Win Some, Lose Some: Basis of Property Sold Reduced Due to Lack of Documentation, But Sales Price was Lender's Bid in Foreclosure Sale

In the case of Breland v. Commissioner, TC Memo 2019-59[1] (May 29, 2019) two different issues were decided by the Tax Court:

  • Did the taxpayers properly substantiate the basis of property sold by producing only a Form 8824 from a prior return when the property was obtained as part of a like-kind exchange?

  • What was the actual sales price and cancellation of debt resulting from the foreclosure sale of the taxpayer’s properties?

The first question involved the basis of one of the pieces of property sold in the foreclosure sale.  That property had been acquired in a like-kind exchange the taxpayers took part in back in 2003, six years before the sale.  The Form 8824, submitted with the taxpayer’s return showed the basis of the properties received in the exchange (there had been three of them).  The taxpayers reported that the basis had been allocated among the properties in question based on their relative fair market values, with the lot in question (lot 52) being assigned $618,767.  After adjusting for liabilities assumed and satisfied in the transaction, the basis following the transaction was purported to be $988,938.[2]

That property was then sold as part of another §1031 exchange in 2004, purchasing two properties and filing yet another Form 8824 reporting the like-kind exchanges.  Using the numbers from the 2003 calculations, along with the information on debts again and allocating the basis to properties received, coming up with a new basis.[3]

On the sale, the IRS is challenging the basis in the lot received in 2004 to the extent it depended on the basis of the property that was sold as part of the 2003 exchange, a portion of which basis carried over to 2004 exchange (the “Jubilee Point” property).  The evidence the taxpayer presented for evidence of that basis was solely depreciation schedules from the 2003 income tax return.  They had no settlement statement or deed and the taxpayers admitted that the 2003 income tax return had not been audited by the IRS (so the IRS had already reviewed the original transaction).[4]

The Tax Court found that the taxpayers had not properly documented the basis being carried forward from the Jubilee Point property and thus limited the taxpayer’s basis in the property received to the cash they paid and the indebtedness they took on when the property was acquired.[5]

The important take-away from this part of the decision is the need to have records going back to any transaction that continues to have an impact on assets currently held.  Even though the taxpayers had disposed of the Jubilee Point property six years before the foreclosure sale in question, the two §1031 exchanges meant that the basis of that property was still something that had to be proved for the taxpayers to claim that amount as part of the basis of the property sold—and the taxpayers could not do that.

But thing worked out better for the taxpayers, and worse for the IRS, on the second issue.  At the time the properties were foreclosed, the taxpayers owed $10,764,262.  When the foreclosure sale was held, the only bidder for the property was, as is often the case, the lender.  The lender’s bid was $7,203,750.[6]

In a foreclosure sale, the sales price when the debt is in excess of the value of the property depends on whether the debt is a recourse or nonrecourse debt.  As the opinion explains, if a debt is nonrecourse, then the sales price is the balance of the debt at foreclosure in that case.  When the debt is recourse, as it was in this case, the sales price is the fair value of the property.  For the remainder of the debt, if it is forgiven then it’s cancellation of debt income.  If the debt is not forgiven at the time of the foreclosure sale, then it remains as a debt of the taxpayer and will only be cancellation of debt income if the entire balance of the loan is not eventually paid back.[7]

The IRS argued that the price paid by the lender was not the true fair market value, since there was not a willing seller and no appraisal of the property was undertaken before the foreclosure sale.  However, the Tax Court noted that, under Reg. §1.166-6(b)(2), the bid price is presumed to be the fair market value absent clear and convincing evidence to the contrary.  The Court points out that nonexistence of an appraisal is actually a problem for the IRS—because there is no clear and convincing evidence of a true fair value to overcome the presumption that the bank’s bid price is the fair value.[8]

The IRS contends that if that bid price is to be treated as the fair value, then the remaining balance of the note must discharge of indebtedness income which would be taxable as ordinary income.  However, the Tax Court notes that the bank did file a proof of claim in the bankruptcy proceeding the taxpayers later filed.  In this case, the Tax Court found that the preponderance of evidence suggest that the balance of the loan survived the foreclosure sale, and thus there was not a simultaneous cancellation of indebtedness, triggering ordinary income, at that time.[9]

Thus, the Tax Court concludes that the taxpayers had a net capital loss on the foreclosure sales which was less than they had originally reported, but significantly more than the IRS asserted.[10]

[1], May 29, 2019

[2] Breland, PDF of court decision, pp. 3-4

[3] Ibid, p. 4

[4] Ibid, p. 12

[5] Ibid, p. 12-13

[6] Ibid, p. 5

[7] Ibid, pp. 7-8

[8] Ibid, p. 9

[9] Ibid, p. 10-11

[10] Ibid, p. 13