Donald J. Weidner1

INTRODUCTION TO REAL ESTATE TAX SHELTER

(Supplement Pages 53-55)

Two Different Meanings of Real Estate Tax Shelter

a. An Investment That Generates Cash that is Currently Sheltered from Tax

b. An Investment That Generates Tax Losses.

Taxable income or loss can be derived from Net Cash Flow (NCF).

RR = Rent ReceiptsRT = Real Estate TaxesME = Maintenance Expense (including insurance)P = Principal repaid on debt (amortization)I = Interest paid on debtD = Depreciation deduction allowable

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Example of tax shelter in second sense

NCF = RR – RT – ME – (P + I) = $10,000 – 500 – 400 – (900 + 8,000) = $200 Caveat: Capital Expenditures

T.I. = NCF + P – D = 200 + 900 – 1,200 = ($100)

Collapse of tax shelter (same investment with same NCF years later):

T.I. = NCF + P – D = 200 + 8,000 – 700 = $7,500

Example of Tax Shelter in Second Sense

Tax Shelters• Consider the statement in the text at p. 949:

– “So long as depreciation deductions (tax deductions without corresponding cash expenditures) exceed amortization of any debt on the property (cash expenditures without any corresponding tax deductions), the investment will provide a ‘tax shelter’ for the taxpayer’s income.”

• However, there is NOT tax shelter in our second sense unless depreciation deduction exceeds the sum of amortization plus net cash flow.

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AMOUNT REALIZED- ADJUSTED BASIS GAIN

MONEY RECEIVED+ FMV OF PROPERTY RECEIVED AMOUNT REALIZED

INITIAL BASIS (GENERALLY COST)- DEPRECIATION ALLOWABLE+ CAPITAL IMPROVEMENTS (ADDITIONAL COST) ADJUSTED BASIS (UNRECOVERED COST)

BASIC TAX RULES OF GAIN OR LOSS ON SALE OF PROPERTY

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On Purchase of Land and Building1. Allocate cost between land and building.

• The investment in the land is an investment in a non-depreciable asset—an asset that does not waste away and therefore has an unlimited useful life.

2. The building is presumably a wasting asset (through obsolescence or physical deterioration). The investment in the building is depreciable if the building is:

(a) used in a trade or business; or (b) held for the production of income.

Ex. A $100 total cost of land and building must be allocated, say, $20 to the land and $80 to the building. Only the $80 allocable to the building is depreciable.

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On Purchase of Land and Building (cont’d)

3. Determine the “applicable [cost] recovery period” (formerly known as “useful life”) for the asset being depreciated).

1. Code sec. 168(c) says 1. 39 years for nonresidential, 2. 27.5 years for residential rental.

On Purchase of Land and Building (cont’d)

4. Allocate the building cost over the applicable recovery period (39 years for nonresidential).

• Code sec. 168(b)(3) says the “straight line” method is the only method that may be used to compute depreciation deductions on either nonresidential property or residential rental property.• The depreciation deduction will be the

same every year of the cost recovery period• That is, the deductions may not be

“accelerated”—bunched up in the beginning of the cost recovery period.

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Nonrecourse Financing and Crane

• Mortgage debt gets to be treated as part of an investor’s “cost” of property.

• In tax terms, the debt is included in the taxpayer’s depreciable “basis” in property, giving rise to what some refer to as “leveraged depreciation.”

• Debt that is included in basis includes not only funds borrowed by the investor, but any debt to which the property is “subject” at the time of the acquisition.

• In the 1940s, the Supreme Court held that basis includes debt on which the investor has no personal liability.– See text p. 951-52, discussing Crane v. Commissioner,

331 U.S. 1 (1947).

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Crane v. Commissioner331 U.S. 1 (1947) (discussed in Mayerson at Supp. p. 56)

Ms. Crane sold apartment bldg for

(1) $ 2,500 cash

“subject to” (2) 255,000 Mortgage (principal)

______

IRS said: $257,500, the sum of the cash plus the principal balance on the mortgage, is the “amount realized” on the sale.

Recall: The Code defines “Amount Realized” as “the sum of [1] any money received plus [2] the fair market value of the property (other than money) received.”

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Crane (Cont’d)

• Ms. Crane conceded “that if she had been personally liable on the mortgage and the purchaser had either paid or assumed it,” the amount so paid or assumed would be a part of her amount realized.

• Previous cases had said that an “actual receipt” was not necessary. If the buyer paid or promised to pay the mortgage, the seller was “as real and substantial” a beneficiary as if the money had been paid by buyer to seller and then to the creditor.– Even though payment and promise to pay are

economically very different

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LENDER

BORROWER(SELLER)

BUYER

Buyer pays Seller’s $ debt

Sale

Loan $

AMOUNT REALIZED

1) No actual receipt is necessary

2) Buyer discharging the seller’s indebtedness is deemed the equivalent of a payment by buyer to the seller

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Crane (Cont’d)• Ms. Crane said it was not the same as if she had been

paid the amount of the mortgage balance: (1) she was not personally liable on the mortgage (2) nor did her buyer become personally liable.

• She had inherited the property 7 years earlier, when the mortgage encumbering it was already in default.

• She entered into an agreement that gave the mortgagee all the net cash flow – Even so, no principal was paid and the interest in

arrears doubled. • The transaction was, she said, “by all dictates of

common sense, a ruinous disaster.”Note: she had been claiming depreciation deductions.

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Crane v. Commissioner (cont’d)

Supreme Court in Crane stated what has become known as the “economic benefit” theory:

“We are rather concerned with the reality that an owner of property, mortgaged at a figure less than that at which the property will sell, must and will treat the conditions of the mortgage exactly as if they were his personal obligations.”– She will have to pay off the mortgage to

access the equity (see text p. 952) “If he transfers subject to the mortgage, the

benefit to him is as real and substantial as if the mortgage were discharged, or as if a personal debt in an equal amount had been assumed by another.”

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Crane’s Footnote 37As a result of the economic benefit theory, Ms. Crane, a

seller who was “above water,” was required to include, as part of her “amount realized,” the full amount of the nonrecourse mortgage from which she was “relieved” when she sold the property.

