Stop and Think Before You Surrender Property
PEGGY VYBORNY, CPA
Although much of the nation has seen an increase in home sales, there are still areas in the United States that are dealing with sluggish markets. If you find yourself in this situation, it may be better to surrender the property rather than try to satisfy the loan obligations. But be careful. Why? Because discharging the debt may lead to unwelcome tax consequences.
Avoiding Dire Circumstances
If you default on a nonrecourse loan – a type of loan that is secured by collateral which is usually property – your lender’s recourse is to seize the property that secured the loan. When you surrender property, the transaction is generally treated as a sale to the lender for the amount of outstanding debt.
Your capital gain or loss equals the difference between the amount of outstanding debt and your adjusted tax basis in the property. For example, if outstanding debt is $1 million and your tax basis is $700,000, your taxable gain would be $300,000. A discharge of nonrecourse debt, however, does not result in any taxable cancellation of debt income (CODI) because the lender has no right to pursue other corporate or personal assets.
If you default on a recourse loan – a type of loan that allows a lender to seek financial damages if you fail to pay the liability – the lender can hold the corporation or the owners liable for the outstanding debt (if they have signed personal guarantees or if the business is structured as a pass-through entity).
When you surrender property financed with recourse loans, the net amount of taxable gain or loss is the same, but it is categorized differently. The capital gain or loss generally equals the difference between the fair market value (FMV) of the property and your tax basis in the property. So, in the example above, if the FMV is $750,000, the taxable gain would be $50,000 ($750,000 – $700,000).
In addition, CODI (calculated as the amount of outstanding debt less the property’s FMV) is realized when the debt is discharged following the surrender of the property. CODI is taxable as ordinary income. Here, it would be $250,000 ($1 million – $750,000).
The Internal Revenue Code allows taxpayers to exclude CODI after surrendering property in some circumstances, including bankruptcy. CODI generally is excludable if the taxpayer’s debts have been discharged in a Title 11 bankruptcy proceeding or if the taxpayer is insolvent both before and after the debt is discharged outside of a bankruptcy proceeding. In this case, insolvency is determined by deducting the value of the taxpayer’s assets from its liabilities.
If the indebtedness is incurred in connection with trade or business real estate, however, the taxpayer can elect to reduce the basis of depreciable property rather than recognizing CODI, thereby reducing future depreciation deductions. The reduction will be recaptured as ordinary income.
If CODI is excluded from taxable income under one of these exceptions, though, the taxpayer must reduce certain tax attributes to reflect the amount excluded. He or she can elect to reduce the tax basis of depreciable property (including real property inventory) before reducing tax attributes such as tax credits or net operating losses. If all tax attributes are reduced to the point of elimination, any outstanding CODI is permanently excluded.
These exceptions are not available at an entity level for pass-through entities. So, for example, in a limited liability company (LLC), the availability of the first two exceptions turns on the bankruptcy or insolvency of the members, not the LLC.
Similarly, it is not the LLC’s tax attributes that are subject to reduction if CODI is excluded from taxable income. The individual members’ tax attributes are reduced.
Do Your Homework
Surrendering property may be the best option for you, but before doing so, tap into the expertise of your CPA or financial advisor. He or she can help you potentially minimize any adverse tax effects.
If you have any questions about surrendering property, contact Peggy Vyborny at [email protected] or call her at 312.670.7444.
Tax Court Finds Property Owner Was Not a “Real Estate Professional”
KADIR SUNARDIO, CPA
A property owner who qualifies as a “real estate professional” stands to reap more tax benefits than ever these days. If you satisfy the requirements, you may be able to offset some non-rental income with rental losses, as well as avoid the new 3.8% Medicare tax on net investment income.
Satisfying the requirements, though, is no small task. In Hassanipour v. Commissioner, the owner and manager of rental units recently learned that lesson the hard way.
