Originally published on Forbes.com June 17th, 2013
If you own a piece of real estate and the bank takes it away from you, you think that you have lost something. That’s just common sense. So you should be able to put a loss on your tax return. Bad enough that the IRS should question your loss, but they may claim that you have a gain. Talk about rubbing salt in the wound. If you think in double entry, like most good accountants do, it is not at all troubling. Taking the property off the books is a credit, you are going to have to debit something. Taking the debt off the books is a debit, you are going to have to credit something. Call the contra to the two transactions foreclosure gain/loss. If the offset to the debt removal is greater than the offset to the building removal, you end up with a gain.
Thinking in debits and credits produces such clarity, that accountants forget that most people don’t do it. Most people, even when they are doing real estate rental for their own accounts, don’t keep a complete set of books. So when the property is foreclosed, they will think they have a loss. That is how you end up with somebody like Drucella Malonzo representing herself in Tax Court. Here is some of the story:
Petitioner resided in California at the time her petition was filed. During 2005 she purchased a residence in Sacramento, California (residence). She resided there until sometime during 2006, when she moved to San Francisco, California. For some portion of 2007 petitioner rented out the residence, reported the income from the rental, and claimed $12,118 in depreciation. Later in 2007 petitioner was unable to rent out the residence. At that time, the fair market value of the residence was less than the outstanding mortgage loan balance and petitioner stopped making the mortgage payments and in effect abandoned the residence. Although petitioner stopped making the mortgage payments, she took no formal steps to transfer title or to provide her lender with notice of her intention to abandon the residence. After petitioner stopped making mortgage payments, the lending institution determined that petitioner’s note was in default and the mortgage loan securing the residence was foreclosed upon during 2008. The residence was resold by the lender for $278,314.84 in early 2008.
Petitioner paid $333,239 for the residence in 2005, and that amount was considered by respondent to be petitioner’s unadjusted basis in the residence. During 2008 petitioner’s lender sent her a Form 1099-A, Acquisition or Abandonment of Secured Property, reflecting that the outstanding balance of her mortgage obligation was $325,855.06. The same Form 1099-A reflected the fair market value of the residence to be the resale price of $278,314.84. Finally, the Form 1099-A reflected that January 22, 2008, was the “date of lender’s acquisition or knowledge of abandonment”.
The IRS made that out to be a $4,734 gain when they were done with the debits and credits. Entry level requirement for a Revenue Agent is a degree in accounting, so they are going to look at it that way. Rather than just pay the $737 in tax that she was billed, she amended her return to claim a loss in the amount of $313,737. After all that is the common sense view.
The Tax Court went along with the IRS. It was a pretty good discussion bringing up a 1947 Supreme Court decision Crane v Commissioner. Ms. Crane had inherited property encumbered by a non-recourse mortgage and was taxable on the balance when she sold the property. The case was foundational to the tax shelter business and for the next few decades an enigmatic footnote entranced tax professionals
Obviously, if the value of the property is less than the amount of the mortgage, a mortgagor who is not personally liable cannot realize a benefit equal to the mortgage. Consequently, a different problem might be encountered where a mortgagor abandoned the property or transferred it subject to the mortgage without receiving boot. That is not this case.
It hinted that maybe, just maybe, there was a way out of a burned out tax shelter besides dying or giving it to your spouse and getting a divorce. Those hopes were dashed by the Tufts decision in 1983. So poor Ms. Malonzo was at least three decades late with her argument. Still I’m glad she took the case up, reading about the Crane decision makes me feel young again.
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