Transactions Involving Property Subject to a Loan

Taxpayer may use the proceeds of a loan – perhaps from the seller of property or from a third-party lender – to purchase property and to give the property so purchased as security or collateral for the loan. Such property is “encumbered by” or “subject to” the outstanding principal amount of the loan. Can borrower count the money that she/he/it borrowed as part of her/his/its basis when in fact taxpayer did not purchase the property with after-tax money?

Recourse obligation: A recourse obligation is one for which the borrower is personally liable. In the event that the borrower defaults and the collateral that the borrower put up to obtain the loan is insufficient to satisfy the borrower’s obligation, the lender may pursue other assets of the borrower in order to satisfy the debt. The risk that a loss may occur because the fmv of the property decreases prior to default thus falls on the borrower.

Nonrecourse obligation: A nonrecourse obligation is one for which the borrower is not personally liable. Thus, in the event of the borrower’s default, the lender may pursue only the property offered as collateral for the loan. The risk that a loss may occur because the fmv of the property decreases prior to default thus falls entirely on the lender.

Collins v. CIR, T.C. Memo 1963-285, 1963 WL 613 (1963).

Commissioner v. Tufts, 461 U.S. 300 (1983).

JUSTICE BLACKMUN delivered the opinion of the Court.

Over 35 years ago, in Crane v. Commissioner, 331 U.S. 1 (1947), this Court ruled that a taxpayer, who sold property encumbered by a nonrecourse mortgage (the amount of the mortgage being less than the property’s value), must include the unpaid balance of the mortgage in the computation of the amount the taxpayer realized on the sale. The case now before us presents the question whether the same rule applies when the unpaid amount of the nonrecourse mortgage exceeds the fair market value of the property sold.

I

On August 1, 1970, respondent Clark Pelt, a builder, and his wholly owned corporation, respondent Clark, Inc., formed a general partnership. The purpose of the partnership was to construct a 120-unit apartment complex in Duncanville, Tex., a Dallas suburb. Neither Pelt nor Clark, Inc., made any capital contribution to the partnership. Six days later, the partnership entered into a mortgage loan agreement with the Farm & Home Savings Association (F&H). Under the agreement, F&H was committed for a $1,851,500 loan for the complex. In return, the partnership executed a note and a deed of trust in favor of F&H. The partnership obtained the loan on a nonrecourse basis: neither the partnership nor its partners assumed any personal liability for repayment of the loan. Pelt later admitted four friends and relatives, respondents Tufts, Steger, Stephens, and Austin, as general partners. None of them contributed capital upon entering the partnership.

The construction of the complex was completed in August, 1971. During 1971, each partner made small capital contributions to the partnership; in 1972, however, only Pelt made a contribution. The total of the partners’ capital contributions was $44,212. In each tax year, all partners claimed as income tax deductions their allocable shares of ordinary losses and depreciation. The deductions taken by the partners in 1971 and 1972 totalled $439,972. Due to these contributions and deductions, the partnership’s adjusted basis in the property in August, 1972, was $1,455,740.

In 1971 and 1972, major employers in the Duncanville area laid off significant numbers of workers. As a result, the partnership’s rental income was less than expected, and it was unable to make the payments due on the mortgage. Each partner, on August 28, 1972, sold his partnership interest to an unrelated third party, Fred Bayles. As consideration, Bayles agreed to reimburse each partner’s sale expenses up to $250; he also assumed the nonrecourse mortgage.

On the date of transfer, the fair market value of the property did not exceed $1,400,000. Each partner reported the sale on his federal income tax return and indicated that a partnership loss of $55,740 had been sustained. 1 The Commissioner of Internal Revenue, on audit, determined that the sale resulted in a partnership capital gain of approximately $400,000. His theory was that the partnership had realized the full amount of the nonrecourse obligation. 2

Relying on Millar v. Commissioner, 577 F.2d 212, 215 (CA3), cert. denied, 439 U.S. 1046 (1978), the United States Tax Court, in an unreviewed decision, upheld the asserted deficiencies. The United States Court of Appeals for the Fifth Circuit reversed. That court expressly disagreed with the Millar analysis, and, in limiting Crane v. Commissioner, supra, to its facts, questioned the theoretical underpinnings of the Crane decision. We granted certiorari to resolve the conflict.

