Timing a Loss Deduction

Editor: Alan Wong, CPA

Gains & Losses

Many small real estate ventures are structured so that one partner provides the capital and the second partner provides operational experience. As illustrated in the example below, a key question that may arise in such an arrangement is how to treat the loss incurred by the “capital” partner in the event of operational failure and a personal bankruptcy filing by the “service” partner.

Example: In year 1, capital partner CP and service partner SP formed a joint real estate venture as a general partnership. CP invested $1 million along with mortgage financing of $7 million to purchase 12 properties. SP was responsible for leasing and other functions of property management. The partnership agreement for the joint venture specifically provided that all profits, losses, and capital items would be allocated equally between the two partners.

In year 2, CP discovered that, despite SP’s efforts to lease the properties, the real estate venture was running a cash flow deficit. Even with the financial shortfall, SP continued to collect his management fees, although he stopped paying the bills, including the mortgages, and failed to inform CP of the financial difficulties. One month after this discovery, CP filed suit against SP for CP’s investment.

Early in year 3, SP personally filed for bankruptcy. SP failed to appear in Bankruptcy Court, which resulted in the issuance of a bench warrant for SP’s arrest. The court ruled that the bankruptcy was 50% nondischargeable as a result of SP’s fraudulent activities. Since SP’s assets are minimal (less than $40,000), CP’s chances of recovery as an unsecured party are remote at best and amount to approximately 0.5% of the total claim. On his year 3 individual income tax return, CP claimed an ordinary business loss on his investment in the real estate. Secured lenders now own the various properties.

According to Sec. 165(a), a deduction is allowed for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.” Regs. Sec. 1.165-1(b) provides that “[t]o be allowable as a deduction under section 165(a), a loss must be evidenced by closed and completed transactions, fixed by identifiable events. . . . Only a bona fide loss is allowable. Substance and not mere form shall govern in determining a deductible loss.” The issues here are whether recovery is reasonably foreseeable and whether the transaction is closed and complete.

According to Regs. Sec. 1.165-1(d)(2)(i), if an event has a reasonable prospect of recovery, then no recognizable loss has occurred in that year. “A reasonable prospect of recovery exists when the taxpayer has bona fide claims for recoupment from third parties or otherwise, and when there is a substantial possibility that such claims will be decided in his favor” (Ramsay Scarlett & Co., 61 T.C. 795 (1974), aff’d, 521 F.2d 786 (4th Cir. 1975)).

SP’s bankruptcy estate was valued at 0.5% of the liabilities, and CP concluded that there was no reasonably foreseeable recovery. CP has not engaged in any further collection efforts (and cannot while the automatic stay of 11 U.S.C. Section 362(a) is in effect). Based on the information from the bankruptcy reports, CP does not intend to pursue any future collection actions.

Regs. Sec. 1.165-1(d)(2)(i) provides that if a claim for reimbursement exists for which there is a reasonable prospect of recovery, a loss for the amount of that claim cannot be taken until it can be ascertained with reasonable certainty whether reimbursement will be received. The regulations further provide that whether reimbursement will be received may be ascertained with reasonable certainty, for example, by either a settlement, an adjudication, or an abandonment of the claim. “The standard for making this determination is an objective one, under which this Court must determine what was a ‘reasonable expectation’ as of the close of the taxable year for which the deduction is claimed” (Ramsay Scarlett, 61 T.C. at 811; see also Scofield’s Estate, 266 F.2d 154 (6th Cir. 1959), and Parmelee Transp., 351 F.2d 619 (Ct. Cl. 1965)). CP asserts that the bankruptcy filing adjudicated his claim in year 3 and that he has fulfilled the requirement of Regs. Sec. 1.165-1.

The Tax Court in Ramsay Scarlett also addressed the issue of future expectations: “The situation is not to be viewed through the eyes of the ‘incorrigible optimist,’ and hence, claims for recovery whose potential for success are remote or nebulous will not demand a postponement of the deduction” (Ramsay Scarlett, 61 T.C. at 811; see also White Dental Mfg. Co., 274 U.S. 398 (1927), and Scofield’s Estate, 266 F.2d at 159). The court went on to say that

[t]he standard is to be applied by foresight and, hence, we do not look at facts whose existence and production for use in later proceedings was not reasonably foreseeable as of the close of the particular year. Nor does the fact of a future settlement or favorable judicial action on the claim control our determination, if we find that as of the close of the particular year, no reasonable prospect of recovery existed. [Ramsay Scarlett, 61 T.C. at 811–12]

Based on the facts of the example, it is reasonably certain that CP will never receive any reimbursement after SP’s bankruptcy filing in year 3. Therefore, CP should be able to claim an ordinary loss on his investment in year 3, notwithstanding the existence of a remote prospect that he might receive some reimbursement from SP in a future year.

EditorNotes

Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York City.

For additional information about these items, contact Mr. Wong at 212-697-6900, ext. 986 or awong@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.