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When and how to avoid sec. 1038 relief when reacquiring real property.

When a lender receives a conveyance of mortgaged property in satisfaction of debt, gain or loss is realized even if the borrower returns the property voluntarily. However, the lender can elect under Sec. 1038 to limit the gain recognized to the cash and property (other than the repossessed property) previously received from the buyer; a loss cannot be recognized. While in certain cases, Sec. 1038 relief maybe welcome, there may be instances in which the lender wants to avoid the provision altogether. This article explains the law and suggests when and ways to avoid Sec. 1038's application.

When a borrower defaults on a loan secured by real property, the lender may foreclose or repossess. If the lender receives a conveyance of mortgaged property in satisfaction of debt, gain or loss is realized on the transaction, even if the borrower voluntarily returns the property.

Sec 1038 provides special rides for computing gain when a secured seller repossesses real property in satisfaction of debt, and provides for loss nonrecognition. Prior to the enactment of Sec. 1038, a repossession of real property was viewed as a taxable exchange by the seller, requiring gain or loss recognition. Congress enacted Sec. 1038 so that the repossession is treated not as a taxable transaction, but as a nullification of the original sale. According to the Senate Report,(1) such treatment is appropriate because (1) the seller is in no better position than before he made the sale (except to the extent of any additional cash or other property received after the sale); (2) valuation at the time of the repossession is difficult; (3) the seller would be taxed on gain not yet realized, so that funds to pay the taxes might not be available.

Sec. 1038 is generally beneficial to a seller, because it limits the gain recognized to the cash and property (other than the repossessed property) previously received from the buyer. However, in limited circumstances the seller may wish to avoid its application.

When Does Sec. 1038 Apply?

Sec. 1038 is mandatory if it applies, but applies only if four conditions under Regs. Sec. 1.1038-1(a) are met:

1. The repossession is of real property.

2. The debt was received in the original sale of the real property and is secured by the property. (Regs. Sec. 1.1038-1(a)(2)(ii) provides that debt is secured by real property if the seller has the right to take tide to or possession of the property on default.)

3. The repossession is made in full or partial satisfaction of such debt (i.e., the reacquisition is made in furtherance of the security interest).

4. The seller does not pay any additional consideration on the reacquisition; or, if such consideration is paid, it was provided for in the original sales contract or default has occurred or is imminent.

For this purpose, "additional consideration" is defined in Regs. Sec. 1.1038-1(a)(3)(i) to include any amount the seller pays in addition to discharging the debt arising from the original sale and secured by the real property, such as money and other property, and the seller's assumption or reacquisition of the property subject to debt that arose after the original sale. Debt that arose prior to or out of the original sale is not additional consideration.

According to Regs. Sec. 1.1038-1(a)(3)(ii), the manner of reacquisition is immaterial for Sec. 1038 purposes. The seller may reacquire ownership in the property through agreement (e.g., voluntary conveyance, abandonment) or by process of law (including foreclosure proceedings by judicial sale or by power of sale in the loan agreement, strict foreclosure, foreclosure by entry and possession, by writ of entry, or by publication of notice).

Sec. 1038(f) provides that the special rules do not apply to organizations described in Sec. 593(a), such as mutual savings banks, domestic building and loan associations and cooperative banks.

Tax Consequences to Mortgagee

When Sec. 1038 Does Not Apply

When a repossession of real property does not trigger Sec. 1038, the tax consequences are the same as on a reacquisition of personal property. The mortgagee must compute gain or loss on the repossession of the real estate; in certain circumstances, he may also have a bad debt deduction. If the original sale was reported on the installment method, the repossession in satisfaction of the obligation is a "disposition" (i.e., sale or exchange) of the installment obligation.(2) The gain or loss realized is the fair market value (FMV) of the property repossessed plus the FMV of any other property received by the seller, less the adjusted basis of the installment notes and any other expenses incurred in connection with the repossession.