　 II

... Section 1001 governs the determination of gains and losses on the disposition of property. Under § 1001(a), the gain or loss from a sale or other disposition of property is defined as the difference between “the amount realized” on the disposition and the property’s adjusted basis. Subsection (b) of § 1001 defines “amount realized:” “The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.” At issue is the application of the latter provision to the disposition of property encumbered by a nonrecourse mortgage of an amount in excess of the property’s fair market value.

　 A

In Crane v. Commissioner, supra, this Court took the first and controlling step toward the resolution of this issue. Beulah B. Crane was the sole beneficiary under the will of her deceased husband. At his death in January, 1932, he owned an apartment building that was then mortgaged for an amount which proved to be equal to its fair market value, as determined for federal estate tax purposes. The widow, of course, was not personally liable on the mortgage. She operated the building for nearly seven years, hoping to turn it into a profitable venture; during that period, she claimed income tax deductions for depreciation, property taxes, interest, and operating expenses, but did not make payments upon the mortgage principal. In computing her basis for the depreciation deductions, she included the full amount of the mortgage debt. In November, 1938, with her hopes unfulfilled and the mortgagee threatening foreclosure, Mrs. Crane sold the building. The purchaser took the property subject to the mortgage and paid Crane $3,000; of that amount, $500 went for the expenses of the sale.

Crane reported a gain of $2,500 on the transaction. She reasoned that her basis in the property was zero (despite her earlier depreciation deductions based on including the amount of the mortgage) and that the amount she realized from the sale was simply the cash she received. The Commissioner disputed this claim. He asserted that Crane’s basis in the property, under [what is now § 1014] was the property’s fair market value at the time of her husband’s death, adjusted for depreciation in the interim, and that the amount realized was the net cash received plus the amount of the outstanding mortgage assumed by the purchaser.

In upholding the Commissioner’s interpretation of § [1014] [footnote omitted], the Court observed that to regard merely the taxpayer’s equity in the property as her basis would lead to depreciation deductions less than the actual physical deterioration of the property, and would require the basis to be recomputed with each payment on the mortgage. The Court rejected Crane’s claim that any loss due to depreciation belonged to the mortgagee. The effect of the Court’s ruling was that the taxpayer’s basis was the value of the property undiminished by the mortgage.

The Court next proceeded to determine the amount realized under [what is now § 1001(b)]. In order to avoid the “absurdity,” of Crane’s realizing only $2,500 on the sale of property worth over a quarter of a million dollars, the Court treated the amount realized as it had treated basis, that is, by including the outstanding value of the mortgage. To do otherwise would have permitted Crane to recognize a tax loss unconnected with any actual economic loss. The Court refused to construe one section of the Revenue Act so as “to frustrate the Act as a whole.”

Crane, however, insisted that the nonrecourse nature of the mortgage required different treatment. The Court, for two reasons, disagreed. First, excluding the nonrecourse debt from the amount realized would result in the same absurdity and frustration of the Code. Second, the Court concluded that Crane obtained an economic benefit from the purchaser’s assumption of the mortgage identical to the benefit conferred by the cancellation of personal debt. Because the value of the property in that case exceeded the amount of the mortgage, it was in Crane’s economic interest to treat the mortgage as a personal obligation; only by so doing could she realize upon sale the appreciation in her equity represented by the $2,500 boot. The purchaser’s assumption of the liability thus resulted in a taxable economic benefit to her, just as if she had been given, in addition to the boot, a sum of cash sufficient to satisfy the mortgage. 3

In a footnote, pertinent to the present case, the Court observed:

B

This case presents that unresolved issue. We are disinclined to overrule Crane, and we conclude that the same rule applies when the unpaid amount of the nonrecourse mortgage exceeds the value of the property transferred. Crane ultimately does not rest on its limited theory of economic benefit; instead, we read Crane to have approved the Commissioner’s decision to treat a nonrecourse mortgage in this context as a true loan. This approval underlies Crane’s holdings that the amount of the nonrecourse liability is to be included in calculating both the basis and the amount realized on disposition. That the amount of the loan exceeds the fair market value of the property thus becomes irrelevant.

When a taxpayer receives a loan, he incurs an obligation to repay that loan at some future date. Because of this obligation, the loan proceeds do not qualify as income to the taxpayer. When he fulfills the obligation, the repayment of the loan likewise has no effect on his tax liability.

