Prop. Regs. Create Capital Gains and Losses for Non-bank Lenders
On August 7, 2006, the IRS issued Prop. Regs. Sec.
1.1221-1(e), in an attempt to clarify the character of gains and
losses resulting from sales of loans and notes receivable acquired through
purchase or loan origination; see REG-109367-06. While the character
of such gains and losses has never been entirely clear, previous IRS
rulings and judicial precedent have generally found such receivables
to fall within the scope of Sec. 1221(a)(4), thus providing ordinary
gain or loss on their disposal. The proposed regulations would overturn
this historical application by expressly providing that such assets fall
outside the scope of Sec. 1221(a)(4). If ultimately adopted, they could
result in capital loss limitations for some lenders who anticipate selling
off devalued loan portfolios, but they could also result in capital gain
treatment for those selling off appreciated loan portfolios.
Background
Sec. 1221 defines a capital asset as any property held by a taxpayer (whether
or not connected with the taxpayer’s trade or business) other than
those types of property specifically enumerated in that section as falling
outside the definition. For debt instruments, the only applicable exception
listed is Sec. 1221(a)(4), which holds that accounts or notes receivable
acquired in the ordinary course of a trade or business for services rendered
or for the sale of inventories are specifically excepted from capital
treatment.
The purpose of Sec. 1221(a)(4) is to prevent a potential character mismatch
between the ordinary gain or loss resulting from the sale of inventory
or provision of services by the taxpayer and the resulting gain or loss
from the sale of the underlying account or note receivable received as
consideration in the initial sale. If the gain or loss from the sale
of the note receivable is capital, the entire income recognized on the
overall transaction (initial sale plus the sale of the note receivable)
has the potential to be treated as part ordinary and part capital gain.
This could produce a seemingly unfair result to a taxpayer who sells
inventory at an ordinary gain and later sells the resulting note receivable
at a discount (a capital loss).
The application of the Sec. 1221(a)(4) exception to capital-asset treatment
in a lending scenario was first addressed in Burbank Liquidating
Corp., 39 TC 999 (1963), which involved a scenario under which a
savings and loan association originated mortgage loans and later sold
those loans to a third party. The Tax Court did not address Sec. 582
(see below), which renders all debt instruments held by a bank as ordinary
assets. The court held that loans made in the ordinary course of a taxpayer’s
business fall within the Sec. 1221(a)(4) exception to capital-asset treatment.
This decision was made on the grounds that the process of originating
the loans is tantamount to acquiring a note receivable (the loan) in
exchange for services rendered (the process of originating the loan).
The holding in Burbank is commonly used to support ordinary gain
or loss treatment on sales of loans by non-bank lenders. The IRS acquiesced
in the decision, and it was cited in a series of rulings that applied
ordinary treatment to loans originated by a variety of commercial lenders;
see, e.g., Rev. Ruls. 72-238, 73-558, 80-56, and 80-57.
Similarly, in Federal Nat’l Mortgage Ass’n, 100 TC
541 (1993) (FNMA), the Tax Court held that the acquisition of
loans by purchase was integral to the business operations of the taxpayer.
As a result, the purchase of loans was found to be closely associated
with the process of origination, thus making the character of such purchased
loans ordinary in accordance with previous rulings.
Sec. 582
Sec. 582 specifically addresses the character of gains and losses resulting
from sales of debt instruments by financial institutions. Sec. 582(c)(1)
provides that all debt obligations held by a financial institution shall
be treated as ordinary assets. Sec. 582(c)(2) applies this treatment
expressly to banks, savings and loan associations, certain small business
investment companies, and certain business development corporations.
While Sec. 582 addresses the character issue for banks, thrifts, and the
other specialized taxpayers mentioned, its provisions do not extend to
taxpayers closely associated with these entities, even though the taxpayers
may be part of the same affiliated group. For example, a finance company,
a REIT, or some other type of non-bank lender, whether existing as a
stand-alone entity or as part of a bank affiliated group, would not be
covered by Sec. 582. These entities have historically relied on the rulings
previously discussed to determine the character of gains and losses on
acquired or originated loans.
