Deed in Lieu Transactions: Taxes and Bankruptcy

Real Estate, Land Use & Construction Law

Deed in Lieu Transactions: Taxes and Bankruptcy

Apr 23, 2010 | Real Estate, Land Use & Construction Law

In the first part of this posting, we reviewed the deed in lieu process, and how it can be a viable alternative for both the lender and the borrower in situations of serious default where modifications or workouts are impossible. In this second part, we will discuss briefly some important tax and bankruptcy considerations.

Tax Issues

A borrower considering the possibility of foreclosure or a deed-in-lieu of foreclosure should be aware that these events can lead to income taxation of capital gain or cancellation of indebtedness income. The tax results depend in large part on whether the loan is a “recourse” loan or a “non-recourse” loan. A non-recourse loan is one where the lender’s sole option for recovering on the loan is to take back the property. If the lender can pursue the borrower personally for any shortfall by obtaining a deficiency judgment, then it is a recourse loan.

In the case of a non-recourse loan, the conveyance is taxed as if it were sold for the greater of the outstanding debt or the sales price. The nature of the gain and the deductibility of any loss depends on the holding period and the nature of the property.

In the case of a recourse loan, in addition to the potential income and gain resulting from the sale for value, there also may be cancellation of indebtedness income if the debt exceeds the value of the property. Cancellation of indebtedness income is taxed at ordinary income rates, but there are several temporary exceptions. For example, you can exclude cancellation of indebtedness income if the debt is discharged in bankruptcy, to the extent the borrower is insolvent, or in certain situations related to qualified real property business indebtedness. Note that the exception for real property business indebtedness is generally available for rental real estate and other income-producing property, but typically is not available for property held for sale such as a residential development.

Lastly, note that for non-commercial properties, the Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude income from the discharge of debt on their principal residence.

Bankruptcy Issues

If the borrower afterwards files for bankruptcy, then in certain circumstances the conveyance of the property back to the lender could be disallowed. The two main issues to be concerned about with respect to bankruptcy after a deed-in-lieu are preferential transfers and fraudulent conveyances.

Section 548 of the Bankruptcy Code provides that fraudulent conveyances may be set aside if made within the statutorily proscribed timeframes. To be deemed fraudulent, a transfer must be made for less than the reasonable equivalent value and if the borrower meets certain tests of insolvency.

Under Section 547 of the Bankruptcy Code, preferential transfers within ninety days of the date of bankruptcy filing may be set aside. Further, preferential transfers from insiders who had reasonable cause to believe the debtor was insolvent may be set aside if it is made between ninety days and one years prior to the date of filing of the bankruptcy petition. A preferential transfer is a transfer from an insolvent debtor that is made for the benefit of a creditor, providing the creditor to receive more than it would have received in a Chapter 7 liquidation if the transfer had not been made. To prevent the transfer from being voided by the bankruptcy trustee, the lender must show that the lender did not receive more than it would have been entitled to under a Chapter 7 liquidation because the fair market value of the property conveyed is less than the outstanding indebtedness owed to the lender.


Follow us on LinkedIn to view the latest blogs from our team.

About – Business Insights

Our business blog focuses on issues affecting Virginia, D.C. and Maryland business owners as well as those in other jurisdictions throughout the country. We provide timely insight and commentary on federal and state rules and how they affect you. If you are interested in having us cover a specific topic, please let us know.

About – Employment Law

As employment law constantly changes, the attorneys at Bean, Kinney & Korman stay up to date on the law as it develops. Our blog topics focus on those changes and what you need to know about them, ranging from severance agreements and the FLSA to social media in the workplace and recent court decisions. If you are interested in having us cover a specific topic, please let us know.

About- Real Estate

This blog focuses on real estate, land use and construction-related topics affecting Virginia and the Washington, D.C. metro area. With topics ranging from contract drafting and negotiation to local and regional land use project updates, the attorneys at Bean, Kinney & Korman provide timely insight and commentary on the issues affecting owners, builders, developers, contractors, subcontractors and other players in the industry. If you are interested in having us cover a specific topic, please let us know.

Fairfax County Signage Shake-up

Whether you are demonstrating your support for your favorite political candidate, sharing the day’s specials at your restaurant, or showcasing the location of a major office tenant, you’re undoubtedly using signage to get people’s attention. The who, where, when, and...

The Missing Middle

Arlington County’s Planning & Housing study “The Missing Middle” has entered its second phase, “Analysis & Draft Framework.” The initiative has garnered attention from homeowners, homebuilders, and community members who are interested in how the plan might...