In the case of Duffy v. Commissioner, TC Memo 2020-108,[1] the Tax Court gave its view of what impact a state’s law had on whether a debt in question was recourse or nonrecourse.

Short Sales: Recourse vs. Nonrecourse Debts

In this case the issue was key because the taxpayers had entered into a short sale of a residence that had total outstanding debt secured by the property in excess of its fair market value.

Petitioners sold the Gearhart property in March 2011 for $800,000. JPMorgan Chase agreed to accept $750,841 of the proceeds in full satisfaction of the mortgage loan that encumbered the property. The documents which the parties stipulated regarding petitioners’ sale of the Gearhart property do not include any judicial filings by JPMorgan Chase and make no reference to judicial proceedings to enforce petitioners’ obligation to the bank.[2]

The $750,841 that JPMorgan Chase accepted in full payment was $626,046 less than the unpaid principal balance of that mortgage at the time.[3]

If the debt was a recourse debt, the $626,046 would represent cancellation of debt income to the taxpayers, generally taxable as ordinary income to the taxpayers unless they qualified for one of the exclusions under IRC §108.[4] 

Conversely, if the debt is nonrecourse the balance of the unpaid debt ends up being included in the sales price for computing gain or loss from the disposition of the property.[5]

Anti-Deficiency Statutes

A minority of states have what are referred to as “anti-deficiency statutes” that apply to some extent to amounts borrowed and secured by a taxpayer’s residence.[6]  The state of Oregon, where the taxpayers resided in this case, is one such state.

While some states (Arizona and California in particular) provide absolute protection for mortgages used to acquire the property, others provide that protection only when the lender chooses to use a nonjudicial foreclosure proceeding.  Such proceedings tend to be used most often in such cases, since they are much simpler than going through a formal judicial foreclosure.

But the existence of these two paths to foreclose on the property raises a key question—is a debt that is subject to such a provision treated as a recourse or non-recourse debt if the lender forecloses on the property but does not pursue a judicial foreclosure? 

Advisers ran into this issue during the years following the real estate crisis. In the Nichols Patrick CPE, Inc.[7] course from that period, Debt Related Tax Issues: Foreclosures, Short Sales and Cancellation of Debt, we noted that the IRS had taken the position such debts were recourse debts:

In Private Letter Ruling 199935002, the IRS held that when the use of a non-judicial foreclosure proceeding resulted in the lender, under the State’s anti-deficiency statute, being unable to pursue a deficiency judgment, then there was a cancellation of debt event that took place at that time.

The facts of that ruling provided “under State law, a mortgagee has the option of foreclosing using a judicial procedure, under which a deficiency judgment can be enforced, or a non-judicial procedure, under which a deficiency judgment is prohibited.” The ruling went on to hold that “therefore, the deficiency of 22x was discharged by the non-judicial foreclosure.”

Under this view, the key question is whether it was within the power of the debtor to unilaterally walk away from the obligation without the risk of action on the part of the creditor. In the situation considered under the ruling, it was the unilateral decision of the creditor that removed recourse for the deficiency.

Conversely, if a lender would have no option to have obtained a deficiency judgment then the debt should be treated as purely a nonrecourse obligation regardless of any terms of the note. State laws in some states (California and Arizona to name two) provide extremely strong anti-deficiency protection to purchase-money mortgages, protection that the state courts in question have held may not be escaped even if the lender decides to forego enforcing any security interest in the property.

In that case, the same tax result should be obtained even if the lender uses the nonjudicial foreclosure option, since no alternative would exist under which the lender could have obtained full payment of the face value of the debt.[8]

Under this view, the existence of the right to pursue the collection of a deficiency judgment, even if not economically reasonable for the lender in the circumstances, would always render the debt recourse.

Short Sales

Quite often when a borrower attempts to sell property when prices have declined, the borrower finds that even when selling the residence for the best price available there won’t be sufficient funds available from the sale to pay off the debt.  In such cases, the borrower may negotiate an agreement with the lender to accept the net amount available after expenses are paid in full satisfaction of the debt.  That agreement is needed so the buyer can obtain clear title to the property—otherwise there will be no sale.

Lenders are apt to agree to such arrangements since other options available to the lender are likely to result in a lower net return, as the lender would need to go through costly foreclosure proceedings, then have to market and sell the property.  If the lender accepts this offer, they get a check based on the sale without incurring the additional costs.

If the debt is a recourse debt, then clearly we have a debt cancellation event under IRC §61(a)(11).  But what if the debt is a nonrecourse debt?  As we noted in the 2013 manual, there is a risk that this would also be viewed as a cancellation of debt since it’s first a modification of the nonrecourse note, followed by a pay-off of the note:

…[I]f the debtor simply pays less than the balance due on the note to a lender who was not the person the debtor acquired the property from and the lender releases the debtor from any additional liability, there would be a cancellation of indebtedness event. Given that, on paper, what is happening in this short sale is that the lender is accepting an amount less than a full payment from the seller’s funds in the sale, some advisers might worry the IRS would see this as effectively the same transaction—the lender reducing the loan via a modification, along with a sale.[9]

But the IRS eventually decided in 1995 Chief Counsel Advice Memorandum 002758 and a litigating position advanced in a case that was decided two years later that such a treatment did not reflect the economic realities of the situation:

In 1995 Chief Counsel Advice Memorandum 002758 the IRS outlined two theories of taxation that could apply, as well as the justification for each. The IRS labeled the two options as the “two-step” approach and the “one-step” approach.

