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 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
1
Donald J. Weidner
Example of Tax Shelter in Second Sense
Example of tax shelter in second sense
RR
– RT – ME – (P +
I)
= $10,000 – 500 – 400 – (900 + 8,000)
= $200
Caveat: Capital Expenditures
NCF =
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
2
Donald J. Weidner
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.
3
Donald J. Weidner
BASIC TAX RULES OF GAIN OR LOSS ON
SALE OF PROPERTY
MONEY RECEIVED
+ FMV OF PROPERTY RECEIVED
AMOUNT REALIZED
AMOUNT REALIZED
- ADJUSTED BASIS
GAIN
INITIAL BASIS (GENERALLY COST)
- DEPRECIATION ALLOWABLE
+ CAPITAL IMPROVEMENTS (ADDITIONAL COST)
ADJUSTED BASIS (UNRECOVERED COST)
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Donald J. Weidner
On Purchase of Land and Building
1. 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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Donald J. Weidner
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.
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Donald J. Weidner
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 early years
of the cost recovery period.
7
Donald J. Weidner
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).
8
Donald J. Weidner
Crane v. Commissioner
331 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.”
9
Donald J. Weidner
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
10
Donald J. Weidner
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
LENDER
Loan $
BORROWER
(SELLER)
Buyer pays Seller’s $ debt
Sale
11
BUYER
Donald J. Weidner
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.”
However: she had been claiming depreciation deductions.
12
Donald J. Weidner
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.”
13
Donald J. Weidner
Crane’s 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.
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.
14
Donald J. Weidner
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
15
Donald J. Weidner
Mayerson v. Commissioner (Supplement p. 56)
Nonrecourse Seller Financing
a) Mayerson made a $10,000 downpayment
b) Paid balance with a note in the face amount of $322,500
c) Note required no repayment of principal until the
expiration of 99 years
d) 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 principal
f) Note was with recourse as to the $1,500 monthly
“interest” payments as they accrued
g) 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 reconveyed
i) In fact, five years later, Mayerson negotiated a reduced
purchase price of only $200,000
16
Donald J. Weidner
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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Donald J. Weidner
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.
18
Donald J. Weidner
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
19
Donald J. Weidner
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?
20
Donald J. Weidner
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.
– Stated differently, the basis included the amount of the
mortgage and not just the Owner’s equity above 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.”
• The court seems to be saying: 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 and to the extent the debt has not
been “amortized” [paid off] in the interim with
nondeductible dollars).
21
Donald J. Weidner
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)
• If this then, is the general rule, that depreciable basis
includes the amount of the mortgage, the question then
was whether there should be a different rule here, either
because the financing was seller provided or because
the note was nonrecourse.
22
Donald J. Weidner
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.”
– Is it clear that these two situations are
economically the same?
23
Donald J. Weidner
Yet More on Mayerson
• Contrary to the court’s first policy goal, Congress
subsequently declared 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 (for tax purposes) 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)
24
Donald J. Weidner
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
Donald J. Weidner
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 Congress introduced the “at risk” rules to
reverse the policy in other contexts
26
Donald J. Weidner
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
27
Donald J. Weidner
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
Donald J. Weidner
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
29
Donald J. Weidner
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.
30
Donald J. Weidner
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 repeatedly through, now through 2016.
31
Donald J. Weidner
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.”
32
Donald J. Weidner
BASIC TAX RULES OF GAIN OR LOSS
ON SALE (review prior to Tufts)
MONEY RECEIVED
+ FMV OF PROPERTY RECEIVED
AMOUNT REALIZED
AMOUNT REALIZED
- ADJUSTED BASIS
GAIN
INITIAL BASIS (GENERALLY COST)
- DEPRECIATION ALLOWABLE
+ COST OF CAPITAL IMPROVEMENTS
ADJUSTED BASIS (UNRECOVERED COST)
33
Donald J. Weidner
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. These 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
34
Donald J. Weidner
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.
– That is, the Buyer did not undertake any personal
liability with respect to the mortgage.
35
Donald J. Weidner
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.”
36
Donald J. Weidner
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
37
Donald J. Weidner
The Courts Below
•
The Tax Court: held for IRS- partners had to include in
the amount realized the full amount of the nonrecourse
liability.
