1031
Knowledge
Real Estate Owned (REO)
A Look at Issues from The Lender’s Perspective
Short sales, foreclosures and deed-in-lieu transfers of distressed real estate have potential tax implications for the
transferor and can present an investment opportunity for the transferee. To learn more about the benefits of a 1031
exchange transaction involving the disposition of distressed real estate, see 1031 Exchanges in a Foreclosure:
Sometimes Your Loss Really is Your Gain.
From the viewpoint of the secured bank lender, the receipt of the real estate pledged as collateral for the borrower’s
repayment obligation is a payment event. If the lender acquired the note at a significant discount, the receipt of the
collateral can generate a capital gain if the value of the real estate exceeds the lender’s investment in the secured
note. If the collateral is worth less than the investment in the note (as is usually the case), the difference generates a
loss. The loss is characterized for income tax purposes as an ordinary loss if the lender is actively engaged in the
business of lending. A private party that is not in the business of lending will realize a capital loss.
If the collateral is not sold to a third party in a foreclosure sale, the lender ends up taking ownership of the collateral
which is classified under GAAP rules as “other real estate owned” or REO property. Since a regulated bank is not in
the business of owning and managing real estate assets, bank regulations generally require that the bank dispose of
REO property expeditiously but in accordance with prudent business judgment. The accounting standards governing
the disposition of REO Property are set forth in Financial Accounting Standards No. 66 relating to Accounting for
Sales of Real Estate. To satisfy regulators, banks must maintain documentation evidencing sales efforts.
If a bank sells its REO property at a loss, the bank must recognize the actual loss which affects its balance sheet and
reserve requirements. By timing the sale of