Publications & Resources

January/February 2010
Managing Troubled Assets

Tax Considerations for Troubled Assets

By Amy Jessup & Mark Reis

While troubled assets certainly create a burden on a bank's financial statements, they also are a likely source of tax deductions for the bank. However, the tax law regarding the timing of the deductions is not always straightforward. This article highlights some of the tax considerations that banks should be aware of regarding troubled assets.

Form 1099 Requirements on Foreclosed Assets

Generally, a Form 1099 must be filed when debt is satisfied in exchange for a real property interest. Depending on the facts involved, the appropriate Form 1099 applicable to a foreclosure transaction may vary.

For instance, when the debt forgiven is equal to the value of the property received, Form 1099-A, Acquisition or Abandonment of Secured Property, is generally the appropriate form. However, when the debt is cancelled without exchange, or when the value of the property received is less than the basis of the debt forgiven, Form 1099-C, Cancellation of Debt, should generally be used. These forms must be filed regardless of whether the debtor is required to include the cancelation of indebtedness as taxable income.

The amount that should be reported on the appropriate Form 1099 is the principal balance of indebtedness satisfied or otherwise cancelled in exchange for the property, along with the value of any property received by the bank.

Certain courts have held that by filing a Form 1099, the bank is foregoing any future claim against the related debt. If the bank believes that recovery of principal may still be possible, it is generally not advisable to file Form 1099-A or Form 1099-C until the dispute is resolved.

OREO Market Value Adjustments and Carrying Costs

At the time of foreclosure, the bank will realize a tax charge-off to the extent that the bid price of a property, or its fair market value, is less than the outstanding principal loan balance, less any amounts previously charged off. In addition, certain costs, such as legal expenses, back taxes, insurance, and similar items paid by a bank for protecting the value of the property prior to foreclosure, may be realized as a tax charge-off.

However, legal costs and other similar expenses incurred in connection with the foreclosure proceedings should be capitalized for tax purposes and will increase the tax basis of the OREO property. In addition, any subsequent fair market value adjustments are not recognized for tax purposes until the property is sold. Therefore, it is critical for the bank to obtain timely and accurate property valuations so that the bank can maximize its tax deduction related to loan charge-offs rather than deferring a tax loss on an OREO property write-down until the property is sold.

In its 2001 Commercial Banking Training Guide, the IRS indicates that after a bank takes possession of a property, “no portion of the expenses is currently deductible if the bank is holding the property for resale or sale to customers.” This is because the IRS considers OREO property to be similar to inventory. However, if the bank holds certain properties out for rent or converts them into operating assets, then normal maintenance expenses, including depreciation, may be deductible by the bank when incurred.

Thus, the bank will need to maintain detailed records on each of its OREO properties to track the costs that should be capitalized for tax purposes along with the market value adjustments that have been reflected in the GAAP financial statements.

Taxability of Non-Accrual Interest

For tax purposes, accrued interest on nonperforming loans should continue to be included in taxable income until it is deemed to be uncollectible.

There are currently three options available to banks regarding how taxable non-accrual loan interest can be determined:

Make a conformity election, which requires the filing of an automatic Form 3115 for the change in accounting method
Elect the “safe-harbor” method, which requires the filing of an automatic Form 3115 for the change in accounting method
Maintain an analysis of the collectability of the interest on a loan-by-loan basis

If the conformity election is desired, then Rev. Rul. 2007-32 requires that it has to be applied to loan charge-offs as well. Because Rev. Rul. 2007-32 effectively treats the non-recognition of uncollected accrued interest as a bad debt for federal income tax purposes, a subsequent payment on the loan will be characterized as a partial recovery of the bad debt and should first be applied to interest income for tax purposes (regardless of whether the payment represents interest or principal for financial statement purposes). Therefore, any subsequent payment will likely create a book/tax difference.

The “safe-harbor” election under Rev. Proc. 2007-33 can also be used. While this method of accounting may provide some “administrative ease,” it is likely to produce a higher tax addback adjustment than the other two methods. Using this method, the bank establishes an annual recovery percentage by dividing total principal and interest payments received on loans during the prior five years by the total amounts that were due on such loans. This percentage is then applied to all “accrued but uncollected interest” to determine the amount that should be included in taxable income each year.

A loan-by-loan analysis is likely to provide a more favorable result; however, adequate documentation must be maintained to support the tax exclusion of non-accrual interest using this method. For each of its nonperforming loans, the bank must determine and substantiate that the underlying non-accrual interest is uncollectible, based on all facts and circumstances, and that there is no reasonable expectation that the interest will be paid. If subsequent payments on the loan are collected, they will be characterized as first being applied to interest income for tax purposes (regardless of whether the payment represents interest or principal for financial statement purposes).

Timing of the Tax Deduction for Worthless Loans

A bank can perform a substandard loan charge-off analysis to determine whether it has the opportunity to accelerate the tax deduction taken on worthless loans that were not charged-off for financial statement purposes as of the end of the tax year. If the conformity election has not been made, the worthlessness of the loan from a tax perspective can be evaluated on its own merits which may produce a deduction in an earlier tax period than is reflected for book purposes. Such an analysis is key for maximizing a bank’s net operating loss carry-back potential.

Conclusion

While troubled assets can create a significant strain on a bank's financial position, there are several tax planning opportunities available to banks to mitigate the effect. Also, there are potential tax pitfalls that could negatively impact a bank disposing of troubled assets. It is important to consult your tax advisor to help you understand the tax implications surrounding troubled assets and to plan accordingly when identifying and documenting potential tax deductions.

Amy L. Jessup is a CPA senior manager in Moss Adams LLP’s Portland, Ore., office and Mark Reis is a partner in the firm’s Everett, Wash., office. Jessup can be reached at Amy.Jessup@mossadams.com. Contact Reis at Mark.Reis@mossadams.com.