Friday, December 13, 2013

Is There A Deductible Long Term Capital Loss on the Sale of an Inherited Personal Residence?

Issue:   The personal residence of a decedent is now part of an estate and will eventually be placed for sale, either by the fiduciary or by the beneficiaries of the estate.  If the sale results in a capital loss (all sales of inherited property are long-term for tax purposes), is the loss allowed as a deduction?
See IRS Chief Counsel Memo SCA 198-012 (5/12/98) for, perhaps, the answer.  The Memo refers to IRC Sec. 641(b) and Sec. 165(c).  These sections deal with the taxation of individuals and limitations on deduction of personal losses, and the Memo points out that “…an estate generally may not deduct a loss incurred on the sale of the decedent’s personal residence unless it has been converted to an income-producing purpose.”

However, the Memo goes on to say that IRC Sec. 165(c)(2) would allow an estate to “…deduct a loss incurred in any transaction entered into for profit, though not connected with a trade or business.”  “This provision may apply when the estate establishes that it converted the decedent’s personal residence to an income-producing purpose.”

Then, a certain level of ambiguity is introduced when the Memo states “We believe that the conversion of the decedent’s personal residence is not necessarily unusual, especially if the administration of the estate is prolonged.”  One would presume that it would be unnecessary to define a situation where the residence is rented for fair value as a conversion to an income-producing purpose.  That would be self-evident and further supported by the use of Schedule E.

What else, if anything, would convert the residence to an income-producing purpose?  The Memo fails to develop the point and, instead, devotes the remaining 5+ pages to dealing with the issue (not essential to this discussion) of whether it is the fiduciary or the beneficiaries who either may be taxed or may be entitled to deduct a loss.

If the administration of the estate is prolonged, one reason could be that the property has not been sold, perhaps because it needs repairs and/or improvements before it will become attractive to potential buyers.  At what point does expending money for something beyond ordinary fix-up expense become a capital investment and does this “convert” the property to an income-producing purpose?  It would seem to be so, absent anything in the Memo to suggest otherwise, and especially since the Memo cites IRC Sec. 165(c)(2) which allows a loss in a non-business transaction entered into for profit.

At one time, your Editor believed that the property automatically converted if it was left unoccupied and placed for sale, whether or not money was spent to repair/improve.  Now I believe that the correct answer depends upon several factors:

Was the property unoccupied after death and placed for sale within a reasonable time after the date of death.  If so, and there was no significant expenditure of money, it remains a personal residence – no loss allowed.

If, however, a significant expenditure was first made in order to make it ready for sale, a conversion has taken place to an income-producing purpose – loss allowed.

Not so clear is another possibility.  The estate has remained open for a considerable period of time and this unoccupied property has been on the sidelines, awaiting final disposition.  Is this the “We believe that the conversion…is not necessarily unusual, especially if the administration of the estate is prolonged” type of situation addressed in the Memo?  It may be, and your Editor wishes that the Memo had spent more time on what is an important issue.

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