In the recently published case of Tucker v. Commissioner, T.C. Memo 2015-185, the Tax Court held that a taxpayer was not entitled to a loss deduction for real property subject to a recourse mortgage unless and until a foreclosure sale of the property occurred.

The taxpayer in Tucker owned 100% of the interests in Paragon Homes Corp. (“Paragon”), an S corporation.  Paragon owned multiple properties in Florida as part of its land development and building business.  In connection with its business, Paragon entered into mortgages with different banks.  The mortgages were recourse to Paragon and the taxpayer personally guaranteed the mortgages.  The taxpayer claimed that as of the end of 2008, the amount due under the mortgages exceeded the fair market value of the subject properties.  Between 2009 and 2010, the taxpayer and Paragon entered into settlement agreements relieving them of their obligations under the mortgages.  The taxpayer claimed a flow-through loss from Paragon on his 2008 return that largely was attributable to a write-down in the value of Paragon’s properties.  The taxpayer claimed that the loss was permitted because, in 2008, the properties became worthless and the taxpayer abandoned them.  The IRS determined that the taxpayer was not entitled to the loss for 2008.

Generally, a taxpayer is allowed a deduction for a loss that is not recovered through insurance or otherwise.  I.R.C. section 165(a).  To qualify, the loss must be “evidenced by closed and completed transactions, fixed by identifiable events, and . . . actually sustained during the taxable year.”  Income Tax Regs. sec. 1.165-1(b).  In certain instances, a loss is considered sustained during the year that the taxpayer abandons an asset or the year that the asset becomes worthless.  However, if the subject property is secured by a recourse mortgage, a taxpayer cannot claim a deduction until there is a foreclosure sale with respect to the property, even if the taxpayer abandoned the property or the property became worthless in an earlier year.   

The Tax Court held that the taxpayer was not entitled to the loss for 2008.  First, the Tax Court acknowledged that the taxpayer had caused Paragon to transfer funds to a different entity owned by the taxpayer; accordingly, the mortgagees still could expect recovery of the loans during 2008.  Second, the Tax Court acknowledged that Paragon continued to build on and sell the properties during 2008, despite the taxpayer’s claim that he had abandoned the properties.  Most importantly, the Tax Court held that because the mortgages were recourse, the properties could not be considered worthless until there were foreclosure sales of the properties; the foreclosure sales would be determinative of the value of the properties.

Real estate professionals should be advised that even if real property becomes worthless in terms of equity versus fair market value, no deduction is available until the real property becomes worthless for income tax purposes.  As evidenced in Tucker, if the real property is subject to a recourse mortgage, the date for determining worthlessness is the date of the foreclosure sale and no earlier.