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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).

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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

Donald J. Weidner


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

Donald J. Weidner

basic tax rules of gain or loss on sale












Donald J. Weidner

on purchase of land and building
On Purchase of Land and Building
  • 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.
  • 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 is depreciable.

Donald J. Weidner

on purchase of land and building cont d
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).

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

Donald J. Weidner

on purchase of land and building cont d1
On Purchase of Land and Building (cont’d)

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

  • Code sec. 168(b)(3) says the “straight line” method is the only method that may be used to compute depreciation deductions on either nonresidential property or residential rental property.
    • The depreciation deduction will be the same every year of the cost recovery period
      • That is, the deductions may not be “accelerated”—bunched up in the beginning of the cost recovery period.

Donald J. Weidner

nonrecourse financing and crane text p 640
Nonrecourse Financing and Crane(Text p. 640)
  • Text discusses “mortgage financing as part of an investor’s depreciable basis in the property—i.e., ‘leveraged depreciation.’”
  • “The investor’s 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).

Donald J. Weidner

crane v commissioner 331 u s 1 1947 discussed in text at p 640 and in mayerson at supp p 52
Crane v. Commissioner331 U.S. 1 (1947) (discussed in Text at p. 640 and inMayersonat Supp. p. 52)

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.”

Donald J. Weidner

crane cont d
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.

Donald J. Weidner

amount realized


Buyer pays Seller’s $ debt

Loan $





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

Donald J. Weidner

crane cont d1
Crane (Cont’d)
  • Ms. Crane said it was not the same as if she had been paid the amount of the mortgage balance:

(1) she was not personally liable on the mortgage

(2) nor did her buyer become personally liable.

  • She had inherited the property 7 years earlier, when the mortgage encumbering it was already in default.
  • She entered into an agreement that gave the mortgagee all the net cash flow
    • Even so, no principal was paid and the interest in arrears doubled.
  • The transaction was, she said, “by all dictates of common sense, a ruinous disaster.”

Note: she had been claiming depreciation deductions.

Donald J. Weidner

crane v commissioner cont d
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

“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.”

Donald J. Weidner

crane s footnote 37
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.

Crane’s footnote # 37 reflected the economic benefit theory in a way that 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. 645) put FN. 37 to death.

Donald J. Weidner

crane v commissioner cont d1
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

Donald J. Weidner

mayerson v commissioner supplement p 52 and text p 654 nonrecourse seller financing
Mayerson v. Commissioner(Supplement p. 52 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
  • Buyer’s obligations ended if Buyer reconveyed
  • In fact, five years later, Mayerson negotiated a reduced purchase price of only $200,000

Donald J. Weidner

mayerson 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).

The note does not qualify as an investment because

a. It puts nothing at risk; and

b. It is too contingent an obligation.

  • Ex ante and Ex post—look at the discounts. The stated principal was not 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.

Donald J. Weidner

mayerson irs arguments cont d
Mayerson (IRS Arguments Cont’d)

2. Alternatively, if Mayerson did acquire a depreciable interest in the building, the not is too contingent to be included in his basis.

--His basis 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 for orchestrating a tax shelter.

Donald J. Weidner

mayerson present value
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

Donald J. Weidner


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?

Donald J. Weidner

more on mayerson
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).

Donald J. Weidner

more on mayerson1
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.”

Donald J. Weidner

yet more on mayerson
Yet More on Mayerson
  • Consider the court’s first policy conclusion:
  • Equate seller financing with third party financing.
    • “[A] purchase money debt obligation for part of the price will be included in basis. This is necessary in order to equate a purchase money mortgage situation with the situation in which the buyer borrows the full amount of the purchase price from the third party and pays the seller in cash. It is clear that the depreciable basis should be the same in both instances.”
    • Are these two situations economically the same?

Donald J. Weidner

yet more on mayerson1
Yet More on Mayerson
  • Contrary to the court’s statement under point #1, 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. 64)

Donald J. Weidner

yet more on mayerson2
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

Donald J. Weidner

and even more on mayerson
And Even More on Mayerson
  • Consider the court’s second policy conclusion:

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
    • The “at risk” rules discontinue the policy in other contexts

Donald J. Weidner

at risk
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

Donald J. Weidner

and even more on mayerson1
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

Donald J. Weidner

seller provided financing purchase price reduction
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

Donald J. Weidner

notes following mayerson
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. 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 is not available unless I am bankrupt or insolvent.