•
The 5th Circuit: REVERSED and held for taxpayer- the
fair market value of the property securing a nonrecourse
debt limits the extent to which the debt must be included
in the amount realized.
– Note this was clearly not the “right result: a break-even
transaction for economic purposes should be break-even for tax
purposes.
• The question is how do you get there
•
The Supreme Court: REVERSED and held for IRSthe outstanding amount of the nonrecourse obligation
must be included in the amount realized.
38
Donald J. Weidner
TUFTS THEORIES OF TAX TREATMENT ON
“RELIEF” FROM THE MORTGAGE
1)
2)
3)
4)
5)
6)
7)
THEORIES MENTIONED BY JUSTICE
BLACKMUN
Economic Benefit
Cancellation of Indebtedness
Co-Investment
Tax Benefit
Double Deduction
Bifurcated Transaction
Balancing Entry
39
Donald J. Weidner
Economic Benefit
• The taxpayer argued this theory, which Court rejected..
• “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
• Note: 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
• However: Crane “approved the Commissioner’s
decision to treat a nonrecourse mortgage in this context
as a true loan.”
40
Donald J. Weidner
Cancellation of Indebtedness
Assets
$ 100 (cash)
=
Liabilities
$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 taxpayer’s increase in net worth, or equity, as the taxable
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.”
41
Donald J. Weidner
Coinvestment Theory
• Basic concept: the nonrecourse lender is, as an economic
matter, a co-investor with the borrower and should be so
treated (making part of the investment qualifies you for
part of the basis)
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 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.
42
Donald J. Weidner
Tax Benefit Theory
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.”
43
Donald J. Weidner
Tax Benefit Theory (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 the taxpayer does
not report as income because of its
accompanying obligation to repay)?
– Perhaps you don’t see an exclusion because
you don’t see an enhancement in wealth
44
Donald J. Weidner
Double Deduction Theory
•
Millar v. Commissioner, 557 F.2d 212 (3d Cir. 1978),
had held that the principal reason for the Crane
holding was to prevent taxpayers from enjoying a
double deduction.
–The taxpayer here took the position that, after taking
the $395,000 depreciation deduction, it also should be
allowed a $55,000 loss on sale
• despite an economic break-even result
• The IRS argued that this falls within the "double
deduction" concern.
• The Supreme Court took a different approach.
45
Donald J. Weidner
Double Deduction Theory (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.
• Unlike Crane, which focused on the disposition of the
property, Tufts focused on the acquisition and operation
of the property.
46
Donald J. Weidner
Professor Barnett’s Bifurcated Transaction
I. Liability Transaction (starts when you buy, ends on sale)
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 (starts when you buy, ends on sale)
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)
47
Donald J. Weidner
Bifurcated Transaction Theory (cont’d)
• In an asset transaction, the buyer knows
the buyer’s basis (cost) at the purchase,
at the outset.
– The buyer will not know the buyer’s amount
realized until the buyer ultimately sells the
property
• In a liability transaction, the FIRST thing
the maker of the note knows is the amount
realized (the amount you get for your note)
– The note maker doesn’t know the cost (basis)
of the note until the maker pays it off
48
Donald J. Weidner
Bifurcated Transaction Theory (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 the holder of the
nonrecourse note has is to foreclose on the
property mortgaged to secure it’s payment
– 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.”
49
Donald J. Weidner
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
50
Donald J. Weidner
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 sees two transactions and has two results that
happen to total Bittker’s $395,000
(Barnett sees a $450,000 liability gain and a $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.
51
Donald J. Weidner
BALANCING ENTRY: BITTKER’S 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.
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.
52
Donald J. Weidner
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)
53
Donald J. Weidner
Balancing Entry: Bittker’s Example (cont’d)
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.
54
Donald J. Weidner
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 $40,000
AB –100,000 Cost
($ 60,000) Loss from transaction in asset
55
Donald J. Weidner
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.”
56
Donald J. Weidner
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.”
57
Donald J. Weidner
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.”
58
Donald J. Weidner
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
59
Donald J. Weidner
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.
60
Donald J. Weidner
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.
61
Donald J. Weidner
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).
62
Donald J. Weidner
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.
63
Donald J. Weidner
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 use 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.
64
Donald J. Weidner
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 or limited liability company
losses to offset or shelter, either their 1.
earned income; or 2. other portfolio income.
65
Donald J. Weidner
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.