Another consequence to the taxpayer from this obligation occurs when the taxpayer applies the loan proceeds to the purchase price of property used to secure the loan. Because of the obligation to repay, the taxpayer is entitled to include the amount of the loan in computing his basis in the property; the loan, under § 1012, is part of the taxpayer’s cost of the property. Although a different approach might have been taken with respect to a nonrecourse mortgage loan, 4 the Commissioner has chosen to accord it the same treatment he gives to a recourse mortgage loan. The Court approved that choice in Crane, and the respondents do not challenge it here. The choice and its resultant benefits to the taxpayer are predicated on the assumption that the mortgage will be repaid in full.

When encumbered property is sold or otherwise disposed of and the purchaser assumes the mortgage, the associated extinguishment of the mortgagor’s obligation to repay is accounted for in the computation of the amount realized. [footnote omitted]. SeeUnited States v. Hendler, 303 U.S. 564, 566-567 (1938). Because no difference between recourse and nonrecourse obligations is recognized in calculating basis [footnote omitted], Crane teaches that the Commissioner may ignore the nonrecourse nature of the obligation in determining the amount realized upon disposition of the encumbered property. He thus may include in the amount realized the amount of the nonrecourse mortgage assumed by the purchaser. The rationale for this treatment is that the original inclusion of the amount of the mortgage in basis rested on the assumption that the mortgagor incurred an obligation to repay. Moreover, this treatment balances the fact that the mortgagor originally received the proceeds of the nonrecourse loan tax-free on the same assumption. Unless the outstanding amount of the mortgage is deemed to be realized, the mortgagor effectively will have received untaxed income at the time the loan was extended, and will have received an unwarranted increase in the basis of his property. [footnote omitted]. The Commissioner’s interpretation of § 1001(b) in this fashion cannot be said to be unreasonable.

C

The Commissioner, in fact, has applied this rule even when the fair market value of the property falls below the amount of the nonrecourse obligation. Reg. § 1.1001-2(b) [footnote omitted]; Rev. Rul. 76-111. Because the theory on which the rule is based applies equally in this situation, seeMillar v. Commissioner, 67 T.C. 656, 660 (1977), aff’d on this issue, 577 F.2d 212, 215-216 (CA3), cert. denied, 439 U.S. 1046 (1978); 5 Mendham Corp. v. Commissioner, 9 T.C. 320, 323-324 (1947); Lutz & Schramm Co. v. Commissioner, 1 T.C. 682, 688-689 (1943), we have no reason, after Crane, to question this treatment. 6

Respondents received a mortgage loan with the concomitant obligation to repay by the year 2012. The only difference between that mortgage and one on which the borrower is personally liable is that the mortgagee’s remedy is limited to foreclosing on the securing property. This difference does not alter the nature of the obligation; its only effect is to shift from the borrower to the lender any potential loss caused by devaluation of the property. [footnote omitted]. If the fair market value of the property falls below the amount of the outstanding obligation, the mortgagee’s ability to protect its interests is impaired, for the mortgagor is free to abandon the property to the mortgagee and be relieved of his obligation.

This, however, does not erase the fact that the mortgagor received the loan proceeds tax-free, and included them in his basis on the understanding that he had an obligation to repay the full amount. SeeWoodsam Associates, Inc. v. Commissioner, 198 F.2d 357, 359 (CA2 1952); Bittker, Tax Shelters, Nonrecourse Debt, and the Crane Case, 33 Tax L. Rev. 277, at 284 n.7 (1978). When the obligation is canceled, the mortgagor is relieved of his responsibility to repay the sum he originally received, and thus realizes value to that extent within the meaning of § 1001(b). From the mortgagor’s point of view, when his obligation is assumed by a third party who purchases the encumbered property, it is as if the mortgagor first had been paid with cash borrowed by the third party from the mortgagee on a nonrecourse basis, and then had used the cash to satisfy his obligation to the mortgagee.

Moreover, this approach avoids the absurdity the Court recognized in Crane. Because of the remedy accompanying the mortgage in the nonrecourse situation, the depreciation in the fair market value of the property is relevant economically only to the mortgagee, who, by lending on a nonrecourse basis, remains at risk. To permit the taxpayer to limit his realization to the fair market value of the property would be to recognize a tax loss for which he has suffered no corresponding economic loss. [footnote omitted]. Such a result would be to construe “one section of the Act ... so as ... to defeat the intention of another or to frustrate the Act as a whole.” 331 U.S. at 13.