The following footnote # 37 from Crane reflected the economic benefit theory in a way that years later gave hope to sellers in a down market--who were “underwater”--that they would not be required to include the amount of their nonrecourse mortgage in “amount realized:” “Obviously, if the value of the property is less than the amount of the mortgage, a mortgagor who is not personally liable cannot realize a benefit equal to the mortgage. Consequently, a different problem might be encountered where a mortgagor abandoned the property or transferred it subject to the mortgage without receiving boot.”

Commissioner v. Tufts (text p. 940) put FN. 37 to death.

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Crane v. Commissioner (cont’d)

• There is one other part of the opinion that got less attention.

• Recall that Ms. Crane had been taking depreciation deductions.

• Near the end of its opinion, the Court said:– “The crux of this case, really, is whether the law

permits her to exclude allowable deductions from consideration in computing gain.”

• We’ll return to the proper analysis to apply to mortgage discharge when we consider the Supreme Court’s more recent opinion in Tufts.

• First, we consider Mayerson, a major taxpayer victory on the ability to include a nonrecourse mortgage in basis

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Mayerson v. Commissioner (Supplement p. 56) Nonrecourse Seller Financing

a) Mayerson made a $10,000 downpaymentb) Paid balance with a note in the face amount of $322,500c) Note required no repayment of principal until the

expiration of 99 yearsd) Note required monthly “interest” payments of $1,500

a) Interest at 6% after the principal was reduced below $300,000

e) Note was fully non-recourse as to principalf) Note was with recourse as to the $1,500 monthly

“interest” payments as they accruedg) Note provided for substantial discounts if retired in the

next one ($275,000) [the initial cash asking price] or three ($298,000) years

h) Buyer’s obligations ended if Buyer reconveyedi) In fact, five years later, Mayerson negotiated a reduced

purchase price of only $200,000

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MAYERSON (Cont’d)ARGUMENTS OF IRS

1. Mayerson did not acquire a depreciable interest in the building because he made no investment in it (one depreciates one’s “investment” in business property rather than the property itself).

IRS: The note does not qualify as an investment because

a. It puts nothing at economic risk; and b. It is too contingent an obligation.•Ex ante and Ex post—look at the discounts. The stated principal was never intended to be paid, as confirmed by the ultimate $200,000 taken in satisfaction of the note.

The benefit of the depreciation deduction, a deduction given for a non-cash expense on the assumption that there is or may be economic depreciation taking place, should follow the person who bears the risk of economic depreciation.--Mayerson made no investment that would be subject to a risk of depreciation.

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Mayerson (IRS Arguments Cont’d)

2. Alternatively, if Mayerson did acquire a depreciable interest in the building, the note is too contingent to be included in his basis in the building.

--His basis in the building was merely his $10,000 cash downpayment

3. The economic substance of Mayerson’s investment was merely a lease with an option to purchase.

--Under this theory, how did the IRS recharacterize the $10,000 down payment?– As a $10,000 premium paid for a favorable lease

• Which Mayerson could “amortize” over 99 years.

4. Other possibility: The $10,000 payment was a fee paid to the seller for “orchestrating” a tax shelter.

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Mayerson: Present Value

• What is the present value of the right to receive $322,500 at the end of 100 years?– The present value, of course, depends upon the

discount rate– At a 6% rate, compounded monthly, the present

value is $811

• What is the present value of the right to receive $1,500 a month for 100 years?– That, again, depends upon the discount rate

– At 6% interest, compounded monthly, the present value of that income stream is $299,245

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MAYERSON

The Tax Court agreed with 2 propositions:1. “It is well accepted that depreciation is

not predicated upon ownership of property but rather upon an investment in property,” and that

2. “the benefit of the depreciation deduction should inure to those who suffer an economic loss caused by wear and exhaustion of the business property.”

Given these two assumptions, how did court hold for Mayerson?

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More on Mayerson

• The Court said that, under Crane: “the basis of the property was the value at the date of death undiminished by the amount of the mortgage. The inclusion of the indebtedness in basis was balanced by a similar inclusion of the indebtedness in amount realized upon the ultimate sale of the property to a nonassuming grantee.”

• That is, it is not so bad to include the debt in basis when the property is acquired because that inclusion in basis will later be “balanced” or “offset” by an equal inclusion in the amount realized when the property is sold (if the debt has not been “amortized” [paid off] with nondeductible dollars).

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More on Mayerson

• The Code says that the basis for computing depreciation shall be the same as the basis for computing gain or loss on a sale or exchange. Therefore:– Crane “constitutes strong authority for the

proposition that the basis used for depreciation as well as the computation of gain or loss would include the amount of an unassumed mortgage on the property.” (emphasis added)

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Yet More on Mayerson

• Consider the court’s first policy goal:

1.Equate seller financing with third party financing. – “[A] purchase money debt obligation for part of

the price will be included in basis. This is necessary in order to equate a purchase money mortgage situation with the situation in which the buyer borrows the full amount of the purchase price from the third party and pays the seller in cash. It is clear that the depreciable basis should be the same in both instances.”

– Are these two situations economically the same?

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Yet More on Mayerson• Contrary to the court’s first policy goal, current law

says that seller-provided nonrecourse financing must be distinguished from third-party nonrecourse financing

• Do you see why nonrecourse financing provided by a seller is more subject to abuse than nonrecourse financing provided by a third party?– In the seller-provided purchase money financing, no third

party, or anyone, puts up cash in the face amount of the note

– Consider Leonard Marcus, T.C.M. 1971-299 (buyer insists on paying more but only with nonrecourse note).

– See longstanding Section 108(e)(5) (Supp. p. 64)

Yet More on Mayerson

• Section 108(e)(5) treats the reduction in seller-provided financing as a purchase price readjustment– Rather than as discharge of indebtedness

income• Provided the reduction does not occur in a

bankruptcy reorganization or insolvency case

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And Even More on Mayerson• Consider the court’s second policy goal:2.Equate nonrecourse financing with

recourse financing:“Taxpayers who are not personally liable for encumbrances on property should be allowed depreciation deductions affording competitive equality with taxpayers who are personally liable for encumbrances or taxpayers who own encumbered property.”– In general, this policy continues with respect to real

estate– However, the “at risk” rules reverse the policy in other

contexts

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At Risk

• The basic idea behind the “at risk” rules is that a taxpayer should not be able to claim deductions from an investment beyond the amount the taxpayer has “at risk” in that investment.

