Where to include Bad Debt

[equinecpa]

I have a client who is a real estate agent. To get a deal done she took a 2nd lien on a property. House entered foreclosure and sold, and she ended up with nothing on the debt. Since income from this deal was included on Schedule C would it be correct to deduct this as a schedule C expense? I'm thinking of entering it in COGS since realistically that's what this ends up being.

Is this correct handling of this scenario? If not what would you do with it?

Thanks

Carolyn

[jainen]

qualify her buyers

>>income from this deal was included on Schedule C<<

I don't have a problem calling this a business bad debt, but what is her basis? Usually in cases like this what actually happened is she took the note as part of her commission. In other words, the seller didn't pay as much.

It would be a rare real estate agent indeed who pays taxes on money she only hopes to get someday in the future. I'm sorry she didn't make as much as she expected on the deal, but maybe next time she will qualify her buyers a little better.

[LawrenceGR]

Cash vs accrual

It seems to me this person overstated income if they operate on a cash basis. In a cash business income is not recognized until the money is in your hot little hand. Perhaps the return should be ammended to remove the uncollected income.

[equinecpa]

She took out an actual 2nd lien and the payor defaulted. In researching this it's definitely deductible as a business bad debt - I included it with her cost of sales as that seems the most appropriate place.

Carolyn

[jainen]

The question is

>>She took out an actual 2nd lien<<

The question is NOT whether the money was actually owed. Of course it was owed to her, and recording the lien or promissory note to secure it was the correct thing to do. No doubt the sales contract and escrow instructions were amended accordingly as well.

The true question is whether the note was a promise to pay or a promise to REPAY. Did she shell out real money to make up the buyer's shortfall, or did she fund it with her commission? If she did not actually write a check, then she has no basis in the debt and nothing to deduct. (If she did write a check, it's a clear indication that this was a related party transaction or she was a principal, with additional questions.)

Of course, it is theoretically possible that she counted the note received in her taxable income. Technically that's the correct thing to do, but almost unheard of for a non-corporate taxpayer. If nothing else, she would have claimed the FMV of the 2nd lien was much less than the face value (which turned out to be a fact).

As for calling it Cost of Goods Sold, that would only be appropriate for a dealer, not an agent. Even in that case, there is the question of whether she actually put money into the pot or just left money in that she was otherwise entitled to. An uncollected receivable would not be shown as income so again she would have no basis in the debt and nothing to deduct.

Finally, if it were her own property that she sold, the note made it an installment sale. The default probably changes the sales price or otherwise creates a loss, but that would still not be deductible on Schedule C.

[OldJack]

This is obviously a deductible bad debt as appropriate sales income would have been recognized on the deal in the year of sale. When the 2 mortgage was taken that was a separate deal/transaction making her an investor/loaner.

As a bad debt it is not cost of good sold it is deductible as a bad debt like any other bad debt on 1040 Sch-C.. on a miscellaneous line. Cost of goods sold was properly shown in the year of sale and it is not appropriate to now say that was wrong because of poor personal judgement.

[George Boutwell]

What really happened?

She took out an actual 2nd lien

How do you take out a lien? Is that the opposite of dining in?

The scenario that Jainen suggests is almost always what happens in these cases. The agent is due a (for example) $10,000 commission but there's not enough cash to pay it, so instead the agent receives a mortgage, or a promissory note from the buyer that is secured by the property. The lien is subordinate to the primary lender. The agent does not pay tax on the commission until it is received. If instead the primary lender forecloses, and the agent receives nothing, there is no income to report. Your question should involve whether a 1099A or 1099C must be filed.

So tell us what really happened:

1) How much of a commission did the agent expect to collect on this transaction?

2) How much was actually collected at closing?

3) How much was the amount of the lien she received in lieu of a commission check?

4) How much of her own money did she take out of her own bank and turn over to the escrow agent in order for the deal to close?

[OldJack]

The agent does not pay tax on the commission until it is received. If instead the primary lender forecloses, and the agent receives nothing, there is no income to report.

George I understand the logic of what you are saying.. but I totally disagree.

This is a case where an agent has to recognizing commission/sale income as it is considered "received" on a real estate closing statement. If the agent did not report the full stated commission/gain on sale as income it would have been an error. The closing statements shows a commission "paid" and all parties understand it is received/paid as part of the closing, therefore it is deducted by the seller against gross sale to arrive at net proceeds on the sale.

All amounts are to be paid or received, that is why its called a "closing". A closing is considered final with all parties agreeing with their signature thereby acknowledging receipt or payment.

The seller is not going to go back and recompute his/her gain or loss on the deal just because the agent didn't collect a bad debt. The fact that the real estate agent decides to loan money (even if it came from the commission) to the purchaser is a different matter, separate deal, than the closing of the commission/sale price on the transaction and since it may be in different tax years it is treated as a business bad debt. The real estate agent can't reconstruct the sale deal just because (s)he made a bad loan.