Donald J. Weidner

tax relief on mortgage discharge in the wake of the financial crisis
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 . . . notdirectly 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.

Donald J. Weidner

seller provided financing not at risk supp p 92
Seller-Provided Financing: Not “At Risk”(Supp. P. 92)
  • 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.”

Donald J. Weidner

basic tax rules of gain or loss on sale review prior to tufts












Donald J. Weidner

commissioner v tufts 1983 text p 645
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 & L—100% nonrecourse financing from a third party lender.

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

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

Partnership’s adjusted basis in the property:

$ 1,850,000 Initial Basis (Cost)

  • 395,000 Depreciation

$ 1,455,000 Adjusted Basis

Donald J. Weidner

tufts cont d
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.

Donald J. Weidner

tufts cont d1
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.”

Donald J. Weidner

tufts taxpayer versus irs
Tufts: Taxpayer versus IRS

TX argues: Crane footnote 37 limits the Amount Realizedon 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

Donald J. Weidner

tufts theories of tax treatment on relief from the mortgage


  • Economic Benefit
  • Cancellation of Indebtedness
  • Co-Investment
  • Tax Benefit
  • Double Deduction
  • Bifurcated Transaction
  • Balancing Entry

Donald J. Weidner

economic benefit
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 Commissioner’s decision to treat a nonrecourse mortgage in this context as a true loan.”

Donald J. Weidner

cancellation of indebtedness
Cancellation of Indebtedness

Assets = Liabilities

$ 100 (cash) $80




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

Assets = Liabilities

$ 35 (cash) $ 0




Cancellation of indebtedness income theory has traditionally focused on the taxpayer’s increase in net worth, or equity, as the enhancement in wealth (income) ($15 in this example).

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

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

Donald J. Weidner

coinvestment theory
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 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.

Donald J. Weidner

tax benefit
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.”

Donald J. Weidner

tax benefit cont d
Tax Benefit (cont’d)
  • See footnote 8: “Our analysis . . . focuses on the obligation to repay and its subsequent extinguishment, not on the taking and recovery of deductions.”
  • Question: Is not an exclusion a tax benefit that is similar to a deduction?
  • That is, if you are not focusing on the tax benefit of the depreciation deduction, are you focusing on the prior untaxed receipt of the purchase money loan proceeds (which is not included because of its accompanying obligation to repay)?

Donald J. Weidner

double deduction
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].

Donald J. Weidner

double deduction cont d
Double Deduction (cont’d)
  • The Supreme Court said its analysis applies even if no deductions are taken.
    • “Unless the outstanding amount of the mortgage is deemed to be realized, the mortgagor effectively [1] will have received untaxed income at the time the loan was extendedand [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.

Donald J. Weidner

professor barnett s bifurcated transaction
Professor Barnett’s Bifurcated Transaction

I. Liability Transaction

AR $ 1,850,000 (cash received for a note--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)

Asset Loss $ (55,000)

Donald J. Weidner

bifurcated transaction cont d
Bifurcated Transaction (cont’d)
  • In the normal purchase and sale of property, the buyer knows the buyer’s basis (cost) at the purchase, at the outset.
    • The buyer only knows the buyer’s amount realized when the buyer ultimately sells the property
  • In a liability transaction, the FIRST thing you know is the amount realized (the amount you get for your note)
    • The maker doesn’t know the cost of the note until the maker pays it off

Donald J. Weidner

bifurcated transaction cont d1
Bifurcated Transaction (cont’d)
  • Barnett’s conception of the Amount Realized on the asset side of the transaction:
    • The Amount Realized on the transfer of the property was $1.4 million because the only consideration the seller received on the transfer was the cancellation of its nonrecourse liability worth only $1.4 million [the value of the property that secured its payment]
      • Remember, the only remedy on the nonrecourse note is a foreclosure on the property mortgaged to secure it
        • With no deficiency judgment possible
  • As Justice O’Connor put it: “The benefit received by the taxpayer in return for the property is worth no more than the fair market value of the property, for that is all the mortgagee can expect to collect for the [nonrecourse] mortgage.”

