Deed in lieu produces capital gain on mortgage note

Plain-English summary

Chief Counsel assumed that a taxpayer held a mezzanine mortgage note as an investor rather than as inventory or another excluded asset. On that assumption, the note was a capital asset under section 1221. Cancelling the note when the borrower surrendered property by deed in lieu of foreclosure satisfied the sale-or-exchange requirement, so gain or loss was determined under section 1001. The property's fair market value exceeded the taxpayer's basis in the note, producing capital gain. The special bad-debt rule for property acquired through foreclosure did not apply because this was a deed in lieu rather than a foreclosure sale.

Ruling snapshot

• Question: How is cancellation of an investor's mortgage note in exchange for property by deed in lieu of foreclosure treated?
• Outcome: It produces capital gain measured by the property's fair market value over the note's basis
• Key authorities: IRC §§ 1001, 1221, and 1222; Treas. Reg. § 1.166-6(b); Rev. Rul. 61-35

Full text (IRS public release)

ID: CCA-12041200-15 [Third Party Communication:

UILC: 166.00-00 Date of Communication: Month DD, YYYY]

Number: 201602005
Release Date: 1/8/2016
From:
Sent: Friday, 12/4/15 12:00pm
To:
Cc:
Bcc:
Subject: Re: ---------------

Hi --------

Assuming, but not concluding, that the taxpayer is an investor, that is, the mortgage is
not described in § 1221(a)(1) through § 1221(a)(8), then the note evidencing the
mezzanine loan would be a capital asset under § 1221. The cancellation of the note
upon the surrender of the property by a deed in lieu of foreclosure would satisfy the
“sale or exchange” requirement of § 1222. See Allan v. Commissioner, 856 F.2d 1169,
1172 (8th Cir. 1988). Gain or loss on a deed in lieu of foreclosure is determined under
§1001. Thus, the excess of the amount realized, $------------------(the fair market value of
the property), over the taxpayer’s basis in the note, $----------------, would result in a
capital gain of $----------------. We note that §1.166-6(b) does not apply to a deed in lieu
of foreclosure. See Rev. Rul. 61-35, 1961-1 C.B. 48.

We suggest that in the Form 886-A, you describe the process of a deed in lieu of
foreclosure (as compared to a foreclosure sale). Specifically, set forth the facts
supporting a deed in lieu of foreclosure characterization of the underlying transaction to
make clear, in the event the case goes to appeals, that there is no bid price for
purposes of § 1.166-6(b).

--------, also note that your computation of gain is $------------------whereas I came up with
a figure of $----------------. Please contact me if you have any questions or concerns.