• In general (outside real property), a taxpayer is “at risk” only to the extent the taxpayer has either– cash in an investment, or– a recourse liability in the investment

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And Even More on Mayerson

• “The effect of [the Mayerson] policy [of including a nonrecourse mortgage in depreciable basis] is to give the taxpayer an advance credit for the amount of the mortgage.”

• “This appears to be reasonable since it can be assumed that a capital investment in the amount of the mortgage will eventually occur despite the absence of personal liability.”– Sounds like Crane: As a practical matter, the buyer will treat the

debt as if it were recourse.

• The doctrine is self-limiting:– This assumption that the mortgage will eventually be repaid can

not be made if the amount due on the mortgage exceeds the value of the property.

• As it did in the “inflated purchase price” Leonard Marcus (bowling alley) case

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Seller-Provided Financing: Purchase Price Reduction

• What are the tax consequences to a buyer in a Mayerson situation who satisfies the note to his seller at a lower amount than the amount due?

• Section 108(e)(5)– Applies to the debt a purchaser of property

owes to the seller– If the note is reduced, it will be treated as a

purchase price adjustment• rather than discharge of indebtedness income

– provided the purchaser/debtor is solvent.• If the debtor is insolvent, the indebtedness is

excluded from the taxpayer’s gross income

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Notes following Mayerson

• What are the tax consequences to me if my bank allows me to prepay my $100,000 home mortgage for only $80,000?– which it might do if the mortgage is more than the

value of the property, or if it is at an interest rate significantly lower than the current rate

– The mortgage in Rev. Rul. 82-202 (Supp. p. 64) was nonrecourse(saying the same result for recourse)

– Rev. Rul. 82-202 says:• I have $20,000 Discharge of Indebtedness Income

– Citing Kirby Lumber (my net worth is increased)• The Section 108(a) exclusion of discharge of

indebtedness income is not available unless I am bankrupt or insolvent.

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Tax Relief on Mortgage Discharge in the Wake of The Financial Crisis

• In December, 2007, President Bush signed the Mortgage Forgiveness Debt Relief Act of 2007.

• It amended section 108(a)(1) to allow an exclusion for a discharge of “qualified principal residence acquisition indebtedness.”– Up to $2 million– Not including home equity indebtedness– Even if the person is not insolvent (even if the person

has a positive net worth and that net worth is enhanced by the discharge)

– The amount excluded reduces (but not below zero) the basis of the principal residence

– The exclusion shall not apply if the discharge “is . . . not directly related to a decline in the value of the residence or to the financial condition of the taxpayer.”

– Initially retroactive to 1/1/07 and expiring 12/31/09.• Extended in 2008 through 2012 and again through 2014.

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Seller-Provided Financing: Not “At Risk”(Supp. pp. 96)

• Section 465(b)(6)(D)(ii)– “Qualified Nonrecourse Financing” is treated

as an amount “at risk.”• It must be from a “qualified person.”

– The seller is not a “qualified person.” See Section 49(a)(1)(D)(iv)(II).

– However, nonrecourse financing from a third person that is related to the taxpayer can qualify

• but only if it is “commercially reasonable and on substantially the same terms as loans involving unrelated persons.”

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AMOUNT REALIZED- ADJUSTED BASIS GAIN

MONEY RECEIVED+ FMV OF PROPERTY RECEIVED AMOUNT REALIZED

INITIAL BASIS (GENERALLY COST)- DEPRECIATION ALLOWABLE+ COST OF CAPITAL IMPROVEMENTS ADJUSTED BASIS (UNRECOVERED COST)

BASIC TAX RULES OF GAIN OR LOSS ON SALE (review prior to Tufts)

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Commissioner v. Tufts (1983)(Text p. 940)

Builder (Pelt) and his corporation formed a partnership to construct an apartment complex. They contributed nothing. The partnership received a $1,850,000 nonrecourse loan from an S & L—100% nonrecourse financing from a third party lender.

Later, 4 friends/relatives were admitted to the partnership. The partners contributed $45,000.

In first two years, $440,000 in deductions were taken: $395,000 depreciation; $45,000 other.

Partnership’s adjusted basis in the property: $ 1,850,000 Initial Basis (Cost)- 395,000 Depreciation$ 1,455,000 Adjusted Basis

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Tufts (cont’d)

• Oversimplified somewhat, each partner “sold” the partner’s interest in the partnership for zero cash. – For our purposes, assume that the

partnership “sold” the building directly. In effect, this is how the Court treats it.

• The Court was incorrect when it said that the Buyer “assumed the nonrecourse mortgage.” – The Buyer only took “subject to” the

nonrecourse mortgage.

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Tufts (cont’d)

• It was stipulated: on the date of the transfer, the Fair Market Value of the property was only $1,400,000 ($450,000 less than the outstanding mortgage balance).– In today’s parlance, the property was $450,000

“underwater”

• Hence the facts fell squarely within footnote 37 in Crane: – “Obviously, if the value of the property is less than the

amount of the mortgage, a mortgagor who is not personally liable cannot realize a benefit equal to the mortgage.”

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Tufts: Taxpayer versus IRS

TX argues: Crane footnote 37 limits the Amount Realized on account of the mortgage to the property’s FMV

AR $1,400,000 (Mortgage amount up to FMV)AB -1,455,000 (Cost minus Depreciation)Loss $ (55,000)

IRS argues: Crane fn. 37 should be ignored and the entire M should be included in AR

AR $ 1,850,000 (Full Mortgage amount)AB - 1,455,000 (Cost minus Depreciation)Gain $ 395,000

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TUFTS THEORIES OF TAX TREATMENT ON “RELIEF” FROM THE MORTGAGE

THEORIES MENTIONED BY JUSTICE BLACKMUN

1) Economic Benefit2) Cancellation of Indebtedness3) Co-Investment4) Tax Benefit5) Double Deduction6) Bifurcated Transaction7) Balancing Entry

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Economic Benefit• “Crane ultimately does not rest on its limited

theory of economic benefit.”– Crane said Ms. Crane was a “real and substantial

[economic] beneficiary” of the mortgage discharge because it enabled her to receive her equity in the property

• In Crane, there was no economic loss that should have been reflected in a tax loss– Nor did Tufts involve an economic loss that should

have been reflected in a tax loss

• Crane “approved the Commissioner’s decision to treat a nonrecourse mortgage in this context as a true loan.”

