Prepared by Worldwide ERC® Tax Counsel, Peter K. Scott
Peter Scott Associates
Current as of January, 2017
The following definitions will be used in discussing home purchase programs: (See Appendix A, immediately following, for fuller descriptions).
- Appraised value sale
The employee’s residence is appraised by two or more independent appraisers. The employee then sells the residence to the employer or a relocation management company hired by the employer at the average of the appraised values (or at some variation of this method to determine fair market value).
- Amended value sale
The transaction is the same as the appraised value sale, except that before the employee decides whether or not to accept the offer to purchase at the appraised value, the employee may place the residence on the market to determine whether a higher price can be obtained. If a third party makes a bona fide offer to purchase the residence at a price above the appraised value, the employer or relocation company will raise its offer to equal the third party offer. This new price is called the "amended value" of the residence. The employee then sells the residence to the employer, and the employer attempts to execute a contract with the third party buyer and sell to him/her.
- Buyer Value Option
The transaction is similar to an amended value sale, except that no guaranteed offer to purchase is made to the employee, and no appraisals are done, at least initially. Rather, the employee markets the house seeking a bona fide offer in the market place. Once such an offer is received, the employer or relocation company will make an offer to purchase the home at the "buyer value" established by the outside offer. Thereafter, the procedures are the same as the amended value sale. In some programs, if the employee does not find a buyer during the initial marketing period, the employer will have the home appraised and make a guaranteed buyout offer based on the appraisals, which the employee can accept after an additional attempt to find a buyer in the marketplace. Such a procedure is better from a tax perspective.
- Assigned sale
This transaction is the same as the amended value sale, except that when the employee places the residence up for sale and receives an offer to purchase from a third party, the employee accepts the offer, creating a contract of sale. The employee then sells the residence to the employer or relocation company, and assigns the contract of sale to the employer or relocation company, which then sells the residence to the third party.
- Assisted sale ("Direct Reimbursement")
The employee sells the residence directly to a third-party buyer. The employer then reimburses the employee for some or all of the costs of sale.
- Directed offer
The employer or relocation company buys the employee’s residence at a price in excess of fair market value.
B. Disposal of residence through two sales
The disposal of a residence through two separate sales generally results in more favorable tax treatment than disposal through one sale.
- Favorable tax treatment through two sales
A. Planning considerations
The most important planning consideration for a home purchase program is to structure disposal of the employee’s residence so that a sale from the employee to the employer or relocation company is accepted by the IRS as one bona fide sale, and a resale of the residence by the employer or relocation company to a third party is accepted as a second, separate sale.
The following two examples illustrate the different tax treatment between one and two sales. In the first example, the employee executes an "assisted sale," that is, there is in fact only one sale, that between the employee and a buyer who will occupy the residence. The employee incurs closing costs and a broker commission, all of which are reimbursed by the employer. The entire amount of the reimbursement is income to the employee, and will be subject to withholding.
In the second example, the employee’s residence is appraised by two independent appraisers. The employee then sells the residence to the employer at the average of the appraised values. The employee pays all the costs of sale imposed on the seller under local law and custom. The employee has no further control over the sale of the residence. The employer lists the residence with a real estate broker, who sells the residence. The employer pays a sales commission and other closing costs. None of the closing costs on the second sale, including the sales commission, is considered compensation income to the employee.
For the employee, the favorable tax treatment achieved by creating two separate sales is that he/she does not receive compensation income from the employer in the amount it spends disposing of the residence. For the employer, the favorable tax treatment achieved is that the employer has no liability for payroll taxes or withholding on the amounts expended to dispose of the residence; it has disposed of the former residence in a manner that does not create a tax liability for the employee; and if the employer "grosses up" its relocation expenses to account for additional employee income tax on the reimbursement, its gross-up amount is reduced.
- IRS agreement with two sale characterization: Rev. Ruls. 72-339 and 2005-74
The IRS agrees that bona fide, fair market value residence transfers from employee to employer are valid sales even if the employer immediately sells the home to a third party. Thus, even though the employee is able to dispose of his or her home through this means without incurring a real estate sales commission or other closing costs, the employee does not have compensation income. Rev. Ruls. 72-339 and 2005-74.
The rationale for this favorable tax treatment is that two bona fide sales have taken place. The employee sold the residence, and no real estate commission was ever incurred or paid. When the employer resells the residence and a sales commission is paid, the amount of such commission will be the employer's own expense, not an expense of the employee which the employer is paying.
An exception to this rule occurs if closing costs that are treated under local law as borne by the seller-employee are actually incurred on the transfer to the employer, and are paid by the employer, in which case such costs will be income to the employee. Examples of such costs are title insurance or transfer taxes.