Sec. 453B(b) provides that a seller's basis in an installment note is the face value of the note less the income that would be reported if the obligation were satisfied in full; thus, basis equals the outstanding debt (the face amount of the note minus any payments received) minus the outstanding debt multiplied by the gross profit ratio (GPR). Under Regs. Sec. 1.453-9(a), the character of the gain or loss on repossession is the same as the character on the sale of the original asset - capital gain or capital loss if the asset was a capital asset, ordinary gain or loss if the original sale resulted in ordinary income.

Example 1: P sold personal property with an adjusted basis of $60,000 to T for $100,000, with $10,000 down and a 9% installment note secured by the property, payable $10,000 per year for nine years. After paying one $10,000 installment, T defaulted; P repossessed the property and canceled the $80,000 remaining balance of the note. P incurred $3,000 in repossession expenses. The FMV of the property at the time of repossession was $75,000.

The GPR is 40% (($100,000 - $60,000) $100,000). Because the repossession is not one of real property, Sec. 1038 does not apply. The gain is computed as follows:

FMV of the repossessed property $75,000

Less: Repossession expenses 3,000

Amount realized 72,000

Balance due on installment note $80,000

Less: Unreported profit on

installment note (40% x $80,000) 32,000

Remaining basis in installment note 48,000

Gain on repossession $24,000

P's adjusted basis in the repossessed property is $75,000, its FMV on repossession.

Example 2: In Example 1, if the FMV of the repossessed property had been $45,000, the taxpayer would have recognized a $6,000 loss, computed as follows:

FMV of repossessed property $45,000

Less: Repossession expenses 3,000

Amount realized 42,000

Less: Basis of installment notes 48,000

Loss on repossession $(6,000)

If T has no future liability for the deficiency under the contract of sale, P may deduct the $6,000 currently. The loss is characterized as capital or ordinary (depending on the character of the asset in the original sale).

If T is not relieved of liability for the deficiency under the contract, P will be able to deduct the $6,000 as a bad debt loss only in the year in which he can show the debt is uncollectible.(3) If the debt is a nonbusiness bad debt under Sec. 166(d)(1)(B), it will be deductible as a short-term capital loss.

When Sec. 1038 Applies

If the requirements of Sec. 1038 are met, the gain recognized by the seller on repossession will be limited to the difference between (1) the money and FMV of other property (other than obligations of the purchaser) received prior to the reacquisition with respect to the sale of the property and (2) the gain on the sale reported as income in periods prior to the reacquisition (including, under Regs. Sec. 1.1038-1(b)(1)(ii) gain from any payments received in the year of reacquisition).

The gain thus computed is further limited by a Sec. 1038(b)(2) "ceiling rule" to the amount by which the sales price of the property (i.e., gross sales price less selling expenses) exceeded its adjusted basis at the time of sale, reduced by the sum of (1) the gain reported as income for years prior to the reacquisition and (2) the money and FMV of other property paid or transferred by the seller in connection with the reacquisition.

Under Regs. Sec. 1.1038-1(f)(i), if Sec. 1038 applies, no loss is deductible on the reacquisition, nor will the seller win be entitled to a bad debt deduction in the reacquisition year.

Example 3: The facts are the same as in Example 1, except that the property sold and repossessed is real property. The gain on repossession is limited to $12,000, computed as follows:

Money received by P prior to repossession

with respect to the sale $ 20,000

Less: Gain reported by P before

the reacquisition

($20,000 x 40% GPR) 8,000

Gain before ceiling limit $ 12,000

Ceiling limit:

Sales price of the real property $100,000

Less: Adjusted basis of property

when sold $60,000

Gain reported in prior periods 8,000

Expenses of repossession 3,000 71,000

Gain limitation $29,000

P's recognized gain is $12,000. In the absence of Sec. 1038 (see Example 1), the repossession would have been fully taxable to P, who would have reported a $24,000 gain. The result of Sec. 1038 seems equitable, because P received a total of $20,000 of cash from the buyer and will report no more than $20,000 of gain ($8,000 in prior periods and $12,000 on repossession).