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Cancellation of Indebtedness Assets = Liabilities

$ 100 (cash) $80+

Equity$20

Consider the balance sheet after you exercise an opportunity to satisfy the $80 liability with a $65 cash payment:

Assets = Liabilities$ 35 (cash) $ 0

+ Equity

$35Cancellation of indebtedness income theory has traditionally focused on

the taxpayer’s increase in net worth, or equity, as the enhancement in wealth (income) ($15 in this example).

Blackmun stated: “the doctrine relies on a freeing of assets theory to attribute ordinary income to the debtor upon cancellation.”

He also stated: Crane’s economic benefit theory “also relies on a freeing of assets theory.”

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Coinvestment Theory• Basic concept: the nonrecourse lender is a co-investor with

the borrowerCourt says Crane stands for the proposition that the

lender gets no basis (made no investment). See fn. 5: “The [IRS] might have adopted the theory . . . that a nonrecourse mortgage is not true debt, but, instead, is a form of joint investment by the mortgagor and the mortgagee. On this approach, nonrecourse debt would be considered a contingent liability, under which the mortgagor’s payments on the debt gradually increase his interest in the property while decreasing that of the mortgagee. Because the taxpayer’s investment in the property would not include the nonrecourse debt, the taxpayer would not be permitted to include that debt in basis.”

• Court (and the IRS) rejects the coinvestment theory.

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Tax BenefitA tax benefit approach might focus on the $395,000 depreciation deductions that were taken by a taxpayer who suffered no economic depreciation.•That is, there is a need to offset an earlier deduction that was permitted because of an economic assumption that was subsequently proven to have been incorrect• Analogy: if I deduct a payment as a business expense this year, and get a refund of that payment next year, I must correct the error.

– Conversely, if I report a retainer as income this year and have to refund it next year, I get to correct the earlier inclusion in income.

Tufts rejected a tax benefit approach: “Our analysis applies even in the situation in which no deductions are taken.”

Tax Benefit (cont’d)

• See footnote 8: “Our analysis . . . focuses on the obligation to repay and its subsequent extinguishment, not on the taking and recovery of deductions.”

• Question: Is not an exclusion a tax benefit that is similar to a deduction?

• That is, if you are not focusing on the tax benefit of the depreciation deduction, are you focusing on the prior untaxed receipt of the purchase money loan proceeds (which is not included because of its accompanying obligation to repay)?– Perhaps you don’t see an exclusion because

you don’t see an enhancement in wealth

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Double Deduction

• The 3d Circuit had said that a contrary holding to Tufts would result in a “double deduction.” Note that the taxpayer here litigated taking the position that the $395,000 depreciation deduction should be followed by a $55,000 loss on sale

– despite an economic break-even result• [setting aside the $45,000 contributed and

previously deducted].

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Double Deduction (cont’d)

• The Supreme Court said its analysis applies even if no deductions are taken. – “Unless the outstanding amount of the mortgage is

deemed to be realized, the mortgagor effectively [1] will have received untaxed income at the time the loan was extended and [2] will have received an unwarranted increase in the basis of the property.”

• This reflects a new emphasis on the prior untaxed receipt.

• And on the untaxed receipt’s prior inclusion in basis.

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Professor Barnett’s Bifurcated Transaction I. Liability Transaction AR $ 1,850,000 (cash the borrower received for

issuing the note)- AB 1,400,000 (FMV of property the borrower

transferred to pay off the note) Liability Gain $ 450,000 II. Asset Transaction AR $1,400,000 (Seller received only “Relief” from

his N/R note, which was worth no more than the property

mortgaged to secure it)- AB 1,455,000 (Cost – Depreciation = AB) Asset Loss $ (55,000)

Bifurcated Transaction (cont’d)• In the normal purchase and sale of property,

the buyer knows the buyer’s basis (cost) at the purchase, at the outset.– The buyer only knows the buyer’s amount

realized when the buyer ultimately sells the property

• In a liability transaction, the FIRST thing you know is the amount realized (the amount you get for your note)– The note maker doesn’t know the cost of the note

until the maker pays it off

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Bifurcated Transaction (cont’d)• Barnett’s conception of the Amount Realized on the asset

side of the transaction: – The Amount Realized on the transfer of the property

was $1.4 million because the only consideration the seller received on the transfer was the cancellation of its nonrecourse liability worth only $1.4 million [the value of the property that secured its payment]

• Remember, the only remedy on the nonrecourse note is a foreclosure on the property mortgaged to secure it

– With no deficiency judgment possible• As Justice O’Connor put it: “The benefit received by the

taxpayer in return for the property is worth no more than the fair market value of the property, for that is all the mortgagee can expect to collect for the [nonrecourse] mortgage.”

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Bifurcated Transaction (cont’d)• Justice O’Connor: “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.”

• Further: “There is no economic difference between the events in this case and a case in which [1] the buyer buys property with cash; [2] later obtains a nonrecourse loan by pledging the property as security; [3] still later, using cash on hand, buys off the mortgage for the market value of the devalued property; and [4] finally sells the property to a third party for its fair market value.”– But the law treats the two situations differently

• Consider the Example from Bittker’s article

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Professor Bittker’s Balancing Entry versus Professor Barnett’s Bifurcated Transaction

• Bittker’s result is the same result urged by the IRS: The unamortized amount of the mortgage is included in Amount Realized– resulting in a gain of $ 395,000– An amount equal to the amount of depreciation taken

• Barnett’s results total Bittker’s $395,000 (sum of $450,000 liability gain and the $55,000

asset loss)• Barnett says they should not be totaled—they are

of a different character• Bittker says his approach is independent of the

depreciation deduction.– The Court says the same thing about its approach.

