Chapter 31
Tax Savings for Investors in Real Estate

Real estate investors may take advantage of the following tax benefits:

• Gains on the sale of investment property may be taxed at capital gain rates.
• Depreciation can provide a source of temporary tax-free income (31.1).
• Rental income can be used to offset passive losses Chapter 10.
• Tax-free exchanges make it possible to defer tax on exchanges of real estate held for investment (31.3).

However, real estate gains may be subject to the 3.8% net investment income tax (28.3).

Losses on real estate transactions may be subject to the following disadvantages:

• Rental losses may not be deductible from other income such as salary, interest, and dividends unless you qualify as a real estate professional or for the special $25,000 rental loss allowance under the passive loss rules Chapter 10.
• Compromises of mortgage liability may subject you to tax (31.10).

A foreclosure or repossession is treated as a sale on which you realize gain or loss. In addition, if you are personally liable on the loan and the amount of debt canceled in the foreclosure exceeds the fair market value of the transferred property, you will owe tax on cancellation of debt income unless an exception is available (31.9).

31.1 Real Estate Ventures

A real estate investment should provide a current income return and an appreciation in the value of the original investment. As an additional incentive, a real estate investment may in the early years of the investment return income subject to little or no tax. That may happen when depreciation and other expense deductions reduce taxable income without reducing the amount of cash available for distribution. This tax savings is temporary and limited by the terms and the amount of the mortgage debt on the property. Payments allocated to amortization of mortgage principal reduce the amount of cash available to investors without an offsetting tax deduction. Thus, the amount of tax-free return depends on the extent to which depreciation deductions exceed the amortization payments.

To provide a higher return of tax-free income, at least during the early years of its operations, a venture must obtain a constant payment mortgage that provides for the payment of fixed annual amounts that are allocated to continually decreasing amounts of interest and increasing amounts of amortization payments. Consequently, in the early years, a tax-free return of income is high while the amortization payments are low, but as the amortization payments increase, nontaxable income decreases. When this tax-free return has been substantially reduced, a partnership must refinance the mortgage to reduce the amortization payments and once again increase the tax-free return; see Examples 1 and 2 below.

In the case of a building, the tax-free return is based on the assumption that the building does not actually depreciate at as fast a rate as the tax depreciation rate being claimed by the investors. If the building is depreciating physically at a faster rate, the so-called tax-free return on investment is illusory. There is no tax-free return because the distributions to investors (over and above current income return) are, in fact, a return of the investor’s own capital.

Real estate investment trusts (REITs). The tax treatment of real estate investment trusts resembles that of open-end mutual funds. Distributions generally are reported to the investors on Form 1099-DIV as dividend income. However, distributions generally do not qualify for the reduced tax rate on qualified dividends (4.1). A distribution qualifies for the reduced rate only to the extent it represents previously taxed undistributed income or qualifying dividends received by the REIT (from stock investments) that are passed through to the investors. Capital gain distributions reported on Form 1099-DIV must be reported as long-term capital gains regardless of how long the REIT shares have been held (4.4). If the trust operates at a loss, the loss may not be passed on to the investors.

REMICs. A real estate mortgage investment company (REMIC) holds a fixed pool of mortgages. Investors are treated as holding a regular or residual interest. A REMIC is not a taxable entity for federal income tax purposes. It is generally treated as a partnership, with the residual interest holders as partners.

Investors with regular REMIC interests are treated as holding debt obligations. Interest income is reported to them by the REMIC on Form 1099-INT and original issue discount (OID) on Form 1099-OID.

The net income of the REMIC, after payments to regular interest holders, is passed through to the holders of residual interests. A residual interest holder’s share of the REMIC’s taxable income or loss is reported by the REMIC to the interest holder each quarter on Schedule Q of Form 1066, and the investor reports his or her total share of the year in Part IV of Schedule E.

31.2 Sales of Subdivided Land—Dealer or Investor?

An investor faces a degree of uncertainty in determining the tax treatment of sales of subdivided realty. In some situations, investor status may be preferred, and in others, dealer status.