Donald J. Weidner

bifurcated transaction cont d2
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

Donald J. Weidner

professor bittker s balancing entry versus professor barnett s bifurcated transaction
Professor Bittker’s Balancing Entry versus Professor Barnett’s Bifurcated Transaction
  • Bittker’s result is the same result urged by the IRS: The unamortized amount of the mortgage is included in Amount Realized
    • resulting in a gain of $ 395,000
    • An amount equal to the amount of depreciation taken
  • Barnett’s results total Bittker’s $395,000

(sum of $450,000 liability gain and the $55,000 asset loss)

  • Barnett says they should not be totaled—they are of a different character
  • Bittker says his approach is independent of the depreciation deduction.
    • The Court says the same thing about its approach.

Donald J. Weidner



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.

Donald J. Weidner

balancing entry bittker s no depreciation example cont d
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)

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.

Donald J. Weidner




$ 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


AR $ 40,000 Relief from liability worth $40,000

AB –100,000 Cost

($ 60,000) Loss from transaction in asset

Donald J. Weidner

court rejects bittker s bifurcation
Court Rejects Bittker’s Bifurcation


  • 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.”

Donald J. Weidner

court emphasized prior untaxed receipt
Court Emphasized Prior Untaxed Receipt
  • The Court emphasized what happened ex ante (as opposed to economic benefit ex post):
    • “[T]he original inclusion of the amount of the mortgage in basis rested on the assumption that the mortgagor incurred an obligation to repay. Moreover, this treatment balances the fact that the mortgagor originally received the proceeds of the nonrecourse loan tax-free on the same assumption.Unless the outstanding amount of the mortgage is deemed to be realized, the mortgagor effectively will have received untaxed income at the time the loan was extended and unwarranted increase in the basis of his property.”

Donald J. Weidner

tufts much left unchanged
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.”

Donald J. Weidner

tufts requires symmetry
Tufts: Requires Symmetry
  • “We . . . hold that a taxpayer must account for the proceeds of obligations he has received tax-free and included in basis. Nothing . . . requires the Commissioner to permit a taxpayer to treat a sale of encumbered property asymmetrically, by including the proceeds of the nonrecourse obligation in basis but not accounting for the proceeds upon transfer of the property.”
  • This sounds like Bittker’s Balancing Entry approach

Donald J. Weidner

tufts does not validate inflated purchase prices
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.
    • Nonrecourse notes inflated past value have never been included in basis (recall 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.
  • Note: the Passive Law Rules, introduced in 1986, deny most investors the right to use real estate partnership losses against their earned income or other portfolio income.

Donald J. Weidner

footnote to tufts supplement pp 91 89
Footnote to Tufts(Supplement pp. 91, 89)
  • IRC sec. 7701(g) (Supp. 91)(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. 89)deals with a transfer of property to a creditor in which the creditor discharges a recourse note in excess of the value of property. It states that the note is included in Amount Realized only to the extent of the value of the property, and results in discharge of indebtedness income beyond that.

Donald J. Weidner

footnote to tufts cont d
Footnote to Tufts (cont’d)
  • Example 8 provides for the case of an underwater recourse note:
    • In 1980, F transfers to a creditor an asset with a fair market value of $6,000 and the creditor discharges $7,500 of indebtedness for which F is personally liable. The amount realized on the disposition of the asset is its fair market value ($6,000). In addition, F has income from the discharge of indebtedness of $1,500 ($7,500 - $6,000).

Donald J. Weidner

footnote to tufts cont d1
Footnote to Tufts (cont’d)
  • Discharge of indebtedness income treatment sometimes receives preferential treatment.
  • Rev. Rul. 90-16 (Supp. p. 90) takes Example (8) one step further and states that the taxpayer’s discharge of indebtedness income is excluded from gross income when the taxpayer is insolvent
    • and the discharge of indebtedness income does not exceed the amount by which the taxpayer is insolvent.

Donald J. Weidner

penultimate footnote to tufts
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, passive investors may no longer use those losses to shelter their personal service income or other investment income.
    • Ordinary income sheltered by depreciation deductions is “recaptured”—the gain is taxed more like ordinary income (See next slide).

Donald J. Weidner

final footnote to tufts
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 depreciationdeductions 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).

Donald J. Weidner

2013 tax update
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 ACA, there is a new “Medicare Tax” on individuals with an adjusted gross income over $200,000--a “Net Investment Income Tax” of 3.8% on net income from stocks, bonds, investment real estate (including second homes)
  • In short, 23.8% is the new LTCG rate for high-income individuals

Donald J. Weidner

casebook note on foreclosure text p 913
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 property’s fair market value exceeds the liabilities discharged, the amount of liabilities satisfied—whether the liabilities are recourse or nonrecourse—will be included in the amount realized.