In the specific circumstances of Crane, the economic benefit theory did support the Commissioner’s treatment of the nonrecourse mortgage as a personal obligation. The footnote in Crane acknowledged the limitations of that theory when applied to a different set of facts. Crane also stands for the broader proposition, however, that a nonrecourse loan should be treated as a true loan. We therefore hold that a taxpayer must account for the proceeds of obligations he has received tax-free and included in basis. Nothing in either § 1001(b) or in the Court’s prior decisions requires the Commissioner to permit a taxpayer to treat a sale of encumbered property asymmetrically, by including the proceeds of the nonrecourse obligation in basis but not accounting for the proceeds upon transfer of the encumbered property. [citation omitted].

III

....

IV

When a taxpayer sells or disposes of property encumbered by a nonrecourse obligation, the Commissioner properly requires him to include among the assets realized the outstanding amount of the obligation. The fair market value of the property is irrelevant to this calculation. We find this interpretation to be consistent with Crane v. Commissioner, 331 U.S. 1 (1947), and to implement the statutory mandate in a reasonable manner. [citation omitted].

The judgment of the Court of Appeals is therefore reversed.

It is so ordered.

JUSTICE O’CONNOR, concurring.

I concur in the opinion of the Court, accepting the view of the Commissioner. I do not, however, endorse the Commissioner’s view. Indeed, were we writing on a slate clean except for the decision in Crane v. Commissioner, 331 U.S. 1 (1947), I would take quite a different approach – that urged upon us by Professor Barnett as amicus.

Crane established that a taxpayer could treat property as entirely his own, in spite of the “coinvestment” provided by his mortgagee in the form of a nonrecourse loan. That is, the full basis of the property, with all its tax consequences, belongs to the mortgagor. That rule alone, though, does not in any way tie nonrecourse debt to the cost of property or to the proceeds upon disposition. I see no reason to treat the purchase, ownership, and eventual disposition of property differently because the taxpayer also takes out a mortgage, an independent transaction. In this case, the taxpayer purchased property, using nonrecourse financing, and sold it after it declined in value to a buyer who assumed the mortgage. There is no economic difference between the events in this case and a case in which the taxpayer buys property with cash; later obtains a nonrecourse loan by pledging the property as security; still later, using cash on hand, buys off the mortgage for the market value of the devalued property; and finally sells the property to a third party for its market value.

The logical way to treat both this case and the hypothesized case is to separate the two aspects of these events and to consider, first, the ownership and sale of the property, and, second, the arrangement and retirement of the loan. Under Crane, the fair market value of the property on the date of acquisition – the purchase price – represents the taxpayer’s basis in the property, and the fair market value on the date of disposition represents the proceeds on sale. The benefit received by the taxpayer in return for the property is the cancellation of a mortgage that is worth no more than the fair market value of the property, for that is all the mortgagee can expect to collect on the mortgage. His gain or loss on the disposition of the property equals the difference between the proceeds and the cost of acquisition. Thus, the taxation of the transaction in property reflects the economic fate of the property. If the property has declined in value, as was the case here, the taxpayer recognizes a loss on the disposition of the property. The new purchaser then takes as his basis the fair market value as of the date of the sale. [citations omitted].

In the separate borrowing transaction, the taxpayer acquires cash from the mortgagee. He need not recognize income at that time, of course, because he also incurs an obligation to repay the money. Later, though, when he is able to satisfy the debt by surrendering property that is worth less than the face amount of the debt, we have a classic situation of cancellation of indebtedness, requiring the taxpayer to recognize income in the amount of the difference between the proceeds of the loan and the amount for which he is able to satisfy his creditor. 26 U.S.C. § 61(a)(12). The taxation of the financing transaction then reflects the economic fate of the loan.

The reason that separation of the two aspects of the events in this case is important is, of course, that the Code treats different sorts of income differently. A gain on the sale of the property may qualify for capital gains treatment, §§ 1202, 1221, while the cancellation of indebtedness is ordinary income, but income that the taxpayer may be able to defer. §§ 108, 1017. Not only does Professor Barnett’s theory permit us to accord appropriate treatment to each of the two types of income or loss present in these sorts of transactions, it also restores continuity to the system by making the taxpayer-seller’s proceeds on the disposition of property equal to the purchaser’s basis in the property. Further, and most important, it allows us to tax the events in this case in the same way that we tax the economically identical hypothesized transaction.

