IRS Chief Counsel Checks 1986 Committee Reports To Give Break On Foreclosed Real Estate

May 1 2014, 9:16am CDT | by

null .  There was concern that when a wannabee real estate genius had it all fall apart their suspended losses might still be disallowed.  CCA 201415002 (sorry can’t find a free link) at least reassures them that the IRS will not be kicking them when they are down – at least not with that foot.  It is a complicated area, so a little explanation is in order.

Passive Activities – The Basics

null  A host of part-time landlords have, for the most part fruitlessly, fought them in Tax Court.  The rules require us to segregate our activities into those in which we materially participate and those in which we don’t – passive and non-passive.  Rental real estate is “per se” passive, unless you are more involved in real estate trades or businesses than anything else.  Losses in the passive bucket are only allowed to the extent of gains in the passive bucket.  Otherwise the losses are suspended and carry forward indefinitely.

Even in the absence of passive income passive losses will be allowed in the year that a passive activity is fully disposed.  There is a catch though.  You have to dispose of the activity in a fully taxable transaction.  So if you have a rental property that has accumulated losses, you will not be able to free up the losses by giving the property away or exchanging it for a property of like-kind.

What About Foreclosure?

People are distressed to learn that when they lose their property in foreclosure that they might be tagged with taxable income.  (They find the tax deductions that did not require cash outlay and tax free loan proceeds from refinancing quite a bit less distressing)  The income can be in two forms.  To the extent of the fair market value of the property the debt balance is considered sales proceeds.  If you are upside down, the debt is recourse and the creditor decides not to chase you for the balance, you have COD – Cancellation of Debt Income.

Now COD is not necessarily taxable income.  It can be excluded to the extent that you are insolvent before the debt discharge or if you are in bankruptcy.   null ?   That was the question the Chief Counsel’s office addressed and affected taxpayers will like the answer.

Highlights of the Ruling 

Does a foreclosure on real property subject to recourse debt comprising a taxpayer’s entire interest in a passive (or former passive) activity qualify as a fully taxable disposition for purposes of § 469(g)(1)(A) if the foreclosure triggers cancellation of indebtedness (COD) income that is excluded from gross income under § 108(a)(1)(B)?

A foreclosure on real property subject to recourse debt comprising the taxpayer’s entire interest in a passive (or former passive) activity is a fully taxable transaction for purposes of §§ 1001 and 469(g)(1)(A), regardless of whether any COD income from the cancellation of recourse debt is excluded under § 108(a)(1)(B). Thus, the losses from the activity are treated as not from a passive activity under §469(g)(1)(A). Additionally, these losses are not reduced by any excluded COD income under § 108(b)(2)(F).

There was not a lot for them to go on as the statute and the regulations do not expand on what a “fully taxable transaction” is.  They had to go into the Senate Report accompanying the Tax Reform Act of 1986.

When a taxpayer disposes of his entire interest in a passive activity, the actual economic gain or loss on his investment can be finally determined. Thus, under the passive loss rule, upon a fully taxable disposition, any overall loss from the activity realized by the taxpayer is recognized and allowed against income (whether active or passive income). This result is accomplished by triggering suspended losses upon disposition.

S. Rep. No. 99-313, at 725-27 (1986). Accordingly, the legislative history indicates that Congress intended the term “fully taxable transaction” to refer to a transaction constituting a final disposition of all property used in a passive activity that allows for a full accounting of all income, gains, and losses resulting from the ownership and use of such property in the activity over time. While not explicit in either the statute or legislative history, it is generally understood that Congress did not intend § 469 to be a permanent loss disallowance provision. Rather, taxpayers should be able to deduct net losses from a passive activity at a time when the ultimate economic gains and losses derived from a passive activity are finally ascertainable.

In this case, A realizes and recognizes, at the time of the foreclosure, all of the gains and losses that A will ever realize from the activity. Therefore, a foreclosure on real property comprising A’s entire interest in a passive (or former passive) activity is a fully taxable transaction for purposes of § 469(g)(1)(A). This result is not affected by whether or not the taxpayer also has COD income excludable from income under § 108(a)(1)(B).

The other thing about this ruling that pleases me is that it shows that it was smart for me to hang onto this book.

You never know when it will come in handy.

You can follow me on twitter @peterreillycpa.


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