Prop. Regs. Sec. 1.1221-1(e)
The IRS issued Prop. Regs. Sec. 1.1221-1(e) to address the “expansive” interpretation
of Sec. 1221(a)(4), concluding that the previous rulings had stretched
the application of this section beyond congressional intent. The preamble
to the proposed regulations states that Treasury and the Service view
the “extension”
of Sec. 1221(a)(4) to notes acquired through purchase and notes originated
in a lending transaction as being inconsistent with congressional intent.
It also states that the interpretations of Sec. 1221(a)(4) set forth
in Burbank and FNMA impede the effective administration
of the tax laws by causing taxpayers to make judgments as to whether
lending transactions or loan purchases constitute the provision of services,
and the preamble notes that such judgments foster
“uncertainty and disputes.”
Prop. Regs. Sec. 1.1221-1(e)(1) states that an account or note receivable
is not described in Sec. 1221(a)(4) if the account or note is acquired
for more than de minimis consideration (other than the property
or services described in Sec. 1221(a)(1)), or the obligor on the note
or account receivable is a person other than the person acquiring the
property or services. In addition, Prop. Regs. Sec. 1.1221-1(e)(2)
goes on to state definitively that an account or note receivable is not
described in Sec. 1221(a)(4) just because the taxpayer’s act of
acquiring (including originating) the account or note receivable constitutes,
or includes, the provision of a “service” as that term is
used in Sec. 1221(a)(4). While the proposed regulation does provide that
the issuance of a separate note in exchange for the value of the specific
services rendered in the loan’s acquisition would cause that note
to fall within Sec. 1221(a)(4), the balance of the note issued in the
transaction would not qualify.
Thus, the proposed regulation holds that notes and accounts receivable
acquired through purchase and those originated by the taxpayer do not
fall within the scope of Sec. 1221(a)(4). Purchased loans would not qualify
because the purchase price constitutes an amount in excess of a de
minimis amount (other than property or services delivered in direct
exchange for the receivable) to acquire the receivable. Loans and notes
originated by the taxpayer generally would not qualify because the regulation
specifically excludes services provided in originating the loan from
qualifying as “services” under Sec. 1221(a)(4), unless such
services are separately invoiced to the borrower in exchange for a separate
note (a very uncommon scenario).
As a result, the proposed regulation would effectively render purchased
and originated notes and accounts receivable as falling outside of the
Sec. 1221(a)(4) exception to capital-asset treatment. Thus, unless ordinary-asset
treatment is achieved under a different Code section, gains and losses
on the disposal of these assets would be capital in nature. This poses
a particular problem if the sale of these assets results in a loss, due
to the various limitations on deducting capital losses. However, if capital
gains would result from the sale of these assets, the capital-asset treatment
could be beneficial.
While the proposed regulation would exclude these notes and accounts receivable
from the application of Sec. 1221(a)(4), ordinary-asset treatment could
still apply to these assets under other Code sections. For example, as
mentioned above, Sec. 582 treats all debt obligations held by banks and
certain other financial institutions as ordinary assets. Taxpayers who
originate loans for the express purpose of selling those loans could
potentially treat those loans as ordinary assets under the Sec. 1221(a)(1)
exception to capital-asset treatment for property held primarily for
sale to customers.
Conclusion
The proposed regulations would change the long-standing ordinary-asset
treatment applied to loans, accounts, and notes receivable purchased
or originated by non-bank taxpayers. They would expressly remove such
assets from the scope of Sec. 1221(a)(4), even though taxpayers have
historically relied on IRS pronouncements and judicial precedent to the
contrary. Those taxpayers not protected by other Code sections offering
ordinary-asset treatment would no longer be protected against capital-loss
treatment on the sale of these assets, but those selling at a gain may
find the capital-gain treatment beneficial.