Persuaded though I am by the logical coherence and internal consistency of this approach, I agree with the Court’s decision not to adopt it judicially. We do not write on a slate marked only by Crane. The Commissioner’s longstanding position, Rev. Rul. 76-111, is now reflected in the regulations. Reg. § 1.1001-2 (1982). In the light of the numerous cases in the lower courts including the amount of the unrepaid proceeds of the mortgage in the proceeds on sale or disposition [citations omitted], it is difficult to conclude that the Commissioner’s interpretation of the statute exceeds the bounds of his discretion. As the Court’s opinion demonstrates, his interpretation is defensible. One can reasonably read § 1001(b)’s reference to “the amount realized from the sale or other disposition of property” (emphasis added) to permit the Commissioner to collapse the two aspects of the transaction. As long as his view is a reasonable reading of § 1001(b), we should defer to the regulations promulgated by the agency charged with interpretation of the statute. [citations omitted]. Accordingly, I concur.

Notes and Questions:

1. Notice that taxpayers’ allowable depreciation deductions reduced their adjusted basis in the property. Why is it absolutely necessary that this be the rule?

2. What was in this for Fred Bayles? How was he going to profit by assuming a nonrecourse obligation that was greater than the fmv of the property?

3. Does this case unmoor cancellation of indebtedness income from the necessity of establishing a “freeing of assets” or a “shrinking of assets?”

4. Read Reg. § 1.1001-2(a)(2). It seems to apply Justice O’Connor’s/Professor Barnett’s theory to discharge of recourse liability when the fmv of the property is less than the outstanding principal of the loan. Why the difference?

5. Property that is subject to depreciation is not a capital asset. § 1221(a)(2). A special wartime measure, § 1231, allows taxpayer to treat such property held for more than one year to be treated as a capital asset if a sale or disposition produces gain.

Rev. Rul. 90-16

....

Property transfer by insolvent taxpayer in satisfaction of debt secured by property. A transfer of property to a bank in satisfaction of a debt on which the taxpayer is personally liable and which is secured by the property is a disposition upon which gain is recognized under §§ 1001(c) and 61(a)(3) of the Code to the extent the fair market value of the property exceeds the taxpayer's adjusted basis in the property.

ISSUE

A taxpayer transfers to a creditor a residential subdivision that has a fair market value in excess of the taxpayer's basis in satisfaction of a debt for which the taxpayer was personally liable. Is the transfer a sale or disposition resulting in the realization and recognition of gain by the taxpayer under §§ 1001(c) and 61(a)(3) of the Internal Revenue Code?

FACTS

X was the owner and developer of a residential subdivision. To finance the development of the subdivision, X obtained a loan from an unrelated bank. X was unconditionally liable for repayment of the debt. The debt was secured by a mortgage on the subdivision.

X became insolvent (within the meaning of § 108(d)(3) of the Code) and defaulted on the debt. X negotiated an agreement with the bank whereby the subdivision was transferred to the bank and the bank released X from all liability for the amounts due on the debt. When the subdivision was transferred pursuant to the agreement, its fair market value was 10,000x dollars, X's adjusted basis in the subdivision was 8,000x dollars, and the amount due on the debt was 12,000x dollars, which did not represent any accrued but unpaid interest. After the transaction X was still insolvent.

LAW AND ANALYSIS

Sections 61(a)(3) and 61(a)(12) of the Code provide that, except as otherwise provided, gross income means all income from whatever source derived, including (but not limited to) gains from dealings in property and income from discharge of indebtedness.

Section 108(a)(1)(B) of the Code provides that gross income does not include any amount that would otherwise be includible in gross income by reason of discharge (in whole or in part) of indebtedness of the taxpayer if the discharge occurs when the taxpayer is insolvent. Section 108(a)(3) provides that, in the case of a discharge to which § 108(a)(1)(B) applies, the amount excluded under § 108(a)(1)(B) shall not exceed the amount by which the taxpayer is insolvent (as defined in § 108(d)(3)).

Reg. § 1.61-6(a) provides that the specific rules for computing the amount of gain or loss from dealings in property under § 61(a)(3) are contained in § 1001 and the regulations thereunder.

Section 1001(a) of the Code provides that gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in § 1011 for determining gain.

Section 1001(b) of the Code provides that the amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.

Section 1001(c) of the Code provides that, except as otherwise provided in subtitle A, the entire amount of the gain or loss, determined under § 1001, on the sale or exchange of property shall be recognized.

