Certain Reacquisitions of Real Property

Gain or Loss on Reacquisition of Real Property

When a seller of real property, who has a security interest in the property sold and holds a purchase money mortgage from the buyer, repossesses the property as a result of the buyer's default, no loss may be recognized by the seller from the reacquisition and no debt secured by the repossessed property may be treated as worthless or partially worthless as a result of the reacquisition. 1 Gain on the reacquisition is limited to the money and the fair market value of other property received by the seller to the extent that these amounts have not already been reported in income. 2 Gain is further limited to the amount of gain realized from the original sale, reduced by amounts already reported in income and amounts paid by the seller in connection with the reacquisition of the property. 3 These rules apply only where:

• the buyer's debt arose from the sale of the real property;

• the debt is secured by the real property; and

• the seller reacquired the real property in partial or full satisfaction of the debt. 4

/Footnote/ 1 §1038(a) (flush language).

/Footnote/ 2 §1038(b)(1).

/Footnote/ 3 §1038(b)(2).

/Footnote/ 4 §1038(a).

1. What Constitutes a Sale and Reacquisition?

For purposes of this rule, it is not necessary for title to the property to have passed to the purchaser to have a sale. 5 Nor is it required that the purchaser have a right to possession of the property for a sale to have occurred. 6 Thus, the following transactions are considered sales for purposes of this rule:

• a land contract where title does not pass until all payments on the underlying indebtedness have been made,

• a redeemable ground rent agreement, and

• a purchase contract that defers the buyer's right of possession until a certain portion of the purchase price has been paid. 7

/Footnote/ 5 Regs. §1.1038-1(a)(2)(i).

/Footnote/ 6 Id.

/Footnote/ 7 See id.

The buyer's debt to the seller must be secured by the real property sold for this rule to apply. 8 A debt is secured by the real property for purposes of this rule whenever the seller has a right to take title or possession of the property, or both, if there is a default on the debt. 9 It is immaterial that the obligation is nonrecourse in nature. 10

/Footnote/ 8 §1038(a)(1).

/Footnote/ 9 Regs. §1.1038-1(a)(2)(ii).

/Footnote/ 10 Id.

This rule applies only when the seller's reacquisition of the property is in furtherance of his security rights in the property with respect to debt to him that arose at the time of the sale. 11 Accordingly, if the seller in reacquiring the real property does not pay consideration in addition to discharging the purchaser's debt secured by the property, this rule applies to the reacquisition even though the purchaser has not defaulted in his obligations under the contract or is not in imminent danger of defaulting. 12 The IRS has ruled that the statute applies in the case of a voluntary reconveyance by related parties, even though a default had not occurred and was not imminent. 13 If the seller pays consideration in reacquiring the real property, the statute applies only if such payment is provided for in the original contract of sale. 14 Such a situation amounts to an abrogation of the sale at the seller's option, and payment of compensation to the buyer. However, in the absence of such a contractual right to reacquire the property, the rule still applies if the seller pays consideration to a buyer who was in default or where default is imminent. 15

/Footnote/ 11 Regs. §1.1038-1(a)(3)(i).

/Footnote/ 12 Id.

/Footnote/ 13 PLR 8402006.

/Footnote/ 14 Regs. §1.1038-1(a)(3)(i).

/Footnote/ 15 Id.

The regulations state broadly that an occasion of default is not necessarily confined to a failure to pay principal or interest, but can include a situation where the facts and circumstances indicate that the buyer will be unable to perform other obligations under the contract. 16 If the seller takes back the property subject to a debt to a third party, or assumes a debt that arose subsequent to the original sale, it is considered payment by the seller of additional consideration. However, if the third party debt arose before or out of the original sale, assumption of or taking subject to the third party debt is not considered payment of additional consideration by the seller. 17

/Footnote/ 16 Such matters might include an inability to properly maintain the property or keep it fully occupied or to observe any of the numerous conditions found in a typical commercial mortgage. See Regs. §1.1038-1(a)(3)(i).

/Footnote/ 17 Regs. §1.1038-1(a)(3)(i).

For these rules to apply, the seller must reacquire the real property itself. However, the manner in which the seller reacquires the property is immaterial. Accordingly, any method valid under local law brings the transaction under the statute. For example, the following methods of reacquisition qualify:

• voluntary conveyance by the purchaser,

• abandonment to the seller,

• foreclosure proceedings where competitive bids are entered, such as through judicial sale, or by power of sale contained in the loan agreement without recourse to the courts, and

• foreclosure proceedings without competitive bidding, such as strict foreclosure, foreclosure by entry and possession, by writ of entry, or by publication or notice. 18

/Footnote/ 18 Regs. §1.1038-1(a)(3)(ii).