Capital gain on sale. Investor status allows capital gain treatment. Capital losses may offset the gains. For capital gain, an investor generally has to show that his or her activities were not those of a dealer but were steps taken in a liquidation of the investment. To convince an IRS agent or a court of investment activity, this type of evidence may present a favorable argument for capital gain treatment:

• The property was bought as an investment, to build a residence, or received as a gift or inheritance.
• No substantial improvements were added to the tract.
• The property was subdivided to liquidate the investment.
• Sales came through unsolicited offers. There was no advertising or agents.
• Sales were infrequent.
• There were no previous activities as a real estate dealer.
• The seller was in a business unrelated to real estate.
• The property was held for a long period of time.
• Sales proceeds were invested in other investment property.

Section 1237 capital gain opportunity. Section 1237 is a limited tax provision that provides a capital gain opportunity for subdivided lots only if arbitrary holding period rules and restrictions on substantial improvements are complied with. For example, the lots must generally be held at least five years before sale unless they were inherited. If the lots were previously held for sale to customers, or if other lots are so held in the year of sale, Section 1237 does not apply. Furthermore, substantial improvements must not have been made to the lots. According to the IRS, a disqualifying substantial improvement is one that increases the value of the property by more than 10%. The IRS considers buildings, hard surface roads, or utilities, such as sewers, water, gas, or electric lines, as substantial improvements.

Interest expense deductions. The distinction between an investor in land and a dealer is also important in the case of interest expenses. Dealer status is preferable here. Interest expenses incurred by an investor are subject to investment interest deduction limitations; see Chapter 15. On the other hand, interest expenses of a dealer in the course of business activities are fully deductible; see the Morley Example below.

Passive activity. Income from sales of lots is not considered passive activity income. Thus, losses from sales of land may offset salary and other investment income. If you hold rental property and also sell land, make sure that your accounts distinguish between and separate each type of income. This way income and losses from land sales will not be commingled with rent income subject to the passive activity restrictions discussed in Chapter 10. Your activity in real property development counts towards qualifying you as a real estate professional who may deduct rental losses from nonpassive income if material participation tests are met (10.3).

31.3 Exchanging Real Estate Without Tax

You may exchange real estate held for investment for other investment real estate and incur no immediate tax consequences. On a fully tax-free exchange of “like-kind” property, you do not recognize any gain realized on the exchange and you cannot deduct any loss. If you had a gain, the potential tax on the gain is postponed until you sell the new property for more than your basis. A tax-free exchange may also defer a potential tax due on gain from depreciation recapture and might be considered where the depreciable basis of a building has been substantially written off. Here, the building may be exchanged for other property that will give larger tax deductions.

Fully tax-free exchanges. To transact a fully tax-free exchange, you must satisfy these conditions:

• The property traded must be solely for property of a “like kind.” The words like kind are liberally interpreted. They refer to the nature or character of the property, not its grade, quality, or use. Some examples of like-kind exchanges are: farm or ranch for city property; unimproved land for improved real estate; rental house for a store building; and fee in business property for 30-year or more leasehold in the same type of property (6.1). However, you may not make a tax-free exchange of U.S. real estate for real estate in foreign countries; your gain or loss on the exchange must be recognized.

• The property exchanged must have been held for productive use in your business or for investment and traded for property to be held for productive use in business or investment. Therefore, trades of property used, or to be used, for personal purposes, such as exchanging a residence for rental property, cannot receive tax-free treatment. However, if you rent out your vacation home and meet the conditions of an IRS safe harbor (6.1), the residence is treated as investment property rather than personal-use property, so it can be part of a like-kind exchange for other investment property.

  If you trade your principal residence for another principal residence, gain may be tax free under the home sale exclusion rules (29.2).

• The trade must generally occur within a 180-day period, and property identification must occur within 45 days of the first transfer (6.4).

A real estate dealer cannot transact a tax-free exchange of property held for sale to customers. Also, an exchange is not tax free if the property received is held for immediate resale.

Tax-free exchanges between related parties are subject to tax if either party disposes of the exchanged property within a two-year period (6.6).

