By By John Hyre, Tax Attorney, Accountant, Real Estate Investor
Accepting clients and Solving Real Estate Investor's Tax Problems Across the United States.
I have seen a fair number of purchases where the price paid for a property on the HUD-1 (closing statement)is not the same amount ultimately paid for the property. For example:
Buyer purchases a poperty for $100,000 and has a "side deal" to receive a $30,000 rebate from Seller outside of closing. The sales number that will appear on the HUD-1 is $100,000, even though the buyer is really only paying $70,000 after taking the $30,000 rebate into account. From the standpoint of the buyer, many accountants would treat this transaction as a s $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 porperty was treated as a reduction in the basis of the property purchased, and not as income. In our example, that would mean 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 purcharse/sale price reported to the IRS should reflect economic reality, and not necessarily what is on the HUD-1. When dealing with IRS, what happened in reality generally trumps what is written on paper.
Another example of where the Freedom Newspapers case ight 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:
1. Properties purchased in certain areas ravaged by Hurrican Katrina (e.g. certain counties in Mississippi and Louisian) may be eligible for a 50% bonus 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.
2. 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 one to five years. Following our example above, llet'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.
Action Item:
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.
Reprinted with Permission from December 2008 Realestatetaxlaw.com Newsletter
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