§ 2.9 USE OF PROPERTY TO CANCEL DEBT
(a) Transfer of Property in Satisfaction of Indebtedness
When a debtor does not pay secured debts because of financial problems or because of a decline in the value of the mortgaged property, that property sometimes is used to satisfy the debt. If property is transferred in satisfaction of debt, the type of debt (recourse or nonrecourse) determines the federal income tax consequences of the transfer. Although the transfer of property to satisfy a debt that is greater than the value of the property would appear to result in DOI income, that is not necessarily the outcome.
(i) Transfer of Property in Satisfaction of Nonrecourse Debt
In simple terms, the debtor is personally liable for recourse debt, but the debtor is not personally liable for nonrecourse debt. The creditor’s remedy for default of a nonrecourse liability is limited to foreclosure on the property used as security. If the value of that property falls below the amount of the outstanding debt, the debtor is free to abandon the property and be relieved of the obligation. Thus, the creditor bears the risk of the property’s loss in value.278
Bank lends Debtor $100 and the debt is secured by Property 1. The debt is nonrecourse because Bank can foreclose on Property 1 only to satisfy the obligation. The fair market value of Property 1 is $100 when Debtor borrows the money. Several years later, the value of Property 1 declines to $80. At this time, Debtor’s basis in Property ...