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1) Taxpayer buys Blackacre for $100,000, paying:

$ 25,000 cash down payment + 75,000 Nonrecourse purchase money N/M to Seller $100,000 total cost to Taxpayer

2) Blackacre skyrockets in value to $300,000.

3) Taxpayer refinances, increasing the N/M by $175,000 (from $75,000 to $250,000)

[pulling $175,000 cash out].

4) FMV drops to $40,000.

5) Taxpayer gives a deed in lieu of foreclosure.

BALANCING ENTRY: BITTKER’S NO DEPRECIATION EXAMPLE

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Balancing Entry: Bittker’s No Depreciation Example (cont’d)

• Whereas Taxpayer has an economic gain of $150,000: $175,000 AR (cash pulled out) - 25,000 AB (cash put in)• $150,000: Economic Gain--the right result

• If Taxpayer’s amount realized from “relief” from the note is limited to the value of the property, Taxpayer will get a tax loss:

AR $ 40,000- AB 100,000 [adjusted basis][initial basis/no depreciation

deductions taken]- ($ 60,000)

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There should be a symmetrical “Balancing Entry” on relief from the Note and Mortgage, says Bittker, that includes the full amount due on the mortgage in amount realized (even if it exceeds the fair market value of the property):

$250,000 Mortgage balance at D/L/FC [Full M: No FMV Limit]

- 100,000 AB [unadjusted cost basis]

$150,000 Gain

=======

Note: This total amount is equal to the $150,000 economic profit.

Balancing Entry: Bittker’s Example (cont’d)

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BARNETT’S BIFURCATION OF BITTKER’S EXAMPLE

LIABILITY TRANSACTION

$ 75,000 FMV of the Property originally financed with M (the 1st M) + 175,000 Cash when refinanced additional $175,000 (the 2nd M)

$ 250,000 Total property and cash buyer received (amount realized) for issuing its liabilities (notes)

AR $250,000 Amount Realized from undertaking the liabilities

AB - 40,000 Value of property transferred to satisfy the liabilities $210,000 Income from transaction in liabilities

ASSET TRANSACTION

AR $ 40,000 Relief from liability worth $40,000AB –100,000 Cost ($ 60,000) Loss from transaction in asset

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Court Rejects Barnett’s Bifurcation

RECALL

• Bittker’s answer was: $150,000 Capital Gain

• Barnett’s answer would be: $210,000 Liability Gain (Discharge of Indebtedness Income)And a ($ 60,000) Asset Loss [$ 150,000] Same Gross total if you net them out

• Barnett’s point: You can not net them out because they are different kinds of income that should be taxed differently.

• Tufts rejected Professor Barnett’s theory:– Although it “could be a justifiable mode of analysis, it has not

been adopted by the Commissioner. Nor is there anything to indicate that the Code requires the Commission to adopt it.”

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Court Emphasized Prior Untaxed Receipt

• The Court emphasized what happened ex ante (as opposed to economic benefit ex post):– “[T]he 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 unwarranted increase in the basis of his property.”

Donald J. Weidner57

Tufts: Much Left Unchanged

• The Tufts opinion itself left intact tax shelters that offer both

• Conversion and • Deferral

• The Tufts opinion itself left intact the use of nonrecourse mortgages.

• The Tufts opinion said that the nonrecourse nature of a loan– “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.”

Donald J. Weidner58

Tufts: Requires Symmetry

• “We . . . hold that a taxpayer must account for the proceeds of obligations he has received tax-free and included in basis. Nothing . . . 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 property.”

• This sounds like Bittker’s Balancing Entry approach

Donald J. Weidner59

Tufts Does Not Validate Inclusion of Inflated Purchase Money Note in Basis

• The Court does not state that a nonrecourse purchase money note in excess of the value of property may be included in basis at the outset.– The law has never said that nonrecourse notes

inflated past value may be included in basis (recall Leonard Marcus).

• The Court only states how a nonrecourse note that was initially included in basis must be treated when the taxpayer ultimately transfers the property.

Donald J. Weidner60

Some Discharge on Transfer Is Discharge of Indebtedness Income(Supplement pp. 95, 93)

• IRC sec. 7701(g) (Supp. 95)(enacted in 1984)(the year after Tufts): – “[I]n determining the amount of any gain or loss . . . with

respect to any property, the fair market value of such property shall be treated as being not less than the amount of any nonrecourse indebtedness to which such property is subject.”

• However: Some mortgage discharge on disposition is treated as discharge of indebtedness income.

• Treas. Reg. sec. 1.1001-2(a), Ex. 8 (Supp. P. 93) deals with a transfer of property to a creditor in which the creditor discharges a recourse note in excess of the value of property. It states that the note is included in Amount Realized only to the extent of the value of the property, and results in discharge of indebtedness income beyond that.

Donald J. Weidner61

Discharge of Recourse Obligation (cont’d)

• Example 8 provides for the case of an underwater recourse note:– 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).

Donald J. Weidner62

Occasional Favorable Treatment of Discharge of Indebtedness Income

• Discharge of indebtedness income sometimes receives preferential treatment.

• Rev. Rul. 90-16 (Supp. p. 94) takes Example (8) one step further and states that the taxpayer’s discharge of indebtedness income is excluded from gross income when the taxpayer is insolvent – and the discharge of indebtedness income

does not exceed the amount by which the taxpayer is insolvent.

Donald J. Weidner63

Three Rules Confining Tax Shelters• There will be more on the subsequent history of tax

shelters later in the course. In short, the principal changes in the rules that update our discussion of Tufts are:1. The at risk rules leave third-party nonrecourse financing intact

with respect to commercial real estate (noted after Mayerson).

2. The passive loss rules, however, dramatically restrict real estate tax shelters. Although deductions may continue to be computed on a basis that includes nonrecourse financing, passive investors may not us those deductions, or the resulting losses, to “shelter” their personal service income or their other investment income.

