Discussion:Sourcing COD income on nonresident rental

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Discussion Forum Index --> Advanced Tax Questions --> Sourcing COD income on nonresident rental

Discussion Forum Index --> Tax Questions --> Sourcing COD income on nonresident rental

Laketahoecpa (talk|edits) said:

12 October 2010
Client is California resident and had rental in Hawaii. Lost in foreclosure in 2009.

He had refi'd to purchase rental property in California so the HI property had $450K of debt and basis of $200K.

1099-A shows $450K of debt (recourse) and FMV of $460K. So if I don't question the FMV, the sales price would be $450K and gain on sale of property would be $250K. No question the gain on sale is reportable as Hawaii source.

If I have evidence that the FMV is lower, let's say $350K, we've now got $150K gain and $100K COD income. To me it seems that the COD income is an intangible type of income that wouldn't necessarily be sourced to Hawaii.

It doesn't matter for fed or california as client has NOL carryover's from prior business losses and losses on foreclosure of the California rentals in 2008 that offset gain on sale/COD income from Hawaii rental. But since he is nonresident of Hawaii, there is only small Hawaii NOL from prior Hawaii rental losses to offset gain on disposition.

Whaddya think? Do I have leg to stand on?

DaveFogel (talk|edits) said:

12 October 2010
You do not have a leg to stand on.

First, you can’t just decide to accept the $450,000 FMV shown on Form 1099-A if you know it’s wrong. If it’s wrong, then you have a duty to use the correct amount. Otherwise, you are violating §10.22 of Circular 230 (Diligence as to Accuracy).

Second, COD income resulting from foreclosure of rental real estate in Hawaii is not income from intangible property. According to the instructions to Hawaii Form N-15, "The source of income from either real or tangible personal property, is the place where the property is “owned”, which means the place where the property has its situs."

LH2004 (talk|edits) said:

October 12, 2010
But isn't the whole point that COD income isn't obviously "income from real property" just because the debt canceled was secured by real property?

For federal purposes, the sourcing rules are rather murky. There are solid arguments for sourcing the income to: the location of the lender (who is deemed to make a payment to the borrower under reg. sec. 1.1441-2(d)(2)); the location of the transaction giving rise to the COD income; the residence of the borrower (by analogy to the market discount bond sourcing rules); or the deemed source of interest deductions on the loan (on the theory that COD income represents a recapture of previous interest deductions; that's maybe not so convincing when there's a lot of principal canceled). At least 2 and probably 3 of those would not deem this income Hawaii-sourced (if the federal analogy is even relevant).

DaveFogel (talk|edits) said:

12 October 2010
There are no "solid arguments" for sourcing the income to the location of the lender. I fail to see how Reg. 1.1441-2(d)(2) is relevant here, since that regulation does not discuss the sourcing of COD income. In any event, we're talking about state sourcing, not federal. And I don't agree that the residence of the borrower has any relevance.

And COD income does not represent a recapture of previous interest deductions. It's cancellation of principal. Cancellation of interest, to the extent that the interest would have been deductible, doesn't even result in taxable income per Sec. 108(e)(2).

Clearly, COD income resulting from cancellation of a debt secured by real property is derived from the ownership of the property, and therefore, is sourced to the state in which the property is located. In my opinion, any other conclusion would be malpractice.

Laketahoecpa (talk|edits) said:

12 October 2010
Ow - stuck my toe in the water and got my leg bit off.

LH - thanks for the input. Its always appreciated when someone takes time to consider the question and provide an opinion.

Dave - My thinking was that perhaps since the Hawaii property was only collateral and that the funds that gave rise to COD could be traced to other non-Hawaii property that maybe I could source that income elsewhere - but alas I have no evidence to provide persuasive rebuttal to your conclusions.

LH2004 (talk|edits) said:

October 12, 2010
The location of the collateral would be one place to put on the list of possible sources for COD income, but to say that it's clear is just silly. There are no clear rules, which is why you have to analogize to the rules that we have about other situations.

If the source is always the location of collateral, then there are some obvious opportunities for manipulation. You could end up concluding there's a Hawaii source here on some other basis, but I don't think that's the right rule.

KatieJ (talk|edits) said:

12 October 2010
The California FTB addressed this in its "Tax News" dated June 6, 2010. It's clear from that discussion that California would consider the COD income to arise from the property, and therefore to have its source where the property is located. However, it's the cancellation of debt, not the sale of the property, that generates COD income (see federal Reg. Sec. 1.61-12), and arguably the debt is an intangible. Income from intangibles has its source at the residence of the owner, unless the intangible has a business situs somewhere else.

I'm not sure LakeTahoe doesn't have a leg to stand on -- though it may be a bit wobbly <G>. I'd be willing to bet, though, that the Hawaii DOR would claim it's Hawaii source income. Doesn't necessarily mean they'd win in court. As LH suggests, this is an open question.

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