Abandoning worthless investment property versus selling at a loss.

• Author: Fox, Alexander F.

Individual taxpayers owning properties that are considered investment properties not eligible for Sec. 1231 treatment, and that (through devaluation or other unforeseen circumstances) have become worthless, often choose to sell those properties at a loss and claim a capital loss. In some circumstances, it may be more advantageous to consider legally abandoning the property and claiming an ordinary loss against ordinary income. Each alternative his its benefits and drawbacks, and each taxpayer's situation should be examined closely to determine the most advantageous choice.

Example: A single taxpayer, T, has a basis of $60,100 in a property with no fair market value. If T sells this worthless property to a nonrelated party for $100, T may claim the entire $60,000 loss as a capital loss. If T has no capital gain in a particular year to be offset by that loss, Sec. 1211(b) limits the amount of capital losses that T can deduct against ordinary income to $3,000. Thus, if T has insufficient capital gains to offset this $60,000 loss (and expects no significant future capital gains), T may deduct only $3,000 each year for the next 20 years. Generally, this is a safe option, although for taxpayers who make limited investments and do not generate consistent capital gains, it results in only a small annual offset against ordinary income.

On the other hand, some taxpayers may want to consider legally abandoning the property. In some cases, if the property is abandoned, a taxpayer may obtain a much larger current deduction against ordinary income than obtainable under the $3,000 capital loss limitation. This result is beneficial for taxpayers who do not foresee recognizing capital gains that could be offset by the entire loss. But even for some taxpayers who foresee recognizing capital gains, the new lower tax rates may make abandonment worthwhile. Because long-term capital gains are now taxed generally at 20%, capital losses generally provide only a 20% benefit. Accordingly, it may be preferable to pay the capital gains tax and instead use the abandonment deduction to offset ordinary income, which may be taxed at rates up to 39.6%.

Caution: Since this approach may precipitate adverse consequences, each taxpayer's particular situation must be closely analyzed. There are three "hurdles" that taxpayers must overcome before an abandonment strategy will be worthwhile. First, a deduction for abandonment of nonbusiness property held for profit is a...