IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by
the IRS, we inform you that any U.S. federal tax advice contained in this communication
(including any attachments) is not intended or written to be used or relied upon, and
cannot be used or relied upon, for the purpose of (i) avoiding penalties under the Internal
Revenue Code or (ii) promoting, marketing, or recommending to another party any
transaction or matter addressed herein. If you are not the original addressee of this
communication, you should seek advice based on your particular circumstances from an
independent adviser.
I.
EXECUTIVE SUMMARY
If our client forecloses on the property and reduces the amount of the existing first note, it
will probably not recognize any cancellation of debt income under IRC § 61(a)(12). Fulton
Gold held that where a taxpayer takes property subject to a nonrecourse loan (without assuming
any payment obligation), that a reduction of the loan principal will not result in cancellation of
debt income, but will reduce the taxpayer’s basis in the property.
In Rev. Rul. 91-31, the IRS stated its position that when a nonrecouse loan is reduced, the
taxpayer recognizes cancellation of debt income, even if the loan principal is reduced only to the
fair market value of the encumbered property (i.e. there was no accretion of wealth, increase in
equity, or freeing-of-the-assets). In so doing, the Service rejected Fulton Gold and the so called
“freeing-of-the-assets” theory on which it was based.
The ruling, however, does not address a situation, as here, where the taxpayer is not
obligated to make payment on the loan—a key distinction because the taxpayer never obtains the
funds and cannot include the full amount of the liability in its basis. Unfortunately, this
distinction has never been expressly recognized by the courts, the Service or most commentators.
Nevertheless, the Fulton Gold doctrine probably survived Rev. Rul. 91-31—at least where the
taxpayer took possession of the property, but incurred no duty to make payment on the obligation
encumbering the property.
However, even if the Service were to conclude that our client has cancellation of debt
income, an alternative position is that the income is excluded under Section 108. Section 108
excludes what would otherwise be cancellation of debt income in the case of qualified real
property indebtedness which is defined as indebtedness incurred or assumed to acquire real
property used in a trade or business. In the event the income is excluded, the basis in the
property would have to be reduced by the amount of the loan reduction, and any excess would be
immediately recognized.
II.
FACTS
The Property is encumbered by a $11.4 million first deed of trust held by AAA Bank, a
$2.3 million second held by our client, and a $1.5 million third held by the seller. Our client (or
a new entity, “NewCo”) will foreclose and acquire title to the property. After the foreclosure,
AAA Bank has agreed to reduce the principal amount of its first from $11.4 million to $7.4
million. The property will then be refinanced and our client or NewCo will pay AAA Bank $1.5
million and AAA Bank will give a loan for $5.9 million. The $1.5 million payment will be in the
form of a loan from the investors in NewCo. After the loan is restructured, the investors will
contribute their loan to NewCo in exchange for an interest in NewCo. This memorandum
addresses the tax consequences where a taxpayer takes property subject to an existing deed of
trust.
III.
APPLICABLE LAW
Income includes “[i]ncome from discharge of indebtedness.” IRC § 61(a)(12). Where a
new debt instrument is issued in satisfaction of an old debt instrument, the amount of cancelation
of debt (“COD”) income is equal to the difference between the principal amount of the old debt
and the issue price of the new debt instrument. IRC § 108(e)(10).
In Fulton Gold Corp. v. Commissioner, 31 B.T.A. 519 (1934) the taxpayer purchased
property for $600,000 and took the property subject to a mortgage of $450,000. The taxpayer
did not assume the mortgage or any obligation to make payment on the debt. The taxpayer
satisfied the mortgage for the discounted price of $407,853. Years later, the taxpayer sold the
property for $652,166 and reported taxable gain of $46,781—the difference between the
purchase price and the amount realized. The Service argued that the taxpayer had additional gain
on the sale on the grounds that the $600,000 basis was reduced by $42,147—the difference
between the mortgage and the discounted amount paid to satisfy the mortgage.
The Tax Court sided with the Service and held that while the taxpayer did not have COD
income, it had to reduce its basis by the amount of the debt relief. The court distinguished
United States v. Kirby Lumber Co., 284 U.S. 1 (1931), where it was held that a taxpayer who
issued bonds and later repurchased the bonds for less than their issue price recognized ordinary
income. The basis of the distinction was that in Kirby, the taxpayer had a “corresponding
accession to income.” Fulton Gold, 31 B.T.A. at 521. As the court explained:
Here the petitioner, instead of assuming the mortgage, bought the property subject
to it, and by making the purchase on such terms incurred no personal liability for
the debt. Accordingly, payment of the mortgage did not result in the liquidation of
a personal debt. By it the petitioner merely satisfied an encumbrance on property
in which it had an equity and there was no release of assets ‘previously offset by
the obligation‘of the notes or bonds evidencing the debt secured by the mortgage.
