Foreclosure Is a Fully Taxable Transaction for Purposes of Passive Loss Rules.
(Parker Tax Publishing April 26, 2014)

The passive loss rules under Code Sec. 469(g) provide that if a taxpayer disposes of his entire interest in a passive activity in a "fully taxable transaction" to an unrelated party, any suspended passive losses from that activity are "freed up" and become deductible against non-passive income of the taxpayer. But does a foreclosure on real property comprising a taxpayer's entire interest in a passive activity qualify as a fully taxable disposition and if so, does it make a difference if the foreclosed property is subject to recourse debt and the foreclosure triggers cancellation of indebtedness (COD) income which is excludible from gross income because the taxpayer is insolvent? This is an area of tax law in which little guidance exists; the statute does not provide any additional explanation on what constitutes a fully taxable disposition, and there are no regulations on the issue. Thus, a recent memorandum by the IRS Office of Chief Counsel which sheds some light on this area of the tax law is welcome news for practitioners.

In CCA 201415002, the Office of Chief Counsel concluded that a foreclosure on real property subject to recourse debt comprising the taxpayer's entire interest in a passive activity is a fully taxable transaction for purposes of Code Sec. 469(g), regardless of whether any COD income from the cancellation of recourse debt is excluded from the taxpayer's income. Thus, the losses from the activity are treated as not being from a passive activity and are deductible against non-passive income. Further, the losses are not reduced by any excluded COD income.

Facts

Under the facts in CCA 201415002, a taxpayer bought real property for $1 million and financed the purchase with a recourse mortgage of $1 million. The taxpayer then leased the property to a third party. This rental activity was a passive activity of the taxpayer and the real property constituted the taxpayer's entire interest in the passive activity. The taxpayer had no other passive activities. The rental property accumulated net losses of $100,000 over three years that were suspended and carried forward under Code Sec. 469(b).

Four years later, the taxpayer defaulted on the debt and the lender foreclosed the mortgage. The fair market value of the property at the time of foreclosure was $825,000. The taxpayer's adjusted basis in the property was $800,000, and the remaining balance on the debt at the time of the foreclosure was $900,000. At the time of the foreclosure, the taxpayer was insolvent, with liabilities exceeding assets by $200,000. The mortgagee canceled the remaining $75,000 debt after the foreclosure. As a result, the taxpayer had a $25,000 gain on the foreclosure ($825,000 fair market value -$800,000 adjusted basis). The taxpayer also had $75,000 of cancellation-of-debt (COD) income ($900,000 debt - $825,000 fair market value), which was excludable from gross income under Code Sec. 108(a)(1)(B).

Cancellation of Debt

Generally, under Reg. Sec. 1.1001-2(a)(1), the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition. However, Reg. Sec. 1.1001-2(a)(2) provides that the amount realized on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness under Code Sec. 61(a)(12).

Under Code Sec. 61(a)(12), gross income generally includes income from the discharge of indebtedness. However, Code Sec. 108(a)(1)(B) excludes such amounts from income if the discharge occurs when the taxpayer is insolvent. The amount excluded is limited to the amount by which the taxpayer is insolvent. Generally, amounts excluded from gross income under Code Sec. 108(a)(1)(B) are applied to reduce certain tax attributes of the taxpayer. Code Sec. 108(b)(2)(F) provides that the taxpayer's passive activity loss or credit carryover under Code Sec. 469(b) from the tax year of the discharge is a tax attribute subject to reduction. However, reductions to tax attributes required by Code Sec. 108(b) are made after the tax is determined for the year of discharge.

Passive Activity Losses

Under Code Sec. 469(a)(1), no deduction is allowed for an individual's passive activity loss for the year. A passive-activity loss is the excess of the aggregate losses from all the taxpayer's passive activities for the year over the aggregate income from all the taxpayer's passive activities for that year. Code Sec. 469(b) provides a carryover rule under which any loss or credit from an activity that is disallowed is treated as a deduction or credit allocable to that activity in the next tax year.

Code Sec. 469(g)(1)(A) provides a special rule if, during the tax year, a taxpayer disposes of his entire interest in any passive activity (or former passive activity). Under this rule, if a taxpayer disposes of his entire interest in a passive activity in a "fully taxable transaction" to an unrelated party, any disallowed (i.e., suspended) passive losses from that activity are freed up and become deductible against non-passive income of the taxpayer.

Chief Counsel's Analysis

In its analysis, the IRS Office of Chief Counsel noted that it is well established that a foreclosure is a sale or exchange for federal tax purposes from which a taxpayer realizes gain or loss. If a taxpayer will no longer have, after a foreclosure on rental real estate that generated passive losses, any remaining interest in the activity then, at the time of the foreclosure, the taxpayer will realize and recognize all the gains and losses from the activity. Therefore, according to the Chief Counsel's Office, a foreclosure on real property comprising the taxpayer's entire interest in a passive (or former passive) activity is a fully taxable transaction for purposes of Code Sec. 469(g)(1)(A). According to the Chief Counsel's Office, this result is not affected by whether or not the taxpayer also has COD income excludable from income under Code Sec. 108(a)(1)(B).

Based on this analysis, the Chief Counsel's Office concluded that the taxpayer in CCA 201415002 had disposed of his rental property in a fully taxable transaction under Code Sec. 1001 and realized and recognized $25,000 of gain on the foreclosure. Thus, the $100,000 of suspended passive losses are treated as losses that are not from a passive activity. In addition, the Chief Counsel's Office state, the taxpayer can exclude from income the $75,000 of COD income because he was insolvent to the extent of $200,000.

With respect to the $75,000 of COD income excludible under Code Sec. 108(a)(1)(B), the Chief Counsel's Office concluded that such income does not reduce the $100,000 of non-passive losses. Under Code Sec. 108(b)(2)(F), any COD income from the tax year of the discharge reduces any passive activity loss and credit carryover of the taxpayer under Code Sec. 469(b) from the year of the discharge. However, under Code Sec. 108(b)(4), reductions to tax attributes required by Code Sec. 108(b) are made after the tax is determined for the year of discharge. In determining the taxpayer's tax for the year of the discharge, all previously suspended losses under Code Sec. 469(b) are freed-up and fully allowable upon the taxable foreclosure. Thus, there are no remaining Code Sec. 469(b) suspended loss carryovers that are reduced under Code Sec. 108(b)(2)(F). (Staff Editor Parker Tax Publishing)

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