While real estate and construction company owners have incurred both economic and tax losses as a result of the downturn in the real estate and construction markets over the past few years, astute tax planners utilized the expanded net operating loss (NOL) carryback provisions in 2008 and 2009 to obtain income tax refunds for their clients who paid taxes in the preceding five years. For many business owners, the tax losses continued to be incurred since 2009 and, as a result, many real estate and construction company owners may be in a substantial NOL carryover position for the future. Upon a taxpayer’s death, these NOL carryovers do not transfer to the decedent’s estate or spouse, which means the taxpayer and his beneficiaries would lose a substantial income tax benefit. Now is the time to plan in order to minimize the possibility that these tax attributes could be lost forever.
Tax Treatment of Tax Attributes at Death
According to Rev. Rul. 74-175, a capital loss and NOL from business operations sustained by a decedent during his last taxable year are deductible only on the final income tax return filed on his behalf; such losses are not deductible by his estate. When an individual taxpayer dies, the decedent and the decedent’s estate are considered different taxpayers for income tax purposes. An NOL and capital loss is deductible only by the taxpayer sustaining these losses. They are considered personal to the taxpayer who incurred the loss and generally cannot be transferred to or used by another taxpayer, including his surviving spouse even if they have consistently filed joint income tax returns. A NOL carryback incurred in the year of death may be applied to prior years as provided in IRC Section 172.
In addition, under IRC Section 469(g)(2)(B), if a taxpayer who owns an interest in a passive activity dies, suspended passive activity losses generally are allowed on the decedent’s final income tax return. The amount of the suspended losses from the activity allowable to the decedent by reason of this disposition is reduced by the step-up in basis to the fair market value of the interest at death under IRC Section 1014. The release of these suspended passive activity losses could also increase a taxpayer’s NOL. Generally, a taxpayer may carry back his NOL two years or forward twenty years; only the 2008 and 2009 tax years provided opportunities to carryback an NOL for more than two years.
Even though NOLs cannot be carried over and used in future tax years by a surviving spouse or the decedent’s estate, they can be used on the decedent’s final tax return, including the final one filed with a surviving spouse. If a person files a Married Filed Joint income tax return, the decedent’s NOL would be able to be absorbed by both the decedent’s and the spouse’s income through the end of the calendar year of such death. Therefore, if a transaction could not be generated to fully absorb an NOL by the decedent before death, separately held assets by the spouse may be able to be sold during the year of death in order to absorb the NOL.
Ideas to Absorb NOL or Capital Loss Carryforwards
If there is insufficient taxable income to offset with the NOL carryback, the next step would be to consider areas where the taxpayer could generate income or gains to utilize the tax attributes that would expire. Some possible ways to accelerate income or gains to use up a taxpayer’s NOL, capital loss and passive activity losses would include:
- Consider selling properties that have a deferred gain as a result of a prior Section 1031 like kind exchange. The sale with no replacement of the relinquished property will trigger the recognition of the deferred gain.
- Consider selling appreciated property to a related party to generate gain to the seller and a higher tax basis in the property to the related party. If the property is held for sale or inventory property, the sale would generate ordinary income that can be absorbed by the NOL carryover. If investment property is sold, it would be a capital gain to the seller to absorb capital losses. Be aware that if the property is depreciable in the hands of the related party acquirer, IRC Section 1239 would recast all of the gain as ordinary income to the seller.
- If a taxpayer holds an interest in a passthrough entity that has recourse debt, attempt to negotiate a reduction in the debt secured by the property to generate cancellation of debt income (CODI). If no exclusions to recognizing this CODI apply or are elected, this ordinary income could be offset by the NOL carryforward. If the taxpayer is in bankruptcy or to the extent he is insolvent, this CODI would be excluded from income but the taxpayer would be required to reduce his tax attributes to the extent of the excluded CODI. Under IRC Section 108(b)(2), the first tax attribute subject to reduction from CODI is the taxpayer’s NOL for the taxable year of the discharge and any NOL carryover to such taxable year. This CODI exclusion may be more beneficial if the taxpayer does not have as large a state NOL as federal NOL.
- It is typical in real estate and construction entity structures that there would be related party debt with members. Rather than repaying the debt, consider writing off the offsetting payables and receivables, which could generate ordinary income for the debtor. This would generate CODI for the debtor and would also relieve the debtor of ever having to repay the debts. The creditor would be entitled to a bad debt deduction but, in most cases, this would be a nonbusiness bad debt that is statutorily treated as a short-term capital loss.
- If there is cash within the entity, typically we would advise our client not to distribute an amount in excess of the members’ or shareholders’ tax basis in the entity. In a situation such as this, consider distributing the cash to the members or shareholders even if it is in excess of their tax basis to generate taxable gain for the individuals. This would move the cash out of the company and hopefully away from the claims of the entity’s creditors.
- Consider opportunities to fix ownership structural problems from the past. One common structural problem that taxpayers encounter is when they title ownership of real property in an S Corporation rather than in an LLC or partnership. Typically the owners would keep the property within the S Corporation in order to avoid triggering a deemed sale of the property upon its distribution to the shareholders. However, one way to have the flexibility with respect to the property in the future is to distribute the property out of the S Corporation, triggering the deemed sale of the property within the S Corporation at its fair market value. The resulting gain would be taxable to the shareholders but the property’s basis would be stepped up to the appreciated value to reduce the gain recognition in the future (or to generate current depreciation deductions based on this higher tax basis).
- Actual distributions to a traditional IRA owner generally are taxed as ordinary income in the taxable year in which the distribution is received under IRC Section 408(d)(1). Therefore, if a taxpayer has a traditional IRA, the distribution from the traditional IRA (or rollover to a Roth IRA) has two benefits in the situation where a taxpayer has an NOL. First, it will generate ordinary income for the taxpayer to absorb some of the NOL. Second, it will not be taxable as ordinary income to the beneficiaries of the estate when they use these funds under the income in respect of a decedent rule of IRC Section 691.
- When a person holds a note receivable from an installment sale transaction, generally gain is only recognized to the extent principal is received on the note. However, a sale or exchange of an installment obligation is a taxable disposition triggering the remaining deferred gain (plus any gain generated by the sale of the installment note). If the taxpayer sells the installment note, not only will the taxpayer generate the gain to absorb more of his capital loss or NOL, the related party who purchases the installment note will receive the cash received from the obligor of the note tax free (unless the note was purchased at a discount). In addition, a pledge of the note to secure a loan would be treated as a payment on the note for the amount of the loan proceeds received.
An important caveat to accelerating income is to ensure that the income recognition is not artificially generated. In Hydrometals, Inc. v. Comr., the Tax Court determined that the income generated to absorb the NOL for the corporation before it expired was only created for tax-planning purposes and lacked economic substance. The Tax Court treated the advance received against future revenue as a loan and not as income. Therefore, we need to ensure that the income that is generated has economic substance or is required to be recognized under the tax rules (e.g., distribution of appreciated property by an S Corporation to its shareholders).