A transaction falls within the rules if real property is reacquired from the purchaser's transferee or assignee, or from a trustee holding title to the property. The section also applies if the seller reacquires the property from a taxpayer who purchased the property from the original purchaser, if the subsequent purchaser took the property subject to the debt, or assumed the liability to the seller. 19

/Footnote/ 19 Regs. §1.1038-1(a)(4).

2. Gain Resulting from a Reacquisition

Generally, the seller is required to recognize gain to the extent that the money and other property received by him before the reacquisition (other than the purchase money obligations of the buyer) exceeds the amount of gain reported as income before the reacquisition. 20 The concept here, of course, is to keep the seller from achieving a tax windfall by reason of getting his property back and keeping untaxed amounts received before the reacquisition. 21

/Footnote/ 20 §1038(b)(1).

/Footnote/ 21 Regs. §1.1038-1(b)(1)(i).

Example—Determining Amount of Gain

In 1985 A, who uses the calendar year as the taxable year, sells to H for $100,000 real property that has an adjusted basis of $30,000. A properly elects to report the income from the sale on the installment method. In 1985 and 1986, A receives a total of $40,000 on the contract. In May 1987, A receives another $10,000 on the contract but no additional payments thereafter. Because of H's default, A reacquires the property in Aug. 1987. The gain on the sale that is reported as income for periods before the reacquisition is $35,000 ($50,000 x $70,000/$100,000). 22

/Footnote/ 22 See Regs. §1.1038-1(b)(1)(ii) (Example). See also ¶3550 for the rules on how to compute gain on installment sales.

Note: The amount of gain attributable to the $10,000 principal payment in the year of reacquisition ($10,000 x $70,000/$100,000 = $7,000) is reported as usual on the taxpayer's return for that year, in addition to any interest payment received or accrued.

There is a limitation on the amount of gain that must be recognized on a reacquisition. 23 Recognized gain is limited to the amount by which the sales price of the real property exceeds the property's adjusted basis (i.e., the gain on the original sale), less the amount of gain on the original sale that was reported as income before the reacquisition, and the amount of money and the fair market value of other property (other than obligations of the purchaser) paid or transferred by the seller in connection with the reacquisition. 24

/Footnote/ 23 In the various examples that follow, the gain to be recognized is calculated both under the general rule and under the limitation.

/Footnote/ 24 §1038(b)(2); Regs. §1.1038-1(c)(1).

Note: A property's sales price is the gross sales price reduced by selling commissions, legal fees, and other expenses of sale. 25 The Tax Court has held that such a reduction in the sales price applies only for purposes of computing the gain limitation, and that the computation made under the general rule does not include such a reduction in the purchase price. 26 In some circumstances this results in payment of tax on an economic loss. The court explains that taxpayers are "awarded relief by obtaining an increased basis in the repossessed property." 27 The amounts paid by the seller "in connection with the reacquisition of the property" include the expenses of foreclosure.

/Footnote/ 25 §1038(b)(2) (flush language); Regs. §1.1038-1(c)(3).

/Footnote/ 26 Greene v. Comr., 76 T.C. 1018 (1981).

/Footnote/ 27 See §1038(c).

The regulations provide that the limitation on the amount of gain that must be recognized does not apply where the selling price of the property is indefinite or cannot be ascertained at the time of the reacquisition. For instance, the gain limitation does not apply where the selling price is stated as a percentage of the profits received from the development of the property sold. 28

/Footnote/ 28 Regs. §1.1038-1(c)(2).

Example—Calculation of Gain (Low-Basis Property) 29

S sells real property with a basis of $20,000 to P for $100,000. Under the contract, P pays $10,000 down and executes a note for $90,000, with stated interest at 10%, to be paid in nine annual installments. S reports the gain on the installment method. After the second $10,000 annual payment P defaults and S accepts a voluntary reconveyance of the property in complete satisfaction of the debt. S pays $5,000 in connection with the reacquisition of the property. The fair market value of the property at the time of the reacquisition is $110,000.

/Footnote/ 29 See Regs. §1.1038-1(h) Example (1).

