Ramifications of repossessed property.

Often when real estate is sold, the payment is secured by the property itself. When a buyer can no longer make payments and the lender receives this property back in satisfaction of the buyer's debt, gain or loss should normally be recognized, even if the buyer returns the property voluntarily.

Section 1038 of the Internal Revenue Code was enacted to provide some relief to taxpayers in this situation; the repossession is treated not as a taxable transaction but as a nullification of the original sale. The lender can elect to limit the gain recognized to cash and property previously received from the buyer (other than the repossessed property); losses cannot be recognized.

SECTION 1038

In order for the section to apply:

1. The property repossessed must be real estate.

2. The debt had to have been received in the original sale of the real property and secured by it.

3. The repossession was made in full or partial satisfaction of the debt.

4. The seller cannot pay anything to the buyer for reacquisition, unless provided for in the original sales contract or in the case of a default.

Unrelated debt is not additional consideration. In addition, the manner of reacquisition is immaterial, and these rules do not apply to certain organizations (for example, mutual savings banks, domestic building and loan associations and cooperative banks).

CONSEQUENCES OF SECTION 1038

Amount of gain. If the section requirements are met, the seller's gain on the repossession is limited to the difference between the money and the fair market value of other property received before the reacquisition as part of the sale and the gain on the sale reported as income before the reacquisition. The gain is further limited to the amount by which the property's sales price exceeded its adjusted basis at the time of sale, reduced by the sum of any reported prior gain plus the money and other property paid or transferred by the seller in connection with the reacquisition. Again, the seller may not deduct any loss on the reacquisition nor take a bad debt deduction.

Character of gain. While section 1038 controls the amount of gain recognized, it does not affect the character of the seller's repossession gain. If the sale was made in installments, the gain will have the same character as the gain on the original sale. However, if the sale involved deferred payments, and tide was transferred to the purchaser and the property was voluntarily transferred back to the seller, the gain is ordinary income.

Holding period. Since the repossession is viewed as a nullification of the original sale, the holding period includes the time the seller held the property before the original sale but not the time between the sale and the reacquisition. For depreciation purposes, the property is treated as if it had never been sold.

AVOIDING SECTION 1038

Even though section 1038 is designed to help a seller, there may be situations in winch he or she may wish to avoid its application; for example, if a decline in property values means that a loss would occur or the gain would be less than that ordinarily reportable under section 1038, it might be better to steer clear of section 1038. One way to do so involves the seller transferring a secured property obligation to a controlled corporation; the subsequent repossession by the corporation should avoid section 1038. Another way involves the sale or transfer of the obligation to any other related taxpayer, although if the transactions had been prearranged, the Internal Revenue Service might question the arrangement. Obviously another way for the seller to avoid section 1038 is to sell the installment obligation to an unrelated third party. And since the section will not apply if the buyer defaults and the seller pays consideration in addition to discharging the debt, the seller should consider whether additional payment would be a feasible solution.

PRINCIPAL RESIDENCES

If the seller reacquires a principal residence and had excluded gain under section 121 or had deferred gain under section 1034, no gain or loss is reported on the repossession, provided the property is sold within one year.

For a detailed discussion, see "When and How to Avoid Sec. 1038 Relief When Reacquiring Real Property," by George Frankel, in the January 1996 issue of The Tax Adviser

---Nicholas Fiore, editor The Tax Adviser

Editor's Note 

The material discussed provides general information. Before you take any action in this area, the appropriate code sections, regulations, cases and rulings should be examined.