The regulations are proposed to be effective on a cutoff basis and applied
to notes and accounts receivable acquired after the date the final regulations
are published in the Federal Register.
From David A. Thornton, CPA, Columbus, OH
Recent Rulings in Real Estate Development
With the slowdown in the real estate market continuing,
many taxpayers with investments in undeveloped real estate are attempting
to find creative ways to realize the built-in profit on their existing
holdings. This planning may involve a real estate developer’s attempting
to sell a large tract of land originally scheduled for development or
a real estate investor’s subdividing and developing property originally
intended as a long-term investment. Based on this recent trend in the
marketplace, practitioners should review with clients the attributes
of a developer versus an investor of real estate holdings.
Background
Sec. 1221(a)(1) defines a capital asset as property held by a taxpayer
(whether or not connected with the taxpayer’s trade or business)
that is not primarily for sale to customers in the ordinary course of
his or her trade or business. If an asset does not meet this definition,
it will potentially be subject to tax at more than double the current
capital gain tax rates.
Several cases have attempted to clarify the “primarily held for
sale” definition. In Fraley, TC Memo 1993-304, the Tax
Court reaffirmed eight factors that should be considered when making
the “purely factual determination”
of whether or not land is primarily held for sale to customers in the
ordinary course of a trade or business:
- The purpose for which the property was acquired;
- The purpose for which the property was held;
- The extent of improvements made to the property;
- The frequency of sales;
- The nature and substantiality of the transactions;
- The nature and extent of the taxpayer’s dealings in similar
property;
- The extent of advertising to promote sales; and
- Whether the property was listed for sale, either directly or through
brokers.
Note that the courts have concluded that the existence of any one factor
or group of factors does not characterize property as primarily held
for sale to customers. Instead, each situation must be considered based
on its own facts and circumstances.
Recent Developments
Many real estate investors wonder whether they will jeopardize their investor
status if they begin to promote, subdivide, or otherwise begin to take
on certain traits of a developer. In Phelan, TC Memo 2004-206
(the most recent case on this issue), the taxpayer was involved in limited
activities that might be deemed to be inconsistent with capital-asset
status. The taxpayer was contractually obligated, at its sole expense,
to make limited improvements to the land it ultimately sold. The taxpayer
had owned the land for four years prior to the first of three sales of
the property in question.
In Phelan, the court stated:
In determining whether property was held for sale in the ordinary course
of business, the frequency and substantiality of sales is the most important
factor to be considered…. Frequent and substantial sales of real
property more likely indicate sales in the ordinary course of business,
whereas infrequent sales for significant profits are more indicative
of real property held as an investment.
In addition to the Phelan case, there also have been several
recent letter rulings dealing with the attributes of investors and dealers.
Although the recent rulings involve not-for-profit taxpayers, the IRS
was required to review the same factors relating to the “primarily
held for sale to customers” definition, to determine whether the
not-for-profits were subject to the unrelated business income tax.
In Letter Ruling 200510029, the IRS concluded that, because the taxpayer
hired a real estate consultant and its intent was to dispose of the property
via nine sales over a reasonable period of time, the lots would not be
considered as held primarily for sale to customers in the ordinary course
of a trade or business. In Letter Ruling 200530029, a private foundation
received a favorable ruling relating to its sale of land parcels. The
parcels were to be subdivided into 20-acre lots; land planning with engineering
studies was performed to determine how to maximize the land’s value.
Even though some of the foundation’s activity leaned toward development,
the IRS ruled in the taxpayer’s favor. In Letter Ruling 200242041,
a private school that sub-divided surplus property in order to sell and
maximize gain also received a favorable IRS ruling. In addition to the
subdivision of the surplus property, the school needed to construct a
roadway for access to the parcel. It was also required, under an agreement
with the local township, to build the roadway, drainage, landscape, and
trails.