Owner Claims Net Rental Losses
In 2008, the owner/manager was employed full-time as a research associate. He signed and submitted monthly timesheets to his employer, reporting a total of 1,936 hours worked. He also owned 28 rental apartment units in seven buildings in Vallejo, California and had a 50% interest in a single-family residence in Lake Tahoe. He performed various duties in relation to the rental properties, including repairs, administrative tasks, researching landlord/tenant law and preparing tax returns.
On their joint 2008 Form 1040, the owner/manager and his wife reported combined wages of $239,037 and claimed net rental losses of $120,540. The IRS, however, disallowed the rental losses as passive activity losses and found that the couple had underpaid taxes by $38,067.
Real Estate Professional Rules
“Passive activity” is defined as any trade or business in which the taxpayer does not materially participate. “Material participation” is defined as involvement in the operations of an activity that is regular, continuous and substantial. Rental real estate activities are generally considered passive activities regardless of whether you materially participate.
The Internal Revenue Code grants an exception from restrictions on passive activity losses for real estate professionals. If you qualify as a real estate professional and materially participate, your rental activities are treated as a trade or business, and you can offset any non-passive income with rental losses, thereby reducing your taxes. You may also be able to sidestep the 3.8% Medicare tax on net investment income as long as you are engaged in a trade or business with respect to the rental activities.
To qualify as a real estate professional, you must satisfy two requirements: 1) More than 50% of the personal services you perform in trades or businesses are performed in real property trades or businesses in which you materially participate, and 2) you perform more than 750 hours of services in real property trades or businesses in which you materially participate. “Real property trades or businesses” include those that develop or redevelop, construct or reconstruct, acquire, convert, rent, operate, manage or broker real property.
The Property Owner’s Claims
At trial in this case, the owner/manager argued the hours he had spent on rental activities exceeded his time spent working for his employer. He claimed that he had worked 35 hours per week for the employer for a total of 1,610 hours.
To prove that his hours spent on rental activities related to the Vallejo apartments, he presented estimates, summaries and a generic calendar that was not dated 2008, but which he had allegedly kept contemporaneously on dates starting on December 31, 2007. The calendar showed 1,182.9 total hours. He had not kept a contemporaneous record of time spent on the Lake Tahoe property, but estimated that he had spent 150 to 200 hours on that property and more than 500 hours performing tasks not reflected on his calendar.
Court Sides with IRS
Participation in an activity can be established by any reasonable means — you are not required to keep daily time reports, logs or similar documents. A reasonable system could include appointment books, narrative summaries or calendars.
However, in this case, the U.S. Tax Court rejected the owner/manager’s evidence as unreliable. For starters, his “2008” calendar was copyrighted in 2009 and appeared to be reconstructed, rather than contemporaneous. And, his testimony regarding his 35 hours per week work for his employer was contradicted by his monthly timesheets. Additionally, some of the estimates he added to the hours recorded in the calendar duplicated tasks or time that was already logged in the calendar.
The court concluded that the owner/manager had failed to establish that he was a real estate professional in 2008, without needing to consider the material participation aspect. His rental activities, therefore, were passive, and he could not offset his rental losses against other income.
It can be difficult to satisfy all the requirements to qualify as a real estate professional, particularly if you have another full-time job. Contemporaneous records may not be required, but they will go a long way toward helping build your case.
If you have questions or concerns about whether you qualify as a real estate professional, contact Kadir Sunardio at [email protected] or call him at 312.670.7444.
Sidebar: Property Owner’s Underpayment Leads to $7,600 Penalty
The IRS imposes a 20% accuracy-related penalty on any underpayment of federal income tax that is attributable to a substantial understatement of income tax. An understatement of income tax is substantial if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000.
The IRS assessed a $7,600 penalty against the owner/manager in the case described in the main article for his rental loss–related underpayment of taxes for 2008. Because the understatement of income tax was substantial, he had the burden of showing the penalty was inappropriate because he had acted with reasonable cause and in good faith.
He argued that he should be excused from the penalty because the rules are complicated. The court disagreed, noting that he had not consulted “competent tax professionals,” and had failed to show good faith or reasonable cause. Therefore, he was liable for the penalty.