Tax Law’s Most Important Cases, Volume 4: Aizawa and its Impact on Foreclosures
[Ed Note:As Iwas driving across the country today,passingthe time by making up new mottos for each state — Ohio: 12 Million Residents, Zero Sleeves!!! — it dawned on me thatthis would be agreat time for another installmentof Steve Talkowsky’s “Best of”series.Why do something like this?
Because unless you happen to be this chick, the tax law is considerably older than you are. As a result, no matter how diligent and dutiful you may be in absorbing current events, the reality is that much of the current law was established long before you were a twinkle in your daddy’s eyes.
To speed up your learning curve,Mr. Talkowskywill stopby from time to time to reintroduce and dissect those landmark decisions that have had a far-reaching impact on the tax law as we know it.
Next up: The Tax Court’s decision in Aizawa V. Comm.,74 AFTR2d94-5493 (29 F3d 630), 07/20/1994.In our current economic climate, tax advisers are working with Aizawaon a weekly basis, though they may not realize it. It was Aizawathat applied the rules found in Crane v. Commissioner, previously discussed by Steve here, torecourse mortgages, concluding that when property istransferred subject to a recourse — rather thana nonrecourse — mortgage, the“amount realized” on the transfer is not the full balance of the debt, but rather is limited to the FMV of the property.Now on to Steve…]
Aizawa V. Comm.,74 AFTR2d94-5493 (29 F3d 630), 07/20/1994.
My award-winning blogger, writer (check out the August release of the Tax Adviser for more awards bestowed) and friend [Ed note: I am not actually an award winning friend, just writer and blogger] requested that I write about Aizawa. While this is not a Supreme Court decision it is valuable nonetheless as it teaches us a lesson as to what constitutes “amount realized” under IRC Sec 1001 upon a foreclosure sale.
First, an important primer: real estate mortgages fall into two categories: nonrecourseand recourse. In a nonrecoursemortgage, under state law, the only option the lender has should the borrower default on the mortgage is to seize the property and sell it at foreclosure. If the sales price of the property at foreclosure is less than the outstanding balance of the nonrecourse debt…well, that’s the lender’s loss.
Conversely, if the mortgage is recourse and the property is seized by the lender and sold at auction, if the sales price at auction is less than the outstanding balance of the recourse debt, the lender can pursue the borrower for the remaining deficiency.
In the facts of the case, the Aizawa’s purchased a rental property in 1981. They put down some cash and financed the rest on a recourse basis from the sellers. They defaulted on the note to the sellers. The sellers received a judgment against the Aizawa’s for the principal, unpaid interest and attorney fees totaling $133,506.
The sellers purchased the property back in a foreclosure sale for $72,700. At the time of the foreclosure the Aizawa’s basis was $100,091.
The issue before the court was what was the amount realized by the Aizawa’s for purposes of calculating their loss on foreclosure.
The Aizawa’scontended that their amount realized was $29,193. How did they come up with this you ask? Well they took $72,700 received and reduced it by the attorney fees and unpaid interest. Therefore, they contended their loss was $70,898 ($29,193-100,091). Pretty novel approach, with aboslutley no basis in the tax law.
The IRS, applying the principlesestablished in Crane v. Commisioner,argued that the amount realized was $90,000 (the unpaid principal balance), resulting in a loss of $10,091.Remember, Crane established thatif non-recourse debt is forgiven it is treated as part of the purchase price or amount realized.
The court rejected both of these arguments and determined the amount realized to be $72,700 – the amount of proceeds on the foreclosure sale.Under the court’s reasoning, the full balance of the recourse debt could not be included in the taxpayer’s amount realized, because unlike when property is transferred subject to a nonrecourse mortgage, if adebtor transfers property subject to a recourse mortgage, the lender can still come after them for any deficiency created by the excess of the balance of the loan over the FMV of the property.
Thus, after the foreclosure,the Aizawaswere still on the hook for $18,000, the excess of the balance of the recourse mortgage ($90,000) over the amount the property fetched at foreclosure ($72,000). Toinclude the full$90,000 in amount realized would be unfair, because the Aizawa’s might still pay the remaining $18,000 deficiency. If instead the $18,000 deficiency wasforgiven, the Aizawa’s would deal with it then, in the form of cancellation of indebtedness (COD)income.
As a result, Aizawa gave birth to the “bifurcated approach” we see today when a taxpayer has a property thatsecures a recourse mortgage foreclosed upon. First, thetaxpayer recognizes gain or loss for the difference between theFMV or sales price ofthe propertyand the taxpayer’s tax basis in the property. In the second step, any remaining deficiency in the recourse debt must be dealt with. If the borrower pays the deficiency, no further gain or loss occurs. If the remaining deficiency is forgiven, the taxpayer recognizes COD income. Only the COD piece — not any gain resulting from the difference between the sales price of the property and the tax basis – may be excluded under Section 108.
So there you have it – pretty simple – the amount realized upon a foreclosure sale with recourse debt is the actual cash received.Until next time.
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