1. Income from cancellation of debt

2. Gain on sale of the foreclosed property

Let’s discused the first one:

There are two types of loans: recourse and non-recourse. Recourse loans are the ones for which the borrower is personally liable (i.e. the mortgage company tries and may be able collect from you even AFTER the house is foreclosed).  Non-recourse loans are the ones which are only secured by the property foreclosed. In CA, if you used the borrowed funds to purchase the principal residence (under 4 units), your loan is non-recourse. If you refinanced after the purchase, it will become recourse (in most cases). You need to check your loan documents to verify the type of the loan if you refinanced the property after your purchase.

After you figured out the type of your loan, you can determine if there is cancellation of debt. Generally, there will be no cancellation of debt on non-recourse loans.  Different story with recourse loans. Most likely, cancellation of those loans will result in cancellation of debt income. There are exceptions which allow you to exclude that income (insolvency, bankruptcy, qualified rental/farm real estate indebtedness etc.), but they result in the unpleasant consequence of decreasing your basis in the property (up to the amount of the excluded debt, but not below zero).

The second step is to determine the gain (or loss) on sale of your property. Foreclosure is considered sale for tax purposes, so it is possible to end up having a capital gain on sale of property, which must be included in income, unless you have some capital losses to offset it or you can claim the principal residence exclusion ($500,000 for married filing jointly/$250,000 for married filing separate). 

In the case of principal residence, the loss will not be deductible. But could be deductible with rentals, which will happen rarely since most rental real estate debt is recourse, the basis will be reduced to zero and the foreclosure will end up being considered a sale at a gain.

Pretty complex stuff, and every situation is unique. Don’t try to save a few dollars, ask a tax practicioner (and a reputable one) for help.

Net investment income (dividends, interest, royalties, net operating gains LESS directly related expenses) is taxed at 2%, unless foundations make additional distribution for charitable purposes, then it is taxed at 1%.

Self-Dealing

This provision penalizes almost ANY transaction between the foundation and its ”disqualified person” (which we will discuss later), even if the transaction was at arm’s length and benefits the foundation. The penalty is 5% of the amount involved in self-dealing imposed on the self-dealer and 2-1/2% (with $10,000 maximum) on foundation managers who knowingly participate in the transaction. However, the IRS will allow the organization to correct the problem (i.e. the self-dealer to pay the organization back) and will assess the tax only if the situation is not remedied.

Minimum Distribution Requirements

Private foundations must make annual “qualifying distributions” in the amount of 5% of the fair market value of their net investment assets. If the organization fails to do so, the IRS will assess 15% penalty on the undistributed income and if the funds are not distributed within a specified period, the IRS will assess 100% penalty.

          Qualifying distributions are:

• grants for charitable purposes;
• reasonable administrative costs related to the grantmaking process
• payments to purchase assets used in conduct of the foundation’s activities
• expenses of conducting direct charitable activities
• amounts set aside for future projects
• program-related investments

Excess Business Holdings

The rationale for this penalty tax is the position of Congress that it is inappropriate for a private foundation to hold a substantial share of the principal donor’s family business.

If the percentage is owned by disqualified persons – the holding allowable for the foundation is determined as follows: 20% minus the percentage owned by disqualified person. For example, if a disqualified person owns 4%, the foundation can own 16% of the business.

If the percentage is owned by not disqualified persons – the 20% above is substituted for 35% – i.e. the combined share allowable is 35%.

The foundation is allowed to own less than 2% of any business regardless of the percentage held by disqualified persons – this is known as the de minimus rule.

The amount of tax imposed is 5% of the value of the excess holdings. If the foundation fails to divest the unallowed shares within the specified period (which can be between 5 to 10 years), the penalty becomes 200%.

Jeopardy Investments

If an organization invests its funds in a manner that jeopardizes the carrying out of its exempt purposes, the penalty is 5% on the amount invested. There is also 5% penalty ($5,000 maximum) on foundation managers who knowingly participate in the jeopardy investments. If the organization fails to make necessary correction, there is an additional 25% penalty against the foundation and 5% penalty (with $10,000 maximum) against managers.

Taxable Expenditures
Any expenditures for noncharitable purpose, such as lobbying, electioneering, voter registration, grants to individuals, grant to any organization that is not a public charity. The penalty of 10% of the prohibited expenditure is imposed on foundation and 2-1/2 % on foundation’s managers ($5,000 maximum). If the action is not corrected, additional tax of 100% is imposed on foundation and 50% on the managers ($10,000) maximum.

