Abandoning worthless investment property versus selling at a loss.

Individual taxpayers owning properties that are considered investment properties not eligible for Sec. 1231 treatment, and that (through devaluation or other unforeseen circumstances) have become worthless, often choose to sell those properties at a loss and claim a capital loss. In some circumstances, it may be more advantageous to consider legally abandoning the property and claiming an ordinary loss against ordinary income. Each alternative his its benefits and drawbacks, and each taxpayer's situation should be examined closely to determine the most advantageous choice.

Example: A single taxpayer, T, has a basis of $60,100 in a property with no fair market value. If T sells this worthless property to a nonrelated party for $100, T may claim the entire $60,000 loss as a capital loss. If T has no capital gain in a particular year to be offset by that loss, Sec. 1211(b) limits the amount of capital losses that T can deduct against ordinary income to $3,000. Thus, if T has insufficient capital gains to offset this $60,000 loss (and expects no significant future capital gains), T may deduct only $3,000 each year for the next 20 years. Generally, this is a safe option, although for taxpayers who make limited investments and do not generate consistent capital gains, it results in only a small annual offset against ordinary income.

On the other hand, some taxpayers may want to consider legally abandoning the property. In some cases, if the property is abandoned, a taxpayer may obtain a much larger current deduction against ordinary income than obtainable under the $3,000 capital loss limitation. This result is beneficial for taxpayers who do not foresee recognizing capital gains that could be offset by the entire loss. But even for some taxpayers who foresee recognizing capital gains, the new lower tax rates may make abandonment worthwhile. Because long-term capital gains are now taxed generally at 20%, capital losses generally provide only a 20% benefit. Accordingly, it may be preferable to pay the capital gains tax and instead use the abandonment deduction to offset ordinary income, which may be taxed at rates up to 39.6%.

Caution: Since this approach may precipitate adverse consequences, each taxpayer's particular situation must be closely analyzed. There are three "hurdles" that taxpayers must overcome before an abandonment strategy will be worthwhile. First, a deduction for abandonment of nonbusiness property held for profit is a miscellaneous itemized deduction subject to the 2%-of-adjusted gross income (AGI) limitation. Second, the deduction might be further reduced by the itemized deduction phase-out for high-income taxpayers. Third, too large a deduction might trigger the alternative minimum tax (AMT), which could eliminate the regular tax savings and produce an increased overall tax.

Treatment of Abandonment Loss

A deduction for losses generally is allowed under Sec. 165(a). Regs. Sec. 1.165-2(a) allows deductions for losses "incurred in a business or in a transaction entered into for profit and arising, from the sudden termination of the usefulness ... of any non-depreciable property, in a case where such business or transaction is discontinued or where such property is permanently discarded from use therein." (Emphasis added.) Sec. 165(c) prescribes limitations on Sec. 165(a) deductions, depending on the loss's source.

Sec. 165(c)(1) governs losses incurred in a trade or business. These losses are fully deductible and may be used to offset ordinary business income. This rule applies to a taxpayer actively engaged in the trade or business of purchasing and developing real estate.

Sec. 165(c)(2) deals with losses incurred in activities entered into for profit, but not otherwise connected with a trade or business. Many types of losses fall into this category and will be allowed as deductions provided they were entered into for profit. Treatment of these types of losses was considered in McKinney, 574 F2d 1240 (5th Cir. 1978), cert. den., 439. US 1072, in which it was held that an embezzler could not claim a net operating loss deduction for repayment of embezzled funds, as embezzlement was not a "trade or business" for Sec. 172 purposes. "The only tax benefit to which the Plaintiff was entitled for the repayment of the embezzled funds ... was a deduction under [sections] 165(c)(2) ... for a loss incurred in a transaction entered into for profit, although not connected with a trade or business, and the IRS gave Plaintiff this deduction."

The Tax Court reached the same conclusion in O'Hagan, TC Memo 1995-409, holding that the Service had properly characterized a repayment of misappropriated funds as a miscellaneous itemized deduction. Consequently, if a taxpayer purchases property only for investment (i.e., not in connection with a trade or business), any losses arising therefrom would be allowable under Sec. 165(c)(2). Therefore, these losses would be deductible against ordinary income, subject to the 2% limitation on miscellaneous itemized deductions under Sec. 67.

Observation: A taxpayer must determine, based on AGI, whether this limitation would eliminate the entire benefit of an abandonment, or reduce it to the point at which it would be more advantageous to sell the property for $1 and claim a smaller deduction over a longer period of time.

Additionally, a taxpayer may also be subject to Sec. 68's itemized deduction phase-out if AGI exceeds the prevailing threshold (generally, $121,200 for 1997). For these taxpayers, their total itemized deductions (with the exceptions set forth in Sec. 68(c)) are reduced by the lesser of 3% of the excess of AGI over the prevailing threshold amount (indexed annually for inflation) or 80% of the otherwise allowable itemized deductions.

Like the 2% limitation, this phase-out could have a serious effect on the possible benefit of this strategy.

Finally, if a taxpayer ultimately is subject to the AMT, he must add back to taxable income all miscellaneous itemized deductions, including any Sec. 165(c)(2) abandonment loss. This adjustment would nullify that loss. An even worse result would occur if the adjustment triggers the AMT. Again, great care must be taken to ensure that this strategy provides all the benefits of a current deduction without exposing a taxpayer to a heavier tax burden than he would otherwise incur. If the AMT applies, a taxpayer might be better off claiming the capital loss and avoiding the AMT adjustment. Even if a capital loss produces a small benefit in the first year, the offset will be available for future years when it may be put to greater use.

How Does Abandonment Work?

Assuming a taxpayer will benefit from abandoning a property, how can this be done? According to the standard set forth in Jones, 120 F2d 828 (8th Cir. 1941), cert. den., 314 US 661, abandonment requires an intent to abandon the property coupled with an overt or identifiable act that manifests that intent. While intent is a subjective standard left to the taxpayer's own state of mind, the demonstrative overt act is objective.

For instance, nonpayment of property taxes or utilities is not necessarily indicative of abandonment but, nonetheless, is an important factor that tends to demonstrate that the taxpayer relinquished control and responsibility over the property.

A more certain approach is the one taken in Jamison, 8 TC 173 (1947), in which the Tax Court held that the taxpayer who deeded property to the taxing authorities (i.e., the county in which the taxes should have been paid) abandoned the property. Jamison purchased the property and later wished to sell it, but was unable to do so, due to property devaluation in the area. After listing his property with brokers, he was unable to secure an acceptable price and was informed that future prospects for doing so were not good. He then had his attorney prepare a transfer deed for the property that he conveyed to the county. The court allowed an abandonment loss.

This strategy's tax benefit varies, depending on the taxpayer's particular circumstances. Thus, close inspection of each particular situation is required. For taxpayers with offsetting capital gains, it may be desirable to sell the property at a loss and obtain a dollar-for-dollar capital loss deduction. Others may have AGIs so high that the limitations (both the 2% and the phase-out) completely eliminate an abandonment loss that otherwise would be fully deductible against ordinary income. These taxpayers also must always consider AMT consequences.

However, an abandonment strategy may help the casual investor who has invested in property that is no longer bearing economic fruit. Sec. 165(c)(2) may provide a larger current deduction than a capital loss (even after reductions under Secs. 67 and 68) unless the AMT would produce an adverse result.