Conclusion
In the midst of the current real estate slowdown, many investors are looking
for innovative ways to accelerate and maximize the gain inherent in their
real estate holdings. It is clear that a taxpayer may have attributes
of a developer while still being considered an investor in real estate.
Fortunately for these taxpayers, many of the recent rulings in this area
have been favorable. However, it should be noted that the courts and
the IRS continue to take a factual approach to each investor/developer
situation.
There are no guarantees that these favorable rulings will continue. Practitioners
should review the rulings and the attributes of “primarily available
for sale” with all real estate investors eager to liquidate their
holdings.
From Eric R. Elliott, CPA/ABV, MBA, Knoxville, TN
Short Sale or Foreclosure of a Principal Residence
It would be a bad dream for any homeowner: selling
a home when the debt that secures the property is greater than its fair
market value (FMV). With the real estate market slowing, more homeowners
are discovering that this can actually happen.
When the real estate market was booming, homeowners either borrowed heavily
to buy in at the top or took out home-equity loans, which added to their
debt. Now that the real estate market has cooled, some homeowners are
finding that their debt exceeds the FMV of the property. Not only do
they owe money to the bank and are forced to sell, but there could be
some unexpected income tax consequences as well.
This item discusses the tax implications of short sales and foreclosures,
both of which may be only a missed mortgage payment or two away, and
are often the only solutions to an otherwise uncertain situation.
Definitions
Short sale: Through a bank workout program called a short sale,
lenders approve a house sale if a homeowner is behind on payments and
owes more than the property’s FMV. The lender takes a discount
by allowing the homeowner to sell the home at less than the mortgage
debt. Short-sale contracts help lenders unload unwanted property and
avoid many expenses associated with the foreclosure process. The bank
will lose a little now to avoid losing more in foreclosure.
Deed in lieu of foreclosure: This is a deed
instrument in which a mortgagor (the borrower) conveys all interest in
real property to the mortgagee (the lender) to satisfy a loan that is
in default and avoid foreclosure. It offers several advantages to both
the borrower and the lender. The principal advantage to the borrower
is that it immediately releases him or her from most or all of the personal
indebtedness associated with the defaulted loan. The borrower also avoids
the public notoriety of a foreclosure proceeding and may receive more
generous terms than in a formal foreclosure. Advantages to a lender include
a reduction in the time and cost of repossession and additional advantages
if the borrower subsequently files for bankruptcy.
Foreclosure: This is the legal process reserved
by the lender to terminate the borrower’s interest in a property
after a loan has been defaulted. The lender sets a minimum price that
it is willing to accept for a property to be sold at auction. When the
process is completed, the lender may sell the property and keep the proceeds
to satisfy its mortgage and any legal costs. Any excess proceeds may
be used to satisfy other liens or be returned to the borrower.
Lenders do not want to own real estate and will go to great lengths not
to foreclose. It is a process that costs them time and money and leaves
them owning the property. Foreclosing on a property creates a nonperforming
asset on the lenders’ books.
DOI Income
Either a short sale or foreclosure (or deed in lieu of foreclosure) can
result in discharge of indebtedness (DOI) income to the debtor if the
lender forgives some or all of the unpaid debt. In general, cancellation
or forgiveness of a debt results in gross income for the debtor, unless
an exception applies because the taxpayer is bankrupt or insolvent (Secs.
61(a)(12) and 108(a)).
Example 1: J purchased his home in
2004 for $450,000, financing it with a balloon payment mortgage loan
from a local bank. In 2006, his employer transferred him to another state
and he was forced to sell his home, the value of which had dropped to
$400,000. J found a buyer for this amount and then renegotiated
the principal balance of his mortgage from $450,000 to $400,000. He used
the $400,000 to pay off the loan and walked away from the deal with no
out-of-pocket loss.
