... Estate Tax Shelter. An Investment That Generates Cas

1
INTRODUCTION TO REAL ESTATE TAX
SHELTER(Supplement Pages 49-52)

• Two Different Meanings of Real Estate Tax Shelter
  
• An Investment That Generates Cash that is
  Sheltered from Tax
• An Investment That Generates Tax Losses.

Taxable income or loss can be derived from
Net Cash Flow (NCF). RR Rent Receipts RT
Real Estate Taxes ME Maintenance Expense
(including insurance) P Principal repaid on
debt (amortization) I Interest paid on
debt D Depreciation deduction allowable
2
Example of Tax Shelter in Second
Sense

• 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
• T.I. NCF P D
• 200 8,000 700
• 7,500

3
BASIC TAX RULES OF GAIN OR LOSS ON SALE
4
On Purchase of Land and Building

• Allocate cost between land and building.
• The investment in the land is an investment in a
  non-depreciable assetan asset that does not have
  a limited useful life.
• The building is presumably a wasting asset. 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 is depreciable.

5
On Purchase of Land and Building (contd)

• 3. Determine the applicable cost recovery
  period (formerly known as useful life) for
  the asset being depreciated).
• Code sec. 168(c) says
• 39 years for nonresidential,
• 27.5 years for residential rental.

6
On Purchase of Land and Building (contd)

• 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
  acceleratedbunched up in the beginning of the
  cost recovery period.

7
Nonrecourse Financing and Crane(Text p. 640)

• Text discusses mortgage financing as part of an
  investors depreciable basis in the
  propertyi.e., leveraged depreciation.
• The investors tax basis in acquired property
  normally is his cost, which includes not only his
  investment but any debt incurred to purchase or
  improve the property.
• This includes not only funds borrowed by the
  investor, but any debt to which the property is
  subject at the time of the acquisition.
• The Supreme Court has held that basis includes
  debt on which the investor has no personal
  liability.
• Citing Crane v. Commissioner, 331 U.S. 1 (1947).

8
Crane v. Commissioner331 U.S. 1 (1947)
(discussed in Text at p. 640 and in Mayerson at
Supp. p. 53)

• 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.

9
Crane (Contd)

• 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.

10
AMOUNT REALIZED

• No actual receipt is necessary
• Buyer discharging the sellers indebtedness is
  deemed the equivalent of a payment by buyer to
  the seller

11
Crane (Contd)

• 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.

12
Crane v. Commissioner (contd)

• 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
• 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.

13
Cranes Footnote 37

• As 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.
• Cranes footnote 37 reflected the economic
  benefit theory in a way that gave hope to sellers
  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. 645) put FN. 37 to
  death.

14
Crane v. Commissioner (contd)

• 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.
• Well return to the proper analysis to apply to
  mortgage discharge when we consider the Supreme
  Courts more recent opinion in Tufts.
• First, we consider Mayerson, a major taxpayer
  victory on the ability to include a nonrecourse
  mortgage in basis

15
Mayerson v. Commissioner (Supplement p. 53 and
Text p. 654) Nonrecourse Seller Financing

• Mayerson made a 10,000 downpayment
• Balance paid with a note in the face amount of
  322,500
• Note required no repayment of principal until the
  expiration of 99 years
• Did require monthly interest payments of 1,500
• Interest at 6 after the principal was reduced
  below 300,000
• Note was fully non-recourse as to principal
• Note was with recourse as to the 1,500 monthly
  interest payments as they accrued
• Provided for substantial discounts if retired in
  the next one (275,000) the initial cash asking
  price or three (298,000) years
• Buyers obligations ended if Buyer reconveyed
• In fact, five years later, Mayerson negotiated a
  reduced purchase price of only 200,000

16
MAYERSONARGUMENTS OF IRS

• One is entitled to depreciate ones investment
  in a depreciable interest in property (one is not
  entitled to depreciate ownership).
• ---Mayerson did not invest in a depreciable
  interest in the property by signing this note.
• The note puts nothing at risk and does not
  qualify as an investment.
• The note is too contingent an obligation to
  qualify as an investment
• Ex ante and Ex postlook at the discounts. The
  stated principal was not intended to be paid, as
  confirmed by the ultimate 200,000 taken in
  satisfaction.
• 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 does not bear the risk of
  depreciation.

17
Mayerson (IRS Arguments Contd)

• 2. Alternatively, if Mayerson had a depreciable
  interest in the building, the obligation is too
  contingent to be included in basis.
• 3. The economic substance of Mayersons
  investment was 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 for orchestrating a tax shelter.