Reg. § 1.1001-2(a)(1) provides that, except as provided in § 1.1001-2(a)(2) and (3), the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition. Section 1.1001-2(a)(2) provides that the amount realized on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness under § 61(a)(12). Example (8) under § 1.1001-2(c) illustrates these rules as follows:

Example (8). In 1980, F transfers to a creditor an asset with a fair market value of $6,000 and the creditor discharges $7,500 of indebtedness for which F is personally liable. The amount realized on the disposition of the asset is its fair market value ($6,000). In addition, F has income from the discharge of indebtedness of $1,500 ($7,500 − $6,000).

In the present situation, X transferred the subdivision to the bank in satisfaction of the 12,000x dollar debt. To the extent of the fair market value of the property transferred to the creditor, the transfer of the subdivision is treated as a sale or disposition upon which gain is recognized under § 1001(c) of the Code. To the extent the fair market value of the subdivision, 10,000x dollars, exceeds its adjusted basis, 8,000x dollars, X realizes and recognizes gain on the transfer. X thus recognizes 2,000x dollars of gain.

To the extent the amount of debt, 12,000x dollars, exceeds the fair market value of the subdivision, 10,000x dollars, X realizes income from the discharge of indebtedness. However, under § 108(a)(1)(B) of the Code, the full amount of X’s discharge of indebtedness income is excluded from gross income because that amount does not exceed the amount by which X was insolvent.

If the subdivision had been transferred to the bank as a result of a foreclosure proceeding in which the outstanding balance of the debt was discharged (rather than having been transferred pursuant to the settlement agreement), the result would be the same. A mortgage foreclosure, like a voluntary sale, is a ‘disposition’ within the scope of the gain or loss provisions of § 1001 of the Code. SeeHelvering v. Hammel, 311 U.S. 504 (1941); Electro- Chemical Engraving Co. v. Commissioner, 311 U.S. 513 (1941); and Danenberg v. Commissioner, 73 T.C. 370 (1979), acq., 1980-2 C.B. 1.

HOLDING

The transfer of the subdivision by X to the bank in satisfaction of a debt on which X was personally liable is a sale or disposition upon which gain is realized and recognized by X under §§ 1001(c) and 61(a)(3) of the Code to the extent the fair market value of the subdivision transferred exceeds X’s adjusted basis. Subject to the application of § 108 of the Code, to the extent the amount of debt exceeds the fair market value of the subdivision, X would also realize income from the discharge of indebtedness.

Notes and Questions:

1. What would have been the result if the adjusted basis of the property had been $7000x?

2. Why is it so important to this revenue ruling that taxpayer is insolvent?

3. You should recognize that the holding in Gehl is in exact accord with the IRS’s position in this revenue ruling.

4. Read Reg. § 1.1001-3(b). You might have to get this regulation on Westlaw or Lexis. A “material modification” of a debt instrument results in an exchange for purposes of § 1001(a). What is the effect of this treatment?

5. Would the result have been the same if the loan had been without recourse? Read on.

Rev. Rul. 91-31

DISCHARGE OF INDEBTEDNESS

...

ISSUE

If the principal amount of an undersecured nonrecourse debt is reduced by the holder of the debt who was not the seller of the property securing the debt, does this debt reduction result in the realization of discharge of indebtedness income for the year of the reduction under § 61(a)(12) of the Internal Revenue Code or in the reduction of the basis in the property securing the debt?

FACTS

In 1988, individual A borrowed $1,000,000 from C and signed a note payable to C for $1,000,000 that bore interest at a fixed market rate payable annually. A had no personal liability with respect to the note, which was secured by an office building valued at $1,000,000 that A acquired from B with the proceeds of the nonrecourse financing. In 1989, when the value of the office building was $800,000 and the outstanding principal on the note was $1,000,000, C agreed to modify the terms of the note by reducing the note’s principal amount to $800,000. The modified note bore adequate stated interest within the meaning of § 1274(c)(2).

The facts here do not involve the bankruptcy, insolvency, or qualified farm indebtedness of the taxpayer. Thus, the specific exclusions provided by § 108(a) do not apply.

LAW AND ANALYSIS

Section 61(a)(12) of the Code provides that gross income includes income from the discharge of indebtedness. Reg. § 1.61-12(a) provides that the discharge of indebtedness, in whole or in part, may result in the realization of income.

