In the first part of this posting, we reviewed the deed in lieu process, and how it can be a viable alternative for both the lender and the borrower in situations of serious default where modifications or workouts are impossible. In this second part, we will discuss briefly some important tax and bankruptcy considerations.
Tax Issues
A borrower considering the possibility of foreclosure or a deed-in-lieu of foreclosure should be aware that these events can lead to income taxation of capital gain or cancellation of indebtedness income. The tax results depend in large part on whether the loan is a “recourse” loan or a “non-recourse” loan. A non-recourse loan is one where the lender’s sole option for recovering on the loan is to take back the property. If the lender can pursue the borrower personally for any shortfall by obtaining a deficiency judgment, then it is a recourse loan.
In the case of a non-recourse loan, the conveyance is taxed as if it were sold for the greater of the outstanding debt or the sales price. The nature of the gain and the deductibility of any loss depends on the holding period and the nature of the property.
In the case of a recourse loan, in addition to the potential income and gain resulting from the sale for value, there also may be cancellation of indebtedness income if the debt exceeds the value of the property. Cancellation of indebtedness income is taxed at ordinary income rates, but there are several temporary exceptions. For example, you can exclude cancellation of indebtedness income if the debt is discharged in bankruptcy, to the extent the borrower is insolvent, or in certain situations related to qualified real property business indebtedness. Note that the exception for real property business indebtedness is generally available for rental real estate and other income-producing property, but typically is not available for property held for sale such as a residential development.
Lastly, note that for non-commercial properties, the Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence.
Bankruptcy Issues
If the borrower afterwards files for bankruptcy, then in certain circumstances the conveyance of the property back to the lender could be disallowed. The two main issues to be concerned about with respect to bankruptcy after a deed-in-lieu are preferential transfers and fraudulent conveyances.
Section 548 of the Bankruptcy Code provides that fraudulent conveyances may be set aside if made within the statutorily proscribed timeframes. To be deemed fraudulent, a transfer must be made for less than the reasonable equivalent value and if the borrower meets certain tests of insolvency.
Under Section 547 of the Bankruptcy Code, preferential transfers within ninety days of the date of bankruptcy filing may be set aside. Further, preferential transfers from insiders who had reasonable cause to believe the debtor was insolvent may be set aside if it is made between ninety days and one years prior to the date of filing of the bankruptcy petition. A preferential transfer is a transfer from an insolvent debtor that is made for the benefit of a creditor, providing the creditor to receive more than it would have received in a Chapter 7 liquidation if the transfer had not been made. To prevent the transfer from being voided by the bankruptcy trustee, the lender must show that the lender did not receive more than it would have been entitled to under a Chapter 7 liquidation because the fair market value of the property conveyed is less than the outstanding indebtedness owed to the lender.