18
Mayerson Present Value

• What is the present value of the right to receive
  322,500 at the end of 100 years?
• That 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 depends upon the discount rate
• At 6 interest, compounded monthly, the present
  value of that income stream is 299,245

19
MAYERSON

• The Tax Court agreed with 2 propositions
• It is well accepted that depreciation is not
  predicated upon ownership of property but rather
  upon an investment in property, and that
• the benefit of the depreciation deduction should
  inure to those who suffer an economic loss caused
  by wear and exhaustion of the business property.
• How could the taxpayer possibly win?

20
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 amount realized
  when the property is sold (if the debt has not
  been paid off).

21
More on Mayerson

• Because the Code says that the basis for
  depreciation shall be the same as the basis for
  computing gain or loss on a sale or exchange,
  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.

22
Yet More on Mayerson

• Consider the courts first policy conclusion
• 1. 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?

23
Yet More on Mayerson

• Contrary to the courts statement,
  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
  pays more if he can do it with nonrecourse note).
• See longstanding Section 108(e)(5) (Supp. p. 58)

24
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

25
And Even More on Mayerson

• Consider the courts second policy conclusion
• 2. 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
• The at risk rules change the policy in other
  contexts

26
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
• cash in an investment
• a recourse liability in the investment

27
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

28
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 taxpayers gross income

29
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 is at an interest
  rate significantly lower than the current rate
• The mortgage in Rev. Rul. 82-202 (Supp. p. 68)
  was nonrecourse
• 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 is not available
  unless I am bankrupt or insolvent.

30
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 it 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
  2013.

31
Seller-Provided Financing Not At Risk(Supp.
P. 101)

• 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.

32
BASIC TAX RULES OF GAIN OR LOSS ON SALE (review
prior to Tufts)
33
Commissioner v. Tufts (1983)(Text p. 645)

• 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
  L100 nonrecourse financing.
• 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.
• Partnerships adjusted basis in the property
• 1,850,000 Initial Basis (Cost)
• 395,000 Depreciation
• 1,455,000 Adjusted Basis

34
Tufts (contd)

• Oversimplified somewhat, each partner sold the
  partners 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.

35
Tufts (contd)

• 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 todays parlance, the property was 450,000
  underwater
• Hence the facts present the situation discussed
  in 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.

36
Tufts Taxpayer versus IRS

• TX argues Crane footnote 37 limits the Amount
  Realized on account of the mortgage to the
  propertys FMV
• AR 1,400,000 (Mortgage amount up to FMV)
• AB -1,455,000 (Cost minus Depreciation)
• Loss (55,000)
• Does fn. 37 suggest the AR from the M is zero?
• 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

37
TUFTS THEORIES OF TAX TREATMENT ON RELIEF FROM
THE MORTGAGE

• THEORIES MENTIONED BY JUSTICE BLACKMUN
• Economic Benefit
• Cancellation of Indebtedness
• Co-Investment
• Tax Benefit
• Double Deduction
• Bifurcated Transaction
• Balancing Entry

38
Economic Benefit

• Crane ultimately does not rest on its limited
  theory of economic benefit.
• Crane said she 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 Commissioners decision to
  treat a nonrecourse mortgage in this context as a
  true loan.

39
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
• 35
• Cancellation of indebtedness income theory has
  traditionally focused on the taxpayers 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 Cranes economic benefit theory
  also relies on a freeing of assets theory.

40
Coinvestment Theory

• Basic concept the nonrecourse lender is a
  co-investor with the borrower
• Court 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 mortgagors payments on the debt gradually
  increase his interest in the property while
  decreasing that of the mortgagee. Because the
  taxpayers 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.

41
Tax Benefit

• A 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.

42
Tax Benefit (contd)

• 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)?

43
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.

44
Double Deduction (contd)

• 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 receipts prior inclusion in
  basis.

45
Professor Barnetts Bifurcated Transaction

• I. Liability Transaction
• AR 1,850,000 (cash received for
  a liability the promise to
  repay)
• AB 1,400,000 (FMV of property the
  borrower transferred to satisfy the
  liability)
• Liability Gain 450,000
• II. Asset Transaction
• AR 1,400,000 (Relief from a
  N/R loan, which was worth no more than the
  property pledged to secure it)
• AB 1,455,000 (Cost Depreciation
  AB)
• Assset Loss (55,000)

46
Bifurcated Transaction (contd)

• In the normal purchase and sale of property, the
  buyer knows the buyers basis (cost) at the
  purchase, at the outset.
• The buyer only knows the buyers 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 maker doesnt know his cost until the maker
  pays it off

47
Bifurcated Transaction (contd)

• Barnetts 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 OConnor 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.