In Rev. Rul. 82-202, a taxpayer prepaid the mortgage held by a third party lender on the taxpayer’s residence for less than the principal balance of the mortgage. At the time of the prepayment, the fair market value of the residence was greater than the principal balance of the mortgage. The revenue ruling holds that the taxpayer realizes discharge of indebtedness income under § 61(a)(12) of the Code, whether the mortgage is recourse or nonrecourse and whether it is partially or fully prepaid. Rev. Rul. 82-202 relies on United States v. Kirby Lumber Co., 284 U.S. 1 (1931), in which the United States Supreme Court held that a taxpayer realized ordinary income upon the purchase of its own bonds in an arm’s length transaction at less than their face amount.

In Commissioner v. Tufts, 461 U.S. 300 (1983), the Supreme Court held that when a taxpayer sold property encumbered by a nonrecourse obligation that exceeded the fair market value of the property sold, the amount realized included the amount of the obligation discharged. The Court reasoned that because a nonrecourse note is treated as a true debt upon inception (so that the loan proceeds are not taken into income at that time), a taxpayer is bound to treat the nonrecourse note as a true debt when the taxpayer is discharged from the liability upon disposition of the collateral, notwithstanding the lesser fair market value of the collateral. See § 1.1001-2(c), Example 7, of the Income Tax Regulations.

In Gershkowitz v. Commissioner, 88 T.C. 984 (1987), the Tax Court, in a reviewed opinion, concluded, in part, that the settlement of a nonrecourse debt of $250,000 for a $40,000 cash payment (rather than surrender of the $2,500 collateral) resulted in $210,000 of discharge of indebtedness income. The court, following the Tufts holding that income results when a taxpayer is discharged from liability for an undersecured nonrecourse obligation upon the disposition of the collateral, held that the discharge from a portion of the liability for an undersecured nonrecourse obligation through a cash settlement must also result in income.

The Service will follow the holding in Gershkowitz where a taxpayer is discharged from all or a portion of a nonrecourse liability when there is no disposition of the collateral. Thus, in the present case, A realizes $200,000 of discharge of indebtedness income in 1989 as a result of the modification of A’s note payable to C.

In an earlier Board of Tax Appeals decision, Fulton Gold Corp. v. Commissioner, 31 B.T.A. 519 (1934), a taxpayer purchased property without assuming an outstanding mortgage and subsequently satisfied the mortgage for less than its face amount. In a decision based on unclear facts, the Board of Tax Appeals, for purposes of determining the taxpayer’s gain or loss upon the sale of the property in a later year, held that the taxpayer’s basis in the property should have been reduced by the amount of the mortgage debt forgiven in the earlier year.

The Tufts and Gershkowitz decisions implicitly reject any interpretation of Fulton Gold that a reduction in the amount of a nonrecourse liability by the holder of the debt who was not the seller of the property securing the liability results in a reduction of the basis in that property, rather than discharge of indebtedness income for the year of the reduction. Fulton Gold, interpreted in this manner, is inconsistent with Tufts and Gershkowitz. Therefore, that interpretation is rejected and will not be followed.

HOLDING

The reduction of the principal amount of an undersecured nonrecourse debt by the holder of a debt who was not the seller of the property securing the debt results in the realization of discharge of indebtedness income under § 61(a)(12) of the Code.

Notes and Questions:

1. CompareGershkowitz (summarized in Rev. Rul. 91-31) and Tufts. When and why does it matter whether taxpayer is relieved of a nonrecourse obligation through doi or through realization of the amount of the obligation?

2. What is the rule of Rev. Rul. 82-202, as stated in Rev. Rul. 91-31?

3. If the creditor is the seller of the property – i.e., the debt was purchase money debt – the revenue ruling implies that the holding might be different.

4. To what extent should taxpayer take into account nonrecourse debt in determining whether he/she/it is insolvent for purposes of applying § 108? In Rev. Rul. 92-53, the IRS stated that the amount by which a nonrecourse debt exceeds the fair market value of the property securing the debt is taken into account in determining whether, and to what extent, a taxpayer is insolvent within the meaning of § 108(d)(3) of the Code, but only to the extent that the excess nonrecourse debt is discharged.

Nonrecourse debt up to the fmv of the property is taken into account. Why shouldn’t the full excess of the amount of the nonrecourse debt over the fmv of the property – even that which is not discharged – be taken into account? How does the IRS’s treatment of nonrecourse debt preserve taxpayer’s “fresh start” – but no more?