Donald J. Weidner

casebook note on foreclosures cont d
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.

3. 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.

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 mortgagor’s other assets, there is no cancellation of indebtedness income (instead, the mortgage is treated as in Tufts).

Donald J. Weidner

casebook note on foreclosures cont d1
Casebook Note on Foreclosures (cont’d)
  • 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 taxpayer’s principal residence.
    • Excluding from gross income a discharge of “qualified principal residence indebtedness”
      • IRC 108(a)(1)(E)
    • Subsequently extended through 2013

Donald J. Weidner


Bolger v. Commissioner (Supplement p. 65)

Institutional “Lender”


Pays “rent”directly to MEE

Sell $1,355,500 Notes

[@ $92,508/yr.]

Rent in Excess of CP’s DS

1M + Lease Assignment


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

Kinney Shoe

Financing CP


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





This Net lease is subordinated to the 1M

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



Donald J. Weidner

some terms of the net lease
Some Terms of the Net Lease
  • The lease’s base term was equal to or longer than the term of the notes.
  • The rent on the lease was only nominally higher than the debt service on the notes.
  • The rent was “net” to the landlord. That means that the Tenant paid all:
    • taxes
    • insurance
    • repairs and
    • all Lessor acquisition costs above the purchase price.
  • The Tenant’s interest under the lease was subordinated to the Mortgage.

Donald J. Weidner

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

Situation 1.

FO Lease

FO Mortgage

Situation 2.

FO Mortgage

FO Lease

Donald J. Weidner

terms of the lease cont d
Terms of the Lease (cont’d)
  • Rent payments were to continue even if the building were destroyed; however
    • In the event of building destruction, Lessee could offer to purchasefor a price that approximated the cost of prepaying the note.
      • That is, the lessee had the right to make a “rejectable offer to purchase”
    • Lessor’s refusal to accept the offer would terminate [tenant’s obligations under] the lease.

Donald J. Weidner

terms of the lease cont d1
Terms of the Lease (cont’d)
  • The Lessee was permitted to sublet or assign its interest under the lease, provided
    • The sublessee or assignee promised to comply with the terms of the mortgage and lease, and
    • The Lessee remained personally liable for all its obligations under the Lease.

Donald J. Weidner

the mortgage anticipated the financing corporation would transfer title
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.

Donald J. Weidner

the financing corporation a k a special purpose entity or special purpose vehicle
THE FINANCING CORPORATION (a.k.a. “Special Purpose Entity” or “Special Purpose Vehicle”)
  • In each case, a corporation was formed with nominal capital.
  • The corporation “purchased” the building.
  • The corporation’s shareholders were the individuals to whom the corporation would convey title for a nominal consideration.
  • The corporation promised to maintain its existence
  • The corporation promised to refrain from any other activity.

Donald J. Weidner

purposes of the special purpose entity
Purposes of the Special Purpose Entity

Court said the purposes of the corporation were to:

1. Facilitate multiple lender financing

2. Avoid usury limits on loans to individuals

3. Provide nonrecourse financing to Bolger and the other transferees

Donald J. Weidner

court s 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 thatinterest?

Donald J. Weidner

is the write off in the corporation
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 activityor
      • a business purpose that is the equivalent of business activity.

Donald J. Weidner

deductions locked up in the corporation cont d
Deductions Locked Up in the Corporation? (cont’d)
  • 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.”

Donald J. Weidner

the reversionary interest argument of the irs
The “Reversionary Interest” Argument of the IRS
  • IRS also argued that Bolger got only a “reversionary interest” in the buildings, that is, a future interest not sufficiently possessory to support a claim to depreciation deductions.
  • It emphasized that:
    • the long-term lease left possession in the tenant for 40 years (counting renewal options) and
    • With zero cash flow (virtually all of the rent was dedicated to service the debt).

Donald J. Weidner

bolger s present interest
Bolger’s Present Interest
  • What “bundle of sticks” did Bolger get?
  • Court said Bolger has the economic benefits from:
    • a) amortization and
    • b) appreciation,
  • which are reachable by
    • a) refinancing or
    • b) sale.
  • Further, Bolger has a tax burden:
    • the rents are includable in income even though they are applied to service the debt.

