Discussion:COD exclusion

Princ. res. exclusion. When this exclusion is claimed, the reduction of basis due to COD applies to the entire basis, including the land, correct? (As opposed to bus. real property exclusion, when only depreciable basis is subject to reduction.)

Bus. real prop. exclusion. If taxpayer has only one property which was used for rental, and it gets foreclosed, what basis he needs to reduce? Instructions say, the basis of “other properties”. But if he has no other business property? Should he reduce the basis of the foreclosed one, or will the COD just vanish into the thin air? (i.e. he gets to write it off without reduction of any basis at all – i.e. without any further negative tax effect?)

Insolvency. Similar situation as above, insolvency claimed. If taxpayer has no attributes to reduce, what happens to the written-off COD? Vanishes into the thin air, or is he precluded from claiming the exclusion because of lack of attributes? Or should the basis of the same foreclosed property be reduced in the absence of any other attributes?

Thanks a bunch in advance!

I figured these questions out by more careful reading of IRS pubs. Sorry for taking your time to read it!

Insolvency: Yes, they do just vanish. The tax attributes are reduced at the end of the year, right? So from a planning standpoint, you would want to use up those attributes up during the year.

COD Question - On a Recourse debt, when is the COD recognized? Immediately upon transfer of the property? Or sometime later when the creditor decides not to pursue and then writes that debt off? This could happen in the next tax year. I guess in a perfect world we would know because we would get a 1099-C.

Application of basis reduction. In general, the basis reduction is applied to the property still owned at the beginning of next tax year. Consequently, if you don’t have any property (any remaining basis) at the start of next tax year, there is nothing to reduce (no basis reduction attribute to claim). The foreclosed/repo’d property which gave rise to COD, is not subject to basis adjustment (because its basis at year end is zero), and therefore, does not create a gain on disposition of this property due to COD exclusion.

The only exception to the above is when claiming qualif. real prop. bus. indebt. exclusion. If, after foreclosure of one such property you don’t have any other bus. real property remaining for basis reduction, you have to reduce the basis of the foreclosed property, realizing gain on disposition (or reduced loss) in the year of discharge (Per 1017(b)(3)(F)(iii)).

Also, in case of principal residence, when claiming 108(h)(1), the foreclosed property’s basis does not get adjusted for the excluded COD. Therefore, the excluded COD can not give rise to the gain from sale (See Pub 4681 text and detailed example #2.) Only if you retain the property (i.e. modify the loan), you reduce its basis.

Disposition of asset vs. cancellation of debt. The 1099-A is an evidence of disposition. 1099-C is an evidence of either only cancellation of debt, or both cancellation of debt and disposition (depending whether a 1099-A was also issued for the same debt).

So, from a preparation viewpoint, if for a given tax year only 1099-A was issued, then gain or loss from disposition has to be reported, but there is no need to deal with COD this year (either to claim it or to exclude), since COD has not happened yet.

Thank you!

Anyhow, I wonder what is the consensus on the basis reduction issue as per my statements in previous post? Would it ever apply to the foreclosed property itself, as opposed to the properties that are still in possession at the beginning of next tax year?

Some preparers insist it will under 108(h)(1) (princ. res. indebt. exclusion). The resulting higher gain can then be written off through sec 121, if available. They cite 108(h)(1) as authority on this, but 108(h)(1) is not specific enough to avoid ambiguity in this regard. No wonder then that Pub 4681 has interpreted it differently. (They claim that the Pub is wrong, that I should ignore the Pub in this case.)

In the case of a California judicial foreclosure, the discharge could occur in a year subsequent to the sale of the residence. In such a case, it would be impossible to adjust the basis of the residence.

In the case of the Qualifying Real Property Indebtedness Exclusion, all basis adjustments are deemed to occur immediately before disposition. Code Sec. 1017(b)(3)(F)(iii). Perhaps Congress meant to include a similar provision for foreclosed principal residences, but I doubt it. In other words, in the case of Sec. 108(h), I do not believe that it is necessary to reduce the basis of a residence lost in foreclosure.

Glad to see that you have the same opinion re basis reduction under 108(h) as I. It would be interesting to hear other pros in this matter as well.

But where and how is it spelled out in writing? What documents can I rely on?

In contrast, the trustee under the trust deed is not involved in a judicial foreclosure. The homeowner will be served with a summons and complaint instead. Judicial foreclosures are rare in California.

I was hoping to see input by other pros as well regarding basis reduction for foreclosed properties under 108(h)(1), but it looks like nobody else wants to chip in. I am just wondering what the consensus is on this matter, since it can potentially make a huge difference on client's bottom line (just imagine a client who doesn't qualify for Sec 121 exclusion and has a gain!). Should I post this specific question in a new thread, perhaps?

I myself have become almost certain (thanks to Riley's input and other ask-around I have done in the meanwhile) that the basis reduction does not apply to a foreclosed property under 108(h). But I have also gotten a feel that many preparers have no idea yet of how to handle it (just like me when I began researching this), because it is a relatively new thing and they have not come across of this situation yet in their practice.

In case of judicial foreclosure (if I'll ever run into one), should I just wait for the 1099-C to be issued in a future tax year, if not issued in the year of foreclosure? Should I just deal with the gain in this year and disregard the potential COD for now?

In case of non-judicial foreclosure, do I have to calculate the COD income myself in the absence of direct evidence, such as form 1099-C, using info from 1099-A? (Loan balance minus FMV on 1099-A?)

Can you provide a reference to IRC or any other authority which spells it out that on non-judicial foreclosure the COD happens at the time of sale? (I tried to search IRC, but did not find anything relevant.) I would like to read it with my own eyes (provided, I can comprehend all the legalese).

Thanks, again, for your great replies!

The test for determining such moment requires a practical assessment of the facts and circumstances relating to the likelihood of payment. Brountas v. Commissioner, 74 T.C. 1062, 1074 (1980), CRC Corp. v. Commissioner, 693 F.2d 281 (3d Cir. 1982); Bickerstaff v. Commissioner, 128 F.2d 366, 367 (5th Cir. 1942); Kent Homes Inc. v. Commissioner, 55 T.C. 820, 828-831 (1971), Cotton v. Commissioner, 25 B.T.A. 1158 (1932).

Any "identifiable event" which fixes the loss with certainty may be taken into consideration.

United States v. S.S. White Dental Mfg. Co., 274 U.S. 398 (1927)

The time of the sale is a good identifiable event, and, it is a facts and circumstances assessment.