accounting tax research project 6 pages

FACTS

John Smith, through Malibu JDC Properties a single-member limited liability company, owns a house located at 9826 Malibu Farm Road, Malibu, California (the “House”). Currently, there are liens filed by both the Internal Revenue Service (“IRS) and the Franchise Tax Board (“FTB”) with respect to the 2006 tax year. In approximately 2004, John entered into prepaid forward contracts. John used the funds from these contracts to invest in real estate. The prepaid forward contracts closed-out in 2006, which resulted in the Smiths reporting approximately $11.6 million of “capital gain” on Schedule D of their 2006 return. The Smiths’ Federal taxable income for 2006 was approximately $12,474,000 and they had a Federal tax liability of $1,936,000. For 2007, the Smiths’ Federal taxable income is approximately $915,000 with a Federal tax liability of approximately $158,000.

The House

Construction on the House began in 2004. The construction loan documents with Bank of America stated that the purpose of the House was to be a primary residence for the Smiths. In January 2007, John obtained a permanent loan on the House from Thornberg, the loan documents again stated that the House was to be a primary residence for the Smiths. Several months after the loan was obtained from Thornberg inquired as to whether the Smiths were living in the House. John stated that they were because he was concerned Thornberg would call the note. However, the Smith never lived in the House. The House has an outstanding mortgage of approximately $13,000,000 with Thornberg and a second and third with Comerica (recourse?) totaling approximately $3,500,000. There are also and tax liens of approximately $4,000,000. The House recently appraised for $28,000,000. Thornberg is threatening to foreclose on the House.

John encountered problems with final construction of the House. As such in ????, he acted as the foreman for the final construction in order to get the House completed. John received the “Certificate of Occupancy” in the summer of 2007. John “pocket listed” the House in the fall 2007 and he has had it listed on the market since April 2008. The delay in listing the House was due to waiting until the construction was completed and the promotion of the House in Architectural Digest. John estimates that there is a 10% chance that the House will be sold by the end of 2008. Although he has gotten offers on the House, these offers are lowball (approximately $14,000,000). His real estate broker has told John that only one home in Southern California has sold for more than $10,000,000 in 2008.

The House is currently held in the name of Malibu JDC Properties, a single member LLC. The property has gone from John & Jeanne Smith to Malibu JDC Properties and back a few times, which is tied to the financing and refinancing of the property.

For income tax purposes, in preparing the Smiths’ 2005 and 2006 returns, the House was treated as an investment for the purpose of getting an investment interest deduction. However, the returns for these years do not reflect such a deduction (due to ???). The costs for constructing the House have all been capitalized. The Smiths’ 2007 Federal returns identifies John as a “Developer”

John Smith

John’s background is in computer programming. His prior returns may have identified him as a “Developer”, however, this related more to developing computer programs not real estate. Since selling his computer programming business in 1999, John participated in several real estate development businesses, to include:

· San Marcos Property. In 2002 and 2003, Los Posas No. 1 LP (“Los Posas”), a limited partnership in which Mr. Smith is a 60% general partner, accumulated 14.21 acres of land in San Marcos, California called “Palomar Station”. In May 2004, Los Posas went before the City of San Marcos (the “City”) council to get entitlement (i.e., the right to develop land with the City’s approvals for zoning density, utility installations, occupancy permits, use permits, streets, etc.) for the San Marcos Property but it was rejected. In 2005, Los Posas went before the City counsel on reconsideration of the counsel’s earlier decision. The City counsel again rejected entitlement for the San Marcos Property and requested that Los Posas “start over from scratch.”

In 2006, Los Posas entered into a contract with a buyer for the purchase the San Marcos Property once the entitlement was received, which Los Posas continued to work with the City to obtain entitlement. In 2006, an Environment Impact Report (“EIR”) suit was filed by a San Marcos resident against the City with respect to the development of the San Marcos Property. Los Posas was initially advised by its land entitlement consultant (an individual working for the City) that the EIR suit could only delay entitlement (and ultimately the sale) for the San Marcos Property by approximately 30-days. Thus, Mr. Smith felt confident that the sale of the San Marcos Property would be completed in 2006. During 2006, Los Posas’ worked with the City to resolve entitlement issues. These efforts paid off when the City council eventually granted entitlement. Because of the delay in getting the entitlement and because of the EIR suit, the buyer contracted to purchase the San Marcos Property from Los Posas did not purchase the property. Had the 2006 contract on the San Marcos Property been completed, Mr. Smith’s share of gain was estimated to be approximately $12 million, which he would have used to pay any 2006 tax liability.