Donald J. Weidner

the measure of bolger s basis
The Measure of Bolger’s Basis
  • Crane and Mayerson carried the day on whether the nonrecourse mortgage could be included in Bolger’s basis.
  • In Mayerson, “we were not deterred by the fact that the taxpayer made only a nominal cash investment.”
  • The effect of Crane is to give an advance credit in the amount of the mortgage because it can be assumed that a capital investment in that amount will eventually occur.
    • Does that assumption appear to be warranted in Bolger?
    • IRS said no:
      • Net Cash Flow is minimal and
      • the property is fully encumbered.

Donald J. Weidner

bolger s bitter pill crane plus accelerated methods of computing depreciation
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 for computing depreciation.

Donald J. Weidner

other possibilities in bolger
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 shareholder from its corporation)

Donald J. Weidner

bollinger v commissioner supp p 78
Bollinger v. Commissioner(Supp. p. 78)
  • Kentucky usury law limited to 7% the annual interest rate on loans to non-corporate borrowers.
    • “Lenders willing to provide money only at higher interest rates required the nominal debtor and record title holder of the mortgaged property to be a corporate nominee of the true owner and borrower.”

Donald J. Weidner


Bollinger v. Commissioner (Supp. p. 78)


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

[Take-out commitment]

Permanent Lender

(Mass Mutual)

Jesse Bollinger

Armed with take-out commitment, Creekside, Inc. got CL.

(Bollinger is the sole SH)

Creekside, Inc

(Bollinger’s Corp., which signed a “nominee agreement” to act as his agent)

Note and Mortgage

Citizens Fidelity Bank

and Trust Co. (Construction Lender)

Construction Loan

Transferred all loan proceeds

Bollinger personally guaranteed the note

Perm. L.

(Mass Mutual)

Construction Lender

Jesse Bollinger’s Construction Account

Bollinger acted as General Contractor

Took Out

Donald J. Weidner

ex ante the nominee agreement
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 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;
  • That Bollinger
    • would indemnify and hold the corporation harmless from any liability it might sustain as his agent and nominee.”

Donald J. Weidner

ex post
Ex Post
  • Subsequent to this agreement, the corporation
    • executed “all necessary loan documents including the promissory note and mortgage” and
    • transferred the loan proceeds to Bollinger’s individual construction account.
  • Bollinger acted as General Contractor.
  • On completion of construction, Bollinger, through the corporation, obtained permanent financing from Mass Mutual in accordance with their “take-out” commitment.
    • The Mass Mutual funds paid off the Citizens Fidelity construction loan (“took out” the construction loan).

Donald J. Weidner

ex post cont d
Ex Post (cont’d)
  • Bollinger hired a resident property manager, who deposited rent receipts into, and paid expenses from, an operating account that was first opened in the name of Creekside, Inc., but was later changed to “Creekside Apartments, a partnership.”
  • The Partners claimed the deductions.
  • The IRS said “no,” the deductions belong to the corporation that held title, not to the Partners (who did not).
    • The Same IRS argument as in Bolger
    • However: the developer’s documentation is different here
      • Instead of a conveyance to the partners there was a nominee agreement saying the corporation was acting as the agent of the partners

Donald J. Weidner

ex post cont d1
Ex Post (cont’d)
  • 7 other apartment house complexes were constructed the same way.
    • The basic pattern was the same.
    • However, for the other seven, a partnership (rather than Bollinger individually) entered into the agreement with Creekside (the corporation) naming it as the partnership’s agent.
      • Consistent with this form, the corporation transferred the construction loan proceeds into a partnership account (rather than into an individual account of Bollinger).

Donald J. Weidner

bollinger cont d
Bollinger (cont’d)
  • Justice Scalia said: “The corporation had no assets, liabilities, employees, or bank accounts.” (sound familiar?)
  • “In every case, the lenders regarded the partnership as the owner of the apartments and were aware that the corporation was acting as agent of the partnership in holding record title.”
  • The IRS argued: a corporation must have an arm’s-length relationship with its shareholders before it will be recognized as their agent.
  • To fit the partners into this rule, the IRS first had to classify them as shareholders.
    • The IRS argued that all partners were, in substance, shareholders, even though they were not in form shareholders.
    • To this end, the IRS deemed the partnership’s payments of corporate expenses to be contributions to the capital of the corporation.