Id.
Fulton Gold was followed in Hotel Astoria, Inc. v. Commissioner, 42 B.T.A. 759 (1940).
In Hotel Astoria, the taxpayer purchased property which was subject to delinquent tax liens from
the previous owner. As in Fulton Gold, the taxpayer had no personal obligation to pay the
delinquent taxes. Nevertheless, in order to avoid foreclosure, the taxpayer paid the delinquent
taxes for an amount less than the full amount due. The Tax Court again held that the taxpayer
had no COD income, saying:
In our opinion petitioner did not acquire a taxable gain by the payment of
delinquent taxes in 1935 in bonds of the city of Astoria and the Port of Astoria
which it had acquired for that purpose in 1935 at a large discount. The cost of the
bonds so applied simply represented an additional investment by the petitioner in
the hotel property. It was a capital transaction and is to be treated just as though
the amount paid by the petitioner for the bonds had been paid directly to the tax
collector in settlement of the delinquent real property taxes. Id. at 764.1
The Tax Court distinguished Kirby Lumber on the grounds the taxpayer there was
directly responsible for the debt, whereas the costs of paying the tax lien were “a part of the cost
of acquiring the property.” Id. at 762. As the court explained:
where a solvent debtor is under direct obligation to make payments for physical
property purchased by him or by his assignor, which is still held by him, and
satisfies this obligation by paying less than the amounts called for by the
obligation, the property continuing to be of a value sufficient to pay the
indebtedness, the transaction will result in taxable income to the debtor in the
amount by which the face value of the obligation exceeds the amount paid by him
for its satisfaction. The cases cited by petitioner having to do with similar
transactions, in which the debtor is insolvent or in which the debt involved is a
mere lien on the property sold and not a personal, direct obligation of the
taxpayer, are not pertinent except to give examples of the limitations contained in
our statement of the general rule applicable to the instant case . . . . Id. at 763.
1
While Fulton Gold and Hotel Astoria both reached the same result, they appear to be based on different rationales.
The key factor underlying Fulton Gold was the absence of a “freeing of the assets.: Stated differently, the reduction
in the mortgage did not result in any accretion of wealth to the taxpayer (at least in the short term). Hotel Astoria on
the other hand seems to rest more on the idea that the obligation satisfied was not personal to the taxpayer, and when
it was paid, such payment was a part of the acquisition cost of the property.
In Ernst Kern Co. v. Commissioner, 1 T.C. 249 (1942), the taxpayer acquired property
encumbered with bonds for which the taxpayer assumed no obligation to pay. The taxpayer
issued its own securities worth $1,081,500 in satisfaction of the bonds worth $1,545,000. As in
Hotel Astoria and Fulton Gold, the court held that the taxpayer did not recognize COD income:
Since neither by the terms of the plan of readjustment nor by other facts of record
is petitioner shown to have assumed the payment of the leasehold bonds and
interest thereon, but it merely agreed to issue to the bondholders a specified
amount of its own debentures and stock in lieu of the cancellation of such bonds,
we are unable to say that it realized any gain under the principle of the Kirby case,
supra. When the petitioner issued its debentures and stock to the bondholders in
the amounts agreed upon it discharged its obligation in full and not for any lesser
sum than that obligation. It, therefore, realized no gain. Id. at 266.
Despite early support for these authorities, the Service has since taken the position that
COD income results when the principal amount of a nonrecourse loan is reduced. In Rev. Rul.
82-202, the principal amount of the nonrecourse loan securing the taxpayer’s property was
discounted. At all times, the fair market value of the property exceeded the principal amount of
the loan. Under those facts, the Service ruled that the taxpayer had COD income to the extent of
the reduction in the nonrecourse debt.
Rev. Rul. 82-202 did not mention either Fulton Gold or Hotel Astoria. While the extent
of the ruling is unclear, it has been argued that the ruling is a mere limitation on Fulton Gold and
the accretion of wealth / freeing-of-the-asset theory. As explained by one commentator:
Rev. Rul. 82-202 can be viewed as limiting the Fulton Gold doctrine to the extent
that the reduction of the nonrecourse liability freed up the debtor's assets subject
to the liability. The fact that the FMV of the property exceeded the liability meant
that the reduction in the liability necessarily created equity that, dollar-for-dollar,
inured to the benefit of the debtor. In that light, Rev. Rul. 82-202 is not too
troublesome, and arguably became merely a reasonable restriction on Fulton
Gold. Schmalz, et al, IRS Insists that Reduction or Cancellation of Nonrecourse
Debt Always Results in Ordinary Income, 75 J. Tax’n 68 (1991).