Basis of Repossessed Property

Under Sec. 1038(c), the seller's basis in the repossessed property is the sum of (1) the adjusted basis of the debt to the seller secured by the property, (2) the gain on reacquisition (3) the money and FMV of other property paid by the seller in connection with the reacquisition and (4) any portion of the debt previously treated as worthless which the seller must restore to income on the repossession.(4)

Example 4: The facts are the same as in Example 3. The property's basis after repossession is determined as follows:

Adjusted basis of installment notes to P:

Face value of note $80,000

Less: Unreported profit in note

($80,000 X 40% GPR) 32,000 $48,000

Gain resulting from repossession 12,000

Expenses of repossession 3,000

Basis in reacquired property $63,000

When the Ceiling Rule Applies

In Example 3 above, the computed gain did not exceed the ceiling amount; however, in some circumstances, the ceiling amount limits the gain to be reported.

Example 5. The facts are the same as in Example 3, except that the, adjusted basis of the property is $90,000; the GPR is 10% (($100,000 - $90,000) / $100,000). The computation of the reported gain is as follows:

Money received by P prior to

repossession with respect to the sale $ 20,000

Less: Gain reported by P before

the reacquisition

($20,000 X 10% GPR) 2,000

Gain before ceiling limit $ 18,000

Ceiling limit:

Sales price of the real property $100,000

Less: Adjusted basis of property

when sold (90,000)

Gain reported in prior periods

($20,000 (payments received) X 10%) (2,000)

Expenses of repossession (3,000)

Gain limitation $ 5,000

P's gain on repossession is limited to $5,000.

P's basis in the real property is computed as follows:

Adjusted basis of installment note to P:

Face value of note $100,000

Less: Unreported profit in note

($80,000 X 10% GPR) 8,000 $ 92,000

Gain resulting from repossession 5,000

Expenses of repossession 3,000

Basis of reacquired property $100,000

Holding Period

As was discussed, the repossession is viewed as a nullification of the original sale; thus, under Regs. Sec. 1.1038-1(g), the holding period includes the period the seller held the property prior to the original sale, but does not include the period after the sale and before the reacquisition. For depreciation purposes, the property is treated under Sec. 168(i)(7)(C) as though it had never been sold.

Character of Gain

Regs. Sec. 1.1038-1(d) provides that Sec. 1038 does not affect the character of the seller's repossession gain. If the sale was made on the installment method, under Regs. Sec. 1.453-9(a), the reacquisition gain will have the same character as the gain on the original sale.

If the sale was not on the installment method, but was a deferred payment sale (as described in Regs. Sec. 1.453-6(a)), title was transferred to the purchaser and the property was voluntarily reconveyed to the seller, the gain is ordinary income. However, if the obligation satisfied was a corporate security (as defined in Sec. 165(g)(2)(C)), the repossession gain is capital.

Bad Debt Deduction Prior to Repossession

Regs. Sec. 1.1038-1(f)(2) provides that, if in a year prior to the repossession, the seller took a bad debt deduction for a partially or wholly worthless bad debt under Sec. 166(a), he is treated in the year of repossession as having received income in the amount of the previous deduction. However, the amount reportable as income will be subject to the Regs. Sec. 1.111-1 tax benefit rule. Under Regs. Sec. 1.1038-1(f)(3), the adjusted basis of the debt must be increased by the amount included in gross income as a recovery of the bad debt.

Avoiding Sec. 1038

In certain limited cases, a seller may wish to avoid the application of Sec. 1038; this might occur if the property's FMV at the date of the repossession has declined to the extent that (1) a loss would occur or (2) the gain would be less than that reportable under Sec. 1038 (e.g., because the cash receipts constitute a return of capital). For example, if the property repossessed in Example 2 above had been real property, it would be advantageous for the seller to avoid Sec. 1038 and deduct the $6,000 loss.

The value of the property at the time of repossession determines whether the seller would want to avoid Sec. 1038. Examining Examples I and 3 and assuming that in Example 1, the property repossessed is real property, the gain is $24,000 if Sec. 1038 does not apply and $12,000 if it does apply. If the FMV of the property declined to below $63,000 on repossession, it would be more advantageous for Sec. 1038 not to apply. Thus, in determining whether to attempt to avoid Sec. 1038, a taxpayer needs to compare the results if Sec. 1038 does and does not apply.

