In June of 2012, Reuters reported that for the first time in more than two years, the number of foreclosures increased.1 And the banks are stuck paying all the expenses and taxes associated with the foreclosed properties. The tax treatment of these on-going expenses associated with the foreclosure of a bank's "other real estate owned" (OREO) remained unclear until recently. Some banks deducted the expenses in the year that they were incurred and took an immediate tax benefit, while others capitalized those expenses.
In June of 2012, the IRS took the position in a Field Attorney Advice Memorandum that OREO expenses should be capitalized. See FAA20123201F. The IRS argued that foreclosed homes were capital assets subject to capitalization under section 263A of the Internal Revenue Code. IRS examiners relied upon FAA20123201F to disallow any current deductions taken by banks, including a client of Kilpatrick Townsend.
Shortly thereafter, the tax team at Kilpatrick Townsend filed, on behalf of its bank client (Bank), the first U.S. Tax Court action challenging the IRS' capitalization position. The Bank previously deducted the OREO expenses, and the IRS disallowed the expenses based on its capitalization argument. Kilpatrick Townsend argued in the Petition that OREO property was not primarily held or acquired for resale and as a result should not be considered capital assets. Thus, expenses associated with such properties should be currently deductible by the financial institution.
In almost every case, when a bank forecloses on property, it is to mitigate losses with respect to unpaid loans and not for purposes of resale. These properties are received during the course of the lender-borrower relationship to enforce collateral rights to collect on its loan to the borrower. The IRS often referred to Section 263A and the regulations thereunder that require the capitalization of expenses associated with property acquired for resale. However, in order to be "property acquired for resale" under section 263A(b)(2)(A), the property must both be "held" by the taxpayer primarily for sale to customers in the ordinary course of trade or business and "acquired" for resale.
Kilpatrick Townsend argued that the Bank neither acquired nor held OREO property primarily for sale to customers in the ordinary course of trade or business. First, banks receive OREO property during the course of the lender-borrower relationship to enforce collateral rights to collect on its loan to the borrower. In fact, banks are prohibited from acquiring real estate for investment purposes except in limited circumstances. Even assuming that these properties are held by the banks for sale to customers in the ordinary course of trade or business, these properties are not acquired for resale. Sales of foreclosed properties are made to maximize recovery on a loan and not for the purpose of resale. Additionally, Treasury Regulation § 1.263A-1(b)(13) explicitly states that the bank's activity of originating loans is not considered the acquisition of property for resale within the meaning of section 263A(b)(2)(A). Therefore, Kilpatrick Townsend argued that Bank's acquisition and sale of the property securing the loan should not convert Bank into a reseller if the foreclosure and sale of the OREO property is merely an extension of the Bank's loan origination activity.
Following the Bank's filing of the Petition in U.S. Tax Court, the IRS reconsidered its earlier position and ultimately agreed that the OREO expenses could be currently deductible. The IRS set forth its new position in a memo cited as AM2013-001 (AM).
The AM presented a generic fact pattern almost identical to the Bank's facts laid out in the Petition. The AM considered cases in which a bank, in the ordinary course of its lending business, secures each loan with the purchased property. The IRS found that under Treasury Regulation § 1.263A-1(b)(13), the banks' origination of loans is not considered the acquisition of property for resale within the meaning of section 263A(b)(2)(A). Rather, the IRS concluded that solely taking title to and possession of mortgaged property from defaulted borrowers in an effort to mitigate loss is an extension of the primary activity of originating loans, not reselling properties. Consequently, AM2013-001 concluded that the OREO properties were not properties acquired for resale within the meaning of section 263A(b)(2).
The final resolution of the OREO expenses issue is a great example of why taxpayers and their advisors must carefully scrutinize the IRS' position on unsettled issues. In light of section 263A, the Treasury Regulations thereunder, and Chief Counsel's recent Advice Memorandum, financial institutions may be able to deduct OREO expenses on foreclosed homes in the tax year in which they are incurred rather than capitalizing those expenses over the course of multiple years. Of course, a bank must speak to its tax advisors to confirm its facts are similar to those laid out in AM2013-001.
Unfortunately, many banks capitalized these expenses in the past and now face the task of changing their method of accounting for these expenses. The American Bankers Association have been very involved in this issue and recently requested the IRS to allow banks to automatically change their method of accounting rather than seek written approval.2
Footnotes
1. Sussman, Anna Louie. "Foreclosures Up for the First Time in 27 Months." Reuters. June 14, 2012. "http://www.reuters.com/article/2012/06/14/us-usa-housing-realtytrac-idUSBRE85D05P20120614 .
2. American Bankers Association. "Letter re: Application for Industry Issue Resolution Program - bad debts and other issues." March 29, 2013. http://www.aba.com/Solutions/Acct/Documents/ABAIRRApplication032913.pdf" .
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