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Observation: To the extent the major tenant. Finally, when he was un- possible assigned to the property. This
underlying debt discharged is allocated able to make further payments on the will minimize the amount of gain from
to a passive activity, the COD income is debt, he deeded the property to the bank the deemed sale and maximize the
treated as arising from a passive activity. in lieu of foreclosure on Nov. 30, 20X4. amount of COD income, which can be
Conversely, to the extent the underlying When the property was deeded back fully or partially excluded from income
debt is attributable to a nonpassive to the bank, the outstanding balance on under Sec. 108. In addition, a taxpayer
activity, the COD income is nonpassive the debt was $4,325,000. M’s adjusted who deeds real property to a lender and
(Rev. Rul. 92-92). basis after depreciation in the property has debt discharged may be eligible
Note: The bid price in a foreclosure was $4,052,500 — $3,552,500 in build- to make the election for real property
sale is presumed to be the property’s ing and $500,000 in land. The FMV of business debt.
FMV unless there is clear and con- the property at the time of foreclosure Alternatively, if the borrower is
vincing proof to the contrary (Regs. was $4,150,000. solvent at the time of the foreclosure,
Sec. 1.166-6(b)(2); Community Bank, In a deed in lieu of foreclosure it is usually advantageous to value the
819 F.2d 940 (9th Cir. 1987)). The transaction, the transfer of the property property as high as possible. This will
Tax Court has acknowledged that the to the recourse debt lender is treated as a maximize gain that may be eligible
amount bid by a lender may be arbitrary, sale with proceeds equal to the lesser of for preferential capital gain treatment
so if the taxpayer presents clear and the FMV of the property ($4,150,000) and minimize the amount of ordinary
convincing proof (e.g., an appraisal) or the amount of the outstanding debt income from debt discharge.
of a more accurate FMV, the FMV ($4,325,000). Thus, M recognizes a Sec. It is common for the FMV of a
amount rather than the bid price is used 1231 gain of $97,500 ($4,150,000 FMV property to fall within a reasonable
in determining the sales proceeds from less adjusted basis of $4,052,500). The range of amounts. Thus, with proper
the transaction and any related COD gain is allocated between the land and planning prior to the foreclosure or
income (Frazier, 111 T.C. 243 (1998)). building based on the relative FMV deed in lieu of foreclosure, borrowers
COD income will occur in a of each. can often negotiate with the lender
foreclosure transaction only if the The excess of the debt principal to get the most advantageous FMV
lender discharges part or all of any extinguished in the transaction assigned to the property. This is most
deficiency (excess of indebtedness over ($4,325,000) over the FMV of the likely to occur when the lender intends
the property’s FMV) upon taking the property ($4,150,000) results in COD to forgive the debt deficiency rather
property. If the lender continues to income of $175,000. If the lender than continue to pursue the borrower.
pursue the borrower for the deficiency, forgives the deficiency at the time of the Furthermore, a borrower may have
COD income will not occur until that transaction, M recognizes the income more negotiating ability if the property
deficiency is discharged for less than then. If, however, the lender pursues is voluntarily deeded back rather than
full value. If the lender fails to pursue M for this deficiency, this part of the foreclosed upon.
the borrower or to discharge all the transaction remains open, and M does Note: Certain lenders, generally
indebtedness, the COD income will not recognize income until the lender banks, savings and loans, and other
occur when the state law for enforcing eventually forgives it or the debt is financial institutions, that foreclose
the debt expires. settled for an amount less than full value. on property or take property in
As Example 1 illustrates, the FMV lieu of foreclosure must issue the
Example 1. Property foreclosure assigned to the property at foreclosure borrower a Form 1099-A, Acquisition
involving recourse debt: M bought or deed in lieu of foreclosure determines or Abandonment of Secured Property,
a commercial building on Jan. 1, the amount of the borrower’s gain or loss reporting the details of the foreclosure.
20X1, for $5,000,000. He put from the deemed sale of the property Among other information, Form
$500,000 down and financed the and potential COD income. If the 1099-A shows the FMV of the
balance with a $4,500,000 recourse property is used in a trade or business property at the time of the transfer
debt. The purchase price was allocat- or rental activity, a gain from the sale and whether the borrower is personally
ed $500,000 to land and $4,500,000 is often treated as a capital gain under liable for repayment of the remaining
to the building. Sec. 1231. Conversely, COD income is loan balance. Without planning and
ordinary income to the borrower. pretransfer negotiation with the lender,
In 20X3, M started to experience If the borrower is insolvent at the the borrower may be surprised by and
financial difficulties from the property time of the foreclosure, it may be unable to rebut the information reported
due to falling rents and the loss of a advantageous to get the lowest FMV on Form 1099-A.

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