Despite the fairly limited holding in Rev. Rul. 82-202, the Service went dramatically
further in Rev. Rul. 91-31 where it took the position that a solvent debtor always has COD
income on the reduction of a nonrecourse liability, even if there is no freeing of the assets of the
debtor. In Rev. Rul. 91-31, the taxpayer had a $1 million nonrecourse loan securing real
property worth just $800,000. The taxpayer and the lender agreed to reduce the principal amount
of the loan to $800,000. The Service, relying on Commissioner v. Tufts, 461 U.S. 300 (1983)
and Gershkowitz v. Commissioner, 88 T.C. 984 (1987) held that the taxpayer had COD income
even though the taxpayer had no accretion of wealth. The Service expressly stated that it would
not follow Fulton Gold, saying that it was “inconsistent with Tufts and Gershkowitz.”
In Tufts, the taxpayers were partners in a partnership that owned real property having an
adjusted basis of $1.45 million and a value of $1.39 million. The property was subject to a
nonrecourse loan of $1.85 million. The property was sold to a third party, and the taxpayers
claimed a loss of $55,000 representing the difference between the value of the property and its
basis. The Court held that amount realized (under §1001, not §61(a)(12)) is the difference
between the face value of the nonrecourse loan and the adjusted basis of the property. See also,
Crane v. Commissioner, 311 U.S. 1 (1947) (holding that the unpaid balance of a nonrecourse
mortgage is included in the amount realized on the sale of the property).
In Gershkowitz, a $250,000 nonrecourse note was secured with stock having a basis of
$50,000 and a fair market value of $2500. The taxpayer realized that if the lender foreclosed on
the stock, that it would have §1001 capital gain of $200,000 under Tufts. To avoid this
unfortunate result, the lender agreed to satisfy the debt for $40,000. The transaction was an
obvious sham. Why, for example, would anyone pay $40,000 to satisfy a nonrecourse loan
when the secured property has just $2500 in value? The transaction was also a tax shelter in that
the taxpayer used the loan proceeds to increase its basis from which it took “sizable deductions.”
The Tax Court held that the taxpayer had $210,000 of COD income, reasoning that:
This finding is totally in keeping with the spirit and reasoning of Crane. While
not personally liable upon the loan from Jamison, the taxpayers utilized those
funds to increase the basis of their stock, which then permitted them to claim
sizable deductions calculated against that basis. Having substantially reduced the
adjusted basis of their stock in this manner and thereafter surrendering their
devalued stock in exchange for the cancellation of their indebtedness, the
taxpayers clearly realized taxable gain equal to the value of the cancelled
obligation, less the adjusted basis of their surrendered stock. A finding that the
taxpayers did not realize gain as a result of this exchange, after having realized
the full economic benefit of this transaction, would entitle them to the type of
double deductions of which the Supreme Court so clearly disapproved in Crane.
Id. at 1012.
....
We therefore hold that although petitioners transferred cash, rather than the stock
which secured the loan, to Prentice-Hall in exchange for the discharge of the
partnerships' debts, they must recognize gain to the extent that the amount of debt
discharged exceeded the cash transferred. Further, the restrictions of the Kirby
Lumber doctrine are not applicable in the instant case to permit the partnerships to
avoid recognition of the full amount of indebtedness which was discharged. Id. at
1014.
IV.
ANALYSIS
A. Rev. Rul. 91-31 Should Only Apply Where the Taxpayer has Assumed the
Obligation to Pay the Nonrecourse Loan
The fact pattern in Rev. Rul. 91-31 (and Gershkowitz) involved a taxpayer who was
obligated to make payment on the nonrecourse loan. In the proposed transaction, our client (or
NewCo) will not be obligated to make payments on the AAA Bank note, but will rather take the
property subject to that note and deed of trust.
This is significant because unlike the situation in Rev. Rul. 91-31 (and especially in the
case of Gershkowitz), our client has not benefitted economically from receipt of the loan
proceeds. In Gershkowitz, the taxpayers enjoyed both the proceeds from the $250,000 loan, and
also used the loan amount to increase their basis allowing them to take larger deductions. In
contrast, when our client forecloses, its basis will probably be limited to the current fair market
value of the property. Pleasand Summit Land Corp. v. Commissioner, 863 F.2d 263 (3rd Cir.
1988).2 Our client will probably not be able to take depreciation based on the full amount of the
AAA Bank note. 3 Thus, it cannot artificially inflate its depreciation deductions or otherwise
operate as a tax shelter.
Furthermore, our client will never enjoy the proceeds of the AAA Bank loan. Assuming
that the AAA Bank note is reduced to the fair market value of the property, our client will see no
immediate economic benefit. To the extent the loan is reduced below the fair market value, Rev.