In Rev. Rul. 72-339, IRS held that the real estate commission was not taxable in an appraised value transaction, but the ruling did not detail the procedures used to purchase and sell the home, nor did it articulate a clear rationale for the result. Therefore, until release of Rev. Rul. 2005-74 there was no authoritative, published IRS position relating to acceptable procedures, or to any program in which the employee marketed the home seeking an outside buyer.
In Rev. Rul. 2005-74, IRS accepted for the first time not only the procedures contained in ERC guidelines for appraised value programs, but also accepted amended value programs. Although the ruling is silent as to both BVO’s and assigned sales, the analysis used in the ruling to find two separate, independent sales occur in a properly structured amended value program would also apply to BVO’s, so that there is now a strong case that such programs are effective. In contrast, IRS has always held assigned sales to be taxable, and will continue to do so notwithstanding the lack of mention of such programs in the ruling
In 1997, the Tax Court decided Amdahl v. Commissioner. In Amdahl, the issue was whether the company purchasing employee homes was entitled to ordinary deductions for the costs incurred in buying and selling them, or was limited to a capital loss. In arguing against capital loss treatment, the taxpayer contended that it never actually became the owner of the homes, and that the real seller was the employee. The facts were similar to current home purchase programs, with a few variations. The Court agreed with the taxpayer. Beginning shortly thereafter, IRS employment tax agents adopted the Amdahl decision and began contending that all types of home purchase programs, particularly those in which a blank deed is used to transfer title, result in employment tax liability for the costs incurred.
Rev. Rul. 2005-74, not only accepts standard appraised value and amended value programs, but states that use of the blank deed does not negatively affect either program. The ruling also says IRS will not follow Amdahl on facts similar to those set forth in the ruling. Consequently, the focus of audits of home purchase programs will now shift to whether the facts are within the favorable pattern blessed by Rev. Rul. 2005-74, and not the Amdahl case or the blank deed.
C. Directed offer compensation
When the employer or relocation company purchases the employee’s residence for an amount in excess of fair market value, the amount paid over fair market value is wage income to the employee, and must be reported on the W-2 and withheld upon. Failure to report that the employee has received such income may subject the employer or relocation management company to penalties.
D. Employee’s residence as capital asset
The employer usually incurs a loss on the resale of the employee’s residence. Whether the loss is capital or ordinary depends upon whether the residence is a capital or an ordinary asset in the employer’s hands. It is much more advantageous for the employer to have an ordinary loss than a capital loss because an ordinary loss is deductible against either ordinary income or capital gain, while a capital loss can only be deducted to offset capital gain.
The IRS has taken the position that the employee’s residence in the hands of the employer is a capital asset. See Rev. Rul. 82-204. Moreover, in 1990, the IRS issued a Private Letter Ruling (PLR) applying this position to an employer who bought and sold an employee’s house through a relocation management company, holding that the employer, not the relocation management company, was the real owner of the house. That conclusion is formalized in Rev. Rul. 2005-74. Although Rev. Rul. 2005-74 does not specifically reiterate the capital loss holding of Rev. Rul. 82-204, it is clear under the 2005 ruling that the IRS continues to consider the costs to be capital, not ordinary.
In 1993, in another PLR, the IRS ruled that if the relocation management company has all the risks of loss and possibility of gain, then it and not the employer will be treated as the owner of the home.
Notwithstanding the IRS position in Rev. Rul. 82-204, the law is unclear regarding whether losses on residences purchased due to the relocation of employees will be considered capital or ordinary, and there is a good case for ordinary loss or deduction treatment. As noted above, the issue was litigated in the United States Tax Court in the Amdahl case, decided in 1997. The court held that the taxpayer could deduct the expenses as ordinary business costs. However, the court did not decide whether or not the homes were capital assets. Rather, on the facts of the case, the court adopted the taxpayer's argument that neither it nor the relocation company ever became owner of the homes. The IRS did not appeal.
Substantial authority supports the position that the employer should be entitled to ordinary, not capital, losses or deductions on sale of homes purchased from employees. The homes are properly treated as property held for sale in the ordinary course of a trade or business under section 1221(a) (1) of the Code, and not capital assets. Consequently, most employers do not follow the IRS position.
Even if the IRS position is accepted, the law is clear that the employer’s costs of owning and maintaining the residence are ordinary. Thus, costs incurred in carrying the mortgage, for taxes, and for upkeep such as mowing the lawn, painting, and minor repairs, and fees to a relocation management company, are ordinary deductions. In order to be prepared for a possible audit by the IRS, employers should be able to separate the costs of buying and selling the residence (which may be capital) from the costs of owning and maintaining the home. The ability to separate such costs is necessary to ensure the desired ordinary treatment, and to prevent the IRS from adding all costs incurred together and treating all of them as capital expenditures.