December 08, 2010
Real Estate Solutions, Taxation Alerts

Tax Opportunities in Financial Distress
by Arthur L. Silberman

Almost every financial transaction will have a tax consequence, and with proper planning a potential adverse consequence can be eliminated or at least minimized.  The following brief discussion is an example of ways in which the tax laws may aid a taxpayer in either a personal or an investment difficulty.

Residential Foreclosure
In many cases of foreclosure, the mortgage amount may exceed the taxpayer’s basis in the property, as well as its fair market value.  This may be particularly true if the property has been owned for many years and has frequently been refinanced to obtain cash.  If the property has declined significantly in value because of the recession, the mortgage debt may well be in excess of its present value.  Thus, a foreclosure, which is treated as a sale for the mortgage amount, could have various adverse tax consequences, such as:

  • Recognizable gain equal to the difference between the taxpayer’s basis in the property and the mortgage amount.
  • Realization of taxable income equal to the mortgage amount, if forgiven, in excess of the fair market value of the property.

Fortunately, the taxpayer may qualify under various provisions in the tax code for relief to exclude all or part of the paper income from tax, particularly for debt forgiven in years 2007 through 2012 under the Mortgage Forgiveness Debt Relief Act of 2007.  Similar exclusions may also be available under Internal Revenue Code §121 for the gain on the sale of the residence, and under IRC §108 in cases of bankruptcy or insolvency.  In any event, serious tax analysis is warranted.

Investment Failure
Many investors in real estate development entities have experienced the loss of their investment because of market conditions or, in far too many cases, misappropriation of the funds by the promoter/manager.  In either case, the loss may be partially recovered through appropriate tax planning.

For example, individual taxpayers may deduct losses incurred in a trade or business or a transaction entered into for profit under IRC §165(c)(1) and (2), or if such loss arises from a theft, under IRC §165(c)(3).  Because of timing issues, the taxpayer should consult with a tax expert as to the most advantageous approach.

Once it is determined that the taxpayer has suffered a deductible loss under IRC §165, further inquiries should be made to determine if all or any part of the loss may be carried back to a prior year to facilitate an immediate benefit by recovering previously-paid taxes.  IRC §172 provides for carry back of net operating losses incurred in the current year, and has been periodically amended to specifically benefit taxpayers incurring losses in the recent recession, as was done in the American Recovery and Investment Act of 2009.

The application of the tax laws to assist taxpayers experiencing financial difficulties, such as those mentioned above, may yield significant benefits to the distressed taxpayer, and should be explored in every situation where a significant amount is at stake.

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