Tax Court rules on property basis reduction timing

Editor: Mark G. Cook, CPA, CGMA

On Oct. 13, 2013, a real estate investor, Richard S. Hussey, filed his Form 1040, U.S. Individual Income Tax Return, for 2012. That year, his Form 4797, Sales of Business Property, showed an $83,675 gain for sale of 17 properties, 16 of which were related to a series of investment purchases he made in 2009. Hussey later came to believe that his accountant had made a mistake, since Hussey had sold most of these properties at a loss. He arranged to have a Form 1040-X, Amended U.S. Individual Income Tax Return, for 2012 prepared by tax attorney Michael Kohn, who also filed Hussey’s 2013 and 2014 individual returns.

In 2018, the IRS notified Hussey that the loss deductions claimed in 2013 and carried over to 2014 were to be disallowed, resulting in deficiencies and accuracy-related penalties. In Hussey, 156 T.C. No. 12 (2021), the U.S. Tax Court held that the loss deduction in 2013 was claimed with reasonable cause and good faith, but it was ultimately incorrect. The court held that Hussey was required to reduce his bases in the properties for 2012, not, as he claimed, in 2013, but that he was not liable for an accuracy-related penalty.

In 2009, Hussey bought 27 properties. To finance the transactions, he borrowed $1,714,520 from one bank. By 2012, Hussey was struggling to make his payments and started selling properties. In 2012, he sold 16 of these properties for $241,861. Of the 16 properties, 15 were sold at a loss and resulted in the bank’s issuing of 15 Forms 1099-C, Cancellation of Debt, on indebtedness totaling $754,054. This was part of an arrangement under which the original loan would be replaced with a note for $265,600 (Note A) and another note for $575,864 (Note B). In 2013 Hussey sold seven more properties for $241,500 and arranged to have $10,200 from the second note (which, at that point, was worth $539,341) turned into a third note (Note C). The bank did not issue a Form 1099-C for the 2013 sales but did note internally that it did not expect to collect on the remaining balance of Note B and moved it to its loan loss reserve.

The IRS disallows the loss

Hussey claimed a loss in 2012 and 2013. In the 2012 amended return, Hussey claimed a loss of $613,263 with regard to the sale of the 16 investment properties. Additionally, Hussey filed a Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Adjustment), on which he reported excludable income totaling $685,281 “for a discharge of qualified real property business indebtedness applied to reduce the basis of depreciable real property.”

Normally, a discharge of debt is treated as income. This is quite intuitive, as a cancellation of debt is the elimination of a liability. However, Secs. 61(a)(10) and 108(a)(1)(D) allow taxpayers to exclude such income up to the amount that the property’s value is less than the qualified real property business indebtedness (QRPBI). For example, suppose that Taxpayer A borrowed $100,000 from Bank A to buy Property A. Soon after, Property A’s value plummeted to $30,000, resulting in Bank A’s discharging $90,000 of the loan. Taxpayer A may exclude $70,000 of that loan forgiveness from its tax return, since the difference between the property value now and at purchase is $70,000. However, according to Sec. 108(c)(1), this must also result in a basis reduction to account for the income exclusion. This is also quite intuitive. Suppose that a few years after the previous example, Taxpayer A sold Property A for $50,000; it would be strange to say that Taxpayer A should get to claim a $50,000 loss. Thus, Taxpayer A must reduce its basis in Property A by the $70,000 amount excluded from income, resulting in a $20,000 gain on its later sale.

In Hussey’s case, there were two issues regarding this exclusion. First, Hussey aggregated the bases of all his properties and thus claimed that he did not need to reduce his bases for the 2012 loss and that he could reduce the bases of the remaining properties exclusively. Second, as mentioned earlier, the bank noted that it did not expect to collect on the remainder of Note B and moved it to the loan loss reserve; the IRS tried to claim that this was a discharge of the debt, a portion of which Hussey would be required to declare as income.

The court’s ruling

The court considered Hussey’s point that Sec. 1017(a) states that basis reduction generally happens in the year following the discharge; however, the court rejected that claim since Sec. 1017(b)(3)(F)(iii) requires that if a property is “taken into account under Sec. 108(c)(2)(B),” then the basis reduction is made “as of the time immediately before the disposition,” if earlier than when it would be taken into account under Sec. 108(c)(2)(B). The court held that this was indeed the case, since Sec. 108(c)(2)(B) defines the overall limitation for excluding discharged QRPBI as not exceeding the aggregate bases.

The discharged amount was large enough to require the use of the properties’ aggregated bases to fully exclude, and thus Hussey was required to reduce his bases in 2012, which would consequently reduce his bases in the 2013 sales as well. The court rejected Hussey’s claim that since his remaining properties after the 2012 sales exceeded the discharge amount, he should not have to use it in 2012, finding that Sec. 1017(b)(3)(F)(iii) and Sec. 108(c)(2)(B) do not refer to “remaining basis” after the sale of properties and that selling properties from a group of properties triggers Sec. 1017(b)(3)(F)(iii) with respect to the bases of the properties sold regardless of the remaining bases in the properties in the group not sold.

On the other hand, the court rejected the IRS’s claim that Hussey had additional debt discharged based on the bank’s recategorizing the remainder of Note B to loan loss reserve. The court did not believe that the bank intended to discharge the debt, as it was not convinced that the move to the loan loss reserve account demonstrated that the bank was giving up on the loan, the bank did not issue a Form 1099-C, and there was no record of any agreement between the bank and Hussey to discharge the loan.

The court also held that it did not believe that Hussey was negligent with his filing but rather that he had made a good-faith error and was thus exempt from accuracy-related penalties. Also, Hussey’s reliance on Kohn’s 30 years of experience was reasonable as per Sec. 6664(c)(1).

EditorNotes

Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-623-0478 or mcook@singerlewak.com.

Contributors are members of SingerLewak LLP.