Foreclosures and Involuntary Conversions

Foreclosures and Repossessions

A foreclosure or repossession is generally treated in the same way as a sale. Your gain or loss for tax purposes is the difference between your adjusted basis in the property, and the amount realized. The amount realized on a foreclosure or repossession depends upon whether you are personally liable for the debt (recourse debt) or not (nonrecourse debt).

Amount realized on a nonrecourse debt. If you are not personally liable for repaying the debt, the amount you realize includes the full debt canceled by the transfer - even if the fair market value of the property is less than the canceled debt.

Amount realized on a recourse debt. If you are personally liable for the debt, the amount realized is the amount of the canceled debt up to the fair market value of the property. However, you receive ordinary income in the amount that the debt exceeds the property's fair market value.

Example Karl purchased a new car for $25,000. After he lost his job, he stopped making payments and the car was repossessed. At the time of the repossession, the loan balance was $22,000 and the FMV of the car was $15,000. Assuming the loan is a nonrecourse loan (Karl is not personally liable), the amount Karl realized on the repossession is $22,000 - the full amount of the debt canceled, even though the FMV of the car was much less. He determines his gain or loss on the repossession by comparing the amount realized ($22,000) to his adjusted basis in the car immediately before the repossession ($25,000). He has a $3,000 loss. (Unless the car is used in business, the loss is non-deductible.) Assuming the loan is a recourse loan (Karl remains liable for the balance of the loan after the car is repossessed), the amount he realized on the repossession was $15,000 - the FMV of the car. The gain/loss on the repossession is determined by comparing the amount realized ($15,000) to his adjusted basis in the car ($25,000.) He has a $10,000 deductible loss. However, because the loan is a recourse loan, Karl will also have cancellation of indebtedness income. To determine the amount of COD, he must compare the balance due ($22,000) to the FMV ($15,000) of the car. Thus, he will have $7,000 in ordinary income as the result of the cancellation of indebtedness.

Cancellation of Indebtedness Income. In general, COD income is ordinary income. However, COD income is not taxed in the following cases:

• The cancellation is intended as a gift.
• The debt is qualified farm debt.
• The debt is qualified real property business debt.
• You are insolvent or bankrupt.
• The debt is qualified principal residence indebtedness.

If any of these apply to you, you must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to report the income exclusion.

Involuntary Conversions

If your property is lost or destroyed by theft, vandalism, condemnation, or a natural disaster such as a fire, tornado, flood, landslide etc., you may have a taxable gain if you receive some insurance payment, condemnation award, or damages in a lawsuit. If the amount you receive is less than the amount of your loss, you may have a deductible casualty loss provided that the property was used in a trade or business or was investment property.

However, even if there is a taxable gain, you generally can postpone payment of tax on the gain if you reinvest the proceeds in similar property costing at least as much as the amount you received. Your tax basis in the new property would be the same as your tax basis in the old, destroyed property, and you would not be taxed on the cumulative gains until you sell the replacement property. The replacement property would generally have to be purchased within two years of receiving any payments that exceed your tax basis in the old property, or within three years if the property was used in a trade or business, or for investment. A special four-year replacement period applies to homes (and their contents) damaged by federally declared disasters.

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