Disadvantage of tax-free exchange. Although the postponement of tax on gain from a tax-free exchange is equivalent to an interest-free loan from the government equal to the amount you would have owed in taxes had you sold the property, this tax advantage is offset by a disadvantage in the case of an exchange of depreciable real estate. You must carry over the basis of the old property to the new property; see the following Example.

Partially tax-free exchanges. To be completely tax-free, the exchange must be solely an exchange of like-kind properties. If you receive “boot,” such as cash or property that is not of like kind, gain is taxed up to the amount of the boot.

If you trade mortgaged property, the mortgage released is treated as boot (6.3). When there are mortgages on both properties, the mortgages are netted. The party giving up the larger mortgage and getting the smaller mortgage treats the excess as boot. Taxable boot cannot exceed the amount of your gain. See the Example below and also the Example in 6.3, which illustrates how to report an exchange on Form 8824.

31.4 Timing Your Real Property Sales

Generally, a taxable transaction occurs in the year in which title or possession to property passes to the buyer. By controlling the year title and possession pass, you may select the year in which to report profit or loss. For example, you intend to sell property this year, but you estimate that reporting the sale next year will incur less in taxes. You can postpone the transfer of title and possession to next year. Alternatively, you can transact an installment sale, giving title and possession this year but delaying the receipt of all or most of the sale proceeds until next year (5.21).

31.5 Cancellation of a Lease

Payments received by the tenant on the cancellation of a business lease held long term are treated as proceeds received in a Section 1231 transaction (44.8). Payments received by the tenant on cancellation of a lease on a personal residence or apartment are treated as proceeds of a capital asset transaction. Gain is long-term capital gain if the lease was held long term; losses are not deductible.

Payments received by a landlord from a tenant for canceling a lease or modifying lease terms are reported as rental income when received (9.1).

Cancellation of a distributor’s agreement is treated as a sale if you made a substantial capital investment in the distributorship. For example, you own facilities for storage, transporting, processing, or dealing with the physical product covered by the franchise. If you have an office mainly for clerical work, or where you handle just a small part of the goods covered by the franchise, the cancellation is not treated as a sale. Your gain or loss is ordinary income or loss. If the cancellation is treated as a sale, the sale is subject to Section 1231 treatment (44.8).

31.6 Sale of an Option

The tax treatment of the sale of an option to buy property depends on the tax classification of the property to which the option relates.

If the option is for the purchase of property that would be a capital asset in your hands, profit on the sale of the option is treated as capital gain. A loss is treated as a capital loss if the property subject to the option was investment property; if the property was personal property, the loss is not deductible. Whether the gain or loss is long term or short term depends on your holding period.

If the option is for a “Section 1231 asset” (44.8), gain or loss on the sale of the option is combined with other Section 1231 asset transactions to determine if there is capital gain or ordinary loss.

If the option relates to an ordinary income asset in your hands, then gain or loss would be ordinary income or loss.

If you fail to exercise an option and allow it to lapse, the option is considered to have been sold on the expiration date. Gain or loss is computed according to the rules just discussed.

The party granting the option realizes ordinary income on its expiration, regardless of the nature of the underlying property. If the option is exercised, the option payment is added to the selling price of the property when figuring gain or loss.

31.7 Granting of an Easement

Granting an easement presents a practical problem of determining whether all or part of the basis of the property is allocable to the easement proceeds. This requires an opinion as to whether the easement affects the entire property or just a part of the property. There is no hard and fast rule to determine whether an easement affects all or part of the property. The issue is factual. For example, an easement for electric lines will generally affect only the area over which the lines are suspended and for which the right of way is granted. In such a case, an allocation may be required; see Example 1 below. If the entire property is affected, no allocation is required and the proceeds reduce the basis of the property. If only part of the property is affected, then the proceeds are applied to the cost allocated to the area affected by the easement. If the proceeds exceed the amount allocated to basis, a gain is realized. Capital gain treatment generally applies to grants of easements. The granting of a perpetual easement that requires you to give up all or substantially all of a beneficial use of the area affected by the easement is treated as a sale. The contribution to a government body of a scenic easement in perpetuity is a charitable contribution (14.10), not a sale.