Can Sec. 1038 be avoided? The Service has interpreted Sec. 1038 as applying only to the reacquisition of the property by the original seller of e property. In Rev. Rul. 86-120,(5) a corporation had adopted a plan of complete liquidation under old Sec. 337. During the next 12 months, it sold real property and received installment notes secured by the property; it later distributed the notes in exchange for a shareholder's interest in the corporation. The purchaser of the real property later defaulted; the shareholder repossessed the real property and sought to apply Sec. 1038.

The Service held that Sec. 1038 did not apply to the former shareholder. It reasoned that Congress intended Sec. 1038 only to apply to property "originally held by the seller." A direct transfer of the real estate by the corporation to the shareholder would have been taxable to the shareholder under Sec. 331. To permit the shareholder to limit gain under Sec. 1038 when the shareholder indirectly acquired the property from the defaulting purchaser would have put the shareholder in a better position than if he received the property directly from the corporation.

Thus, a transfer of a secured obligation by the seller of the property to a controlled corporation and a subsequent repossession of real property by the corporation would avoid Sec. 1038. A sale or transfer of the obligation to any other related taxpayer would also avoid Sec. 1038. However, if the transactions were prearranged, the IRS might use the step-transaction doctrine to argue that Sec. 1038 applies to the shareholder.

Another way for the seller to avoid the application of Sec. 1038 is for the taxpayer to sell the installment obligation to an unrelated third party. The seller would have to consider whether this option makes economic sense, because the note is likely to sell at a deep discount.

Sec. 1038 also will not apply if the buyer defaults and the seller pays consideration in addition to discharging the debt, if such consideration was not provided for in the original contract. The seller should consider whether the payment of additional consideration is feasible.

Reacquisition by Seller's Estate or Beneficiary

Sec. 1038(g) provides that an estate or beneficiary will report gain under Sec. 1038 if (1) the decedent sold the property under the installment method, (2) the installment obligation is income in respect of a decedent under Sec. 691(a)(4)(B), and (3) the real property is repossessed by the estate or beneficiary in satisfaction of the debt.

Sec. 1038(g)(2) provides that the basis of the real property acquired by the estate or beneficiary is increased by an amount equal to the deduction under Sec. 691(c) for estate taxes that would have been allowable had the repossession been taxable.

Principal Residences

Under Sec. 1038(e), if the seller reacquires a principal residence and had excluded gain under Sec. 121 (relating to the one-time exclusion of gain from sale of a principal residence by an individual age 55) or gain was not recognized under Sec. 1034 (relating to the rollover of gain on sale of a principal residence), no gain or loss is reported on the repossession provided that the property is resold within one year. For purposes of computing the Sec. 121 exclusion or the Sec. 1034 gain rollover, the resale of the property is treated as a part of the transaction constituting the original sale of the property.


Congress enacted Sec. 1038 to eliminate the harsh result that would otherwise occur on the reacquisition of real property, and its provisions are mandatory if certain criteria are met. In most circumstances, the seller will welcome the relief However, when the repossession of the real property would result in a loss, or when the consideration received before the repossession constitutes a return of capital, the taxpayer should consider the techniques discussed to avoid Sec. 1038's application.

(1) S. Rep. No. 88-1361, 88th Cong., 2d Sess. (1964), 1964-2 CB 828, at 831. (2) See, e.g., Lucille L. Morrison, 12 TC 1178 (1949); Boca Ratone Co., 86 F2d 9 (3d Cir. 1936) (18 AFTR 546, 36-2 USTC [paragraph] 9482); Est. of Jerrold Delman, 73 TC 15, 36 (1979). (3) See IRS Pub. No. 537, Installment Sales. (4) Regs. Sec. 1.1038-1((f)(3). (5) Rev. Rul. 86-120, 1986-2 CB 145.
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Author:Frankel, George
Publication:The Tax Adviser
Date:Jan 1, 1996
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