Taxpayer Denied Abandonment Loss for "Underwater" Home.
(Parker's Federal Tax Bulletin: June 19, 2013)

Losses arising from the actual physical abandonment of depreciable property are deductible if the intent of the taxpayer is to irrevocably discard the property so that it will not be used again by the taxpayer or retrieved by the taxpayer for sale, exchange, or other disposition. In Malonzo v. Comm'r, T.C. Summary 2013-47, the taxpayer tried to use this rule to take an abandonment loss on her "underwater" home. After buying the home and living there for a year, the taxpayer then rented it, and subsequently abandoned the home when it was worth less than the mortgage. But there is a caveat to taking an abandonment loss deduction. Reg. Sec. 1.1001-2(a)(1) and the Supreme Court's decision in Crane v. Comm'r, 331 U.S. 1 (1947), provide that the subsequent foreclosure of a mortgage loan securing the property constitutes a sale or exchange. As a result, the taxpayer's abandonment loss was denied.

Background

In 2005, Drucella Malonzo bought a home in Sacramento, California. She lived there until sometime during 2006, when she moved to San Francisco. For some portion of 2007, Drucella rented out the Sacramento home. She reported the income from the rental, and claimed $12,118 in depreciation. Later in 2007, Drucella was unable to rent the home. At that time, the home's fair market value was less than the outstanding mortgage loan balance, and Drucella stopped making the mortgage payments and, in effect, abandoned the home. Although she stopped making the mortgage payments, Drucella took no formal steps to transfer title or to provide her lender with notice of her intention to abandon the home. After Drucella stopped making mortgage payments, the lending institution determined that her note was in default, and the mortgage loan securing the home was foreclosed upon during 2008. The lender resold the residence for approximately $278,300 in early 2008. Drucella had paid $333,239 for the home in 2005, and that amount was considered by the IRS to be Drucella's unadjusted basis in the residence.

During 2008, Drucella's lender sent her a Form 1099-A, Acquisition or Abandonment of Secured Property, reflecting that the outstanding balance of her mortgage was $325,844. The same Form 1099-A reflected the fair market value of the residence to be the resale price of $278,300. Finally, the Form 1099-A reflected that January 22, 2008, was the date of lender's acquisition or knowledge of abandonment.

IRS Audit

Upon auditing Drucella's 2008 income tax return, the IRS determined that she had a $4,734 long-term capital gain, which, in turn, resulted in a $737 income tax deficiency for 2008. The IRS computed the gain as follows: $325,855 amount realized (i.e., the outstanding mortgage) less Drucella's basis of $333,239 plus recaptured depreciation of $12,118. Thus, the IRS calculated Drucella's basis in the home as $321,121 ($333,239 - $12,118) and that left a gain of $4,734. The foreclosure, the IRS said, resulted in a sale or exchange because Drucella's mortgage exceeded her adjusted basis in the residence.

In response, Drucella submitted an amended 2008 Form 1040 reporting a $313,737 ordinary loss from the abandonment of the residence. Drucella saw her intended abandonment as a situation where she lost the value of the residence at a time when the debt obligation exceeded the value.

Tax Court Decision

The issue before the Tax Court was whether the circumstances in Drucella's case resulted in an ordinary loss attributable to abandonment of the home in Sacramento or a capital gain attributable to a sale or exchange.

The Tax Court began by noting that the basic principles that govern situations such as Drucella's could be found in a well established line of cases beginning with the Supreme Court's opinion in Crane v. Comm'r, 331 U.S. 1 (1947). In Crane, the taxpayer inherited real property that was encumbered by a mortgage that had not been assumed by the taxpayer. For tax purposes, the taxpayer claimed depreciation using the value of the property. When the taxpayer subsequently sold the property, the value of the property and the mortgage balance were approximately equal, and she received a net amount of $2,500, which she treated as the gain from the sale. The IRS, on the other hand, treated the value of the property less depreciation as the taxpayer's basis and the outstanding balance of the mortgage plus the $2,500 as the sale price, thereby resulting in a larger gain and an increased tax burden. The Supreme Court concluded that the amount of the unassumed mortgage should be considered part of the proceeds of sale.

Thirty-six years later, in Comm'r v. Tufts, 461 U.S. 300 (1983), the Supreme Court considered whether the same rule applied even where the unpaid amount of a nonrecourse mortgage exceeded the fair market value of the property sold. In that case, the Court held that the taxpayer, although required to include the outstanding mortgage obligation as proceeds of sale, was not entitled to a loss to the extent the mortgage exceeded the fair market value of the property.

In a case decided soon after Tufts, the Fifth Circuit affirmed the Tax Court's holding in Yarbro v. Comm'r, 737 F.2d 479 (5th Cir. 1984), aff'g T.C. Memo. 1982-675, that an abandonment of real property subject to a nonrecourse debt is a sale or exchange for purposes of determining whether a loss is a capital loss.

As a result of the above-mentioned decisions, the Tax Court held that Drucella was not entitled to an ordinary loss on the abandonment of her home in Sacramento. Allowing such a loss, the court said, would ignore the fact that she held a capital asset that was subject to a mortgage. Thus, the court agreed with the IRS that Drucella had a $4,734 capital gain.

Staff Editor Parker Tax Publishing

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