Some tax issues still tricky under today's system
Many readers will be familiar with the concept that a debtor may realize taxable income -- either in the form of income from the discharge of indebtedness or in the form of gain from the disposition of property -- when the debtor conveys mortgaged property to a creditor in lieu of foreclosure. Although the debtor may not receive any proceeds in the form of cash or other property, the simple fact that the debtor is relieved from liabilities may be sufficient to subject the debtor to tax.
Perhaps less obvious are the tax issues facing a creditor who accepts a deed in lieu of foreclosure. A recent decision of the Tax Court illustrates how the wrong combination of facts can result in a tax disaster for the creditor in such a situation. Goldberg v. Commissioner (February 11, 1997).
During March and April 1990, Leo and Alla Goldberg loaned a total of $130,000 to Lee and Catherine Wood. The loans were secured with a deed of trust on the Woods' properties in Laguna Hills and Truckee, California. The Woods soon found themselves in financial difficulties and, on June 19, 1991, the Goldbergs and the Woods agreed that the Woods would convey the properties to the Goldbergs in lieu of foreclosure and that the Goldbergs would release the Woods from liability under the 1990 loans. The Goldbergs took title to the properties subject to a variety of senior liens, aggregating $803,900, and paid other acquisition and related costs (such as delinquent real estate taxes) totaling $77,430.
The Goldbergs did not hold the properties for a long time. On October 29, 1991, they sold the Truckee property for $225,000 and, on January 1, 1992, they sold the Laguna Hills property for $850,000; they reported a $10,312 gain on the sale of the Truckee property on their 1991 tax return, but no other income resulting from these transactions. Based on these facts, the Internal Revenue Service asserted in the Tax Court that the Goldbergs realized additional ordinary income of $53,358 on receipt of the deeds in lieu of foreclosure from the Woods; this amount was computed by subtracting from $1,075,000 the sum of $130,000 (the amount the Goldbergs had loaned to the Woods), $803,900 (the senior liens encumbering the properties), $77,430 (the Goldbergs' miscellaneous costs), and $10,312 (the gain that the Goldbergs had already reported on their tax return).
In its notice of deficiency to the Goldbergs, the Service initially characterized this amount as "debt which was cancelled or forgiven" and referred to "debt extinguishment," terms more typically used in describing a debtor's tax consequences and that seem to have little application to the Goldbergs' situation. Before the Tax Court, the Service changed the articulation of its position and contended that the Goldbergs realized income on the collection of their loans to the Woods, rather than on their cancellation. The Tax Court agreed with the Goldbergs that this last-minute change in theory shifted the normal burden of proof from the Goldbergs and to the Service. Unfortunately for the Goldbergs, this procedural victory was fleeting, as the Tax Court concluded that the Service had in fact met its burden of proof.
The Tax Court stated that it was convinced that the Service had correctly determined that the Goldbergs' sales of the properties shortly after they had accepted the deeds in lieu of foreclosure were indicative of the properties' fair market values on June 19, 1991, the date of the deeds in lieu. (The Tax Court did not indicate why the Woods' willingness to give the deeds in lieu of foreclosure was not equally indicative of the fact that the properties had no value in excess of the debt on that date.) That value, adjusted for the senior liens and the Goldbergs' miscellaneous costs, was the "amount realized" by the Goldbergs on their collection of the Woods' indebtedness to them. From this amount realized the Goldbergs were entitled to subtract the amount loaned to the Woods and the gain already reported, but the remaining amount realized constituted income to the Goldbergs. Had the Goldbergs been the sellers of the properties and had the indebtedness thus arisen as a purchase money note, the Goldbergs might have been eligible for a special "nonrecognition" rule in the Internal Revenue Code under which the deeds in lieu of foreclosure would not have been currently taxable to them. As the facts were, however, the Goldbergs had lent cash to the Woods and the special rule was inapplicable.
The Tax Court also held that the character of the income realized by the Goldbergs was ordinary income rather than capital gain. Capital gain treatment is ordinarily dependent on the existence of a "sale or exchange" of property. Nevertheless, gain recognized by a creditor on the "retirement" of a "debt instrument" is specifically made eligible for capital gain treatment, even though such a "retirement" would under general principles of tax law be considered an "extinguishment" of the debt instrument, rather than a "sale or exchange." An exception to this favorable rule, however, relates to any obligation issued by a "natural person," the Code's term for a human being. Apparently because the Woods individually were debtors to the Goldbergs, rather than having formed a partnership or corporation to borrow the money, the Goldbergs' gain on the collection of the Woods' indebtedness failed to qualify as capital gain.
It may be some small consolation to the Goldbergs to know that the Clinton Administration believes that at least a portion of their tax problem should not exist in a perfect world. One of the Administration's pending "tax reform" proposals would eliminate the "extinguishment" doctrine and permit capital gain treatment even in the absence of a sale or exchange. If this proposal had been law during 1991, the Goldbergs would still have been required to include additional income, but it would at least have been taxed at the preferential rates applicable to capital gains. In both real estate investment and taxes, timing is sometimes everything!