Discussion:Helping to flip a house and bankruptcy

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Discussion Forum Index --> Tax Questions --> Helping to flip a house and bankruptcy


Maryh722 (talk|edits) said:

11 December 2012
Taxpayer's brother bought a house to remodel and sell. The brother took out a mortgage on the house. No one lived in the house during the renovation. The taxpayer helped his brother to remodel the house. He went there on a regular basis for three years. If supplies and materials were needed he bought them using his own money. He drew on his IRA for cash. The brother filed for bankruptcy and the bank took the house. The taxpayer is listed as an unsecured creditor of the bankruptcy. Can the taxpayer take a loss on Schedule C? I was thinking bad business debt, but to have bad debt you had to have already included that amount in income. So far, the taxpayer hasn't claimed any income from the flip. Do you see a way he can take a deduction for his loss?

DaveFogel (talk|edits) said:

11 December 2012
If the taxpayer was listed as an unsecured creditor in his brother's bankruptcy, then it appears that the money he used for materials and supplies was a loan to his brother. The taxpayer can take a bad debt for the loss, but I believe that it's a nonbusiness bad debt unless the taxpayer is engaged in the lending business (yes, I know that there will probably be a debate here over business v. nonbusiness bad debt). If the taxpayer drew on his IRA for the money, then the money was already included in income as IRA distributions.

RoyDaleOne (talk|edits) said:

12 December 2012
"If the taxpayer was listed as an unsecured creditor in his brother's bankruptcy, then it appears that the money he used for materials and supplies was a loan to his brother."

Is this not a correct possibility, "If the brothers were partners in venture for profit, could there be partner to partner liability for such amount."?

Thank you for your response.

DaveFogel (talk|edits) said:

12 December 2012
"If the brothers were partners in venture for profit, could there be partner to partner liability for such amount."

If this were true, then I would expect the bankruptcy petition to have listed the liability as arising from a partnership or joint venture. Maryh722 doesn't mention any facts that indicate this.

PollyAdler (talk|edits) said:

12 December 2012
NO PROFILE. Consumer here! [That worked - OP has updated her user page!]

Maryh722 (talk|edits) said:

12 December 2012
The brothers were working on the house as partners in the fact that when the house sold, the taxpayer was supposed to receive a portion of the profit - not just a refund on the money he put into the project and no interest. However, the bankruptcy did not list him as a partner.

DaveFogel (talk|edits) said:

12 December 2012
The question here is whether you have a worthless investment in a joint venture, or whether you have a loan. I assume that there was no partnership return filed, no formal documents to create a partnership, etc. Therefore, as I see it, the problem you face is that the taxpayer's brother reported to the bankruptcy court that it was a loan. The IRS will point to this as evidence of a loan.

Maryh722 (talk|edits) said:

12 December 2012
If he had made money, I would think his portion of the proceeds would have been shown on Schedule C with the expenses deducted. Is it wrong to show $0 sales and $20,000 expenses?

Kevinh5 (talk|edits) said:

12 December 2012
Yes, as joint ventures, other than a QJV, are not shown on Sch C. And as Dave has pointed out, there is evidence in a Federal court that this wasn't a joint venture, but a loan. It certainly wasn't your client's sole proprietorship.

Ckenefick (talk|edits) said:

12 December 2012
However, the bankruptcy did not list him as a partner.

It doesn't really matter what the bankrupcty court says here, what matters, for the income tax deduction, is how this would be cast for income tax purposes based on federal tax principles. Based on the loosey goosey nature of this arrangement, I wouldn't have expected the bankruptcy court to make any mention of this purported partnership.

With that said, we probably do have a common law partnership. But I'm with Dave, sounds like all parties have denied the existence of said partnership...and the IRS would probably deny it to, meaning that we have a loan.

DaveFogel (talk|edits) said:

12 December 2012
"It doesn't really matter what the bankrupcty court says here"

The bankruptcy court really wouldn't have SAID anything specific. The brother reported in his bankruptcy petition that the amount owed to the taxpayer was an unsecured debt, and the brother signed the petition under penalties of perjury. The bankruptcy court would have discharged the debt under its general discharge of unsecured debts.

Ckenefick (talk|edits) said:

12 December 2012
The brother reported in his bankruptcy petition that the amount owed to the taxpayer was an unsecured debt

I hear you..."tax law" would say that brother's statement to bankruptcy judge was erroneous, although perhaps made in good faith. There is a clear common law partnership here. Non-bankrupt brother could say, "I see my brother listed me as a creditor. I see the debt was treated as unsecured by the bankruptcy court. I see that this debt was discharged. This is all nice and good, but there was never any debt to begin with. You see, I made an equity investment. As such, it doesn't really matter what the bankruptcy court says or how the court treats my 'investment.'"

These situations are not all that uncommon. We've seen several posts on them - a cash investor, a worker bee and a bank loan usually in the mix somewhere.

But I do agree that if we've never filed a 1065 (for one thing) it's hard to make the case after-the-fact that we now have a partnership when its existence has been denied up until now.

DaveFogel (talk|edits) said:

12 December 2012
"This is all nice and good, but there was never any debt to begin with."

If the taxpayer says this, then he's accusing his brother of bankruptcy fraud, which is a lot more serious than a tax deduction.

Ckenefick (talk|edits) said:

12 December 2012
If the taxpayer says this, then he's accusing his brother of bankruptcy fraud, which is a lot more serious than a tax deduction.

I don't think so. As noted above, bankrupt brother, in good faith, may have believed he owed a debt to his brother. The fact is, even TA Posters have trouble accounting for these loosey goosey arrangements - is it a loan? Is it not a loan? Is the profit payout interest income and an interest deduction? Do we send a 1099-MISC to the cash investor b/c worker bee reported everything on his 1040? But, once the "common law partnership" idea is thrown in, the light bulb typically comes on...because that's really what it is.

And, from a financial standpoint, I don't think non-bankrupt brother has been deprived of anything with a debt determination. A bad debt...a worthless partnership interest...it's all the same financially - a loss.

DaveFogel (talk|edits) said:

12 December 2012
"I don't think so."

I do.

"A bad debt...a worthless partnership interest...it's all the same financially - a loss."

Yes, but different for tax purposes. While a nonbusiness bad debt is deductible as a short-term capital loss (limited to $3,000), a worthless partnership interest can be deducted as an ordinary loss. See Rev. Rul. 93-80.

Ckenefick (talk|edits) said:

12 December 2012
My key word was "financially."

Also, I don't see a fraud accusation when one party to a arrangement treats the arrangement as Thing-1 and another party treats it as Thing-2. Different treatment doesn't necessarily mean one is accusing the other of fraud. Sure, it could mean this in some situations, but probably not here. Again, even sophisticated TA Posters have been confused by these arrangements. And the case law is full of "Is it Debt or Equity" cases...no fraud, just differing interpreations.

Moreover, in this case, both parties may believe there was a debt flowing from bankrupt brother to other brother. But, upon further investigation, which may involve bringing to light alternative thinking, one or both may say, "Yes, that's it. A common law partnership."

Yes, if there is an accusation of fraud, it would be easy to refute in this case. Bankrupt brother would say, "SHOW ME THE 1065," which I believe, is what Jerry McGuire said.

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