On March 1, 2013, the Internal Revenue Service (IRS) Chief Counsel released Technical Advice Memorandum (TAM) AM2013-001 stating that certain expenses incurred by a bank to maintain other real estate owned (OREO) no longer need to be capitalized for tax purposes. The previous position held by the IRS was that direct and indirect costs to maintain non-income producing OREO property held primarily for resale must be capitalized under Internal Revenue Code Section (Sec.) 263A. The IRS has now agreed that a bank does not acquire the property with the intent of increasing the value of the property and reselling the property for a profit. As a result, certain costs incurred to maintain OREO property held by a bank do not meet the capitalization requirements under Sec. 263A and should therefore be deductible. It should be noted that the 2013 TAM is considered informal guidance that specifically states that it cannot be used or cited as precedent.
Activity of originating loans versus acquisition of property for resale
The rules described in Sec. 263A state that property, real or personal, acquired for resale and any costs associated with that property (acquisition costs and certain indirect costs) are required to be capitalized. The property must be held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer's trade or business. Taxpayers and interested parties have long argued that banks are not in the business of selling OREO, but are in the business of making loans. Banks do not acquire these properties with the intent of increasing the value of the properties and then reselling them for a profit. Banks acquire OREO properties to mitigate losses on loans which are an extension of the primary activity of originating loans. The Treasury Regulations specifically state that a bank’s activity of originating loans is not considered the acquisition of property for resale within the meaning of Sec. 263A.
When a bank lends money to a borrower to purchase property from a third party, that loan is secured by the property. If the borrower defaults on the property, the bank begins the foreclosure process to claim title and possession of the property in order to minimize any loss on the loan. Once the bank has title to the property, it tries to sell the property in the same condition it was received. The acquisition and sale of property securing the loan are determined to be an extension of the bank's loan origination activity and is not considered acquired for resale. If the property is sold for greater than the outstanding loan balance, the bank may be required to return some proceeds to the borrower. The activities of acquiring, holding, and selling of real property by banks are regulated by government authorities.
Repairs and maintenance
It is unclear what types of expenses constitute improvement versus maintaining a property. The IRS has not given any detail as to whether expenses to bring a property up to code constitute a repair or improvement. Other costs such as maintenance costs or taxes can be expensed based on the position in the TAM.
Change in accounting method
As many banks have been capitalizing OREO expenses for at least two years, they have established an accounting method and are generally required to follow the same method until a change in accounting method has been filed with the IRS. This is done through the filing of Form 3115, Application for Change in Accounting Method. As it stands right now, the change from capitalizing expenses under Sec. 263A to immediately deducting expenses is not a permitted automatic change in accounting method. This means a bank would have to request advance consent by filing a Form 3115 prior to the end of the tax year for which the change is to be effective and must be approved by the IRS prior to the filing of the tax return for the year of change. This would also require the bank to pay a user fee with the filing of the accounting method change. If the IRS were to provide guidance to allow an automatic change of accounting method, the Form 3115 could be attached to the originally filed tax return for the year of change and no user fee would be required. We are watching these developments closely, as it is yet unclear whether further guidance will be issued by the IRS with respect to this issue.