Now that Los Posas has received entitlement to the San Marcos Property from the City counsel, it is attempting to sell the San Marcos Property. The estimated current FMV of the San Marcos Property is $3,000,000. At this time, the pending buyer withdrew their offer today. Had it gone through, the San Marcos Property would have closed by December 31, 2008.

– Texas Property: this property development involves the conversion of an office building to residential rentals located at 1600 Pacific Building, Dallas, Texas along with a Tower Garage. The property is held in the name of Prescient Realty Advisors and John is a 50% general partner interest/investor (as identified on his Form 433-A submitted to the IRS). The estimated current FMV of this property is $600,000 - $3,600,000. John has $537,416 in equity.

– Telluride Property: this property consists of two lots (#14 and 15) located at 75 & 97 Wagon Way, Tele, California. This property is held in the name of John & Jeanne Smith. (as identified on his Form 433-A submitted to the IRS). The estimated current FMV of this property is $6,300,000 with an outstanding loan balance of $5,350,000.

– Indio Property: this property consists of Lot 320, Indio, California. This property is held in the name of The Indio property is a motorhome lot with no physical building/structures.

John also has a 70% ownership interest in Michael’s Cookies, a business that sells cookies to high-end hotels. The estimated current FMV of this business is $630,000 and Coamerica, the IRS and the FTB all have filed liens on this business. The company is not making any money and attempts to sell it have not yielded any valid offers.

Lastly, John is involved in the following investments/businesses:

Year End Tax Planning:

As the possibility of the House selling in 2008 is remote and Thornberg is threatening to foreclose on the House, John would like to know what his options are.

ISSUES and SHORT ANSWER

1) Can John be characterized as being in the Trade or Business of being a Real Estate Professional (as opposed to investing in real property)?

2) Which would provide the most tax benefit to John: (a) the House is foreclosed on, (b) John executes a deed in lieu of foreclosure, (c) John abandons the House?

If John can be characterized as being in a Trade or Business with respect to the House,

3) How would any loss with respect to the House be characterized (ordinary v. capital)? Would the characterization change if the loss was generated from foreclosure, deed in lieu of foreclosure, or abandonment?

4) Would John receive discharge of indebtedness income? If so, would it make a difference if John would deemed to be solvent or insolvent (i.e., IRC §107)?

5) In addition to a sale or foreclosure by the end of the year, there may be other ways available to generate favorable result?

ANALYSIS

1. Trade or Business of being a Real Estate Professional

Section 469(c)(7) defines a “Real Estate Professional” as a taxpayer whose more than one half of the his professional services in all trades or businesses are performed in real property trade or businesses and the taxpayer performs more than 750 hours of service in the taxable year in real property trade or businesses. “Real Property Trade or Businesses” include real property development, redevelopment, conversions, construction, reconstruction, acquisition, rental, operation management, leasing or brokerage trading or business.

The Tax Court has held, although no money exchanged hands, a reconveyance constituted an “abandonment” and petitioner was relieved of from indebtedness (i.e., sale). There was no forgiveness of debt (debt paid with property). See Freeland v. Comm’r, 74 T.C. 970 (1980) (reconveyance by quitclaim deed of unimproved real estate encumbered by a nonrecourse, purchase money mortgage by the petitioner to the mortgagee, i.e., deed in lieu of foreclosure).

If the IRS would respect the House as an investment property and also respect John’s status as a developer of that property, when John sold the House or it is foreclosed on or John abandons it in 2008, a large potential net operating loss may be generated. A Net Operation Loss can be carried back 2 years, which would offset the 2006 tax liability currently in Collections.

If the IRS respects the House as an investment property, but considers John to be an investor instead of a developer, a capital loss would be generated, which cannot be carried back to prior tax years. If the IRS does not respect the House as an investment property, but rather considers it a personal residence, then no useful tax loss would result.

2) Which would provide the most tax benefit to John: (a) the House is foreclosed on, (b) John executes a deed in lieu of foreclosure, (c) John abandons the House?

3) If John can be characterized as being in a Trade or Business with respect to the House, how would any loss with respect to the House be characterized (ordinary v. capital)?

Would a foreclosure on a developer yield an ordinary loss versus capital loss.

a) Would the characterization change if the loss was generated from foreclosure, deed in lieu of foreclosure, or abandonment?

4) Would John receive discharge of indebtedness income?

What is the income tax treatment of any discharge of the debt that may occur related to the House. Would it matter if the debt on the House is recourse or nonrecourse?

a) If so, would it make a difference if John would deemed to be solvent or insolvent (i.e., IRC §107)?

Would it matter whether John is treated as solvent or insolvent for purposes of the discharge of indebtedness rules?

5) In addition to a sale or foreclosure by the end of the year, there may be other ways available to generate favorable result?

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