basis: $700,000
Capital Loss: $250,000 (nondeductible, personal loss if it’s a primary residence or second/vacation home)
So, as you can see, the already frightening results can be even worse if you have a recourse loan.
Congress is wrestling with this to provide relief, but until they do, those who are considering a foreclosure, deed-in-lieu of foreclosure, or a short sale should consult with a knowledgeable attorney and accountant before they do.
For professional investment advice on this topic contact:
Allgen Financial Services, Inc.
888.6ALLGEN (888) 625-5436
advisors@allgenfinancial.com
www.allgenfinancial.com
