Investor Gets No Tax Breaks from Pennsylvania Judges

A recent Pennsylvania tax law case highlights some pitfalls for out-of-state investors.

In 1985, an out-of-state investor joined a partnership that purchased a large business building in Pittsburgh as a shelter from income taxes, putting $150,000 into the partnership that went towards the purchase. At that time, the interest rate was 14 percent on the loan. The investor received a few thousand dollars in disbursements on his investment over the 20 or so years of the partnership group's ownership of the building.

Unfortunately, the building failed to generate enough income to cover the interest payments on the mortgage, causing the mortgage principle to rise from $300 million to over $2 billion by the time the bank foreclosed on the loan. The investor lost $143,000 of his investment. More importantly, he was also hit with a tax bill from the state of Pennsylvania for $160,000 since he "gained" income from the foreclosure.

Pennsylvania tax law states that when a mortgage is foreclosed, the mortgage balance and unpaid interest are "proceeds" in the foreclosure sale, despite no one receiving a payout. Stated another way, the investor realized a gain by being forgiven the debt due to the foreclosure.

Tax laws in Pennsylvania, as with any state, can be complicated. The state does not allow loss carry-over, and has five classes of income and loss in one cannot be offset in another.

Source: Forbes, "Pennsylvania Court Gives No Relief To Investor In Tax Shelter From Hell," Peter J. Reilly, August 26, 2012

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