Condemnation. If you realize a gain on a grant of an easement under a condemnation or threat of condemnation, you may defer tax by investing in replacement property (18.19).

Release of a restrictive covenant. A payment received for a release of a restrictive covenant is treated as a capital gain if the release involves property held for investment.

31.8 Special Tax Credits for Real Estate Investments

To encourage certain real estate investments, the tax law offers the following tax credits:

Low-income housing credit. Qualifying investors are allowed to claim a tax credit in annual installments over 10 years for qualifying newly constructed low-income housing and certain existing structures that are substantially rehabilitated. The amount of the credit depends on whether the building is new and whether federal subsidies are received. If you are the building owner, you must receive a certification from an authorized housing credit agency on Form 8609. Individual investors who get their share of the credit from a pass-through entity (from a partnership, S corporation, estate, or trust) may claim their credit directly on Form 3800 (General Business Credit) and do not have to complete Form 8586, which otherwise must be used; see the Form 8586 instructions.

Building owners are subject to a 15-year compliance period during which recapture of the credit may be required (on Form 8611) if the building is disposed of or the qualified basis of the building is reduced. Owners must file Form 8609-A for each year of the compliance period.

Rehabilitation credit for pre-1936 buildings or certified historic structures. On Form 3468, you may claim a 10% tax credit for rehabilitating pre-1936 buildings or a 20% credit for rehabilitating certified historic structures. For both types of rehabilitation credits, you must generally incur rehabilitation expenses that exceed the greater of $5,000 or your adjusted basis in the building.

For purposes of figuring depreciation deductions, you must reduce basis by the full amount of either rehabilitation credit.

Both rehabilitation credits are subject to recapture if you dispose of the property within five years after it was placed in service or you change use of the property within the five-year period so it no longer qualifies for the credit; see Form 4255 for recapture details.

Pre-1936 buildings. The 10% credit for pre-1936 buildings applies only to nonresidential property. A substantial portion of the building’s original structure must be retained after the rehabilitation. At least 75% of the external walls must be intact, with at least 50% kept as external walls. At least 75% of the existing internal structural framework must be kept in place.

Certified historic structure. A certified historic structure may be used for residential or nonresidential purposes. The National Park Service must certify that a planned rehabilitation is in keeping with the building’s historic status designation for the credit to be available.

In one case, a developer who rehabilitated a certified historic structure and donated a conservation easement to a historic society in the same year was required to base the credit computation on the rehabilitation expenses minus the charitable deduction claimed. If the donation had been made in a later year, a portion of the original credit claimed would be subject to recapture.

Tax credit limitations. Tax credits for low-income housing and rehabilitating historic or pre-1936 buildings may be limited by passive activity restrictions on Form 8582-CR (Chapter 10) and by tax liability limits for the general business credit on Form 3800 (Chapter 40).

31.9 Foreclosures, Repossessions, Short Sales, and Voluntary Conveyances to Creditors

If you are unable to meet payments on a debt secured by property, the creditor may foreclose on the loan or repossess the property. A foreclosure sale or repossession, including a voluntary return by you of the property to the creditor, is treated as a sale of the property on which you must figure gain or loss. Similarly, if the lender agrees to a “short sale” for less than the outstanding mortgage balance in which it accepts the sales proceeds in satisfaction of the mortgage, you must figure gain or loss. A loss on a principal residence or other personal real estate is not deductible. If you were personally liable on the debt, then in addition to realizing gain or loss on the transfer, you also have debt forgiveness income from the canjjcellation of the debt to the extent the canceled debt exceeds the value of the property, unless an exception (11.8) applies. For example, if you were insolvent at the time of the debt discharge, the debt forgiveness is not taxable. In the case of a principal residence, a special exclusion for up to $2 million of forgiven debt (11.8) was allowed through 2016; see the e-Supplement at jklasser.com for an update on a possible extension of the exclusion to 2017.

