IRS Practice and Procedure News Briefs for July 2020

Why this Case is Important: While taxpayers are generally required to pay income taxes on the cancellation of any debts they owe, there is an exception for most debts incurred to purchase a primary residence. As this case demonstrates, though, not all home loans qualify for this exception.

Facts: The taxpayer in Weiderman accepted a new job that required her to move to Southern California. As part of her compensation package, her new employer provided her with an interest-free $500,000 loan to help finance her purchase of a new home in the area. She received the loan proceeds in February 2007 and signed a promissory note agreeing to repay the loan within 10 years or upon the termination of her employment, if earlier. The taxpayer used the loan proceeds to purchase a new home - the loan was not secured by a mortgage on that home. In 2008, her employment with the new employer was terminated. As part of her severance package, her employer agreed to waive $255,000 of the outstanding balance, leaving her with a debt to the company of $245,000. On her 2009 income tax return, rather than reporting this $255,000 as cancellation of debt (COD) income and paying taxes on it, she reduced her tax basis in her home by $255,000, under the COD exception for “qualified principal residence indebtedness.” After auditing the return, the IRS determined that the exception did not apply and that the full $255,000 was taxable, resulting in a tax deficiency of over $30,000 and penalties of over $6,000. The taxpayer filed a Tax Court petition challenging this determination.

Law and Conclusion: Under Section 61(a)(12) of the Internal Revenue Code, when a taxpayer’s debt is forgiven, the amount of forgiveness generally constitutes taxable income. One exception to this rule is contained in Section 108(a)(1)(EB), which excludes from taxation “qualified principal residence indebtedness.” The general requirements for debt to constitute qualified principal residence indebtedness are that it is used to purchase, construct, or substantially improve the taxpayer’s residence, and that it is secured by a mortgage on the residence. In this case, because the loan to the taxpayer was not secured by a mortgage on the home she purchased, the debt was not qualified principal residence indebtedness. That being the case, the Court determined that the $255,000 was taxable as COD income and found in favor of the IRS.

Why this Case is Important: Whether an asset is a “capital” asset determines whether the sale of that asset will result in capital or ordinary gain or loss, which, due to differing tax rates and rules for deducting losses, can have a substantial impact on income tax liabilities. At issue, in this case, was whether the taxpayer’s sale of a home that he intended to rent but never actually rented generated a capital or ordinary loss. 

Facts: In this case, the taxpayer had purchased a historic mansion with the intention of restoring and renting it. When the restoration process took longer and cost more than expected and when informal discussions with possible tenants were not productive, the taxpayer decided to sell the property, never having rented it. The property was sold in 2009 at a loss of over $2 million. On his 2009 income tax return, the taxpayer reported this loss as ordinary rather than capital. With ordinary losses being 100% deductible against taxable income (as opposed to net capital losses, which are subject to a maximum annual deduction of $3,000), this characterization was extremely beneficial to the taxpayer. This loss generated a large net operating loss, which the taxpayer was able to carry back and forward to eliminate unpaid tax debts related to his 2004 through 2010 tax returns. After auditing the taxpayer’s 2009 return, the IRS determined that the home was a capital asset and that the sale of the home, therefore, resulted in a capital loss. The result of this recharacterization on the taxpayer’s 2004 through 2010 returns was a tax deficiency of over $1.2 million and over $230,000 of penalties. The taxpayer filed a Tax Court petition contesting the determination.

Law and Conclusion: Section 1221(a) of the Internal Revenue Code excludes from the definition of a capital asset any real property used in a taxpayer’s trade or business. The rental of real estate rental is considered a “trade or business” for purposes of this exception if the taxpayer engages in “regular and continuous activity in relation to renting the property.” In analyzing whether a taxpayer was engaged in regular and continuous rental activity, the Second Circuit takes into account factors such as the taxpayer’s efforts to rent the property and whether, with respect to the property, the taxpayer performs maintenance and repairs, employs labor to manage the property or provide tenant services, and/or purchases materials, collects rent, and pays expenses. In this case, because the taxpayer only made limited efforts to rent the property and never actually rented it, the Court agreed with the IRS that the taxpayer did not conduct a rental business, meaning that the home was a capital asset and the taxpayer’s ability to deduct that loss was severely restricted. 

If you would like more details about these cases, please contact me at 312-888-4113 or jnesser@lavellelaw.com.