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.
Caution
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.
| Amount of money received ($5,000 plus $4,000) | $9,000 |
| Less: Amount of gain taxed in prior years ($1,000 plus $800) | 1,800 |
| Gain | $7,200 |
| Original profit | $5,000 | |
| Less: | ||
| Gain reported as income | $1,800 | |
| Repossession costs | 500 | 2,300 |
| Taxable gain on repossession | $2,700 |
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.
| 1. Face value of debt ($20,000 note less $4,000 payment) | $16,000 | |
| 2. Less: Unreported profit (20% of the $16,000 still due on the note) | 3,200 | |
| 3. Adjusted basis in installment obligation at date of repossession | $12,800 | |
| 4. Plus: Gain on repossession | $2,700 | |
| Repossession costs | 500 | 3,200 |
| 5. Basis of repossessed property | $16,000 |
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.