Figuring gain or loss and income from cancellation of debt on a foreclosure, short sale, or repossession. You have gain or loss equal to the difference between your adjusted basis (5.20) in the property and the amount realized on the foreclosure, short sale, or repossession. The amount realized depends on whether or not you are personally liable for the debt that secures the property, as discussed below. Note that if the property was your home or other personal-use property and a loss is realized on the foreclosure or repossession, the loss is nondeductible. If the property was your principal residence and you realize a gain on a foreclosure, short sale, or repossession, you may be able to exclude from income up to $250,000 of the gain, or $500,000 on a joint return, under the home sale exclusion rules (29.1).

In addition to realizing gain or loss on the transfer of the property to the lender, you may also have to report income from the cancellation of the debt if you are personally liable for the debt (11.8).

Amount realized if you are not personally liable (nonrecourse debt). If you are not personally liable on the debt secured by the property, the amount realized on the foreclosure, short sale, or repossession includes, in addition to any sale proceeds you receive, the full amount of the debt that is canceled as part of the transfer to the lender, even if the fair market value of the property is less than the canceled debt.

You do not realize income from the cancellation of nonrecourse debt upon a foreclosure, short sale, or repossession. However, if in lieu of foreclosure (or repossession) the lender offers a discount for early repayment or agrees to a loan modification (“workout”) in which the principal balance of the nonrecourse loan is reduced, and you retain the collateral, the debt reduction results in income from the cancellation of debt even where you are not personally liable on the loan (31.10).

Amount realized if you are personally liable (recourse debt). If you are personally liable on the debt secured by the property, the amount realized includes the smaller of the canceled debt or the fair market value of the property transferred to the lender. This is in addition to any sale proceeds received.

Where the canceled debt exceeds the fair market value of the transferred property, the excess must be reported as ordinary income from the cancellation of debt, unless the law allows it to be excluded. Exclusions that may be available are the exclusions for insolvency, bankruptcy, or qualified farm debt, discussed in 11.8, or the exclusion for qualified business real estate debt discussed in 31.10. See the e-Supplement at jklasser.com for an update on whether the exclusion for qualified principal residence indebtedness, which expired at the end of 2016 (11.8), is extended to 2017.

31.10 Restructuring Mortgage Debt

Rather than foreclose on a mortgage, a lender (mortgagee) may be willing to restructure the mortgage debt by canceling either all or part of the debt. As a borrower (mortgagor), do not overlook the tax consequences of the new debt arrangement. If the lender agrees to a “workout,” under which part of your loan principal is reduced as part of a loan modification, or if you pay off the loan early in return for a “discount” that reduces the debt, and you keep the collateral, the reduction or discount is canceled debt, reportable as ordinary income (cancellation of debt income) unless an exception applies. This is true whether or not you are personally liable for the debt. However, if you were not personally liable (nonrecourse debt) and do not keep the collateral, there is no cancellation of debt income.

You may be able to avoid the ordinary income from the cancellation of the debt by taking advantage of one of the exclusions in the law, such as the exclusions for insolvency, bankruptcy, qualified business real estate debt (see below), or qualified farm debt. Details of these exclusions are discussed in 11.8. The Jones example below illustrates the IRS approach to figuring insolvency upon a reduction of a nonrecourse debt.

In the case of partnership property, tax consequences of the restructuring of a third-party loan are determined at the partner level. This means that if you are a partner and are solvent (11.8), you may not avoid tax on the transaction, even if the partnership is insolvent.

Restructuring debt on business real estate. A solvent taxpayer may avoid tax on a restructuring of qualifying business real estate debt (11.8) by electing to reduce the basis of depreciable real property by the amount of the tax-free debt discharge. The election to reduce basis is made on Form 982.

31.11 Abandonments

To abandon property, you must terminate your ownership by voluntarily and permanently giving up possession and use of the property without passing it on to someone else. On an abandonment of mortgaged real estate (whether held for business, investment, or personal use), the type of debt determines if there is gain or loss on the abandonment. If you are personally liable for the debt (recourse debt), there is no gain or loss until a later foreclosure or repossession. If you are not personally liable (nonrecourse debt), the IRS treats the abandonment itself as a sale on which gain or loss is realized.