Donald J. Weidner

bollinger cont d1
Bollinger (cont’d)
  • Justice Scalia’s Proposition # 1:
    • “For federal income tax purposes, gain or loss from the sale or use of property is attributable to the owner of the property.”
  • Justice Scalia’s Proposition # 2:
    • “The problem we face here is that two different taxpayers can plausibly be regarded as the owner.”
  • Neither the Code nor the regulations provides any guidance.
  • However: “It is common ground . . . that if a corporation holds title to property as agent for a partnership, then for tax purposes the partnership and not the corporation is the owner.”

Donald J. Weidner

moline and taxpayer gaming the system
Moline and Taxpayer Gaming the System
  • IRS argued: the normal incidents of agency “cannot suffice for tax purposes, when, as here, the alleged principals are the controlling shareholders of the alleged agent corporation,” citing Moline Properties.
  • Justice Scalia said that Moline “held that a corporation is a separate taxable entity even if it has only one shareholder who exercises total control over its affairs.”

Donald J. Weidner

moline and taxpayer gaming the system cont d
Moline and Taxpayer Gaming the System (cont’d)

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

“Obviously, Moline’s separate-entity principle would be significantly compromised if shareholders of closely-held corporations could, by clothing the corporations with some attributes of agency with respect to particular assets, leave themselves free at the end of the tax year to make a claim—perhaps even a good faith claim—of either agent or owner status, depending upon which choice turns out to minimize their tax liability.”

--If the evil the rule is intended to prevent is not present, don’t apply the rule.

Donald J. Weidner

national carbide requirement 1
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

Donald J. Weidner

justice scalia on the usury issue
Justice Scalia on the Usury Issue

Justice Scalia added:

  • Don’t impose “a federal tax sanction” for any arguable “evasion” of Kentucky usury law.
  • There was no “evasion.” This is the way the usury law works.
  • In any event, if the Kentucky usury law applies, it treats the borrower as a victim, not as in pari delictu.

Donald J. Weidner

national carbide requirement 2
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:

  • 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.”

Donald J. Weidner

bollinger s safe harbor
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
    • 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,
    • the corporationfunctions as agent and not principal with respect to the asset for all purposes, and
    • the corporation is held out as the agent and not principal in all dealings with third partiesrelating to the asset.”

Donald J. Weidner






Limited Partnership


Agreed to sell

Deed (in escrow, not recorded)

Nonrecourse promise to pay “sales price” of $1,224,000 over 10 years, 7.5% interest on unpaid balance

$9,045 Debt Service (mostly interest) monthly for 10 years

$75,000 prepayment of interest (only cash paid to Seller)

$975,000 balloon in 10 years (less any mortgages the seller had on property when balloon due)

Limited Partnership Leased back to Romneys

Romneys to pay $9,045 monthly net rent for 10 years

Romneys permitted to place additional mortgages on the property without LPP’s consent

Romneys have right to propose new capital improvement. However,

Condemnation Award to go to LPP

Donald J. Weidner

estate of franklin further facts
Estate of Franklin: Further Facts
  • The Romneys bought the motel and quickly “flipped” it by selling it to the LPP.
    • Shortly before the sale to the LPP, the Romneys purchased the motel, plus additional property, for 30% less than the price it charged the LPP for the motel alone.
  • The eight limited partners were all doctors and dentists.
  • Of the money contributed by the limited partners:
    • Half went to the General Partner for services, and
    • The other half went for the “prepayment of interest” to the Romneys
      • Hence, none of the money paid by the LPs went into the property
  • The LPP’s Sole Corporate General Partner never sent an appraiser to the property.
  • The LPP did not assume any personal liability either a) on the underlying mortgages or b) to the Seller.

Donald J. Weidner

estate of franklin the irs position
Estate of Franklin: The IRS Position
  • IRS said that either
    • The acquisition by the LPP was a sham (by which I think they meant that the “sale” suggested by the documents did not take place—in substance, the LPP did not purchase the property); or
    • The LPP acquired only of an option to purchase.

Donald J. Weidner

estate of franklin tax court
Estate of Franklin --Tax Court
  • Tax Court held that, in substance, the Romneys sold an option to the LPP, they did not sell the property to the LPP, emphasizing:
    • The LPP had the power, at the end of 10 years, to walk away from the transaction, losing only its $75,000 “interest prepayment”
      • the monthly debt service payments and the payments on the lease back cancelled each other out.
    • The deed to the LPP was never recorded.
    • The sellers retained the “benefits and burdens of ownership” (the “bundle of sticks”).

