This article sets forth the income and profit tax aspects the seller-in-foreclosure faces when the value of his residence falls below the unpaid balance on a recourse or nonrecourse loan, and an EP investor purchases the property through a short sale.

Nonrecourse paper

An owner purchased his residence for $250,000. The purchase price was funded by a $225,000 purchase-assist loan. Due to a decline in local real estate values, the residence is currently worth $200,000. Worse, the owner can no longer continue to make loan payments.

The owner lists the real estate with a broker in an attempt to sell it and get out from under the loan.

The broker and the owner realize the fair market value of the real estate is below the outstanding debt encumbering the property. Thus, as part of his sales effort, the broker must negotiate with the lender for a discount on a loan payoff demand, commonly called a short payoff.

If the lender agrees, the property can be sold, called a short sale. Thus, the lender avoids the need to foreclose and acquire the property at a trustee’s sale.

The discount in a short sale

A short sale is a sale of real estate at a price less than the amounts due on the loan of record. From the net proceeds of the owner’s short sale, the lender accepts as the final payoff an amount less than the principal and interest remaining due on the note, sometimes referred to as a type of pre-foreclosure workout.

The difference between the principal balance on the loan and the lesser amount of the net proceeds from the short sale is a discount.

Taxwise, a discount on a loan payoff is characterized by the Internal Revenue Service (IRS) as either:

• income to the owner of the property, called discharge of indebtedness income; or

• part of the price realized on the sale of the property, (which price is the actual loan amount).

Whether the discount is treated as part of the price realized by the owner (purchase price plus the discount) or as income for the discharge of indebtedness turns on the classification of the loan as either:

• nonrecourse paper; or

• recourse paper.

Lender cooperation

Further, the broker’s ability to negotiate a short payoff with the lender depends on the type of loan which encumbers the seller’s property.

If the loan is a loan insured by the Federal Housing Administration (FHA) on an owner-occupied single family residence, the lender may only accept a short payoff if the owner qualifies for FHA pre-foreclosure sale treatment. To qualify, the owner must be in default on at least three months’ payments, in addition to other requirements. [HUD Mortgagee Letter 94-45]

Further, if the loan is a conventional loan covered by private mortgage insurance (PMI), the lender’s willingness to negotiate a short payoff is subject to its ability to negotiate a settlement of its claim against the private mortgage insurer for its loss without first completing a foreclosure sale.

As observed by all involved in the thousands of short sales statewide in the years 1992 through 1996, lenders and mortgage insurers all finally figured out the financial advantages of reducing their losses by negotiating a short payoff of loans in foreclosure.

Nonrecourse paper

A nonrecourse note is a debt which, at the time of origination, limits a lender’s or carryback seller’s source of recovery to the security.

Thus, notes secured by real estate are nonrecourse notes when the note is:

• secured by an owner-occupied, one-to-four unit residential property purchased with the loan proceeds;

• a seller carryback note secured only by the real estate sold; or

• a note containing an exculpatory clause.

For real estate encumbered by a nonrecourse note with a balance which exceeds the property’s fair market value, completion of the short sale requires the owner to report the discounted and discharged balance of the note as part of the price realized on the sale.

Taxwise, the owner’s profit or loss from the sale of his residence is calculated by subtracting the cost basis from the price realized on the sale, even though the actual price paid by the buyer is a lesser amount.

Thus, with a nonrecourse note, the fair market value (actual price) paid by a buyer on the short sale does not alone establish the price realized by the owner. Since the entire nonrecourse note is satisfied at the time of the sale, the discount on the note is considered part of the price realized on the short sale. Thus, on a nonrecourse loan, the discount is not reported as discharge-of-indebtedness income. The entire balance remaining unpaid on the note becomes the price realized on the sale for tax reporting. [Revenue Regulations §1.1001-2(a)]

Also, an owner of real estate encumbered with a nonrecourse note, typically a homeowner or carryback installment buyer, will incur no profit on the short sale when his cost basis for the cost of acquiring and improving the property exceeds the principal balance on the note. The remaining loan amount is the price reported on the sale. [Commissioner v. Tufts (1983) 461 US 300]

Recourse paper

On a short sale of real estate subject to a lien securing recourse paper, the amount of the payoff discount is reported as discharge-of-indebtedness income.

Recourse paper is not given the preferential tax treatment allowed on nonrecourse paper.

 With recourse paper, when the amount of the debt exceeds the price of the real estate and a discount is given by the lender in a short sale, the owner incurs a federal tax liability from 10% to 39.6% (35% by 2006) on income generated by the discharge of indebtedness incurred due to the discount.

Thus, the owner’s tax liability on the short sale of real estate encumbered by a recourse note includes:

• profit/loss calculated based on the actual price received for the real estate minus the owner’s remaining cost basis in the property, called capital gain or loss; and

• income for the difference between the price received at the sale and the balance owed on the note – being the discount which is reported as part of the owner’s investment or business income.

For example, an owner’s property is encumbered by a $200,000 trust deed. The trust deed note is a recourse obligation with deficiency judgment exposure for the owner. The real estate is only worth $160,000. The owner’s cost basis in the real estate is $250,000.

The owner sells the real estate through a short sale. The net amount paid by the buyer for the real estate is $160,000. The lender accepts the net proceeds from the sale as a short payoff of the recourse note and cancels the remaining unpaid balance of $40,000.

The owner’s tax liability is calculated by including the following:

• the owner incurs a capital loss in the amount of $90,000 on the sale of the real estate – the price received at the sale, $160,000, minus the owner’s basis, $250,000; and

• the owner also incurs discharge-of-indebtedness income of $40,000.

Thus, the owner incurs both:

• a capital loss on the sale; and

• ordinary income on the discounted payoff of the recourse loan encumbering the property sold.

The capital loss is from the disposition of real estate; the ordinary income is from the discharge of indebtedness. Thus, the capital loss spills over to offset the ordinary income, unless the short sale involved the owner’s personal residence.

Homeowner’s recourse loans

Frequently, a homeowner obtains an equity loan or refinances the existing loans encumbering his residence. Equity loans and refinancing are recourse loans since their net proceeds do not themselves finance the purchase or improvement of the residence.

Again, on the sale of the owner’s personal residence, the loss resulting when the basis exceeds the sales price cannot be written off or used to offset other income, including any income from discharge-of-indebtedness generated by discounts on recourse loans in the same transaction. [IRC §165(c); Vukasovich v. Commissioner (9th Cir. 1986) 790 F2d 1409]

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