Second Circuit: Deed In Lieu of Foreclosure Resulted in COD Income

(Parker Tax Publishing November 2025)

The Second Circuit affirmed a district court and held that a married couple had cancellation of indebtedness (COD) income in 2015, when the property was in foreclosure and they executed an agreement to relinquish their right to possess the property and transferred the deed to the mortgagee. The court rejected the taxpayers' argument that the agreement was unenforceable because the mortgagee never signed it, finding that the variance doctrine precluded that argument since the taxpayers did not present it to the IRS when the filed their refund claim. Salta v. U.S., 2025 PTC 338 (2d Cir. 2025).

Background

In 2007, Romeo Salta Jr. purchased real property in Point Lookout, New York (the Point Lookout Property). The contract price was $1,214,865, with $1,000,000 of the purchase price funded by a loan. Salta signed a promissory note promising to repay the loan amount.

In May 2009, the mortgage holder filed a foreclosure suit against Salta. The principal balance due was $1,028,992, and the last payment that Salta had made on the loan was on July 1, 2008. In 2013, BSI Financial Services, Inc. (BSI) advised Salta that it was now the mortgage servicer for the loan. In May 2014, the mortgage was reassigned to an entity called Newbury REO 2013, LLC (Newbury REO).

In January 2015, Salta and BSI executed a "Relocation Agreement" under which Salta agreed to relinquish any rights he had in the Point Lookout Property in exchange for a cash payment of $25,000 from BSI and a waiver by BSI of its right to any deficiency judgment it would otherwise be entitled to in foreclosure. The agreement specifically noted that BSI was required by law to report the forgiven debt to the IRS, which "may increase [Salta's] taxes." BSI issued Salta a From 1099-A, Acquisition or Abandonment of Secured Property, for tax year 2015, reporting the cancellation of the outstanding principal balance on the mortgage on the Point Lookout Property.

On their joint federal tax return for 2015, Salta and his wife, Phyllis Polega, reported $1,028,993 of cancellation-of-indebtedness (COD) income resulting from the discharge of Salta's mortgage debt on the Point Lookout Property. Salta and Polega (the taxpayers) later requested a refund from the IRS, then brought a lawsuit against the government in a district court seeking return of the $113,087 in taxes they paid on the debt cancellation.

The taxpayers contended that their COD income was taxable not in 2015 but in 2017, when Newbury REO sold the Point Lookout property. For that year, BSI, as servicer, issued Salta a Form 1099-C, Cancellation of Debt. A representative of BSI stated that it issued this form after Newbury REO had sold the Point Lookout Property to a new owner in June 2017, and "there was a difference between the amount received" from the sale "and the amount owed" on the mortgage. The taxpayers also contended that the 2015 Relocation Agreement was not enforceable because it was signed only by BSI as the mortgage holder's agent, but was never signed by Newbury REO.

Under Code Sec. 61(a)(11), income from a discharge of indebtedness is generally treated as taxable income. Under Cozzi v. Comm'r, 88 T.C. 435 (1987), debt is considered discharged for tax purposes "the moment it becomes clear that the debt will never have to be paid." The Tax Court added that "any identifiable event which fixes the loss with certainty may be taken into consideration."

In Salta v. U.S., 2024 PTC 349 (S.D.N.Y. 2024), the district court held that Salta's debt was properly discharged in 2015 and dismissed the taxpayers' refund claim. The district court found that the 2015 Relocation Agreement was the first "identifiable event" that made clear the debt would not need to be repaid. The district court rejected the taxpayers' argument the Relocation Agreement was unenforceable because the taxpayers did not present it to the IRS when they filed their refund claim. In addition, the court noted that under New York law, a six-year statute of limitations applies to mortgage foreclosure actions. The filing of a foreclosure action accelerates the mortgage debt and begins the running of the statute of limitations. Thus, the district court found that as the successor mortgage holder, Newbury REO could not have pursued Salta for the mortgage debt after 2015, six years after the loan was accelerated in 2009. For this separate reason, the court concluded that for this separate reason, the mortgage debt was discharged in 2015.

Salta and Polega appealed to the Second Circuit. On appeal, they again argued that Salta's debt was discharged not in 2015 but in 2017, when the Point Lookout Property was sold. They also renewed their argument that the Relocation Agreement was not enforceable in 2015 because it was not signed by the mortgagee.

Analysis

The Second Circuit affirmed the district court and held that Salta and Polega's income from the discharge of Salta's mortgage debt accrued in the 2015 tax year.

The Second Circuit found that in January 2015, when the Point Lookout Property was in foreclosure, Salta relinquished his rights to possess the property and transferred the deed to the mortgagee. In exchange, the mortgagee and the mortgage loan servicer waived their rights to pursue a deficiency judgment against Salta. The court said that through this deed-in-lieu-of-foreclosure arrangement, the mortgagee in essence accepted the property itself as full satisfaction for the amount owed on the mortgage loan, leaving Salta with no remaining debt. The court noted that this arrangement was memorialized in the Relocation Agreement signed by Salta and BSI and in several contemporaneous documents executed by Salta. In the court's view, the deed-in-lieu-of-foreclosure transaction was an "identifiable event" that made it clear the debt was discharged in 2015, rendering 2015 the proper tax year for recognizing Salta and Polega's cancellation of indebtedness income.

The Second Circuit found that the variance doctrine precluded the taxpayers from challenging the contract's enforceability since they did not present that argument to the IRS when the filed for a refund. The taxpayers contended that they could not have raised the unenforceability theory in 2015 because they only discovered years later that the mortgagee never signed the Relocation Agreement. But the court said that argument failed because (1) the taxpayers cited no authority for an exception to the variance doctrine where a taxpayer learns after filing a refund request that a private contract may have been unenforceable, and (2) the taxpayers knew or reasonably should have known the facts underlying their enforceability theory in 2015. The court reasoned that they knew or reasonably should have known that the mortgagee did not sign the Relocation Agreement because the document had no place for the mortgagee to sign. According to the court, when Salta signed the Agreement in Lieu of Foreclosure and the Terms of Release of Premises, it was clear from the face of the documents that the mortgagee had not signed them. The court therefore concluded that when Salta and Polega requested a refund, they knew or reasonably should have known the facts on which their unenforceability argument relied. Since they did not raise that argument with the IRS, they could not make the argument now.

For a discussion of discharge of indebtedness income in foreclosures and repossessions, see Parker Tax ¶72,370.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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