48
Bifurcated Transaction (contd)

• Justice OConnor 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

49
Professor Bittkers Balancing Entry versus
Professor Barnetts Bifurcated Transaction

• Bittkers 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
• Recall, this is the amount of depreciation taken
• Barnetts results total Bittkers 395,000
• (sum of 450,000 liability gain and the
  55,000 asset loss)
• Barnett says they should not be totaledthey are
  of a different character
• Bittker says his approach is independent of the
  depreciation deduction.

50
BALANCING ENTRY NO DEPRECIATION EXAMPLE

• 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.
• 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.

51
Balancing Entry No Depreciation Example (contd)

• 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 Taxpayers 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 basisinitial basis/no
  depreciation deductions taken
• ( 60,000)

52
Balancing Entry (contd)

• 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.

53
BIFURCATION OF NO-DEPRECIATION EXAMPLE
LIABILITY 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 AR 40,000 Relief from
liability worth 40,000 AB 100,000 Cost (
60,000) Loss from transaction in asset
54
Bifurcation Rejected by Court

• RECALL
• Bittkers answer was 150,000 Capital Gain
• Barnetts 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
• Barnetts point You can not net them out
  because they are different kinds of income that
  should be taxed differently.
• Tufts rejected Professor Barnetts 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.

55
Court Emphasized Prior Untaxed Receipt

• The Court emphasized what happened ex ante (as
  opposed to economic benefit ex post)
• 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 unwarranted
  increase in the basis of his property.

56
Tufts Much Left Unchanged

• The Tufts opinion leaves intact tax shelter that
  offers both
• Conversion and
• Deferral
• The Tufts opinion leaves intact the use of
  nonrecourse mortgages.
• The Court 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.

57
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 Bittkers Balancing Entry
  approach

58
Tufts Does Not Validate Inflated Purchase Prices

• The Court does not state that a nonrecourse note
  in excess of the value of property may be
  included in basis at the outset.
• That is, it does not validate inflated purchase
  prices (or reverse Leonard Marcus).
• The Court only states how a nonrecourse note that
  was included in basis must be treated when the
  taxpayer ultimately transfers the property.

59
Footnote to Tufts(Supplement pp. 98, 100)

• IRC sec. 7701(g) (Supp. 100)(enacted in 1984)(the
  year after Tufts)
• In 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.
  98)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 to the extent of the value of the
  property, and results in discharge of
  indebtedness income beyond that.

60
Footnote to Tufts (contd)

• 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).

61
Footnote to Tufts (contd)

• Discharge of indebtedness income treatment
  sometimes receives preferential treatment.
• Rev. Rul. 90-16 (Supp. p. 99) takes Example (8)
  one step further and states that the taxpayers
  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.

62
Penultimate Footnote to Tufts

• 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
• The at risk rules leave third-party nonrecourse
  financing intact with respect to commercial real
  estate.
• The passive loss rules, however, dramatically
  restrict real estate tax shelters. Although
  losses may continue to be computed on a basis
  that includes nonrecourse financing, those losses
  may no longer be used to shelter the personal
  service or other investment income of passive
  investors.
• Ordinary income sheltered by depreciation
  deductions is recapturedthe gain is taxed more
  like ordinary income (See next slide).

63
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)
• See I.R.C. section 1(h).

64
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, 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)

65
Casebook Note on Foreclosure(Text p. 913)

• 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.
• PROPERTY ABOVE WATER. If the propertys fair
  market value exceeds the liabilities discharged,
  the amount of liabilities satisfiedwhether the
  liabilities are recourse or nonrecoursewill be
  included in the amount realized.

66
Casebook Note on Foreclosures (contd)

• 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.
• 3. If the liability was recourse a) the
  liability will be included in amount realized to
  the extent of the propertys 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.
• 4. 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 mortgagors other assets, there is no
  cancellation of indebtedness income (instead, the
  mortgage is treated as in Tufts).

67
Casebook Note on Foreclosures (contd)

• The Emergency Economic Stabilization Act of 2008
  amended IRC 108 to provide an exclusion from
  income of up to 2 million of debt forgiveness on
  the taxpayers principal residence.
• Excluding from gross income a discharge of
  qualified principal residence indebtedness
• IRC 108(a)(1)(E)
• Subsequently extended through 2013

68
Bolger v. Commissioner (Supplement p. 69)
Institutional Lender (Notepurchaser)
Pays rentdirectly to MEE
Sell 1,355,500 Notes _at_ 92,508/yr.
Rent in Excess of CPs DS
1M Lease Assignment
1,020/yr.
Deed (in exchange for 1,355,500 sale price)
Kinney Shoe
Financing CP 1,000
Contemporaneous net lease back _at_ 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 _at_ 37,413/yr.
Bolger-SH
Deed
Assumption Agreement
This Net lease is subordinated to the 1M
The notes issued by the Financing Corporation
provided for payment over a period equal to or
less than the base term of the lease.
CPs SHs
69
Some Terms of the Net Lease

• The leases 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 Tenants interest under the lease was
  subordinated to the Mortgage.