1. Donors may take advantage of the favorable income tax charitable deduction rules – similar to the ones for public charities – 50% AGI limitation for charitable contributions deducted on Schedule A.
2. Operating foundations are NOT subject to the income distribution requirement for private foundations under 4942.

How to qualify for the private operating foundation status? Satisfy two tests:

• Income test – 85% or more of foundation’s income is used for “active conduct of charitable activities” (not just for grantmaking)
• One of three tests:

                 The assets test – at least 65% of the foundation’s asset are devoted to the active conduct OR to functionally-related businesses

                The endowment test – the foundation must spend at least 3-1/3% of net investment assets on the active conduct

                The support test – 85% of its support must come from the general public and five or more unrelated non-profits.

• purpose test – requires the organization to carry out a purpose of the supporting organization;
• control test – the supported organization must control the supporting organization.

1. public support test (different from the First Exception: Traditional Public Charity) – in the prior 4 years, the organization must have received more than 1/3 of its total support from any combination of:

• qualifying gifts, grants, contributions or membership fees, AND
• gross receips from admissions, sales of merchandise, performance of services or other activities related to its exempt functions.

2. investment income test – total of the organization’s investment income and net unrelated business income is NOT MORE than 1/3 of the total support.

1. By definition – if an organization is:

• churches
• colleges
• universities
• schools
• nonprofit hospitals
• medical research institutes
• support organizations to schools and governmental unit.

2. By the amount of public support the organization receives. There are 2 tests under which the organization may qualify as a public charity:

• mechanical test - look to the most recent 4 years - if public support >= 1/3 of total support  – the charity is a public charity. Let’s talk about definitions involved in this test:

             public support – generally the support will fall in one of these categories:

1. contributions from individuals, foundations, trusts and corporations.
2. support from governmental units.
3. membership dues, if the purpose of such payment is to support the organization and NOT to purchase admissions, use facilities, etc.

             total support – everything included in public support PLUS:

1. gross investment income
2. contributions and dues from individuals, foundations, trusts or corporations that are MORE than 2% of total support
3. net income from unrelated business activities.

• facts and circumstances test – if the organization fails to qualify under the mechanical test, it can still try to qualify under the facts and circumstances test. For this, evidence of three elements must be demonstrated:

1. the total amount of government and public support = or > than 10% of total support for the applicable period.
2. the organization continuously tries to attract new and additional public and governmental support.
3. the organization is entitled to be recognized as public rather than private. Most often, two factors are considered:

            a. To what degree the board of directors represents the general public (and not just donors)

            b. To what extent services or facilities of the organization are available to the general public.

Now, ALL 501(c)(3) organizations are private foundations, unless they come within any of these 4 categories:

1. “traditional public charities” – churches, hospitals, schools, etc.

2. “broad publicly supported organizations” – receive more than 1/3 of their support from gifts, grants, fees, and gross receipts from admission, sales of goods or services (but the income-generating activity must be related to the organization’s exempt purpose.)

3. “supporting organizations” – they have closely defined relationship with one or more public charities

4. “testing for public safety” organizations.

Why do we care? Private foundations must follow very distinct reporting and operational rules (no self-dealing, required 2% excise tax on net investment income, etc.). We will discuss this later.

1. What constitutes “influencing legislation”? and

2. When does lobbying become substantial part of the organization’s activities?

The regulations attempted to clarify that such influence is exerted when the organization:

• “contacts legislators or urges the public to contact them to propose, support or oppose legislation, or advocates the adoption or rejection of legislation” OR
• if the organization’s primary objective is such that may be attained only by legislation or the defeat of proposed legislation (e.g. repeal of taxes or promotion of constitutional amendment permitting prayer in the schools). I.e. there is no other way to achieve the goal of the organization but by legislation.

Treas. Reg. 1.501(c)(3)-1(c)(3).

Thus, if the organization is substantially involved in any of the activities above, it will not qualify for the exemption under the 501(c)(3).

Now, to the second question, when is lobbying substantial? There is no clear guidance, but the courts devised a subjective “balancing” test, under which all facts and circumstances are considered in the context of the objectives and circumstances of the organization.” Haswell v. US, 500 F.2d 1133 (Ct. Cl. 1974). The factors which will be considered include:

1. the percentage of an organization’s budget (or employee time) spent on lobbying;
2. the continuous or intermittent nature of the organization’s legislative involvement;
3. the nature of the organization and its aims;
4. and the controversial nature of the organization’s position and its visibility.

So, in plain language, before deciding to engage in any political activity, the organization should consider whether such activity would fall under the two-prongs of prohibited political activities. If it does, the organization should apply the four factors enumerated above to determine if the activity could be considered “significant.”