Tax Court Addresses Basis Reduction Rules When Investment Property Debt Is Discharged

(Parker Tax Publishing July 2021)

The Tax Court held that a taxpayer who sold investment properties in the same year he received a discharge of indebtedness for the properties from the mortgage lender, and who properly excluded the discharge from income under the exclusion for qualified real property business indebtedness in Code Sec. 108(a)(1)(D), was required to reduce the bases in the properties in the year of the discharge, rather than the year following the discharge under Code Sec. 1017(a). The court found that under Code Sec. 1017(b)(3)(F)(iii), the basis reduction occurs in the year the debt is discharged if the taxpayer sells, in the same year as the discharge, depreciable real property that had been used to prove the taxpayer had aggregated bases that exceeded the discharge amount. Hussey v. Comm'r, 156 T.C. No. 12 (2021).

Background

In 2009, Richard Hussey purchased 27 investment properties on which he assumed outstanding loans totaling $1,714,520. All of the loans were held by the same bank. By 2012, Hussey was struggling to make payments on the loans.

In 2012, Hussey sold 16 of the properties, 15 of which he "sold short", i.e., sold at a loss. The total sale proceeds for the 16 properties were $241,861. After the sales, Hussey's loans were modified and replaced with two notes: Note A, totaling $265,600, which replaced the original loan assumption; and Note B, totaling $575,864, which replaced a line of credit Hussey had established with the bank. The bank issued to Hussey 15 Forms 1099-C, Cancellation of Debt, for 2012 (one for each property sold at a loss), which stated that he had a total discharge of debt of $754,054.

In 2013, Hussey sold short seven of the remaining properties for $241,500. After these sales, Hussey requested and the bank agreed to a loan modification, resulting in a portion of the debt from Note B being transferred to a new note, Note C. At that time, $539,341 remained on Note B. The bank's records showed that Note B was replaced with Note C with no further payments required on Note B. The bank recorded a net charge-off of $529,665 for Note B and determined that payments received up to that amount would be posted as a loan loss reserve recovery. The bank did not issue any Forms 1099-C to Hussey for 2013.

On his tax return for 2012, which was prepared by his then accountant, Hussey reported the sale of 17 investment properties (16 associated with the lending bank and one he had purchased earlier) for a gain totaling $83,675. Hussey has no background in tax or accounting. When he suspected that his original return for 2012 was incorrect, he contacted his long-time financial adviser to seek his opinion. The adviser also believed that the return was incorrect and recommended that Hussey consult with a CPA. The CPA reviewed Hussey's 2012 return and also said he believed the return was incorrect. The CPA recommended that Hussey meet with a tax attorney at the Kohn Partnership.

Hussey met with Michael Kohn of the Kohn Partnership. Kohn had more than 30 years of experience as a practicing tax attorney. During the meeting Kohn described what he said were various errors on Hussey's 2012 tax return. He also described how he believed the tax law applied to Hussey's real estate transactions. As a result, Hussey hired the Kohn Partnership to prepare an amended return for 2012 and to prepare his returns for 2013 and 2014. Kohn called Hussey several times to request documents while he worked on Hussey's tax returns. Hussey provided the requested documents.

Hussey's amended return for 2012, prepared by the Kohn Partnership, stated that he had sold 17 properties for a loss totaling $613,263. The return reported that Hussey had excludable income of $685,281 for a discharge of qualified real property business indebtedness (QRPBI). Hussey's 2013 and 2014 returns were also prepared by Kohn. The 2013 return reported that Hussey had sold six investment properties for a loss totaling $499,417. Hussey's 2014 return reported a net operating loss (NOL) carryforward of $423,431 from 2013. In 2018, the IRS issued a notice of deficiency disallowing the 2013 loss deduction and the 2014 NOL carryover deduction. The IRS also determined that Hussey was liable for accuracy-related penalties under Code Sec. 6662. Hussey took his case to the Tax Court.