Two-Step Approach. In the two-step approach, the short sale is viewed as two separate transactions. First the lender reduces the outstanding balance of the debt owed by the debtor. Such a loan modification transaction, discussed in Module 4, is a cancellation of indebtedness event that triggers ordinary income regardless of whether the underlying obligation is recourse or nonrecourse. The amount of the reduction would be ordinary income, but Section 108’s provisions might cause the income not to be recognized by the taxpayer.

The second step is the sale of the property to the third party buyer. That sale transaction treats the amount paid by the third party buyer as the sales price and computes a gain or loss based on that amount. As was noted earlier, if that property was a personal use property, IRC §262(a) would block any deduction for that loss. Thus, in some situations, there could be recognition of ordinary income based on the cancellation of debt event and the inability to deduct an offsetting loss due to IRC §262(a), even though the taxpayer’s underlying net worth was unchanged or had even gone down.

The memo noted that the policy argument in favor of this treatment is that “separates the tax consequences of the borrowing from the tax consequences of ownership of the property.”

Under this view, the borrower is in the same position with regard to the debt as a homeowner who, rather than negotiating a short sale, negotiates an equivalent debt modification but retains the home where the transaction’s tax impact is explained by Rev. Ruls. 91-31 and 92-99. A taxpayer who modified the debt and then sold a year later at that same price would end up with a different tax result than one that undertook both transactions at the same time.

One-Step Approach. In the alternative the IRS looked at what was labeled a “one-step” approach to handling the transaction. The argument in this case is that the economics of the transaction taken as a whole should govern rather than paying attention to the detailed formalities. The argument goes that the holder of a property secured by a nonrecourse debt has an effective “put” option to “dispose of the property for an amount equal to the amount of the debt.”

Thus, in this view, the entire balance of the mortgage would be treated as the sales price for the short sale despite the fact that the third party borrower was only paying a smaller amount.

The memorandum notes that if this approach is not used, a taxpayer could potentially elect whether to have a capital gain (which could be offset by capital losses or subject to a preferential tax rate) or cancellation of debt (potentially excludable under §108) by simply selecting either a deed in lieu of foreclosure (to give the property back to the lender) or a short sale (whether the property transfers to a third party with the consent of the lender). Arguably the net economic effect of those two transaction are the same, and the one-step approach would have them each taxed in the same manner.[10]

While that memorandum indicated that there was no settled law on the issue, the IRS would pursue and win the case of 2925 Briarpark, Ltd. v. Commissioner, TC Memo 1997-298, following the “one step approach” that a short sale involving a nonrecourse debt did not lead to cancellation of debt—rather, the unpaid portion of the debt would be added to the stated sales price to determine the total proceeds from sale.

Taxpayer’s Short Sale and Lender’s Failure to Use Judicial Proceedings

So now back to the facts of this case—the taxpayers had entered into a short sale where the lender agreed to accept $626,046 less than the amount due on the mortgage as full payment of the debt in order to allow the short sale to go through.

The IRS took a position consistent with Private Letter Ruling 199935002, cited earlier, in this case:

Respondent’s position reflects his determination that the JPMorgan Chase loan was a recourse liability of petitioners because the lender, had it chosen to do so, could have proceeded against petitioners for the unpaid balance of the loan after application of $750,841 of the proceeds from the sale of the Gearhart property.[11]

The IRS conceded that if this was a nonrecourse debt the taxpayer would have no income from the sale of the property, since the sale of the personal residence would still have resulted in a nondeductible loss even with the additional proceeds:

Respondent acknowledges that, if the JPMorgan Chase loan were instead nonrecourse—in that the bank’s remedies were limited to the Gearhart property—the unpaid loan would have been included in petitioners’ amount realized from the sale of the property. See sec. 1.1001-2(a), Income Tax Regs. In that event, respondent accepts that the canceled loan would have reduced petitioners’ nondeductible loss without resulting in cancellation of indebtedness income.[12]

That would be true even if the taxpayer had converted the property to a rental (a position subject to a separate dispute in this case) when the fair value was far less than their basis at the time of conversion, as the Court noted:

The adjusted basis of a personal residence converted to business use is stepped down to fair market value for purposes of determining a loss on a subsequent sale of the property but not for purposes of determining gain on such sale. See Simonsen v. Commissioner, 150 T.C. 201, 214 (2018).[13]

The Court described Oregon law related to this issue as follows:

Under Oregon law, when property subject to an obligation secured by a trust deed is foreclosed upon, the lender’s ability to bring a deficiency action against the debtor to obtain repayment of any portion of the obligation not satisfied by the proceeds of the foreclosure sale turns on the nature of both the property and the foreclosure proceedings. See Or. Rev. Stat. sec. 86.770(2) (2011). The statute bars deficiency actions after a judicial foreclosure of a residential trust deed and after an administrative foreclosure on any type of property.[14]

The IRS took the position that since this note was not secured by a trust deed, the debt was recourse both under its terms (which provided no limit on collection of a deficiency) and under Oregon law.  That is, had the lender taken judicial action, the lender could have obtained a deficiency judgement.

