Federal Taxation Case Facts: Wilma

Federal Taxation Case Facts: Wilma inherited a home from her deceased uncle, Bob. The home had a reverse mortgage on it that was taken out by said uncle during his later years. The mortgage is payable to the bank in full upon Bob's death, but the bank will wait one year to foreclose if the mortgage is not paid by that time.

The only asset that is attached by the mortgage is the house Bob gave to Wilma, and no heirs can be held liable for any of the mortgage debt. Fair Market Value (FMV) of Bob's home is $90,000, and the balance of the reverse mortgage is $210,000. Wilma has taken title to the house and is examining her options in order to decide what the best course of action will be for her financial future.

Issues: The overarching issue here is what Wilma will do with the house, but there are several concerns that have to be examined. She is looking into three options that will all have some drawbacks and some advantages for her. The first is to allow the bank to foreclose on the home. The cancellation of debt, though, could be realized as a gain for tax purposes, costing Wilma money.

The second option is to offer the bank $90,000 (the FMV) to settle the loan, but again she will have the issue of gain to be concerned with. The third option is to sell the house to the neighbors, because they would like to purchase the house for their son. She is attempting to get the bank to settle the loan for $80,000. At that point she would sell the house for $90,000, pay commission and closing costs, and receive $3,700 profit.

She is concerned about the gains she will have to report in that case, as well. Analysis: If the property was still in the name of the estate and Wilma had not taken title, she would be advised to simply allow the bank to foreclose on the house. She would not receive any gain from the house, but she would also not be subject to any tax on it.

Wilma would also not have to worry about negotiating with the bank, and anything else she inherited from Bob would have simply become hers with no attachment and no obligation to pay any of Bob's debt on the house. This would have been the best course of action for Wilma from a strictly financial standpoint. Now that Wilma has taken title her options are far different (and much more significant for tax purposes) than if she had never taken title to Bob's house at all.

The title means that the house has now become her responsibility. According to Commissioner v. Tufts (1983), the amount of the FMV is not relevant, and neither is the nature of the loan. What the Court focused on was the fact that any gains of property or money that is acquired or received must be taxed, and must be accounted for.

It is not possible for someone to take a loss on something they have acquired for taxable purposes if there is no actual economic loss that corresponds with that taxable loss. This was an affirmation of Crane v. Commissioner (1947). When individuals have taxable income, they must claim that income, and the same is true with any kind of gain they receive - such as property (Barris, 2008; Baum, Nunnigton, & Mackmin, 2011). Even if no actual money changed hands, anything inherited and then sold may have taxable value (Prendergast, 1982; Yin, 2002).

Cases such as Crane v. Commissioner (1947) and Commissioner v. Tufts (1983) reaffirm the concept that there are many different kinds of taxable gains and a large number of individuals fail to realize that anything they acquire must be accounted for (Bittker, 1978; Pino-Anderson, 1982). By addressing the different between recourse and nonrecourse debt, those who find themselves in inheritance situations attempt to avoid taxation on the property they acquire because there was debt owed on that property at the time it was bequeathed to them (Cunningham, 1984; Isaac & O'Leary, 2012).

The belief is that the object that was inherited is worth only as much as (or appreciably less) than the debt that was owed on it, so there should not be any taxation of that object (Isaac & O'Leary, 2012; Yin, 2002). However, the debt was not acquired by the person who inherited the object, so there is taxable value in the object itself (Yin, 2002). Conclusion: Since Wilma has already taken title to Bob's house, she is trapped in the sense that she cannot simply walk away with no repercussions.

However, if she allows the bank to foreclose on the house the debt will be gone and the house will no longer be hers to deal with. Since she did not make any money off the sale of the house, she will not have any gain realized.

If she does not allow the bank to foreclose, but works with the bank to take a settlement on the mortgage instead, she will gain the house but she will also gain the value of the house and have to pay taxes on that value. This is true whether she gets the bank to settle for the FMV to pay off the loan.