For example, if in 2017 you abandon investment real estate that secures your recourse debt, you do not have gain or loss for 2017, but if the lender forecloses on the loan in 2018, you will have a gain or loss in 2018. Under the foreclosure sale rules for recourse debt property (31.9), the amount realized in 2018 will include the smaller of the canceled debt or the fair market value of the property. In addition, if the canceled recourse debt exceeds the fair market value, the excess is ordinary income from cancellation of debt (31.9). On the other hand, if you were not personally liable for the debt securing the property (nonrecourse debt), then an abandonment in 2017 would be treated by the IRS as a 2017 sale, and the full outstanding debt would be treated as the amount realized in figuring gain or loss; there would not be any cancellation of debt income (31.9).

If the abandoned property was held for personal use, any loss on the abandonment or on a foreclosure or repossession is not deductible. If recourse debt is canceled in a foreclosure or repossession, you will realize ordinary income from cancellation of the debt if the canceled amount exceeds the value of the transferred property (31.9).

Abandoning a partnership interest. Where real estate values have sharply declined, partnerships may be holding realty subject to mortgage debt that exceeds the current value of the property. Some investors in such partnerships have claimed that they can abandon their partnership interests and claim abandonment losses. In one case, an investor in a partnership holding land in Houston, Texas, argued that he abandoned his partnership interest by making an abandonment declaration at a meeting of partners, and also declaring that he would make no further payments. He offered his interest to the others, who refused his offer. The IRS held that he failed to prove abandonment of his partnership interest or that the partnership abandoned the land. The Tax Court sided with the IRS, emphasizing his failure to show that the partnership abandoned the land. However, the appeals court for the Fifth Circuit reversed and allowed the abandonment loss. It held that the emphasis should be on the partner’s actions, not the actions of the partnership. Although neither state law nor the IRS regulations described how a partnership interest is to be abandoned, the appeals court held that the partner’s acts and declaration were sufficient to effect an abandonment of his partnership interest. The appeals court also held that the loss on the partnership interest could have been sustained on the basis of the worthlessness of his interest. The partnership was insolvent beyond hope of rehabilitation: (1) the partnership’s only asset was land with a fair market value less than the mortgage debt; (2) the partnership had no source of income; and (3) the partners refused to contribute more funds to keep the partnership afloat.

In a subsequent case, the Tax Court held that a doctor had abandoned a movie production partnership interest when he refused to advance any more money or to participate in the venture because he disapproved of the content of the film being produced and feared it might jeopardize his position at a hospital operated by a religious organization. Also, the limited partners had voted to dissolve.

31.12 Seller’s Repossession After Buyer’s Default on Mortgage

When you, as a seller, repossess realty on the buyer’s default of a debt that the realty secures, you may realize gain or loss. (If the realty was a personal residence, the loss is not deductible.) A debt is secured by real property whenever you have the right to take title or possession or both in the event the buyer defaults on his or her obligation under the contract.

Figuring gain on the repossession. Gain on the repossession is the excess of: (1) payments received on the original sales contract prior to and on the repossession, including payments made by the buyer for your benefit to another party, over (2) the amount of taxable gain previously reported prior to the repossession.

Gain computed under these two steps may not be fully taxable. Taxable gain is limited to (1) the amount of original profit less gain on the sale already reported as income for periods prior to the repossession, plus (2) your repossession costs.

The limitation on gain does not apply if the selling price cannot be computed at the time of sale as, for example, where the selling price is stated as a percentage of the profits to be realized from the development of the property sold.

These repossession gain rules do not apply if you repurchase the property by paying the buyer a sum in addition to the discharge of the debt, unless the repurchase and payment was provided for in the original sale contract, or the buyer has defaulted on his or her obligation, or default is imminent. In such cases, gain or loss on the repossession, and basis in the repossessed property, must be determined under the different rules for personal property; see IRS Publication 537 for details.

The basis of repossessed property. This is the adjusted basis of the debt (face value of the debt less the unreported profits) secured by the property, figured as of the date of repossession, increased by (1) the taxable gain on repossession and (2) the legal fees and other repossession costs you paid.

If you treated the debt as having become worthless or partially worthless before repossession, you are considered to receive, upon the repossession of the property securing the debt, an amount equal to the amount of the debt treated as worthless. You report as income the amount of any prior bad debt deduction and increase the basis of the debt by an amount equal to the amount reported as income.

