The Proper Tax Treatment of OREO Date: 8/27/09 It is not an uncommon scenario these days for banks to be in possession of ‘other real estate owned’ or OREO as it’s known in the industry.  The upswing in this scenario presents an opportunity to review the appropriate tax treatment for OREO, specifically the appraisal based write-downs that are taken to arrive at the proper carrying value of the property. When collateral is foreclosed upon, in most cases, three entries are made to the books: 1.    The loan is written off (credit to the asset). 2.    The OREO property is booked as an asset at its fair value less anticipated selling expenses. 3.    The difference between 1 and 2 is booked as a charge off to the Allowance for Loan Loss account. The tax treatment of the initial write-down of the collateral booked as a charge-off is governed by the tax method used for bad debts i.e. the direct charge-off method or the experience method.  If a bank has made the conformity election, the IRS has agreed not to question the amount of charge-offs recorded under a system determined to be appropriate by the regulators during their safety and soundness examinations.   Indeed, this election is supposed to take the issue of questioning charge-offs ‘off the table’ so to speak upon IRS audit.  Of utmost importance however, the conformity election requires that the bank obtain an express determination letter from the federal regulators each time they examine the bank.  If this letter is not obtained after each examination, the election will be nullified and the IRS could technically challenge charge-offs deducted in the tax return.   Handled properly, the conformity election could shorten the duration and decrease the complexity (and headache) of an IRS audit. After the initial write-down of the OREO, oftentimes additional write downs become necessary due to further declines in value.  In this case, the OREO asset (or a reserve attached to it) is credited, reducing the carrying value to its new appraised value.  The offset on the books would be to an expense account, decreasing net income.  The IRS is generally averse to write-downs that are not ‘proven’ as a result of an actual sales transaction.  Thus, this write-down, if done in a taxable year subsequent to the acquisition of the collateral, will not be allowed for tax purposes.  This results in the OREO having a higher basis for determining the tax gain or loss.  When the OREO is ultimately sold, the previously disallowed write-downs will be allowed resulting in a tax gain that is lower than the book gain (or, alternatively, a tax loss that is higher than the book loss). Should the OREO property be acquired and sold within the same taxable year, write-downs subsequent to acquisition will be treated the same for book and tax purposes.  Obviously, this is because there is now a sales transaction proving the legitimacy of the write-down for tax purposes.