There is a tendency to stop thinking about tax planning during recessions. After all, during recessions many individuals and businesses do not pay income tax because they do not have income. In many cases, however, a loss can be carried back to a prior year when the individual or business had substantial taxable income. The loss triggers a refund of the tax paid in the prior year. In this way, accelerating a tax loss can create liquidity even when you do not have income.
The magnitude of the tax refund can be substantial. Individuals who paid income tax at the top marginal federal tax rate in prior years might obtain a $350,000 refund for each $1,000,000 of ordinary loss. The actual refund could be larger because deduction phase-outs can cause the effective tax rate to exceed thirty-five percent. Corporate refunds may also be higher in some circumstances.
Falling asset values have left many persons with unrealized losses. These persons can recognize the losses and obtain tax refunds if they sell their properties. For some persons who need to sell, the tax refund makes it less burdensome to satisfy a short sale deficiency or other obligation.
Despite the opportunity to obtain a tax refund, many persons are hesitant to sell property because they perceive valuations are temporarily or artificially low. In some circumstances, persons who retain an interest in their property can nevertheless recognize a tax loss. This is often possible in two circumstances: First, it is possible if the property is held through a corporation. Second, the person can partially accomplish the objective by selling the property to a new joint venture in which the current owner retains a substantial interest. In either case, persons cannot recognize the losses unless they take action before the end of the tax year. For many, action must be taken on or before December 31, 2009, requiring advance planning now.
The following are some of the particular parameters necessary to create a useful current tax loss using these techniques, while still retaining an interest in property:
- The person must have current taxable income or have had taxable income in one of the two immediately preceding tax years. Congress created a special rule allowing 2008 losses to be carried back up to five years, but has yet to create such a rule for 2009 losses.
- In most circumstances, to create an immediate benefit the loss must be an ordinary business loss, not a capital loss. Generally, property used in a business for more than one year (such as an apartment building or office building) and inventory (including lots or condominiums held by a developer or dealer in real estate) will qualify for an ordinary loss. An exception arises in the currently rare circumstance in which the person will recognize capital gain from the sale of other property in the same year as the loss. If the person will have a capital gain from selling other property this year, recognizing a capital loss may be beneficial.
- The income tax basis in the property (generally, the original purchase price, minus depreciation deductions) must be greater than the current fair market value. An appraisal may be used to establish the current fair market value.
- In most circumstances, the income tax basis must be greater than the amount of indebtedness related to the property.
- Either of the following two conditions is true:
- A corporation owns the property. A planning opportunity is more likely to arise for an S corporation than a C corporation. The corporation must have purchased the property for full-value consideration or have held the property for a substantial period of time. The loss will be disallowed if the corporation acquires the property as a capital contribution shortly before the loss-triggering event. It is sometimes possible to trigger a loss when the corporation indirectly owns the property through another entity, such as a limited liability company treated as a partnership for tax purposes. In most cases, it must be a practical possibility to convert the corporation into a limited liability company, if the entity is not already a limited liability company under state law. A conversion may require lender consent, but it is usually possible to convert without triggering documentary stamp tax or incurring other burdensome transaction costs.
- If a corporation does not own the property, a loss may still be triggered if the owner is willing to enter into a joint venture with an unrelated partner. The owner must not own more than fifty percent of the capital interest or profits interest in the joint venture. It is possible to be flexible in the other terms of the agreement. Lender consent is almost always necessary. The transaction costs, such as documentary stamp taxes, generally mirror those of a typical purchase and sale.
These parameters are useful to identify whether there is a potential opportunity. There are other technical requirements.
This type of planning does not employ the same “infamous” techniques used in many “tax shelter” transactions earlier in this decade. The loss acceleration technique applicable to corporations has been a part of the Internal Revenue Code for many years, and was specifically intended by Congress. The joint venture strategy also follows a “bright-line” rule in the Internal Revenue Code. A few public homebuilding companies utilized the joint venture strategy during 2007 in widely publicized transactions. If either transaction is implemented properly, we are able to provide a legal opinion to support the income tax consequences.
In some cases the tax refund may be delayed because the size of the loss triggers heightened scrutiny from the Internal Revenue Service or Congress’ tax arm, the Joint Committee on Taxation. We have experience with refund claims subject to such scrutiny.
If you use the calendar year as your tax year and believe you could benefit from this type of planning, please contact us as soon as possible. It is not feasible to analyze and implement this planning in the last few days or weeks of the year.
CIRCULAR 230 DISCLOSURE: To comply with Treasury Department Regulations, we advise you that, unless expressly indicated, any federal tax advice contained in this message or any attachments cannot be used for the purpose of (i) avoiding penalties imposed by the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any matters addressed herein. We make this disclosure because providers of tax advice are now required to do so by law when offering advice concerning federal tax matters.