Some examples illustrating application of these rules

Example 1 (Loosely based upon an IRS example)

Abena paid $200,000 for her home. She paid $15,000 down and borrowed the remaining $185,000 in two separate loans from two different lenders. One for $150,000 and the second for $35,000. Abena is not personally liable for the loans as they were purchase money mortgages used to buy a residence of four units or less in which Abena resides (nonrecourse debt). Abena stopped making payments and the holder of the first loan held a non-judicial foreclosure and became the owner of the house.

Liability Analysis:

Since both loans were nonrecourse, Abena has no liability to either lender.

Tax Analysis:

When the bank foreclosed on the loan, the total balances due were $180,000, the fair market value of the house was $170,000, and Abena's adjusted basis was $175,000 due to a casualty loss she had deducted. The amount Abena realized on the foreclosure is $180,000, the debt canceled by the foreclosure. She figures her gain or loss by comparing the amount realized ($180,000) with her adjusted basis ($175,000). She has a $5,000 realized gain.

Example 2

Assume the same facts as in the previous Example, except Abena is personally liable for the loan (recourse debt).

Liability Analysis:

Since both loans were recourse, Abena could potentially have liability exposure. However, since the holder of the first elected to proceed with non judicial foreclosure, it has no right to a deficiency. The second however, lost its security by virtue of the sale by the first and would have a right to sue Abena for breach of contract.

Tax Analysis:

In this case, the amount she realizes is $170,000. This is the cancelled debt ($180,000) up to the fair market value of the home ($170,000). Abena figures her gain or loss on the foreclosure by comparing the amount realized ($170,000) with her adjusted basis ($175,000). She has a $5,000 nondeductible loss. She also is treated as receiving ordinary income from cancellation of debt ("COD"). That income is $10,000 ($180,000 - $170,000).

If she qualifies under IRC§108 to exclude the $10,000 of COD her basis is reduced by this amount to $165,000 with the result that she realizes a gain of $5000.

NOTE: The law does not specify when the basis reduction occurs. These examples assume that the basis reduction occurs before the gain is recognized.

Example 3

George has basis in his house of $350,000. He has two non recourse mortgages, a first for $400,000 and a second for $200,000. He finds himself unable to make the payments. He negotiates a short sale for the current fair market value of the house ($400,000).

Liability Analysis:

Since both loans were nonrecourse, George has no liability to either lender. However it is expected that the holder of the second would negotiate some proceeds for agreeing to release its lien.

Tax Analysis:

Since these were nonrecourse loans, he would recognize a gain on the short sale by comparing the mortgage balance ($600,000) with his basis ($350,000) for a capital gain of $250,000.

Example 4

Same facts as Example 3 but assume both were recourse loans.

Liability Analysis:

Since this is a short sale, it would be incumbent upon George to negotiate any liability issues with each lender in connection with gaining approval for the short sale. The first appears to be made whole so presumably that negotiation should be easy. The second however is getting nothing from the sale on its recourse loan and could be expected to demand that George agree to pay it something, probably evidenced in the form of a long term unsecured promissory note. If a short sale were not consummated, it would be expected that eventually the first will foreclose, the second would be wiped out and would then have the right to sue George directly for breach of contract.

Tax Analysis:

George has cancellation of debt ("COD") income equal to the difference between the mortgage balance and the fair market value of the house. That is $200,000 in this example.

Under the new tax law, the basis of the house would be reduced by the amount of "qualifying" COD. If the entire $200,000 qualifies, the gain on the short sale would be $250,000 (Amount realized $400,000 less adjusted basis [$350,000-$200,00 =$150,000]) which may qualify for the exclusion under Section 121.

Example 5

Same facts as Example 4 but assume that the first were a typical purchase money non recourse loan and the second were a recourse equity line where the proceeds were not used to improve the property.

Liability Analysis:

Same as Example 4 except there would be no need to negotiate any liability issues with the holder of the first.

Tax Analysis :

Following a short sale at $400,000, George would recognize cancellation of debt income of $200,00 if he were released by the holder of the second. He would have a capital gain of $50,000 if he does not qualify for exclusion under IRC§108, which would increase by the amount the cancellation of debt is excluded

Example 6

Kelly has refinanced his property numerous times over the years. Currently the fair market value of his home is $450,000 but he owes $650,000 in a first mortgage to the bank. The loan has negative amortization; the $650,000 includes $50,000 of accrued unpaid interest. Kelly's basis is $350,000 which includes $120,000 in remodeling that was financed by the indebtedness currently secured by his property.

Liability Analysis:

As this is a recourse loan, Kelly would be personally liable. However, assuming that the lender does a non-judicial foreclosure, the lender would be prevented from seeking a deficiency.

Tax Analysis:

His COD income is $150,000 - the excess of the mortgage (without the negative amortization) over the fair market value. Assuming that the only remaining qualified acquisition indebtedness is the $120,000 of improvements, only this amount of COD qualifies under the new law. If the loan is foreclosed, Kelly has $30,000 of ordinary COD income and $370,000 of gain that may be sheltered by Section 121.