3. Ordinary income sheltered by depreciation deductions is “recaptured”—the gain is taxed more like ordinary income.

The Passive Loss Rules

• The Passive Loss Rules, introduced in 1986 (three years after Tufts), gut tax shelters (in our second sense) as they existed at the time of Tufts.– unless a real estate investor is a real estate

professional, the investor may not use real estate partnership losses to offset or shelter, either their 1. earned income; or 2. other portfolio income.

Donald J. Weidner64

The Passive Loss Rules (cont’d)• Losses from “passive activities” may be set off

only against income from other “passive activities” (but not other portfolio income generally)

• “Unused passive losses can be carried forward and set off against passive income in subsequent tax years.” Text at 954.

• In 1993, the passive loss rules were amended “to relieve bona fide real estate professionals from the passive loss limitations.” Text at 956.

Donald J. Weidner65

Donald J. Weidner66

Final Footnote to Tufts• Example of gain traceable to depreciation deductions:

– Taxpayer purchased a building several years ago for $100x– Taxpayer was allowed $20x in depreciation deductions– Taxpayer sells the building this year for $125x

• The gain is $45 ($125 AR - $80 AB = $45 GAIN).• How is the $45 gain taxed? It is seen as having 2 parts:

– The $20 of gain attributable to previously allowed depreciation deductions is taxed as “unrecaptured section 1250 gain” at a less preferential capital gain rate of 25%

– Thus, limiting the “conversion” that would otherwise take place if a depreciation deduction, used to offset ordinary income, were only taken into account subtracting it from basis, resulting in a larger capital gain

• The $25 of gain attributable to appreciation (rather than to previously allowed depreciation deductions) is taxed as long term capital gain, subject to the recent 15% rate (until 2013) (now up to 23.8%)– See I.R.C. section 1(h).

2013 Tax Update• Capital Gains get more complicated in 2013.

– The rate goes from 15% to 20% for individuals earning over $400,000 and marrieds over $450,000

– Those in the two lowest brackets pay 0%

• Effective 2013, as part of the “Affordable Care Act,” there is a new “Medicare Tax” on individuals with an adjusted gross income over $200,000--a “Net Investment Income Tax” of 3.8% on net income from stocks, bonds, investment real estate (including second homes)

• In short, 23.8% is the new LTCG rate for high-income individuals

Donald J. Weidner67

Donald J. Weidner68

Casebook Note on Foreclosure(Text p. 733)

• General Rule: mortgage foreclosures are treated the same as voluntary sales or exchanges

– With capital or ordinary gain or loss treatment given accordingly.

• The casebook then summarizes the rules we have just recently considered.

1. PROPERTY ABOVE WATER. If the property’s fair market value exceeds the liabilities discharged, the amount of liabilities satisfied—whether the liabilities are recourse or nonrecourse—will be included in the amount realized.

Donald J. Weidner69

Casebook Note on Foreclosures (cont’d)

2. PROPERTY UNDER WATER. If the liabilities discharged exceed the fair market value of the property, the tax consequences will differ depending on whether the liability was recourse or nonrecourse.– If the liability was recourse: a) the liability will be included in amount

realized to the extent of the property’s fair market value; and b) the excess of liabilities over fair market value will be considered a cancellation of indebtedness and thus treated as ordinary income.

– If the liability was nonrecourse: the full amount of the liability will be included in amount realized

• Because the mortgagee has no personal action against the mortgagor, and no recourse against the mortgagor’s other assets, there is no cancellation of indebtedness income (instead, the mortgage is treated as in Tufts).

Donald J. Weidner70

Casebook Note on Foreclosures (cont’d)

• Note the amendment of IRC 108 to provide an exclusion from income of up to $2 million of debt forgiveness on the taxpayer’s principal residence.– Excluding from gross income a discharge of

“qualified principal residence indebtedness”• IRC 108(a)(1)(E)

– Subsequently extended through 2014

Donald J. Weidner71

Institutional “Lender”

(Notepurchaser)

Kinney Shoe

CP’sSHs

Pays “rent”directly to MEE

Bolger-SH

Financing CP

$1,000

Deed (in exchange for $1,355,500 “sale price”)

*Contemporaneous net lease back @ $93,528/yr. for 25-year base term **Lessee has right to make a “rejectable offer to purchase” if building is destroyed (at cost of prepaying the notes) ***Lessee has right to three, 5-year renewal terms @ $37,413/yr.

This Net lease is subordinated to the 1M

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Rent in

Exc

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/yr.

Bolger v. Commissioner (Supplement p. 69)

The notes issued by the Financing Corporation provided for payment over a period equal to or less than the base term of the lease.

Donald J. Weidner72

Some Terms of the Net Lease• The lease’s base term was equal to or longer than

the term of the notes.• The rent on the lease was only nominally higher than

the debt service on the notes.• The rent was “net” to the landlord. That means that

the Tenant paid all:– taxes– insurance– repairs and – all Lessor acquisition costs above the purchase price.

• The Tenant’s interest under the lease was subordinated to the Mortgage.

Donald J. Weidner73

Subordination of Lease to Mortgage(a first look at subordination)

Situation 1.

FO Lease

FO Mortgage

Situation 2.

FO Mortgage

FO Lease

Donald J. Weidner74

Terms of the Lease (cont’d)• Rent payments were to continue even if the

building were destroyed; however– In the event of building destruction, Lessee

could offer to purchase for a price that approximated the cost of prepaying the note.• That is, the lessee had the right to make a

“rejectable offer to purchase”– Lessor’s refusal to accept the offer would

terminate [tenant’s obligations under] the lease.

Donald J. Weidner75

Terms of the Lease (cont’d)

• The Lessee was permitted to sublet or assign its interest under the lease, provided– The sublessee or assignee promised to

comply with the terms of the mortgage and lease, and

– The Lessee remained personally liable for all its obligations under the Lease.

Donald J. Weidner76

The Mortgage Anticipated The Financing Corporation Would Transfer Title

• Each transferee of the corporation was to sign an highly idiosyncratic “assumption agreement.”

– Why idiosyncratic?• What did it say?

