Posted on April 24th, 2014

Mortgage foreclosure was passive activity disposition despite COD income exclusion

In Chief Counsel Advice, IRS has concluded that a foreclosure on real property subject to recourse debt qualifies as a fully taxable disposition for purposes of the disposition-of-passive-activity rules, even though the taxpayer’s cancellation of debt (COD) income that resulted from the foreclosure was excluded under Code Sec. 108. As a result, the taxpayer could make use of his previously suspended passive losses and in effect deduct his previously suspended deductions plus not recognize all cancellation of income from the discharge.

Background.  Code Sec. 61(a)(12) provides that gross income includes income from the discharge of indebtedness.

Code Sec. 108(a)(1)(B) provides, in general, that gross income does not include any amount which (but forCode Sec. 108(a)(1)(B)) would be includible in gross income by reason of the discharge of indebtedness of the taxpayer if the discharge occurs when the taxpayer is insolvent. Code Sec. 108(b)(1) provides that, in general, amounts excluded from gross income under Code Sec. 108(a)(1)(B) are to be 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. Code Sec. 108(b)(4) provides that reductions to tax attributes required by Code Sec. 108(b)are made after determination of tax for the year of discharge.

Code Sec. 469(a)(1) provides that the passive activity loss for a tax year is not allowed. Under Code Sec. 469(b), except as otherwise provided in Code Sec. 469, any loss from an activity which is disallowed underCode Sec. 469(a) is treated as a deduction allocable to such activity in the next tax year. Code Sec. 469(d)(1) provides that, for purposes of Code Sec. 469, the term “passive activity loss” means the amount (if any) by which the aggregate losses from all passive activities for the tax year exceed the aggregate income from all passive activities for such year.

Under Code Sec. 469(g)(1)(A), if during the tax year a taxpayer disposes of his entire interest in any passive activity, and all gain or loss realized on such disposition is recognized, the excess of (i) any loss from such activity for such tax year (determined after the application of Code Sec. 469(b)), over (ii) any net income or gain for such tax year from all other passive activities (determined after the application of Code Sec. 469(b)), is treated as a loss which is not from a passive activity. The caption to Code Sec. 469(g)(1) refers to such a disposition as a “fully taxable transaction.”

Code Sec. 1001(a) provides the rule on the recognition of gain from the sale or other disposition of property.

IRS says that there was a “fully taxable transaction.”  IRS concluded that the facts described a fully taxable transaction for purposes of Code Sec. 469(g)(1)(A).

IRS noted that the statute does not provide any additional guidance on what constitutes a fully taxable disposition and that there are no regs providing any rules on this issue. However, it said S. Rep. No. 99-313, the Senate Report accompanying the Tax Reform Act of 1986, indicates that Congress intended the term “fully taxable transaction” to refer to a transaction constituting a final disposition of all property used in a passive activity that allows for a full accounting of all income, gains, and losses resulting from the ownership and use of such property in the activity over time. While not explicit in either the statute or legislative history, it is generally understood that Congress did not intend Code Sec. 469 to be a permanent loss disallowance provision. Rather, taxpayers should be able to deduct net losses from a passive activity at a time when the ultimate economic gains and losses derived from a passive activity are finally ascertainable.

IRS went on to say that a foreclosure is a sale or exchange for federal tax purposes from which a taxpayer realizes gain or loss. (Aizawa, (1992) 99 TC 197) Therefore, a foreclosure qualifies as a fully taxable transaction for purposes of Code Sec. 1001(a). Foreclosure is also a fully taxable transaction for purposes of Code Sec. 469(g)(1)(A) where the taxpayer no longer possesses, after the foreclosure, any remaining interest in the activity that generated the suspended passive losses.

In this case, A realized and recognized, at the time of the foreclosure, all of the gains and losses that A will ever realize from the activity. Therefore, the foreclosure on real property comprising A’s entire interest in a passive activity was a fully taxable transaction for purposes of Code Sec. 469(g)(1)(A).

A disposed of the property in a fully taxable transaction and realized and recognized $25,000 of gain on the foreclosure. Thus, the transaction was a fully taxable transaction for purposes of Code Sec. 469(g)(1)(A), and the $100,000 of suspended passive losses are treated as losses not from a passive activity under Code Sec. 469(g)(1)(A). Additionally, A may exclude the $75,000 COD income from the cancellation of the recourse mortgage under Code Sec. 108(a)(1)(B) because A was insolvent to the extent of $200,000. 

A does not reduce the $100,000 of non-passive losses by the $75,000 COD income excludable under Code Sec. 108(a)(1)(B). 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 determination of tax for the year of discharge. So this is where the taxpayer gets his double deduction.

Thus, in determining A’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. And, there are no remaining Code Sec. 469(b) suspended loss carryovers that are reduced under Code Sec. 108(b)(2)(F).

 As a result of IRS’s conclusion, the taxpayer can use his previously suspended $100,000 of passive losses to wipe out the $25,000 gain he had from the foreclosure. And, if, in the year of the foreclosure, the remaining $75,000 ($100,000 – $25,000) of the suspended losses exceeded his other income against which those losses may be applied, the taxpayer would have a net operating loss for that year.