The gain derived by S on the reacquisition of the property is $6,000, determined as follows:

Gain before application of limitation:

Money with respect to the sale

received by S before the reacquisition $ 30,000

Less: Gain reported by S in income for periods

before the reacquisition ($30,000 X [($100,000 -

$200,000)/$100,000]) $ 24,000

-------

Gain before application of limitation $ 6,000

Limitation on amount of gain:

Sales price of real property $100,000

Less:

Adjusted basis of the property

at the time of sale $20,000

Gain reported by S as income

for periods before the reacquisition $24,000

Amount of money paid by S in connection

with the reacquisition $ 5,000 $ 49,000

-------

Limitation on amount of gain $ 51,000

--------

Gain resulting from the reacquisition

of the property $ 6,000

The basis of the reacquired real property at the date of the reacquisition is $25,000, determined as follows:

Adjusted basis of P's debt to S ($70,000 -

[$70,000 X $80,000/$100,000]) $14,000

Gain resulting from the reacquisition of

the property $ 6,000

Amount of money paid by S in

connection with the reacquisition $ 5,000

-------

Basis of reacquired property $25,000

Example—Calculation of Gain (High-Basis Property) 30

The facts are the same as in the previous example except that S's basis in the property is $80,000.

/Footnote/ 30 See Regs. §1.1038-1(h) Example (2).

The gain derived by S on the reacquisition of the property is $9,000, determined as follows:

Gain before application of limitation:

Money with respect to the sale received by

S before the reacquisition $30,000

Less: Gain reported by S in income for

periods before the reacquisition

($30,000 X [($100,000 - $80,000/$100,000]) $ 6,000

-------

Gain before application of limitation $24,000

Limitation on amount of gain:

Sales price of property $100,000

Less:

Adjusted basis of the property

at the time of sale $80,000

Gain reported by S in income

for periods before the reacquisition $ 6,000

Amount of money paid by S in

connection with the reacquisition $ 5,000 $91,000

--------

Limitation on amount of gain $ 9,000

Gain resulting from the reacquisition

of the property $ 9,000

The basis of the reacquired real property at the date of the reacquisition is $70,000, determined as follows:

Adjusted basis of P's debt to S ($70,000 -

[$70,000 X $20,000/$100,000]) $56,000

Gain resulting from the reacquisition

of the property $ 9,000

Amount of money paid by S in connection

with the reacquisition $ 5,000

-------

Basis of reacquired property $70,000

Note: Observe that the gain on the reacquisition was greater in the case of the high-basis property because less gain had been taken into income before the default.

Example—Calculation of Gain (Devalued Property) 31

S sells real property with a basis of $70,000 to P for $100,000. Under the contract, P pays $10,000 down and executes a note for $90,000, with stated interest at 11%, to be paid in nine annual installments. S reports the gain on the installment method. After the first $10,000 annual payment P defaults and S accepts a voluntary reconveyance of the property in complete satisfaction of the debt. S pays $5,000 in connection with the reacquisition of the property. The fair market value of the property at the time of the reacquisition is $50,000.

/Footnote/ 31 See Regs. §1.1038-1(h) Example (3).

The gain derived by S on the reacquisition of the property is $14,000, determined as follows:

Gain before application of limitation

Money with respect to the sale received

by S before the reacquisition $20,000

Less: Gain reported by S in income for

period before the reacquisition ($20,000 X

[$10,000 - $70,000/$100,000]) $ 6,000

-------

Gain before application of

limitation $14,000

Limitation on amount of gain:

Sales price of property $100,000

Less:

Adjusted basis of the property at the

time of sale $70,000

Gain reported by S in income for periods

before the reacquisition $ 6,000

Amount paid by S in connection with

the reacquisition $ 5,000 $ 81,000

------- --------

Limitation on amount of gain $ 19,000

Gain resulting from the reacquisition of property $ 14,000

The basis of the reacquired real property at the date of the reacquisition is $75,000, determined as follows:

Adjusted basis of P's debt to S

($80,000 - [$80,000 X $30,000/$100,000]) $56,000

Gain resulting from the reacquisition

of the property $14,000

Amount of money paid by S in connection

with the reacquisition $ 5,000

-------

Basis of reacquired property $75,000

Note: The foregoing example illustrates an anomalous result possible under the statute: S gets back property worth only half its value prior to the sale, pays $5,000 to repossess it, pays tax on a phantom gain, and ends up actually out of pocket.

Example—Devalued Property -- Reconveyance Accompanied by Tender of Cash 32

S sells real property with a basis of $20,000 to P for $100,000. Under the contract, P pays $10,000 down and executes a note for $90,000, with stated interest at 6%, to be paid in 9 annual installments. S reports the gain on the installment method. After the second $10,000 annual payment, P defaults and S accepts from P in complete satisfaction of the indebtedness a voluntary reconveyance of the property plus cash in the amount of $20,000. S does not pay any amount in connection with the reacquisition of the property. The fair market value of the property at the time of the reacquisition is $30,000.

