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Q: I am a single taxpayer, age 65, receiving IRA distributions but no Social Security benefits. I am sole owner of a house used solely as a rental property, with no personal use, since January 2008. I materially participate in the rental activity by handling all aspects of leasing and maintaining the property. I plan to sell it in 2013. Will the sale be reported on Form 4797 as a business loss? I will have a net loss of approximately $100,000 upon the sale, after accounting for cost basis, improvements, recapture of depreciation, and carry forward of previous losses. If this is a business loss and my taxable income before the 4797 loss is $80,000, does the remaining $20,000 loss carry forward to the following year? Could I take an additional $20,000 distribution from my IRA to take full advantage of the excess loss in 2013, reducing my AGI to zero and resulting in a tax-free distribution? Would it make sense to take yet another distribution this year from my IRA of an amount that would still result in a zero tax liability? Some people have advised me that my loss would be a capital loss, reported on Schedule D, and be subject to the $3,000-a-year limit on losses. This is not an inviting scenario for someone my age. Which is correct?
A: Well, you have a very interesting issue. If the house is a capital asset the loss would be capital and limited to either offsetting capital gains or $3,000 a year. If the property is instead a Section 1231 asset, the loss is allowed without limit.
The Section 1231 loss can create a net operating loss, and will allow a cushion for you to recognize other income tax-free. You can also use the personal exemption and standard deduction/itemized deductions to permit even more income to be tax-free.
You could think about a traditional-to-Roth IRA conversion to have a tax-free result and create a Roth account for future tax-free growth. But this all depends on whether the loss can be classified as Section 1231.
A Section 1231 asset is one that is used in a trade or business. So the issue is, can the rental of a single house be a trade or business?
This issue has arisen a lot lately; when the real estate market was hot, no one cared whether the gain was capital or Section 1231. Now that people have losses, they do care.
So the answer is, I don’t know and neither does anyone else. But what I mean by that is there is no clear answer. The Tax Court has almost consistently held that a single rental house can be a trade or business, dating back to a case called Hazard, 7 TC 372 (1946).
The IRS responds, “Well, it depends.” It depends on how much activity one has, and the IRS would generally see a single rental house as falling below the threshold for a trade or business.
Appellate Courts have not been as kind as the Tax Court, but to my knowledge the 10th Circuit, which is where our appeals would lie, has said nothing on this issue.
I have been willing to treat these losses as Section 1231, that is, ordinary, based on Tax Court decisions. This is so although I do not agree with the Tax Court. I think that more activity is required for an investment to rise to a trade or business.
But that’s just an academic exercise. Since the Tax Court has allowed Section 1231 treatment, and my job is to be an advocate for the client provided the position has substantial authority, I go with the Section 1231 reporting.
This issue is unsettled enough that it could be challenged. So in general I would tell you to accelerate income to zero out your 2013 tax liability, but you do need to consider the risk that if the position is challenged you may get an audit adjustment that limits the loss to $3,000 and all that income you added is taxable (albeit at a low rate).
James R. Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.