[OldJack]

duplicate posting of the same message... why unknown therefore deleted.

[jainen]

screw up the tax return

>>I totally disagree.<<

Let us take comfort that the good order of the universe has been restored.

>>The closing statements shows a commission "paid"... it is deducted by the seller against gross sale.<<

No it isn't. There isn't enough cash in the deal to close, probably because the seller must net enough to pay off his mortgage or to buy his replacement property. The days of $10,000 commissions are long gone, Old Jack, at least where I live. Our median price is $780,000 and 6% of that is $46,800. So the agent agrees to charge the seller $20,000 and tries to make it up with a promissory note from the buyer. And that's exactly what the closing statement says. The first mortgage wouldn't accept anything different.

The situation usually happens either because the property won't appraise at the needed value or the buyer can't qualify. Typically it's the property because good collateral overcomes most problems and you can always find another buyer unless the property has to be overpriced. Unfortunately, in either case it's a mighty poor bet for the mortgage in subordinate position.

>>The fact that the real estate agent decides to loan money... is a different matter, separate deal<<

No again. It's all one deal, and we can be sure it didn't happen that way. The agent would not be allowed to put in new money (except as a co-buyer) because the bank would never sign off on such an unusual transaction because they would not be able to sell such a loan on Wall Street. Also, her broker would not permit it because it would involve him in a risky deal without adequate compensation.

Of course, if she held her own license she might be foolish enough to dabble in hard-money lending, but it still wouldn't look like this. If the first wasn't totally spooked by her participation, the loan-to-value should have been low enough for her to cure the default herself with a refinance to protect her own lien.

But even if I'm way off base about this, it's still no reason to screw up the tax return.

[George Boutwell]

The fact that the real estate agent decides to loan money (even if it came from the commission) to the purchaser is a different matter, separate deal, than the closing of the commission/sale price on the transaction and since it may be in different tax years it is treated as a business bad debt.

I'm sure there are a subject and a verb in that sentence -- maybe more than one of them -- and as soon as I find them, I will let you know.

Let's say you employ Charlie, who did Bertha's tax return under your supervision. Bertha is supposed to pay you and then you pay Charlie a percentage, when the fee is collected. But Bertha doesn't have the cash right now so she gives you an IOU. Are you saying you are going to pay tax on that? Maybe Bertha says she will even secure the note with a lien on her house. Does that make a difference to you? You weren't going to pay tax on it before, but now you think you should? What if Bertha's friend Darrell owes her money, so she pays you with the promissory note that Darrell gave her. Are you going to pay tax on Darrell's note? If so, how much? Face value, or a discount taking into account the probability that Darrell will actually pay it? That's an interesting question, and you may be correct that you have received something of value, even if not cash. But what about Charlie, who doesn't get paid his percentage until you collect some cash? Are you going to make him pay tax on a percentage of Darrell's note? I'm asking, because Charlie is in the same position as the agent here, and you're in the same position as the broker.

[OldJack]

But Bertha doesn't have the cash right now so she gives you an IOU. Are you saying you are going to pay tax on that? Maybe Bertha says she will even secure the note with a lien on her house. Does that make a difference to you? You weren't going to pay tax on it before, but now you think you should?

Nonsense George. Your example is not the same situtation as I have not agreed to anything verbal or written when I receive an IOU. And as to accepting someone elses debt instrument, you need to review the rules on "barter".

Some of us ozark hillbillies don't know where code cites are for "verbs" but we try to stick to the subject.

[OldJack]

But even if I'm way off base about this, it's still no reason to screw up the tax return.

Jainen.. you are confusing reality with tax law, much the same as logic verses tax law. On the closing statement the commission in full is shown and the loan in full is shown on separate lines as they are different arrangements of the real estate transaction with different parties of the transaction. That is the economic deal in writing... that is the tax situation that you have to recognize.

[George Boutwell]

Your example is not the same situtation

I just thought I would run it up the flagpole and see if anyone saluates.

[jainen]

I can't dispute that

>>That is the economic deal in writing... <<

I haven't seen the writing, so I can't dispute that. However, it seems extremely unlikely to me. Impossible, in fact, if the transaction involves the limitations I mentioned -- the seller must net a certain amount to cover his mortgage or other obligations.

For example, suppose he had a $300,000 mortgage on a house that has dropped in value to $300,000. If he has to pay a 6% commission, he can't close because he will be $18,000 short. They can't bump the price because the lender is stuck with the appraisal amount. So the agent takes an $18,000 promissory note based on the buyer's equity ($60,000 down payment) and the bank covers the other $240,000 (80% of FMV). The buyer has appropriate equity so the first loan meets FNMA requirements, and the seller has enough for payoff. The closing papers report all this correctly as part of the loan documentation. The agent has a promissory note which probably should be counted as income but undoubtedly would not be.