66
Donald J. Weidner
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).
67
Donald J. Weidner
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 highincome individuals
68
Donald J. Weidner
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.
69
Donald J. Weidner
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).
70
Donald J. Weidner
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
71
Donald J. Weidner
Bolger v. Commissioner (Supplement p. 69)
• Study the facts of this paradigmatic case involving saleleaseback financing.
• The facts of this transaction pull together much of what
we have done in the course to date.
• The issue as presented to the Tax Court was: who has
the depreciable interest in the building, the Financing
Corporation or its shareholders to whom it transferred its
title to the building.
72
Donald J. Weidner
Bolger v. Commissioner (Supplement p. 69)
Institutional “Lender”
(Notepurchaser)
Pays
“rent”directly to
MEE
Kinney gives Deed for $1,355,500 “sale price”
Financing CP
SHs of CP
$1,000
Bolger-SH
* Financing Cp. gives net lease back to Kinney
for rent @ $93,528/yr. for 25-year base term
**Tenant Kinney has right to make a “rejectable
offer to purchase” if building is destroyed (at cost
of prepaying the notes)
***Tenant Kinney has right to three, 5-year
renewal terms with rent @ $37,413/yr.
This Net lease is subordinated to the 1M
Kinney Shoe
The notes issued by the Financing Corporation provided for payment over a
period equal to or less than the base term of the lease.
73
Donald J. Weidner
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.
74
Donald J. Weidner
Subordination of Lease to Mortgage
(a first look at subordination)
Situation 1.
FO
FO
Lease
Situation 2.
FO
FO
Mortgage
Mortgage
Lease
75
Donald J. Weidner
Terms of the Lease (cont’d)
• Rent payments from Kinney 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.
76
Donald J. Weidner
Terms of the Lease (cont’d)
• Tenant Kinney 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.
77
Donald J. Weidner
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.
78
Donald J. Weidner
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.
79
Donald J. Weidner
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
80
Donald J. Weidner
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?
81
Donald J. Weidner
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.
82
Donald J. Weidner
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
83
Donald J. Weidner
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).
84
Donald J. Weidner
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.
85
Donald J. Weidner
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.
86
Donald J. Weidner
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
an owner of commercial property may use to compute
depreciation.
87
Donald J. Weidner
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 and the other shareholders
--(by purchase or by the receipt of a distribution of
property by a shareholder from its corporation)
88
Donald J. Weidner
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.”
89
Donald J. Weidner
Bollinger v. Commissioner (Supp. p. 82)
COMMITMENT TO PROVIDE PERMANENT FINANCING OF
Permanent Lender agrees to loan $1,075,000 at 8% to Bollinger’s
Jesse Bollinger corporate nominee [Ky. usury law limited to 7% the interest on loans to
non-corporate borrowers], but only if Bollinger personally guaranteed
repayment
Permanent
Lender
(Mass
Mutual)
[Take-out commitment]
Armed with
Creekside, Inc
take-out
commitment, (Bollinger’s Corp.,
which signed a
Creekside,
“nominee
Inc. got CL.
agreement” to act
(Bollinger is
as Bollinger’s
the sole SH)
agent)
Transferred all
loan proceeds
Note and
Mortgage
Construction Loan
Citizens
Fidelity Bank
and Trust Co.
(Construction
Lender)
Bollinger personally
guaranteed the note
Jesse Bollinger’s
Construction
Account
Bollinger
acted as
General
Contractor
90
Construction
Took Out
Lender
Perm. L.
(Mass
Mutual)
Donald J. Weidner
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.”
91
Donald J. Weidner
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 “takeout” commitment.
– The Mass Mutual funds paid off the Citizens Fidelity
construction loan (“took out” the construction loan).
92
Donald J. Weidner
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
93
Donald J. Weidner
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).
94
Donald J. Weidner
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.
95
Donald J. Weidner
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.”
96
Donald J. Weidner
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 rejected the IRS reading of Moline.
–He 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.”
97
Donald J. Weidner
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.
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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 and allowed the
corporation to be treated as an agent:
•
The taxpayers represented themselves as the
principals in the project, not the corporation.
•
The taxpayers had the corporation imposed upon
them by the Lenders.
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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.
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Donald J. Weidner
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 “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.”
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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, when
1. 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.”
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Donald J. Weidner