Alert April 23, 2013

IRS Allows Banks to Deduct, Rather Than Capitalize, Costs Associated with Selling Foreclosure Property

Banks that foreclose on real property may be entitled to more favorable tax treatment for the expenses they incur to sell the foreclosure property.  In February 2013, the Internal Revenue Service (“IRS”) Office of Chief Counsel announced that a bank may deduct, rather than capitalize, expenses associated with Other Real Estate Owned, or “OREO” property, in situations where the bank originated the loan and later acquired the property in foreclosure proceedings or by deed-in-lieu of foreclosure.  AM 2013-001 (February 22, 2013), the “February 2013 Memorandum”.  Banks that have traditionally capitalized OREO expenses must file for a change in method of accounting with the IRS in order to deduct those expenses.

Background and Legal Standard:

Section 263A of the Internal Revenue Code requires that if a taxpayer (1) acquires real property for resale and (2) holds the property primarily for sale to customers in the ordinary course of its trade or business, then the taxpayer must capitalize costs associated with the property.  As recently as June 2012, the IRS has maintained that a bank must capitalize OREO property expenses because the bank acquired the OREO property with an intent to resell it.  FAA 20123201F (June 18, 2012).  However, the IRS’ most recent February memorandum concludes that OREO expenses are deductible, because a bank’s sale of OREO property is merely an extension of its primary loan origination activity.  Specifically, a bank does not acquire OREO property in order to resell it for profit, but instead takes title and possession of the property only as a last resort.  In fact, applicable law generally requires a bank to return sales proceeds in excess of the mortgage balance to the borrower.  Thus, the IRS concludes that, because a bank’s sale of OREO property is solely an extension of its lending activity, the bank does not have to capitalize expenses under Code Section 263A.

Although the IRS’ February 2013 Memorandum does not specifically reject prior guidance which requires banks to capitalize OREO expenses, the February 2013 Memorandum does seem to indicate a change in the IRS’ stance, and potentially eligible banks should consider talking with their tax advisors about deducting OREO expenses.