– Why do you think it was there?• Each transferee of the corporation also was required:

1. To compel the corporation to remain in existence.2. To prevent the corporation from engaging in any

other business.3. To prevent any merger or consolidation of the

corporation with any other corporation.

Donald J. Weidner77

THE FINANCING CORPORATION (a.k.a. “Special Purpose Entity” or “Special Purpose

Vehicle”)• In each case, a corporation was formed with

nominal capital. • The corporation “purchased” the building. • The corporation’s shareholders were the

individuals to whom the corporation would convey title for a nominal consideration.

• The corporation promised to maintain its existence

• The corporation promised to refrain from any other activity.

Donald J. Weidner78

Purposes of the Special Purpose Entity

Court said the purposes of the corporation were to:

1. Facilitate multiple lender financing

2. Avoid usury limits on loans to individuals

3. Provide nonrecourse financing to Bolger and the other transferees

Donald J. Weidner79

COURT’S DEFINITION OF THE ISSUES

1) Was the corporation a separate taxable entity before its transfer to Bolger?

2) Did the corporation remain a separate taxable entity after its transfer to Bolger?

3) If the corporation remained a separate taxable entity after its transfer to Bolger, is the corporation or Bolger entitled to the depreciation deduction?

4) If a depreciable interest was transferred to Bolger, what was his basis in that interest?

Donald J. Weidner80

Is the Write-Off in the Corporation?

1. Taxpayers’ First Argument to Get the Deductions Out of the Corporation and on to their Individual tax returns:– The “Disregard” or “Straw” Theory: the

corporation is too insubstantial to be recognized as a separate taxpayer.

• Court rejected this argument, stating the following rule: – The corporation is a separate taxpayer if it has

either:• business activity or • a business purpose that is the equivalent of

business activity.

Donald J. Weidner81

Deductions Locked Up in the Corporation? (cont’d)

2. Taxpayers’ Second Argument to Get the Deductions Out of the Corporation and on to their individual returns:• The “Agency” or “Nominee” Theory: The corporation is

substantial enough to exist, but it exists as an agent holding title for its principals—the grantees.

• Court rejected this argument, stating: for the same reasons we will not disregard the corporation, we will not regard it as the agent of the shareholders. – “Indeed, the existence of an agency relationship would

have been self-defeating in that it would have seriously endangered, if not prevented, the achievement of those objectives which, in large part, gave rise to the use of the corporations, namely, the avoidance of restrictions under state law.”• But see Bollinger

Donald J. Weidner82

The “Reversionary Interest” Argument of the IRS

• IRS also argued that Bolger got only a “reversionary interest” in the buildings, that is, a future interest not sufficiently possessory to support a claim to depreciation deductions. • It emphasized that:

– the long-term lease left possession in the tenant for 40 years (counting renewal options) and

– With zero cash flow (virtually all of the rent was dedicated to service the debt).

Donald J. Weidner83

Bolger’s Present Interest• What “bundle of sticks” did Bolger get?

• Court said Bolger has the economic benefits from:– a) amortization and – b) appreciation,

• which are reachable by – a) refinancing or – b) sale.

• Further, Bolger has a tax burden: – the rents are includable in income even

though they are applied to service the debt.

Donald J. Weidner84

The Measure of Bolger’s Basis

• Once it was established that Bolger had a depreciable interest, Crane and Mayerson carried the day on whether the nonrecourse mortgage could be included in Bolger’s basis. • In Mayerson, “we were not deterred by the fact that the taxpayer made only a nominal cash investment.” • The effect of Crane is to give an advance credit in the amount of the mortgage because it can be assumed that a capital investment in that amount will eventually occur.

– Does that assumption appear to be warranted in Bolger?

– IRS said no: • Net Cash Flow is minimal and • the property is fully encumbered.

Donald J. Weidner85

Bolger’s “Bitter Pill” (Crane plus accelerated methods of computing depreciation)

• Crane “permits the taxpayer to recover his investment in the property before he has actually made any cash investment.”

• “As Mayerson makes clear, petitioner’s case should not be treated differently merely because his acquisition . . . is completely financed and because his cash flow is minimal.”– the same thing happened in Tufts

Note: The accelerated methods of computing depreciation that were available in the time of Bolger are no longer available to commercial real estate. – Today: straight-line is the mandatory (fastest) method

a taxpayer may use to compute depreciation.

Donald J. Weidner86

Other Possibilities in Bolger

• Court seemed to suggest that the IRS may have blown the case by arguing that the interest was either in the David Bolger or in his Corporation. – It never argued that someone else had the interest.

• What if Kinney Shoe defaulted on its lease and Bolger sued to evict it for nonpayment of rent?– What argument would Kinney Shoe raise in defense

against the eviction action?Note: Court never decided how the interest passed to

Bolger --(by purchase or by the receipt of a distribution of property by a shareholder from its corporation)

Donald J. Weidner87

Bollinger v. Commissioner(Supp. p. 82)

• Kentucky usury law limited to 7% the annual interest rate on loans to non-corporate borrowers.– “Lenders willing to provide money only at

higher interest rates required the nominal debtor and record title holder of the mortgaged property to be a corporate nominee of the true owner and borrower.”

Donald J. Weidner88

Jesse Bollinger

Permanent Lender

(Mass Mutual)

COMMITMENT TO PROVIDE PERMANENT FINANCING OF

$1,075,000 at 8% to Bollinger’s corporate nominee [Ky. usury law limited to 7% the interest on loans to non-corporate borrowers], but only if

Bollinger personally guaranteed repayment

[Take-out commitment]

Creekside, Inc

(Bollinger’s Corp., which signed a

“nominee agreement” to act

as his agent)

Jesse Bollinger’s Construction

Account

Citizens Fidelity Bank

and Trust Co. (Construction

Lender)

Note and Mortgage

Transferred all loan proceeds

Bollinger acted as General Contractor

Bollinger personally guaranteed the note

Armed with take-out

commitment, Creekside, Inc. got CL.

(Bollinger is the sole SH)

Construction Lender Took Out

Perm. L.