/Footnote/ 32 Id., Ex. (4). See also Hovhannissian v. Comr., T.C. Memo 1997-444 (Real property devalued by buyer is subject to §1038(b) gain treatment on seller's reacquisition).

The gain derived by S on the reacquisition of the property is $10,000, determined as follows:

Gain before application of limitation:

Money with respect to the sale received

by S before the reacquisition

($30,000 + $20,000) $ 50,000

Less: Gain reported by S in income for

periods before the reacquisition

($50,000 X [($100,000 - $20,000)/$100,000]) $ 40,000

--------

Gain before application of limitation $ 10,000

Limitation on amount of gain:

Sales price of real property $100,000

Less:

Adjusted basis of the property at the

time of sale $20,000

Gain reported by S in income for periods

before the reacquisition $40,000 $ 60,000

-------- --------

Limitation on amount of gain $ 40,000

Gain resulting from the reacquisition of the property $ 10,000

The basis of the reacquired real property at the date of the reacquisition is $20,000, determined as follows:

Adjusted basis of P's debt to S ($50,000 -

[$50,000 X $80,000/$100,000]) $10,000

Gain resulting from the reacquisition of the property $10,000

-------

Basis of reacquired property $20,000

Example—Deferred Payment Sale 33

S sells real property with a basis of $80,000 to P for $100,000. Under the contract, P pays $10,000 down and executes a note for $90,000, with stated interest at 6%, to be paid in 9 annual installments. At the time of sale P's note has a fair market value of $90,000. S does not report the gain on the installment method, but rather treats the sale as a completed transaction. After the third $10,000 annual payment P defaults and S forecloses. At the foreclosure sale S bids on the property at $70,000, cancels P's obligation of $60,000, and pays $10,000 to P. There are no other amounts paid by S in connection with the reacquisition of the property. The fair market value of the property at the time of the reacquisition is $70,000.

/Footnote/ 33 Regs. §1.1038-1(h), Ex. (5).

The gain derived by S on the reacquisition of the property is $0, determined as follows:

Gain before application of limitation:

Money with respect to the sale received

by S before the reacquisition $40,000

Less: Gain reported by S as income for

periods before the reacquisition

([$10,000 + $90,000] - $80,000) $20,000

-------

Gain before application of limitation $20,000

Limitation on amount of gain:

Sales price of real property $100,000

Less:

Adjusted basis of the property at the

time of sale $80,000

Gain reported by S as income for

periods prior to the reacquisition $20,000

Amount of money paid by S in connection

with the reacquisition $10,000 $110,000

------- --------

Limitation on amount of gain (not to

be less than zero) $ 0

Gain resulting from the reacquisition of the property $ 0

The basis of the reacquired real property at the date of the reacquisition is $70,000, determined as follows:

Adjusted basis of P's debt to S (face

value at time of reacquisition) $60,000

Gain resulting from the reacquisition of the property 0

Amount of money paid by S in connection with the

reacquisition $10,000

-------

Basis of reacquired property $70,000

3. Nature of Gain

The reacquisition rules do not affect the character of the gain (if any) that results from a reacquisition of property. 34 However, the character of the gain is determined on the basis of whether the gain on the original sale was returned on the installment method or, if not, on whether the title to the real property was transferred to the purchaser. 35 If the original sale was reported on the installment method, the seller's gain on repossession has the same nature as the gain previously reported. 36 If the original sale was not on the installment method but was a deferred payment sale, where title to the real property was transferred to the purchaser and the seller accepts a voluntary reconveyance of the property, the gain is ordinary income. 37 If the obligation of the purchaser is a "security," 38 then any gain resulting from the reacquisition is capital gain. 39

/Footnote/ 34 Regs. §1.1038-1(d).

/Footnote/ 35 Id.

/Footnote/ 36 Id.

/Footnote/ 37 If title did not pass, the inference is that capital gain would be allowed.

/Footnote/ 38 Certain obligations of corporations, as defined in §165(g)(2)(C), constitute securities of a corporate issuer. Mortgage notes can be so structured.

/Footnote/ 39 Regs. §1.1038-1(d).

Note: The Tax Court has seen fit simply to characterize reacquisition gain in the same manner that the original transaction was characterized, and this has been upheld by a U.S. court of appeals. 40