Rul. 82-202 would fit nicely into place and treat the excess reduction below market value as
COD income. As in Hotel Astoria, the restructuring of the AAA Bank loan is more akin to the
actual acquisition cost of the property.
In addition, to the extent Rev. Rul. 91-31 cast dispersion on Fulton Gold, it was arguably
on the freeing of the assets theory. The revenue ruling simply did not address the situation where
a taxpayer obtains property subject to a mortgage for which it does not assume any obligation to
pay. Nor did the ruling address Hotel Astoria and its theory that satisfaction of a debt for which
the taxpayer has no obligation to pay is a part of the acquisition cost of the property.
2
It should be noted that the Service might even argue that our clients basis would be limited to just the amount it
spent at the foreclosure sale. Estate of Franklin v. Commissioner, 544 F.2d 1045 (9th Cir. 1976); Bergstrom v.
Commissioner, 37 Fed. Cl. 164 (1996).
3
Obviously, for credibility purposes, our client should not include the full amount of the AAA Bank loan in its basis
or take depreciation based on that basis, if it wants to avoid COD income.
Another reason for distinguishing Rev. Rul. 91-31 is the fact that the current owner of the
property will be taxed on the full amount of the AAA Bank note (as well as on the full amount of
our client’s note and the holder of the third trust deed) under Tufts. Since the current owner is
taxed on the foreclosure, it would seem unfair to effectively double tax the subsequent reduction
of the AAA Bank note.
Perhaps the most troubling authority is Section 108(d)(1) defines indebtedness of the
taxpayer as any indebtedness “for which the taxpayer is liable, or subject to which the taxpayer
holds property.” The italicized language suggests that the Rev. Rul. 91-31 analysis would apply
even if the taxpayer is not directly liable for the debt. Note, however, that Section 108 deals with
exceptions to the COD rule, and therefore does not define what COD income is in the first place.
B. Qualified Real Property Acquisition Indebtedness
The preceding analysis has focused on avoiding COD treatment. But even if the
transaction results in COD under §61(a)(12), that income might well be excluded under §108.
Section 108(a)(1)(D) exempts from gross income discharged “qualified real property business
indebtedness” including “qualified acquisition indebtedness” which is defined as secured
“indebtedness incurred or assumed to acquire, construct, reconstruct, or substantially improve”
“real property used in a trade or business.” IRC § 108(c)(3), (4).4 As will be recalled from
above, Section 108 defines indebtedness of the taxpayer to mean indebtedness “for which the
taxpayer is liable, or subject to which the taxpayer holds property.” § 108(d)(1).
Arguably, the AAA Bank note and deed of trust is indebtedness assumed to acquire the
property.5 Neither the regulations nor the case law address whether the AAA Bank note would
be qualified real property indebtedness, but the statutory language is promising—especially
§108(d)(1) which, as explained above, defines indebtedness to include indebtedness subject to
which the taxpayer holds property. Perhaps the bigger hurdle would be whether the
condominium complex would arise to the level of property used in the taxpayer’s trade or
business. The goal would be to have the activity at the property rise above the mere investment
level. See, Lagreide v. Commissioner, 23 T.C. 508 (1954) (holding that rented residential
property was property used in a trade or business). Selling condominiums may not qualify, but
if the property is converted back into apartment leasing, the Lagreide decision is promising.
Assuming the § 108 exception applies, it is subject to two limitations. First, the taxpayer
(here, the partners in our client’s partnership), would have to reduce the bases of all their
4
If it is possible to have AAA Bank reduce the principal amount of the loan with the current owner, it would solve
all problems because the current owner would almost assuredly meet the § 108 exception. After the modification,
our client could foreclose and take subject to the now reduced AAA Bank loan.
5
In order to exclude the COD income, the taxpayer must make an election on Form 982 which is included with the
taxpayer’s annual return. Treas. Reg. § 1.108-4(b).
depreciable real property. Treas. Reg. § 1.108-6(b). Since the COD income exceeds our clients
basis in the property by $1.7 million, that amount would have to be recognized immediately,
unless the partners have other depreciable real property with remaining basis. Second, if the
AAA Bank debt is restructured so that the new principal is below the fair market value of the
property, the taxpayer would have COD income to that extent. Treas. Reg. § 1.108-6(a).
V.
CONCLUSION
Rev. Rul. 91-31 probably should not apply to the proposed restructuring of the AAA
Bank note because our client (1) never receive the loan proceeds, and (2) will not be able to take
depreciation based on the full amount of the note. Further, under Tufts, the deemed sale price
when our client forecloses will include the full amount of the AAA Bank note, and it seems
questionable whether the same note should form the basis for two separate taxes. However,
even if the restructuring results in COD, a good argument can be made that it is excluded under
§108.