But the Tax Court did not agree, rather finding that, absent a showing that Chase undertook such a judicial proceeding, the debt was nonrecourse:

If petitioners sold the Gearhart property in an administrative foreclosure, however, without the involvement of a court, the Oregon antideficiency statute limited JPMorgan Chase’s remedies regardless of whether the trust deed securing that loan was a “[r]esidential trust deed” within the meaning of Or. Rev. Stat. sec. 86.705(5) (2011).

Because the documents which the parties stipulated regarding petitioners’ sale of the Gearhart property do not include any judicial filings by JPMorgan Chase and we find no reference to any judicial proceedings in the documents that were stipulated, we infer that the sale was part of an administrative rather than a judicial foreclosure. Therefore, Oregon’s antideficiency statute prevented JPMorgan Chase from seeking satisfaction from petitioners’ other assets of that part of its loan in excess of the proceeds it received from the sale of the Gearhart property. Petitioners’ amount realized from the sale of the Gearhart property is thus determined under the general rule of section 1.1001-2(a)(1), Income Tax Regs., rather than the exception for the cancellation of recourse liabilities provided in section 1.1001-2(a)(2), Income Tax Regs. It follows that the amount of the JPMorgan Chase loan from which petitioners were discharged is included in their amount realized from their sale of the Gearhart property. Petitioners thus realized no section 61(a)(12) discharge of indebtedness income from the cancellation of the $626,046 principal amount of the JPMorgan Chase loan or $108,661 of accrued but unpaid interest.[15]

The Court effectively holds that in this situation where the lender must take a specific action to avoid the impact of an anti-deficiency statute, if the lender does not take such a position when the property is sold or foreclosed upon, the debt will be treated as nonrecourse.  That is, the analysis in Private Letter Ruling 199935002 which the IRS had continued to use in this case is not accepted by the Tax Court, at least in this situation.

The holding raises questions about a majority of the anti-deficiency statutes that exist in states with such statutes.  Quite often, for some or all of the loans covered by a state’s anti-deficiency provision, the loss of a deficiency judgement is a trade-off the lender makes to make use of the less bothersome administrative foreclosure option.

While this worked to the taxpayer’s advantage in this case, that was due to the fact that the inclusion of the unpaid balance of the loan as sales proceeds merely reduced, but did not eliminate, what was otherwise a nondeductible personal loss.  The result could be less favorable if the taxpayer would qualify for relief under a provision of §108 for any cancellation of debt, and the moving of the unpaid balance of the debt to additional proceeds of the sale would not simply end up reducing what would be a nondeductible loss.

[1] Duffy v. Commissioner, TC Memo 2020-108, July 13, 2020, https://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=12283 (retrieved July 15, 2020)

[2] Duffy v. Commissioner, TC Memo 2020-108, p. 6

[3] Duffy v. Commissioner, TC Memo 2020-108, p. 11

[4] IRC §61(a)(11)

[5] Reg. §1.1001-2(a)(1); 2925 Briarpark, Ltd. v. Commissioner, TC Memo 1997-298

[6] In Arizona this protection is even broader, protecting any property used as a residence even if used as that by someone other than the taxpayer, such as a tenant of a rental residence.  See Arizona Revised Statutes §§33-729 and 33-814(G).

[7] Nichols Patrick CPE, Inc.’s courses and catalog were acquired by Kaplan, Inc. in 2016

[8] Edward Zollars and E. Lynn Nichols, Debt Related Tax Issues: Foreclosures, Short Sales and Cancellation of Debt: New Mexico, Nichols Patrick, CPE, Inc., July 18, 2013 edition, p. 2-10

[9] Edward Zollars and E. Lynn Nichols, Debt Related Tax Issues: Foreclosures, Short Sales and Cancellation of Debt: New Mexico, Nichols Patrick, CPE, Inc., July 18, 2013 edition, p. 3-5

[10] Edward Zollars and E. Lynn Nichols, Debt Related Tax Issues: Foreclosures, Short Sales and Cancellation of Debt: New Mexico, Nichols Patrick, CPE, Inc., July 18, 2013 edition, pp. 3-5 – 3-6

[11] Duffy v. Commissioner, TC Memo 2020-108, p. 23

[12] Duffy v. Commissioner, TC Memo 2020-108, p. 23

[13] Duffy v. Commissioner, TC Memo 2020-108, p. 23

[14] Duffy v. Commissioner, TC Memo 2020-108, p. 24

[15] Duffy v. Commissioner, TC Memo 2020-108, pp. 24-25