Category: Deductions & Credits; Real Estate Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Referring to my memo of October 6, 1995, it is my understanding that the taxpayer in this case did in fact capitalize some interest. The property in question was acquired in 1988 and held for development. Various miscellaneous "soft-costs" were paid and capitalized. Interest and property taxes were also paid and capitalized in one or more early years. As I understand it, the taxpayer purchased land for development. No significant development activities were ever conducted, and no physical changes were made to the land. The taxpayer did not elect to capitalize interest or taxes under Section 266, and the lack of significant development in conjunction with the absence of physical changes to the land appear to fall short of triggering the requirement to capitalize such items under Section 263A. It is unclear to me why any interest was capitalized in the early years of the taxpayer's investment in this property. If additional interest had been paid and was not capitalized, it appears that such interest could have been considered investment interest. Under Sections 163(d)(5)(A) and 469(e)(1), investment interest is any interest paid or incurred to carry property which a) produces portfolio income (interest, dividends, etc.), or b) for investment. The taxpayer's activities with respect to this property during the years in question may not have risen to the level of a trade or business. Accordingly, I feel that the characterization of the property as "held for investment" may be appropriate. (However, see the section below entitled The Taxpayer's Options.) Moreover, this is not inconsistent with the tax treatment attached to the disposition of the property in 1991, i.e., capital loss. It seems to follow based on the foregoing that if any additional interest had been paid with respect to the property, such interest would have been either capitalized or possibly subject to the investment interest limitations. In our phone conversation I postulated that if interest were paid after disposition of the property, such interest should not be subject to capitalization either under Section 266 or Section 263A. I continue to embrace that idea. I do feel, however, that assuming the "held for investment" interpretation of the facts holds sway, such interest would still be subject to the investment interest limitation even after disposition. This latter conclusion is contrary to our earlier conversation. Section 163(d)(3)(A) provides that investment interest means interest paid or accrued on indebtedness properly allocable to property held for investment. The phrase properly allocable means allocable through operation of the various interest tracing rules which are based on tracing the use to which the borrowed funds were put. It seems to me that this analysis survives disposition of the property such that post disposition interest payments would continue to be treated as investment interest. Section 108(e)(2) provides as follows. No income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction. What is the effect on Section 108(e)(2) if payment of the liability to which the debt discharge relates produces a deduction subject to the investment interest limitation, particularly if the taxpayer lacks sufficient investment income in the year in question to allow a deduction? I cannot locate any authority or commentary on this issue. There is a private ruling (PLR 9251023) that touches on the issue, at least obliquely. In the ruling, the taxpayer's lender forgave accrued and unpaid interest. In holding that the accrued interest forgiven does not constitute cancellation of indebtedness income, the ruling commented as follows. In this case, as a cash-basis taxpayer, you have not deducted any of the accrued but unpaid interest on the indebtedness. None of the limitations in sections 163 or 469 of the Code with respect to the deductibility of interest would apply if you paid the accrued interest, assuming that you treat all eight rental properties as a single activity under section 1.469-4T(k)(2) of the regulations. Accordingly, the accrued interest is not includible in the amount realized for purposes of determining gain or loss with respect to properties 1 and 2. See Crane v. Commissioner, 331 U.S. 1, 4 n.6 (1947), 1947-1 C.B. 97, 98. Similarly, the accrued interest with respect to properties 3 through 8 and with respect to the stock in X is also not taken into account. See section 108(e)(2). [Emphasis added.] Notice the holding that Section 108(e)(2) applies is prefaced by the observation that none of the limitations in Sections 163 and 469 would apply had the interest been paid. Private rulings cannot be cited as precedent either by taxpayer's or IRS. Section 6110(j). The sole significance of the ruling is that someone at the National Office of IRS thinks the applicability of Section 108(e)(2) requires unfettered deductibility if the item in question had been paid. I think it could be fairly argued that even if Section 108(e)(2) does not require immediate deductibility of a "paid item", absent sufficient investment income in the year of payment, a taxpayer cannot be assured that payment of investment interest will ever give rise to a deduction. I think this is extremely damaging, quite possibly fatal, to the taxpayer's position in this matter. The taxpayer in this case argues that he received nothing related to
the accrued but unpaid interest and thus should not have a taxable event.
I differ with that argument. The taxpayer received the tax-free use of the
lender's funds. The taxpayer possibly feels that he received nothing because
his investment fared badly. I suspect the taxpayer might view the interest
in a different light if the interest related to the use of the lender's
money had allowed the taxpayer to carry a property that appreciated significantly
over its holding period rather than the other way around. In any event,
the taxpayer is clearly better off economically without the accrued interest
obligation than with it. Section 108 is the principal vehicle by which debt discharge income is excluded from income. I assume that the provisions of Section 108(a) related to bankruptcy and insolvency are not applicable. If so, Section 108(e)(2) seems to represent the taxpayer's only means of possibly excluding the discharge form income. The language of Section 108(e)(2) is vague. What does the phrase "payment ... would have given rise to a deduction" mean? In this case, a payment would have given rise to an allowable interest deduction that simply has not been allowed by virtue of the investment interest rules. As I told you, I cannot locate any case authority or rulings on this matter. The legislative history surrounding the enactment of Section 108(e)(2) as part of the Bankruptcy Tax Act of 1980 is not at all helpful. In such circumstances it is necessary to take the position that the words of the statute should be interpreted in accordance with their ordinary meanings. It seems to me that if the taxpayer had paid the accrued interest in this case and would have been unable by the time the debt discharge occurred to take a tax deduction for such interest, it must be said that the payment has not given rise to a deduction in accordance with the ordinary meaning applied to those words. In my mind, it strains credulity to argue that the phrase "payment ... would have given rise to a deduction" can be equated with payment giving rise to an unused investment interest carryforward item which may or may not ever produce a current tax deduction and certainly would not have produced a deduction at the time of debt discharge. The Taxpayer's Options I think the taxpayer's only position is to embrace a different factual interpretation with respect to the investment nature of the land. The problem here is the application of the investment interest rules with Section 108(e)(2). If the land were viewed as part of the taxpayer's trade or business, the investment interest problem would be moot and the problem with Section 108(e)(2) would instantly vanish. In that case, any interest paid with respect to the land would have been trade or business interest and thus deductible. As such, the requirements for exclusion under Section 108(e)(2) would clearly be satisfied. Whether or not the taxpayer was engaged in a trade or business is essentially a question of fact. As I understand it, the taxpayer is and has been engaged in the real estate business through brokerage, consulting, and speculation. There is a Schedule C in the taxpayer's return reflective of the existence of such a business. On the other hand, the disposition of the property in question was treated as capital loss. This treatment is not necessarily inconsistent with the existence of trade or business. It is possible to be in a real estate trade or business without holding a particular piece of property for sale in the ordinary course of business to customers. Clearly, however, this prior position is not at all helpful and could quite possibly do significant damage to the taxpayer's position if the matter were scrutinized. If challenged, the taxpayer would have the burden of proving the existence of trade or business. The outcome, if a challenge should occur, is not predictable. Given the absolute magnitude of the excluded accrued interest amount, IRS scrutiny is a distinct possibility. The taxpayer should be apprised that there is considerable risk to the assertion and possible imposition of additional tax, interest, and perhaps penalties with respect to this matter. |