Because J was solvent when the loan was renegotiated, the full
amount of the loan reduction ($50,000) is taxable DOI income. Because
it was a nonbusiness bad debt, the DOI income is reported as “other
income” on line 21 of Form 1040. J also has a $50,000
($400,000–$450,000) tax loss on the sale of his home. For homes
used solely as personal residences, losses are not deductible.
Foreclosure by Lender: Recourse Debt
A short sale, foreclosure, or deed- in-lieu-of-foreclosure transaction
may result in DOI income to the borrower when recourse debt is involved.
The lender’s taking of the property in satisfaction of the recourse
debt is treated as a deemed sale with proceeds equal to the lesser of
FMV at the time of foreclosure or the amount of secured debt. If the
amount of debt exceeds the FMV, the difference is treated as DOI income
if it is forgiven (Regs. Sec. 1.1001-2(c), Example (8); Rev. Rul. 90-16).
The bid price in a foreclosure sale is presumed to be the property’s
FMV unless there is clear and convincing proof to the contrary (Regs.
Sec. 1.166-6(b)(2)).
DOI income occurs in a foreclosure transaction only if the lender discharges
part or all of any deficiency on taking the property securing it. If
the lender fails to pursue the creditor or to discharge all of the indebtedness,
DOI income results when the status (under state law) for enforcing the
debt expires.
When certain lenders (e.g., banks, savings and loans, and other financial
institutions) foreclose on property or take property in lieu of foreclosure,
they must issue a Form 1099-A, Acquisition or Abandonment of Secured
Property, to the borrower. This form provides information such as the
foreclosure date, the outstanding loan principal balance, and whether
the borrower is personally liable for repayment of the remaining balance.
State law controls when a debtor is deemed to be relieved of a liability.
The mere issuance of a Form 1099-A is not controlling if state law provides
that the discharge occurs in a different tax year. Some
lenders required to file Form 1099-A must also issue Form 1099-C, Cancellation
of Debt, for debt discharges. However, it is not necessary to file both
Forms 1099-A and 1099-C for the same debtor. Instead, only Form 1099-C
needs to be filed.
Example 2—foreclosure on personal residence with recourse
debt: M and S purchased their
home in 2001 for $300,000. They put down $15,000 and obtained
a 30-year recourse mortgage from lender A. In subsequent
years, the real estate market was red hot, resulting in M and S’s
home being appraised at $450,000 in December 2004. The couple
decided to borrow an additional $100,000 (home-equity line, interest-only
payments) against their home from lender B for a home
improvement project. From 2001 until early 2006, M and S made
their mortgage and home-equity line payments timely. In April
2006, when their outstanding principal balances on the first
mortgage and the home-equity line were $265,000 and $100,000,
respectively, they stopped making payments. The residential real
estate market also weakened in 2006 as prices steadily fell throughout
the year.
In December 2006, A sold the property at a foreclosure sale for
$340,000 and was paid back the outstanding balance of its loan of $265,000. B was
not as fortunate and was paid only $75,000, leaving a deficiency of $25,000
that B forgave. B sent M and S a
2006 Form 1099-C reporting DOI income of $25,000.
What are the tax consequences of this transaction? When property
burdened by recourse debt is foreclosed (or transferred to the lender
in a deed-in-lieu-of-foreclosure transaction) and the debt exceeds the
property’s FMV, the transaction is treated as a deemed sale for
a price equal to the FMV. The deemed sale will trigger a gain on the
sale of M and S’s home of $40,000 ($340,000 foreclosed
bid – $300,000 basis) in 2006. Since B discharged the
$25,000 deficiency, M and S will also realize $25,000
DOI income in 2006, which will be fully taxable unless they are bankrupt
or insolvent.
The good news is that the $40,000 gain on the sale should be eligible
for exclusion under the Sec. 121 home sale gain exclusion (Sec. 121;
Regs. Sec. 1.121-1). This gain exclusion cannot shelter the DOI income
because DOI income does not count as home sale gain. The DOI income arises
in a separate transaction between borrower and lender and is taxable
unless one of the exceptions under Sec. 108 applies.
