Authorities challenge real estate loss deduction

News, information

On 5 December 2010 the Asahi Shimbun reported on an investigation by the Tokyo tax authorities into tax relief claimed on losses from a partnership investing in US real estate.  The investors in the partnership (below the ‘Investors’) were, according to the article, a group of around ten former Japanese baseball players and company directors. The investigation identified alleged tax avoidance of JPY500 million.

Foreign real estate investment

The Investors were alleged to have used a tax avoidance scheme involving investing in foreign real estate in order to realize and overall tax loss which was set off against their other taxable income for the period concerned.  The period under investigation was 2006 through to 2008.

According to the tax authorities the scheme did not meet the conditions that must be met to allow a loss on real estate income arising from a partnership to be offset against other income.

Tax planning schemes

The article noted that in the late half of the 1990s the Japanese tax authorities had been strengthening their review of a variety of tax saving schemes aimed at the wealthy and revising the related tax law. On the other hand, advisers had been developing products, such as this scheme, that they believed complied with the law.

The article explained further that an investment consulting firm called Lexington, based in Tokyo, had solicited the investors and arranged borrowings from a bank which, together with money contributed by the Investors, was used to purchase a Utah-based residential property.  The property was depreciable over a period of approximately 7 years for Japanese tax purposes and the amount of depreciation each year exceeded the corresponding rental income from the property concerned.  The resultant net loss was treated as tax deductible.

Active management of a partnership

Lexington had marketed the investment by reference to its tax saving benefits.  However the tax authorities alleged that the tax loss was not deductible against other income given changes to the tax law in 2005.  Under these changes, in broad outline, only transactions where the partnership investors are involved in the underlying partnership business and hence bearing risk are allowed to recognize a taxable loss that can immediately be offset against other income. In this case the tax authorities view was that the involvement of the Investors in the underlying business was only a formality. For example the investors did not have any voting or similar rights to participate in decision-making concerning the partnership business.


More detail around the rules concerning the offset of losses from a Japanese partnership can be found at this article in the nin’i kumiai section.  These rules are intended to prevent individuals offsetting losses arising from partnership investments when the individuals only have limited managerial or economic exposure to the underlying business concerned.  This case is an example of the tax authorities actively pursuing an investigation into transactions targeted by the 2005 legislative changes.

The tax advantage of the transaction arises from two factors (a) the relatively generous treatment of Japanese real estate investment, which allows the offset of real estate losses against other income and (b) the short period of time over which the property was depreciated, which probably arose as a result of the property being purchased second hand. The combination of leverage and accelerated depreciation allowed the investors to realize an overall tax loss each year.

The real estate section gives more details about real estate taxation for individuals and includes an article with more details around how depreciation is calculated for Japanese tax purposes. 

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