(Mass Mutual)

Bollinger v. Commissioner (Supp. p. 82)

Construction Loan

Donald J. Weidner89

Ex Ante: The Nominee Agreement

The day after the corporation (“Creekside”) was formed, Bollinger and the corporation agreed in writing

1. That the corporation– “would hold title . . . as Bollinger’s agent for the sole

purpose of securing financing, and – would convey, assign, or encumber the property and

disburse the proceeds thereof only as directed by Bollinger– had no obligation to maintain the property or to assume

any liability by reason of the execution of promissory notes or otherwise; [and]

2. That Bollinger – would indemnify and hold the corporation harmless from

any liability it might sustain as his agent and nominee.”

Donald J. Weidner90

Ex Post

• Subsequent to this agreement, the corporation– executed “all necessary loan documents including the

promissory note and mortgage” and – transferred the loan proceeds to Bollinger’s individual

construction account.

• Bollinger acted as General Contractor.• On completion of construction, Bollinger, through

the corporation, obtained permanent financing from Mass Mutual in accordance with their “take-out” commitment. – The Mass Mutual funds paid off the Citizens Fidelity

construction loan (“took out” the construction loan).

Donald J. Weidner91

Ex Post (cont’d)• Bollinger hired a resident property manager, who

deposited rent receipts into, and paid expenses from, an operating account that was first opened in the name of Creekside, Inc., but was later changed to “Creekside Apartments, a partnership.”

• The Partners claimed the deductions.• The IRS said “no,” the deductions belong to the

corporation that held title, not to the Partners (who did not).– The Same IRS argument as in Bolger– However: the developer’s documentation is different here

• Instead of a conveyance to the partners there was a nominee agreement saying the corporation was acting as the agent of the partners

Donald J. Weidner92

Ex Post (cont’d)

• 7 other apartment house complexes were constructed the same way. – The basic pattern was the same.– However, for the other seven, a partnership (rather

than Bollinger individually) entered into the agreement with Creekside (the corporation) naming it as the partnership’s agent.

• Consistent with this form, the corporation transferred the construction loan proceeds into a partnership account (rather than into an individual account of Bollinger).

Donald J. Weidner93

Bollinger (cont’d)

• Justice Scalia said: “The corporation had no assets, liabilities, employees, or bank accounts.” (like Bolger)

• “In every case, the lenders regarded the partnership as the owner of the apartments and were aware that the corporation was acting as agent of the partnership in holding record title.”

• The IRS argued: a corporation must have an arm’s-length relationship with its shareholders before it will be recognized as their agent.

• To fit the partners into this rule, the IRS first had to classify them as shareholders.– The IRS argued that all partners were, in substance, shareholders,

even though they were not in form shareholders.– To this end, the IRS deemed the partnership’s payments of

corporate expenses to be contributions to the capital of the corporation.

Donald J. Weidner94

Bollinger (cont’d)• Justice Scalia’s Proposition # 1:

– “For federal income tax purposes, gain or loss from the sale or use of property is attributable to the owner of the property.”

• Justice Scalia’s Proposition # 2:– “The problem we face here is that two different

taxpayers can plausibly be regarded as the owner.”

• Neither the Code nor the regulations provides any guidance.

• However: “It is common ground . . . that if a corporation holds title to property as agent for a partnership, then for tax purposes the partnership and not the corporation is the owner.”

Donald J. Weidner95

Moline and Taxpayer Gaming the System

• IRS argued: the normal incidents of agency “cannot suffice for tax purposes, when, as here, the alleged principals are the controlling shareholders of the alleged agent corporation,” citing Moline Properties.

• Justice Scalia said that Moline “held that a corporation is a separate taxable entity even if it has only one shareholder who exercises total control over its affairs.”

Donald J. Weidner96

Moline and Taxpayer Gaming the System (cont’d)

Justice Scalia said: focus on the evil Moline sought to avoid:

“Obviously, Moline’s separate-entity principle would be significantly compromised if shareholders of closely-held corporations could, by clothing the corporations with some attributes of agency with respect to particular assets, leave themselves free at the end of the tax year to make a claim—perhaps even a good faith claim—of either agent or owner status, depending upon which choice turns out to minimize their tax liability.”--If the evil the rule is intended to prevent is not present, don’t apply the rule.

Donald J. Weidner97

National Carbide Requirement #1National Carbide said: To be a true corporate

agent: “Its business purpose must be the carrying on of the normal duties of an agent.”

IRS argued: the corporation did not have the normal duties of an agent because its only purpose was to be the principal with respect to the Note and Mortgage.

Justice Scalia rejected the IRS position:• The taxpayers represented themselves as

the principals in the project.• The Lenders were the ones who insisted on

the corporation

Donald J. Weidner98

Justice Scalia on the Usury Issue

Justice Scalia added:• Don’t impose “a federal tax sanction” for

any arguable “evasion” of Kentucky usury law.

• There was no “evasion.” This is the way the usury law works.

• In any event, if the Kentucky usury law applies, it treats the borrower as a victim, not as in pari delictu.

Donald J. Weidner99

National Carbide Requirement # 2National Carbide said: To be a true corporate agent: “its

relations with its principal must not be dependent upon the fact that it is owned by the principal, if such is the case.”

IRS argued: There must be an “arm’s-length relationship” that includes the payment of a fee for agency services.

Justice Scalia rejected the IRS position and the second National Carbide requirement:

1. No one knows what National Carbide means.2. At bottom, it is a generalized concern that taxpayers

should not be left free at the end of the year to claim either agent or owner status.

3. We “decline to parse” National Carbide further because it is not “the governing statute.”

4. Agents can “be unpaid family members, friend, or associates.”

Donald J. Weidner100

Bollinger’s Safe Harbor• “[T]he law attributes tax consequences of property

held by a genuine agent to the principal.”• “[T]he genuineness of the agency relationship is

adequately assured, and tax-avoiding manipulation adequately avoided, when1. the fact that the corporation is acting as agent for its

shareholders with respect to a particular asset is set forth in a written agreement at the time the asset is acquired,

2. the corporation functions as agent and not principal with respect to the asset for all purposes, and

3. the corporation is held out as the agent and not principal in all dealings with third parties relating to the asset.”