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Can an estate deduct a loss on the sale of the decedent's personal residence.

The technical unit of the Brookhaven Service Center of the IRS has processed several Form 1041s, U.S. Income Tax Return for Estates and Trusts, reporting losses from the sale of a decedent's personal residence and passing those losses along to the estate's beneficiaries on Schedule K-1. The Office of Chief Counsel has issued an IRS Service Center Advice Memorandum (SCA 1998-012) in response to questions as to whether these losses are deductible, and, if so, whether they flow from the estate to the beneficiaries.

The memorandum states that, in general, an estate cannot deduct a loss on the sale of a decedent's personal residence. One reason is that an estate computes its taxable income in the same manner as an individual, and individuals may deduct only three types of losses: (1) losses incurred in a trade or business, (2) losses incurred in any transaction entered into for profit and (3) subject to certain limitations, losses from casualty or theft. The memorandum concluded that only the second provision is applicable to the sale of a decedent's personal residence (i.e., if the estate converts the residence to income-producing property). This situation is not unusual, especially when the administration of the estate is prolonged. The Chief Counsel, however, did not indicate that there could be any other situation in which a loss on the sale of a decedent's personal residence would be deductible. The memorandum states that an estate's income tax return reporting such losses should be examined to determine whether the estate converted the decedent's residence from personal property to rental property. The Service appears to be attributing a decedent's personal use of the residence to an estate; therefore, the estate's holding of the property for sale (at a profit), in the normal course of reducing the decedent's assets to cash, is not sufficient to constitute a "transaction entered into for profit." Would the IRS's position be different if an estate held the decedent's residence "for rent or for sale?"

Assuming that the estate converted the decedent's residence to rental property, and the loss is deductible, the memorandum states that if the estate is not the owner under state law, it cannot deduct the loss. When the decedent owned the personal residence as a joint tenant with right of survivorship or as a tenant by the entirety, the survivor becomes the sole owner of the property. In this situation, the loss is reported by the surviving tenant, not by the estate. The memorandum also states that under New York and New Jersey law (and the laws of many other states), title to real property passes directly from the decedent to the heirs and devisees.

This rule would appear to prevent an estate from deducting a loss even if title to the residence was in the decedent's sole name and the property was specifically devised. However, the memorandum states that, although estate representatives have no control over such property, they have the power to sell it if other assets passing under other types of dispositions have been exhausted. Accordingly, an estate should report on Form 1041 the percentage of loss recognized on the sale of such property equal to the percentage of the proceeds the estate uses to satisfy its obligations. The remainder of the loss is reportable directly by the heirs or devisees.

Example: D's will provided for a disposition of a personal residence to his child, C. Needing cash to pay estate expenses and having no other source of funds, the executor sold the residence at a loss. Half of the proceeds from the sale were used for estate obligations and the balance was distributed to C. As a result, D's estate reported 50% of the recognized loss and C reported the remaining 50%.

The memorandum does not indicate whether, in this example, the distribution to C would carry out distributable net income (DNI) (i.e., deductible by the estate under Sec. 661 and includible in the distributees' income under Sec. 662). The general rule is that bequests of specific property do not carry out DNI. It would appear that the distribution of the proceeds to C should not carry out DNI, because, had the property been divisible, C would have received the unsold portion.

Current New York and New Jersey law give estate representatives broad power and control over real property not specifically devised, even though, technically, title has passed directly to an heir or devisee. Estate representatives usually deposit the proceeds from the sale of the decedent's real and personal property in one fund, used for the payment of estate obligations and distributions to the heirs and devisees. In this situation, the Chief Counsel conceded that, for practical purposes, the estate should report the entire loss from the sale of the decedent's personal residence. The memorandum, however, cautioned that "other factual situations may require a different result."

The memorandum also noted that, if the decedent's will requires the executor to sell the personal residence and distribute the proceeds to the beneficiaries, tide to the real property passes to the estate, not the devisees. In this situation, therefore, the estate reports the entire gain or loss on the sale of the real property.

Rev. Rul. 68-49 held that, because title to real property passes under local law directly from the decedent to the heirs or devisees, pursuant to Regs. Sec. 1.661(a)-2(e), a distribution of real property that comprised part of the residuary estate did not carry out DNI; this distribution was a nontaxable inheritance. The memorandum states that the principle of this ruling now applies only to specifically devised real property, The ruling is no longer applicable to nonspecifically devised real property, due to the amount of power and control estate representatives have over such property. A distribution of nonspecifically devised real property, therefore, will carry out DNI, despite the fact that, under local law, tide still passes directly to the beneficiaries.

The memorandum also indicated that the amount of the loss is the excess of the adjusted basis for determining loss over the amount realized from the sale. The basis for loss is the lower of the property's market value at the time of conversion or its adjusted basis at the time of conversion (which in most cases will be the date-of-death value, adjusted for alterations between the date of death and the date of conversion).

The memorandum also explained that losses generally do not flow from the estate to the beneficiaries. Capital gains are not included in the DNI computation to the extent that the gains are allocable to corpus and not paid, credited or required to be distributed to any beneficiary. Capital losses are also excluded from DNI, except to the extent such losses are taken into account in determining the amount of capital gains paid, credited or required to be distributed to a beneficiary. In the final year of an estate, the beneficiaries will succeed to any unused capital loss and net operating loss carryovers.

Estates reporting a loss on the sale of a decedent's personal residence, therefore, should expect an IRS audit. It may be prudent to advise estate representatives to hold the property "for sale or for rent" and retain adequate substantiation of attempts to rent the property. Alternatively, if the loss resulted only from selling expenses being added to basis, consideration should be given to deducting the expenses as administration expenses on the estate tax return or, if there is no estate tax, on the estate's income tax return.

Caution: The income tax deduction may be claimed only if the estate fries a waiver of the right to claim the deduction on the estate tax return. In addition, the deduction may be of little or no benefit to the estate if the Service asserts that these types of administration expenses are deductible only to the extent they exceed 2% of adjusted gross income.
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Article Details
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Author:Aaronson, Marc A.
Publication:The Tax Adviser
Date:Aug 1, 1998
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