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:

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image Planning Reminder
Voluntary Conveyance
Instead of forcing you to foreclose, the mortgagor may voluntarily convey the property to you in consideration for your cancelling the mortgage debt. Your loss is the amount by which the mortgage debt plus accrued interest exceeds the fair market value of the property. If, however, the fair market value exceeds the mortgage debt plus accrued interest, the difference is taxable gain. The gain or loss is reportable in the year you receive the property. Your basis in the property is its fair market value when you receive it.
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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.
EXAMPLES
1. Mortgagee’s bid less than market value. You hold a $40,000 mortgage on property having a fair market value of $30,000. You bid on the property at the foreclosure sale at $28,000. The expenses of the sale are $2,000, reducing the bid price to $26,000. The mortgagor is insolvent, so you have a bad debt loss of $14,000 ($40,000 − $26,000). You also have a $4,000 capital gain (the fair market value of the property of $30,000 − $26,000).
2. Mortgagee’s bid equal to market value. Suppose your bid was $32,000, and you had $2,000 in expenses. The difference between the net bid price of $30,000 and the mortgage of $40,000 is $10,000. As the mortgagor is insolvent, there is a bad debt loss of $10,000. Since the net bid price equals the fair market value, there is neither capital gain nor loss.
3. Mortgagee’s bid greater than market value. Suppose your bid was $36,000 and you had $2,000 in expenses. Your bad debt deduction is $6,000—the difference between the mortgage debt of $40,000 and the net bid price of $34,000. You also had a capital loss of $4,000 (the difference between the net bid price of $34,000 and the fair market value of $30,000).

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.

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