70
Subordination of Lease to Mortgage(a first look
at subordination)

• Situation 1.
• FO Lease
• FO Mortgage
• Situation 2.
• FO Mortgage
• FO Lease

71
Terms of the Lease (contd)

• Rent payments were to continue even if the
  building were destroyed
• 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
• Lessors refusal to accept the offer would
  terminate tenants obligations under the lease.

72
Terms of the Lease (contd)

• 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.

73
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
• To compel the corporation to remain in existence.
• To prevent the corporation from engaging in any
  other business.
• To prevent any merger or consolidation of the
  corporation with any other corporation.

74
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 corporations 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.

75
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

76
COURTS DEFINITION OF THE ISSUES

• Was the corporation a separate taxable entity
  before its transfer to Bolger?
• Did the corporation remain a separate taxable
  entity after its transfer to Bolger?
• If the corporation remained a separate taxable
  entity after its transfer to Bolger, is the
  corporation or Bolger entitled to the
  depreciation deduction?
• If a depreciable interest was transferred to
  Bolger, what was his basis in that interest?

77
Is the Write-Off in the Corporation?

• 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.

78
Deductions Locked Up in the Corporation? (contd)

• 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
  principalsthe 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.

79
The Reversionary Interest Argument of the IRS

• IRS 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 leases left possession in the
  tenant (for 40 years, counting renewal terms) and
  
• virtually all of the rent was dedicated to
  service the debt.
• What bundle of sticks did Bolger get?

80
Bolgers Present Interest

• 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.

81
The Measure of Bolgers Basis

• Crane and Mayerson carried the day on whether
  the nonrecourse mortgage could be included in
  Bolgers 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.

82
Bolgers 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, petitioners case
  should not be treated differently merely because
  his acquisition . . . is completely financed and
  because his cash flow is minimal.
• Does not Tufts suggest the same thing?
• 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 method for
  computing depreciation.

83
Other Possibilities in Bolger

• Court seemed to say that the IRS blew 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 corporation to its
  shareholder)

84
Bollinger v. Commissioner(Supp. p. 87)

• 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.

85
Bollinger v. Commissioner (Supp. p. 87)
COMMITMENT TO PROVIDE PERMANENT FINANCING OF
1,075,000 at 8 to Bollingers 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
Permanent Lender (Mass Mutual)
Jesse Bollinger
Armed with take-out commitment, Creekside, Inc.
got CL. (Bollinger is the sole SH)
Note and Mortgage
Creekside, Inc
Citizens Fidelity Bank and Trust Co.
(Construction Lender)
Construction Loan
Bollinger personally guaranteed the note
Transferred all loan proceeds
Perm. L. (Mass Mutual)
Construction Lender
Jesse Bollingers Construction Account
Bollinger acted as General Contractor
Took Out
86
Ex Ante The Nominee Agreement

• The day after the corporation (Creekside) was
  formed, Bollinger and the corporation agreed in
  writing
• That the corporation
• would hold title . . . as Bollingers 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
• That Bollinger
• would indemnify and hold the corporation harmless
  from any liability it might sustain as his agent
  and nominee.

87
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 Bollingers
  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.

88
Ex Post (contd)

• 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
• Note the 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

89
Ex Post (contd)

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

90
Bollinger (contd)

• Justice Scalia said The corporation had no
  assets, liabilities, employees, or bank
  accounts.
• 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 arms
  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 partnerships
  payments of corporate expenses to be
  contributions to the capital of the corporation.

91
Bollinger (contd)

• Justice Scalias 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 Scalias 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.

92
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.

93
Moline and Taxpayer Gaming the System (contd)

• Justice Scalia said focus on the evil Moline
  sought to avoid
• Obviously, Molines 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 claimperhaps even a good faith
  claimof 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, dont apply the rule.

94
National Carbide Requirement 1

• National 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

95
Justice Scalia on the Usury Issue

• Justice Scalia added
• Dont 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.

96
National Carbide Requirement 2

• National 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 arms-length
  relationship that includes the payment of a fee
  for agency services.
• Justice Scalia rejected the IRS position and the
  second National Carbide requirement
• No one knows what National Carbide means.
• 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.
• We decline to parse National Carbide further
  because it is not the governing statute.
• Agents can be unpaid family members, friend, or
  associates.

97
Bollingers Safe Harbor

• The law attributes tax consequences of
  property held by a genuine agent to the
  principal.
• The genuineness of the agency relationship is
  adequately assured, and tax-avoiding manipulation
  adequately avoided, when
• the fact that the corporation is acting as agent
  for its shareholders with respect to a particular
  asset is set forth in a w