Taxpayers Weren't Required to Include "Cash for Keys" Payment in Ordinary Income

(Parker Tax Publishing November 2016)

The Tax Court determined that gross proceeds received by a married couple upon the foreclosure of their vacation home included a "cash for keys" payment received in conjunction with a deed in lieu of foreclosure agreement. The court rejected the IRS's arguments that the payment was ordinary income, finding it was inexorably linked to the relinquishment of their home and should be treated as part of the amount realized in the exchange. Bobo v. Comm'r, T.C. Summary 2016-74.

Background

In 2008, Karl and Kimberly Bobo owned their primary residence in California but worked in management positions requiring frequent travel to North Carolina. The couple purchased a second house in North Carolina in March 2008 for $850,000, securing a nonrecourse mortgage note to finance 90 percent of the purchase price and making a down payment of $85,000.

The Bobos began experiencing financial difficulties and sought loan modifications from the companies holding mortgages on the California and North Carolina houses. Although the taxpayers did not qualify for a modification for the loan on the North Carolina house, a mortgage company, Green Tree Services, LLC (Green Tree), informed the couple that they might qualify for a "deed in lieu of foreclosure" program. Since they could no longer afford to make payments on the North Carolina mortgage loan, the Bobos applied for and were accepted into this program.

In May 2012, the taxpayers entered into a deed in lieu of foreclosure agreement with Green Tree. Under the terms of this agreement the couple signed the deed to the North Carolina house over to Green Tree and, in exchange, the mortgage company forgave the balance of their note on the property. The couple also agreed to vacate the property by a certain time and meet other specified requirements, including leaving the property in broom-swept condition. In exchange for agreeing to those terms, they would receive a $20,500 "cash for keys" payment.

Observation: Cash for keys programs were designed by mortgage lenders to allow them to gain possession of a property quickly and avoid a long foreclosure process. Lenders issue these payments in exchange for borrowers' vacating a property quickly and leaving it in good condition.

Following the close of the agreement, Green Tree issued Karl a Form 1099-MISC, Miscellaneous Income, for the cash for keys payment. The cash for keys payment was characterized as nonemployee compensation. Green Tree also issued a Form 1099-A, Acquisition or Abandonment of Secured Property, to Karl, reporting an acquisition date of May 29, 2012, a loan principal balance outstanding of $716,426, and fair market value (FMV) of the property of $607,500. Green Tree calculated that the taxpayers had cancellation of debt income of $108,926, the difference between the outstanding loan balance and the FMV of the North Carolina house.

The taxpayers' CPA, Harry Bergland, Jr., prepared their 2012 income tax return. The Bobos attached to their Form 1040 a Form 8949, Sales and Other Dispositions of Capital Assets, relating to the disposition of the North Carolina house. On the Form 8949, the couple claimed a cost basis of $850,000 in the North Carolina house and gross proceeds of $736,926 from the deed in lieu of foreclosure transaction with Green Tree, resulting in a loss of $113,074. Bergland calculated the gross proceeds by adding the cash for keys incentive payment to the fair market value of the North Carolina house and the cancellation of debt income.

Following an examination, the IRS reclassified the $20,500 payment from Green Tree as ordinary income.

Analysis

Under Code Sec. 1001(a), the gain or loss recognized on a sale or exchange is the difference between the amount realized from the disposition and the property owner's adjusted basis. Under Code Sec. 1001(b), the amount realized from the disposition is the sum of any money received in the transfer plus the fair market value of property (other than money) received. When a taxpayer's obligation to repay a nonrecourse mortgage is extinguished, he includes the amount of the extinguished debt in his amount realized under Code Sec. 1001(b). In Allan v. Comm'r, 86 T.C. 655 (1986), the Tax Court held that the transfer of property by deed in lieu of foreclosure constitutes a "sale or exchange" for federal income tax purposes.

Before the Tax Court, the IRS argued that the $20,500 cash for keys payment was an incentive payment which the Bobos received only by fulfilling the conditions of the program. The IRS asserted that the payment was not part of the amount realized in the exchange and should instead be considered ordinary income.

The Tax Court disagreed with the IRS, stating it was clear that Green Tree did not hire Karl for services or have another reason to issue the cash for keys payment. Rather, the court said, the cash for keys payment was part of a single transaction, noting that Green Tree paid the Bobos $20,500 to avoid the lengthy and expensive legal process of foreclosure as part of the deed in lieu of foreclosure process.

The court stated that the instant case was similar to 2925 Briarpark, Ltd. v. Comm'r, T.C. Memo. 1997-298, in which a partnership secured a nonrecourse loan to purchase land and finance construction. The partnership later defaulted on the loan and found a third party willing to purchase the property once the bank holding the loan removed a lien on the property. The bank agreed to release the partnership from the lien and loans if the partnership assigned the sale proceeds from the property to the bank and included payments from the partnership and the general partner. In that case, the Tax Court did not treat the cash sale and the discharge of the loan as two independent events because there was ample evidence the sale and the discharge were the result of a single transaction, the sale of the property.

The court noted that similar to the partnership in 2925 Briarpark, Ltd., which had multiple agreements relating to the exchange of the property, the Bobos had two agreements with Green Tree stemming from the exchange of property: the deed in lieu of foreclosure agreement and the cash for keys agreement. Looking at the substance of the transaction, the court stated, the two agreements were inseparable; Green Tree would not have issued the cash for keys payment but for the taxpayers agreeing to sign over the deed to the property.

The court held that the cash for keys payment should be treated as part of the deed in lieu of foreclosure transaction and included in the amount realized on the North Carolina house, and determined that the Bobos had correctly calculated their loss on the transaction.

For a discussion of determining gain or loss from a sale or exchange of property, see Parker Tax ¶110,140.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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