If your debt is not fully discharged as a result of the repossession, the basis of the undischarged debt is zero. No loss may be claimed if the obligations subsequently become worthless. This rule applies to undischarged debts on the original obligation of the purchaser, a substituted obligation of the purchaser, a deficiency judgment entered in a court of law into which the purchaser’s obligation was merged, and any other obligations arising from the transaction.

Principal residence. Special rules apply to repossessions and resales of a principal residence if you excluded all or part of the gain on your original sale of the residence (29.1), and you resell it within a year after you repossess it.

The original sale and resale is treated as one transaction. You refigure the amount realized on the sale. You combine the selling price of the resale with the selling price of the original sale. From this total, you subtract selling expenses for both sales, the part of the original installment obligation that remains unpaid at the time of repossession, and repossession costs. The net is the amount realized on the combined sale-resale. Subtracting basis in the home from the amount realized gives the gain on the combined sale-resale before taking into account the home sale exclusion (29.1) rules. See Treasury Regulation Section 1.1038-2 for further details.

If the repossessed principal residence is not sold within one year, the combined sale-resale rule does not apply. The seller must report as income previously received payments that were not taxed (they were excluded under the home sale exclusion).

31.13 Foreclosure on Mortgages Other Than Purchase Money

If you, as a mortgagee (lender), bid in on a foreclosure sale to pay off a mortgage that is not a purchase money mortgage, your actual financial loss is the difference between the unpaid mortgage debt and the value of the property. For tax purposes, however, you may realize a capital gain or loss and a bad debt loss that are reportable in the year of the foreclosure sale.

Your bid is treated as consisting of two distinct transactions:

1. The repayment of your loan. To determine whether this results in a bad debt, the bid price is matched against the face amount of the mortgage.
2. A taxable exchange of your mortgage note for the foreclosed property, which may result in a capital gain or loss. This is determined by matching the bid price against the fair market value of the property.

Where the bid price equals the mortgage debt plus unreported but accrued interest, you report the interest as income. But where the accrued interest has been reported, the unpaid amount is added to the collection expenses.

31.14 Foreclosure Sale to Third Party

When a third party buys the property in a foreclosure, you, as the mortgagee, receive the purchase price to apply against the mortgage debt. If it is less than the debt, and the mortgagor was personally liable, you may proceed against the mortgagor for the difference. Foreclosure expenses are treated as offsets against the foreclosure proceeds and increase the loss.

You deduct your loss as a bad debt. The law distinguishes between two types of bad debt deductions: business bad debts and nonbusiness bad debts. A business bad debt is fully deductible. A nonbusiness bad debt is a short-term capital loss that can be offset only against capital gains, plus a limited amount of ordinary income (5.33). In addition, you may deduct a partially worthless business bad debt, but you may not deduct a partially worthless nonbusiness bad debt. Remember this distinction if you are thinking of forgiving part of the mortgage debt as a settlement. If the debt is a nonbusiness bad debt, you will not be able to take a deduction until the entire debt proves to be worthless. But whether you are deducting a business or a nonbusiness bad debt, your deduction will be allowed only if you show the debt to be uncollectible—for example, because a deficiency judgment is worthless or because the mortgagor is declared bankrupt.

31.15 Transferring Mortgaged Realty

Mortgaging realty that has appreciated in value is one way of realizing cash on the appreciation without current tax consequences. The receipt of cash by mortgaging the property is not taxed; tax will generally be imposed only when the property is sold. However, there is a possible tax where the mortgage exceeds the adjusted basis of the property and the property is given away or transferred to a controlled corporation. Where the property is transferred to a controlled corporation, the excess is taxable gain. Further, if the IRS successfully charges that the transfer is part of a tax avoidance scheme, the taxable gain may be as high as the amount of the mortgage liability.

Charitable donations. The IRS holds that a donation of mortgaged property to a charity is a part-sale, part-gift, and the donor has taxable gain to the extent the mortgage liability exceeds the portion of the donor’s basis allocable to the sale part of the transaction (14.8).