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, 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.

Planning Reminder

Keep Records

Preserve evidence of the property’s fair market value. At a later date, the IRS may claim that the property was worth more than your bid and may tax you for the difference. Furthermore, be prepared to prove the worthlessness of the debt in order to support the bad debt deduction.

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