From the standpoint of the buyer in Clemson, many accountants would treat this transaction as a $100,000 purchase, followed by $30,000 in taxable income. Such treatment is harsh ($30k in taxable income!) and likely incorrect.
In a court case called Freedom Newspapers, Inc. v. Commissioner of Internal Revenue, a payment made to the taxpayer to induce it to purchase a property was treated as a reduction in the basis of the property purchased, and not as income.
In our example, that would mean that the purchase price of the property in our example would be treated as $70,000 with no income resulting from the $30,000 rebate. The logical corollary of a reduced purchase price is a reduced sales price of $70,000 for the seller.
NOTE: Side deals outside of closing are often a sign that any bank involved is being given the “mushroom treatment” – that is, fed manure and kept in the dark. Such tactics could easily rise to the level bank fraud and are not a practice that we recommend.
Nonetheless, for those of you who have been involved in such a transaction as a buyer or seller, the purchase/sale price reported to the IRS should reflect economic reality, and not necessarily what is on the HUD-1. When dealing with the IRS, what happened in reality generally trumps what is written on paper.
Another example of where the Freedom Newspapers case might help us:
I have a number of clients who buy properties in the GO-Zone and receive loan forgiveness on certain of those purchases. Let me explain what that all means:
- Properties purchased in certain areas ravaged by Hurricane Katrina (e.g. certain counties in Mississippi and Louisiana) may be eligible for a 50% “bonus depreciation” deduction in the year purchased, also known as “Gulf Opportunity Zone” or “GO-Zone” depreciation. For example, a qualifying $100,000 property could easily give rise to a $50,000 deduction in year one (that’s in addition to the usual deductions for interest payments, utilities, etc.), and more normal deductions in subsequent years.
- Government grants: Some of the properties in the GO-Zone can also qualify for government grants. From what I’ve seen, the grant is designed to promote a reasonable limitation on the amount of rent charged to people in certain income groups. In exchange, the government will pay 30% of the loan on the rental property after 1 to 5 years. Following our example above, let’s assume that the granting agency cuts the property buyer a $30,000 check in year 5. Based on the Freedom Newspapers case, we would reduce the property’s tax basis (investment in the property for tax purposes) by $30,000 – resulting in cash but no extra income tax.
To reiterate:
A $100,000 GZ property could easily result in a tax write-off of $50,000 in the year purchased, in addition to the usual write-off’s one would expect with a rental property AND
If the property is covered by a local grant program, the taxpayer could receive $30,000 cash – tax-deferred or tax-free.
Action Item:
Whether you’re an investor, landlord or newbie investing in the Upstate of South Carolina or elsewhere, if you’ve been involved in a transaction like this, consider these action items.
Review your deals. If any of them had numbers on the HUD-1 (or other documents) that did not reflect the economic reality of the transaction, see which numbers made it to your tax returns. If the “paper” numbers are what was reported to Uncle Sam, then consider amending your tax returns to show the “real numbers”.
Going forward, you now know how such deals should be reported. If your current tax advisor is not up to speed on such reporting, kindly consider switching advisors.
Best Wishes!
John Hyre
This article is brought to you by the Upstate Carolina Real Estate Investors Association. (UCREIA)
Information about UCREIA’s Educational programs can be obtained off this website or by contacting the club’s Dir. of Education, Karla Kuhn
For more information on this topic, contact the author John Hyre; Tax Attorney, Accountant and Real Estate Investor
www.RealEstateTaxLaw.com
Reprinted with Permission