Question

Five years ago, Firm SJ purchased land for $118,000 with $10,000 of its own funds and $108,000 borrowed from a commercial bank. The bank holds a recourse mortgage on the land. For each of the following independent transactions, compute SJ’s positive or negative cash flow. Assume that SJ is solvent, any recognized loss is fully deductible, and SJ’s marginal tax rate is 21 percent. (Negative amounts should be indicated by a minus sign.)

Required:

1. SJ defaults on the $80,000 mortgage. The bank forecloses and sells the land at public auction for $65,800. The bank notifies SJ that it will not pursue collection of the $14,200 remaining debt.
2. SJ defaults on the $80,000 mortgage. The bank forecloses and sells the land at public auction for $65,800. The bank requires SJ to pay off the $14,200 remaining debt.

Answer 1

SJ defaults on the $80,000 mortgage. The bank forecloses and sells the land at public auction for $65,800. The bank notifies SJ that it will not pursue collection of the $14,200 remaining debt.

Basis is 118,000 but loan cleared is only 80,000. It is loss and creates tax savings.

Cash flow = (118,000-80,000)*21% = 7,980

SJ defaults on the $80,000 mortgage. The bank forecloses and sells the land at public auction for $65,800. The bank requires SJ to pay off the $14,200 remaining debt.

Basis is 118,000 but loan cleared is only 65,800. It is loss and creates tax savings.

Cash flow = (118,000-65,800)*21% = 10,962