Foreclosure by Lender: Nonrecourse Debt
Although nonrecourse home mortgages are not very common, they are worth
briefly discussing because the tax treatment of nonrecourse debt forgiveness
is different than the forgiveness of recourse debt.
A foreclosure (or deed in lieu of foreclosure) transaction involving non-recourse
debt is treated as a deemed sale by the borrower to the lender with proceeds
equal to the amount of nonrecourse debt (Tufts, 461 US 300 (1983)).
The deemed sale will trigger a gain if the nonrecourse debt amount exceeds
the home’s tax basis.
Treating the full amount of nonrecourse debt principal as the amount realized
from a deemed sale means there can be no DOI income due to a foreclosure
or deed-in-lieu-of-foreclosure transaction involving only nonrecourse
debt. Unlike the treatment of foreclosures involving re-course debt,
the FMV of the property is irrelevant. Also, insolvent or bankrupt status
of the taxpayer does not affect the results.
Example 3—foreclosure on a
principal residence with nonrecourse debt: Using
the same facts as Example 2—except that the mortgage and
home-equity line are nonrecourse debt—the deemed sale will
trigger a gain of $65,000 on the sale of M and S’s
home ($365,000 nonrecourse debt – $300,000 basis) in 2006.
There is no DOI income because the debt is nonrecourse. Because M and S meet
the Sec. 121 qualifications, the gain should be excludible from
gross income.
Observation: This tax outcome is generally unfavorable
for bankrupt or insolvent taxpayers who can exclude DOI income from taxable
gross income because foreclosures to satisfy nonrecourse debt may result
in nonexcludible gain rather than excludible discharge income.
Bankrupt or Insolvent Taxpayers
A detailed discussion of when DOI income is not taxable is beyond the
scope of this item. However, two of the more common exceptions, bankrupt
and insolvent taxpayers, are worth noting.
Special mandatory relief provisions apply to the DOI income of bankrupt
or insolvent taxpayers (Sec. 108(a)). These relief provisions allow such
taxpayers to exclude DOI income from gross income. However, the borrower
may have to reduce certain tax attributes (i.e., net operating and capital
loss carryovers, tax credit carryovers, basis in property, etc.) by the
amount of DOI income treated as tax free under these exceptions (Secs.
108(a) and (b)).
Bankrupt taxpayers may exclude all DOI income from gross income under
these rules (Sec. 108(a)(1)(A)). Insolvent taxpayers may exclude DOI
income from taxable gross income to the extent of insolvency before the
debt discharge transaction. Any DOI income in excess of insolvency is
included in gross income.
Example 4—excludible DOI
income for insolvent taxpayer: R’s
sole proprietorship business failed in 2006. At the time,
he owed $500,000 in business operating debts to Local Bank.
His business also owns land free and clear (worth $350,000)
that he holds for investment. The bank discharged $200,000
of R’s
debts. This debt discharge occurs outside of bankruptcy in a
voluntary workout between lender and borrower.
Just before the debt discharge, R was insolvent to the extent
of $150,000. Thus, he can exclude $150,000 of the $200,000 DOI income.
However, he must reduce his tax attributes by up to $150,000. The
remaining $50,000 of DOI income must be included in his income. After
the debt discharge, R’s assets are still worth $350,000,
and his liabilities are only $300,000. Thus, $50,000 is taxable because
he has been made solvent by that amount as a result of the debt discharge
transaction.
Conclusion
It is important to understand that a real estate short sale or foreclosure
can potentially result in taxable gain on the sale of a home, taxable
DOI income, or both. The good news is that taxpayers can probably exclude
some or all of the home sale gain if the homeowner meets the qualifications
of Sec. 121, and they might also be able to exclude some or all of the
DOI income.
From Steve R. Picha, CPA, and Yadira E. Hiraldo, CPA, Fort Lauderdale,
FL