Donald J. Weidner

estate of franklin benefits and burdens
Estate of Franklin –Benefits and Burdens
  • The Tax Court said the sellers retained (did not transfer) the benefits and burdens of ownership:
    • The purchase money obligation was nonrecourse (the “buyers” undertook no burden)
    • No cash passed [apart from the $75,000 “prepaid interest”].
      • The rental and purchase money payments cancelled each other out
    • The sellers remained in possession.
    • The sellers remained responsible on the mortgages, which they were entitled to increase.
    • The sellers were entitled to make capital improvements.

Donald J. Weidner

estate of franklin 9 th circuit
Estate of Franklin--9th Circuit
  • 9th Circuit had a “different emphasis” than the burdens and benefits analysis.
  • 9th Circuit said:
    • Not all benefits and burdens remained with the seller, noting that any Condemnation Award went to the limited partnership
  • The missing element was evidence that the purchase price was at fair market value.
  • 9th Circuit said: if the limited partnership acted in a good faith beliefthat the selling price approximated the fair market value, that [a] negated “sham” but it [b] failed to “supply substance.”
    • Subjective good faith does not get the taxpayer very far.
    • The taxpayer must show that there was “Objective economic substance” even if the transaction was not intended to be a sham.

Donald J. Weidner

estate of franklin cont d
Estate of Franklin (cont’d)

Ninth Circuit said there can be genuine indebtedness even though:

  • The Buyer has the power to walk away at end of 10 years and lose only the $75,000 “interest payment”
  • The deed to the Buyer was never recorded
  • Sale payments/leaseback rent payments cancel each other out
  • “Sellers” remain liable on the Mortgages
  • “Sellers” can increase the Mortgages
  • “Sellers” can make capital improvements [and demand lower rent]
  • “Buyer’s” obligation is nonrecourse only

Donald J. Weidner

imprudent abandonment test
Imprudent Abandonment Test
  • What was “fatal: was Taxpayer’s failure “to demonstrate that the purchase price was at least approximately equal to the fair market value of the property”.
  • “An acquisition . . . at a price approximately equal to the fair market value of the property under ordinary circumstances would rather quickly yield an equity in the property which the purchaser could not prudently abandon. This is the stuff of substance.”
    • This case is famous for this “imprudent abandonment test”

Donald J. Weidner

  • As to Depreciation: “It is fundamental that ‘depreciation is not predicated uponownership of property but rather upon an investment in property.’No such investment exists when payments of the purchase price in accordance with the design of the parties yield no equity to the purchaser.”
    • The “purchase price payments” during the years in question “have not been shown to constitute an investment in the property.”

Donald J. Weidner

  • As to Interest: Nonrecourse debt does not support an interest deduction if the “debt has economic significance only if the property substantially appreciates in value prior to the date at which a very large portion of the purchase price is to be discharged.”
    • That is, if the property is underwater

Donald J. Weidner

interest cont d
Interest (cont’d)
  • “For debt to exist, the purchaser, in the absence of personal liability, must confront a situation in which it is presently reasonable from an economic point of view for him to make a capital investment in the amount of the unpaid purchase price.”
    • Is this any different than saying that the purchaser will get an advance credit in the amount of a nonrecourse mortgage only if it is reasonable to assume that the mortgage will be paid?

Donald J. Weidner

bad bargains
Bad Bargains
  • Court seems to say that there was no sale here
    • Rather than to say there was a sale but the note may not be included in basis.
  • On the other hand, “sale” treatment is not denied every time a buyer pays too much:
    • “Bad bargains from the buyer’s point of view—as well as sensible bargains from buyer’s but exceptionally good from the seller’s point of view—do not thereby cease to be sales.”

Donald J. Weidner

estate of franklin and tufts
Estate of Franklin and Tufts
  • The text asks: “Does Tufts discredit Franklin?”
  • No! Tufts addressed a sale of depreciable property subject to a nonrecourse mortgage that was previously included in basis
    • Tufts held that Amount Realized includes the unamortized mortgage balance even if it exceeds the value of the property at the time of sale

Donald J. Weidner

estate of franklin and tufts cont d
Estate of Franklin and Tufts (cont’d)
  • Tufts did not say that an inflated nonrecourse note can be included in basis when the property is first “purchased”
    • The law never allowed inflated purchase price notes to be included in basis (although the holding of Mayerson pushes the envelope)
  • Franklin says that an inflated nonrecourse obligation is not sufficient to support a true sale

Donald J. Weidner