Wirth v. Commonwealth of Pennsylvania
Recently, the Pennsylvania Supreme Court (the Court) upheld a PA Commonwealth Court decision involving the application of the Pennsylvania personal income tax to nonresidents. The nonresident individual partners of a Connecticut limited partnership (the Partnership) were assessed tax, interest, and penalties for their indirect ownership of real property in Pennsylvania.
In 1985, the Partnership purchased a Pittsburgh building (the Building) for $360 million. $52 million was paid in cash and the remaining $308 million was secured by a nonrecourse note where the Building was pledged as collateral. Interest on the note was payable monthly at a rate of 14.55%.
Any unpaid portion would accrue interest at the same 14.55% annual rate. The Partnership incurred net losses in every year of its existence and, under the terms of the note, accrued substantial unpaid interest.
In 2005, when the note matured, the total liability on the note exceeded $2.6 billion, $2.3 billion of which was accrued interest. As the Partnership could not sell the Building and satisfy the debt, the lender foreclosed on the property and the Partnership liquidated shortly thereafter. The partners received no sale proceeds and lost their entire investment in the Partnership.
Because of the debt relief, the Partnership reported $2.6 billion of gain for income tax purposes. Pennsylvania assessed personal income tax (PIT) against the nonresident limited partners for their share of this gain and the partners contested this determination.
The Court’s Decision
The partners argued the foreclosure and related debt discharge did not constitute income under Pennsylvania law because they did not receive cash or other property. However, the Court looked to the Pennsylvania Regulations under Section 103.13, which stated: “A gain on the disposition of property is recognized in the taxable year in which the amount realized from the conversion of the property into cash or other property exceeds the adjusted basis of the property.” Due to its similarity with a federal law, the Court concluded that the foreclosure resulted in taxable gain for PIT purposes even though the partners did not receive ‘cash.’ The Court looked to a US Supreme Court decision from over sixty years ago, whereby it found that cancellation of indebtedness constitutes taxable income since the foreclosed loan never had to be repaid.
The Court ruled that taxable gain could not be offset by the partners’ loss on their investment in the Partnership since this was not a loss sustained by the Partnership, but the partners individually. Generally, partnership interests are intangible assets in the hands of their owners, and gain or loss from the disposition of a partnership interest is sourced to the owner’s state of domicile. The nonresident partners could not reduce their ‘PA foreclosure gain’ by these operating losses.
Last, the Court determined that the partners could not reduce the gain by the net operating losses sustained by the partnership. Due to Pennsylvania’s distinct classes of income and the inability to net income and losses between these classes, the gain (which is considered “net profit from the disposition of property”) could not be reduced by the partnership’s operating losses (which constituted “net profit from business operations”).
The Tax Warrior Perspective
This case highlights the nuances of Pennsylvania personal income tax law and the potential traps for nonresident investors. Federal taxation of real estate investments and debt restructuring is intricate enough, but investing in an activity in a nonresident state adds yet another layer of complexity.
Despite the unfavorable result the taxpayers had there may have been ways to prevent such a conclusion. If the nonresident partners filed PA income tax returns during the years the partnership was generating losses, would they have been able to take advantage of the tax benefit rule and reduce their PA gain by the amount of such losses? The Court addresses this issue in saying “because [the partners] did not deduct anything at all, there is no corresponding portion of the subsequent income or gain (upon foreclosure) that can be excluded from the amount realized pursuant to the tax benefit rule.” Is there another reason (not discussed in the case) why the nonresident individuals failed to file PA tax returns?
The Tax Warriors® at Drucker & Scaccetti have extensive experience in representing individuals who own real estate and operate in the real estate industry. We have sharpened knowledge of Pennsylvania tax laws and have a specialized state and local practice to help you understand and minimize your tax liabilities across state borders. Contact us via the “Ask A Tax Warrior” button below if you have questions about your situation. We are always prepared to help you with this or any other tax matter related to real estate ownership.