Content by Jim Duffy

Generally, the tax consequences to a debtor of debt cancellation depend in large part upon whether the debt is recourse or non-recourse debt. Non-recourse debt is debt where the lender has no recourse against the borrower, but its remedy for nonpayment is limited to property that has been pledged or mortgaged to secure the debt. By contrast, a lender making a recourse loan may have a security interest in property of the debtor, but will also have the ability to seek repayment from the debtor to the extent that the property securing the loan is not adequate for full repayment.

The tax consequences of cancellation of debt are generally as follows. For recourse debt if the lender forecloses (or the debtor gives a deed in lieu of foreclosure), the debtor (i) will have capital gain to the extent that the value of the property transferred to the lender exceeds the debtor’s tax basis in that property and (ii) will have ordinary income (“COD income”) to the extent that the amount of the canceled debt exceeds the value of the property transferred. By contrast, with respect to non-recourse debt, upon the transfer of the collateral to the lender, the debtor will have capital gain equal to the excess of the amount of debt forgiven over the lender’s tax basis in the property. The debtor does not have any COD income in that case even if the value of the collateral is less than the outstanding debt.

Whether a creditor’s security interest in collateral is perfected on either a recourse loan or a non-recourse loan does not affect the foregoing tax treatment of loan cancellation. The significance of perfection of a security interest is that it determines the priority of that security interest vis the other creditors. It does not affect the tax consequences of foreclosure or cancellation.

Bottom Line: If a lender forecloses on an unperfected security interest in collateral, the tax consequences will be the same as foreclosing on a perfected security interest.

Ebenezer Scrooge: Let us deal with the eviction notices for tomorrow, Mr. Cratchit.
Kermit the Frog: Uh, tomorrow’s Christmas, sir.
Ebenezer Scrooge: Very well. You may gift wrap them.” – A Muppet Christmas Carol