Code Sec. 61(a)(10) and Code Sec. 108(a)(1)(D) provide an exclusion from income for forgiveness of QRPBI, which generally means debt which was incurred by a taxpayer in connection with real property used in a trade or business and is secured by such property. When the QRPBI exclusion applies, the taxpayer's basis in his or her depreciable real properties is reduced under Code Sec. 108(c)(1) by the amount of the exclusion. Under Code Sec. 1017(a), the basis reduction is generally made in the year after the debt was discharged. However, under an exception provided in Code Sec. 1017(b)(3)(F)(iii), the basis reduction for a discharge of QRPBI occurs in the same year as the sale of property taken into account under Code Sec. 108(c)(2)(B). That provision generally limits the amount of the income exclusion for the discharge of QRPBI to the aggregate adjusted bases of depreciable real property held by the taxpayer immediately before the discharge.

Hussey and the IRS agreed that Hussey's indebtedness on the properties he sold short in 2012 was QRPBI. They also agreed that Hussey was entitled to exclude the discharge of his QRPBI from income and that he had to reduce his bases in the depreciable real properties as a result of that exclusion. However, Hussey contended that the basis reductions in his depreciable real property should be applied in 2013, while the IRS said that 2012 was the proper year for the reductions under Code Sec. 1017(b)(3)(F)(iii). In addition, the IRS asserted that Hussey had discharge of indebtedness income in 2013 as a result of the bank's modification of his debt in that year. Hussey argued that 2013 was the proper year for the basis reductions under the general rule in Code Sec. 1017(a). He reasoned that, because the aggregated bases in the properties he did not sell in in 2012 exceeded the amount of the discharge, he did not need to reduce his bases until the following year.

Analysis

The Tax Court held that (1) Hussey was required to apply the basis reduction in 2012 rather than 2013; (2) the bank did not discharge any of his indebtedness in 2013; and (3) Hussey was not liable for any penalties because he relied in good faith on professional tax advice in preparing his returns.

The court noted that in 2012, the bank discharged $754,054 of Hussey's QRPBI and that Hussey's aggregate bases in depreciable real properties immediately before the discharge exceeded that amount. Thus, the court found that the properties Hussey sold in 2012 had been taken into account under Code Sec. 108(c)(2)(B) and that the rule in Code Sec. 1017(b)(3)(F)(iii) therefore applied. Hussey was therefore required to reduce his bases in the disposed properties immediately before the sales of those properties in 2012, not in 2013. The court said that Hussey's reported bases for the properties sold in 2012 should have reflected these reductions and that any remaining reductions should have been reflected in the bases of his remaining properties for 2013. Although the court found the statutory language unambiguous, it also reviewed the legislative history and noted that its conclusion was supported by language in a committee report indicating that the taxpayer must make a basis adjustment for the year depreciable property is sold, if the property is sold in the same year as the discharge.

The court found that Hussey misconstrued the rules in Code Secs. 108(c)(2)(B) and 1017(b)(3)(F)(iii). According to the court, the property referred to in Code Sec. 108(c)(2)(B) must be ascertained before the debt is discharged. The reference in Code Sec. 1017(b)(3)(F)(iii) to the properties identified in Code Sec. 108(c)(2)(B), the court explained, is to a set group of properties that is fixed once the debt is discharged. Selling properties from that group triggers Code Sec. 1017(b)(3)(F)(iii) with respect to the bases of the properties sold, regardless of the remaining bases in the properties not sold. The court noted that nowhere in Code Sec. 1017(b)(3)(F)(iii) or Code Sec. 108(c)(2)(B) is there a reference to the "remaining" bases after the disposition of properties.

The court also held that the bank did not discharge any of Hussey's QRPBI in 2013 as a result of the debt restructuring in that year. The court found that if an amount charged off is retained on a creditor's books (i.e., moved to a reserve account), the charge-off is not a discharge of indebtedness. Further, the court noted that the bank did not issue Forms 1099-C to Hussey in 2013 showing that debt had been discharged. The court said that Hussey's short sales in 2013 did not prove that the bank intended to discharge the debt in 2013, given that there was no contract or other documentation in the record showing when (or whether) the debt would be discharged.

Finally, the court held that Hussey was not liable for penalties because he relied in good faith on the Kohn firm to prepare his returns. The court rejected the IRS's argument that Hussey should have known that the tax result determined by Kohn was too good to be true after noting that Hussey took extensive steps to ensure he was receiving adequate professional advice. The court also said that Hussey was not responsible for detecting errors on the returns prepared by Kohn in the reporting of complicated tax transactions.

For a discussion of the qualified real property business debt exclusion, see Parker Tax ¶76,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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