Rev. Rul. 80-56

1980-1 C.B. 154, 1980-9 I.R.B. 14.

                       Internal Revenue Service
                                 Revenue Ruling

    REAL ESTATE INVESTMENT TRUST; FORECLOSURE; PROPERTY VALUE EXCEEDING BID

                            Published: March 3, 1980

Section 856.--Definition of Real Estate Investment Trust, 26 CFR 1.856-1: Definition of real estate investment trust.

(Also Sections 166, 1221, 1.166-6, 1.1221-1.)

  Real estate investment trust; foreclosure; property value exceeding bid. A real estate investment trust that engaged primarily in short term financing activities, such as making construction and development loans, made a construction loan on which it later forclosed. At the foreclosure sale the trust bid in the property for less than its fair market value. The trust's basis in the mortgage note exceeded the property's value, and the balance due on the note was wholly uncollectable. The gain realized by the trust, the difference between the fair market value of the property and the bid price, is ordinary income.

ISSUE

  Is gain realized by a real estate in vestment trust upon the acquisition or mortgaged property at a foreclosure sale ordinary income or capital gain under the circumstances described below?

FACTS

  X, which qualifies as a real estate investment trust under section 856 of the Internal Revenue Code, engages primarily in short-term financing activities, such as originating, making, and servicing construction and development loans that are secured by mortgages on real property.

  In 1977, X made a construction loan of 1000x dollars to Y, a corporation.  The loan was secured by a first mortgage on land and the building to be constructed thereon.  In 1978, Y defaulted on the loan and X acquired the property by bidding it in at the foreclosure sale.  No deficiency judgment was obtained in the foreclosure proceedings, and at the time of the acquisition of the property by X the mortgage note was wholly uncollectible. On the date of the foreclosure sale the fair market value of the property was clearly established to be 500x dollars and the bid price was 400x dollars.  X's basis in the note was 900x dollars.

LAW AND ANALYSIS

  Section 166(a)(1) of the Code provides the general rule that there shall be allowed as a deduction any debt that becomes worthless within the taxable year.

  Section 1.166-6 of the Income Tax Regulations provides for the treatment of the sale of mortgaged or pledged property.  Section 1.166-6(a)(1) provides that if mortgaged or pledged property is lawfully sold for less than the amount of the debt, and the portion of the indebtedness remaining unsatisfied after the sale is wholly or partially uncollectible, the mortgagee or pledgee may deduct such amount under section 166(a) of the Code (to the extent that it constitutes capital or represents an item the income from which has been returned by the mortgagee or pledgee) as a bad debt for the taxable year in which it becomes wholly worthless or is charged off as partially worthless.

  Section 1.166-6(b)(1) of the regulations provides that in the case of a sale described in section 1.166-6(a) if the mortgagee or pledgee buys in the mortgaged or pledged property, loss or gain is also realized measured by the difference between the amount of those obligations of the debtor that are applied to the purchase or bid price of the property (to the extent such obligations constitute capital or represent an item the income from which has been returned by the mortgagee or pledgee) and the fair market value of the property.

  As a result of the foreclosure sale, under section 1.166-6(a)(1) of the regulations, X is entitled to a bad debt deduction of 500x dollars (the difference between the bid price, 400x dollars, and the basis of the note, 900x dollars).  In addition, under section 1.166-6(b)(1), X realized a gain in 1978 of 100x dollars (the difference between the fair market value of the property, 500x dollars, and the bid price, 400x dollars).

  X's loss is an ordinary loss under section 166(a) and 166(c) of the Code.

  Section 1221(4) of the Code provides that the term 'capital asset' means property held by the taxpayer but does not include accounts or notes receivable acquired in the ordinary course of trade or business for services rendered.

  Rev. Rul. 80-57, page 16, this Bulletin, describes a real estate investment trust that, like X, is primarily engaged in short-term financing activities. Based upon Burbank Liquidating Corporation v. Commissioner, 39 T.C. 999 (1963), acq., sub. nom. United Associates, Inc., 1965-1 C.B. 5, modified on other grounds, 335 F.2d 125 (9th Cir. 1964) and Rev. Rul. 72-238, 1972-1 C.B.

65, the ruling concludes that the short-term financing activities of the real estate investment trust are a trade or business and that, under section 1221(4), a note taken in the course of this business is not a capital asset.

  Rev. Rul. 72-238 also concludes that because a mortgage note held by a bank was not a capital asset, the gain realized by the bank when it purchased the mortgaged property at a foreclosure sale for a bid price less than the fair market value of the property was ordinary income rather than capital gain. Although the taxpayer in Rev. Rul. 72-238 was a bank, the ruling is equally applicable in the case of a real estate investment trust when the mortgage note is not a capital asset.

  Even if the mortgage note held by X were a capital asset, the gain realized when X purchased the mortgaged property at a foreclosure sale for less than its fair market value would not be capital gain.  Under tax benefit principles, if a taxpayer receives an ordinary income deduction, any offsetting gain is taxable as ordinary income.  See National Bank of Commerce of Seattle v. Commissioner, 115 F.2d 875 (9th Cir. 1940).

  In Merchants National Bank of Mobile v. Commissioner, 199 F.2d 657 (5th Cir. 1952), the taxpayer bank charged off and deducted certain notes as worthless and then sold them for $18,000 in the following year.  The court held that regardless of the fact that the notes were capital assets and that there was a sale or exchange, the recovery was taxable as ordinary income. The court reasoned at page 659:

    When these notes were charged off as a bad debt in the first instance, the bank deducted the amount thereof from its ordinary income, thus escaping taxation on that portion of its income in those years.  The amount subsequently recovered on the notes restores pro tanto the amount originally deducted from ordinary income, and is accordingly taxable as ordinary income, not as a capital gain.  When the notes were charged off, and the bank recouped itself for the capital loss by deducting the amount thereof from its current income, the notes were no longer capital assets for income tax purposes.  To permit the bank to reduce its ordinary income by the amount of the loss in the first instance, thus gaining a maximum tax advantage on that basis, and then permit it to treat the amount later recovered on the notes as a capital gain, taxable on a much lower basis than ordinary income, would afford the bank a tax advantage on the transaction not contemplated by the income tax laws.

HOLDING

  Any gain under section 1.166-6(b)(1) of the regulations that offsets a bad debt deduction under section 1.166-6(a)(1) is taxable as ordinary income even if the mortgage note is a capital asset.

  Because the mortgage note is not a capital asset in the hands of X, and because the gain realized under section 1.166-6(b)(1) of the regulations upon the acquisition of mortgaged property at foreclosure offsets the bad debt deduction allowed the taxpayer under section 1.166-6(a)(1) of the regulations, the gain of 100x dollars is ordinary income.

Rev. Rul. 80-56, 1980-1 C.B. 154, 1980-9 I.R.B. 14.