I have a new LLC client which purchased a mortgage note (value: $207,998) for a home in Connecticut. The note became non-performing, and the LLC proceeded to foreclose on the property. As of 12/31/15, the LLC was the owner of record for the property. Since then, the home has been sold (at $42,500, a substantial loss; approximately 20% of the value of the mortgage and 50% of the home’s FMV of $96,000).

This is the LLC’s second year in business, and on their 2014 tax return (Form 1065), the mortgage note was still considered “performing” and was listed on their Schedule L Balance Sheet on Line 7(b) Mortgage/Real Estate Loans for the amount that my client paid to obtain the note ($82,889). The LLC has successfully obtained a (probably uncollectible) deficiency judgement against the borrower for $119,897.

I read a guide regarding calculating the creditor’s capital gain/loss on a foreclosure transaction, and using the worksheet they provided, my calculation says the foreclosure resulted in a capital GAIN of $74,910 for my client. But that can’t be correct…they lost over $40K in this arrangement, and lost an additional $112K of once-potential income (expected income had the note matured without incident).

How should this return be filed? Should the amount listed for their 7(b) loan on 2014 return be moved to the Depreciable Assets line? Will the figure remain the same, despite the discrepancy with the FMV, the value of the note, and the future sales price? Should the amount of the deficiency judgement be listed as an asset? What should the capital gain/loss be? Also, I believe they need to issue a Form 1099-A to the borrower, but for what amount?

Please help! Thank you in advance!