The Supreme Court this week tightened up the way certain types of real estate loans are treated for tax purposes when properties securing them are sold.
The case involved so-called nonrecourse loans. These are loans in which the borrower assumes no personal liability, and the lender's sole recourse in the event of default is to foreclose on the property involved.
The specific issue was whether, when a property is sold for its fair market value, but that value is less than the outstanding balance on a nonrecourse loan, the seller realizes a gain when the buyer takes over the loan.
The high court reversed the 5th U.S. Circuit Court of Appeals and ruled unanimously that the full amount of the loan balance must be included in the "amount realized" from the sale in calculating possible taxes.
The case, Commissioner of Internal Revenue vs. Tufts, et al., was brought up by a group of partners who borrowed $1.85 million in 1970 to build a 120-unit apartment complex in a suburb of Dallas. The partners completed the project, but the economy of the area deteriorated and the complex continued to run in the red.
By 1972, the fair market value of the complex had declined to $1.4 million. At that point, the partners sold it to a buyer who gave them no cash but agreed to take over the debt, which was still $1.85 million because the partners had been unable to make any payments on the principal.
In computing their taxes, the partners used the fair market value -- $1.4 million -- as the amount realized from the sale. Because their adjusted basis in the property -- in effect, the purchase price minus depreciation and other write-offs taken during their ownership -- was then $1.45 million, they concluded that they had suffered $55,000 capital loss.
The Internal Revenue Service, however, pointed to the fact that the partners had been relieved of $1.8 million in debt, and argued that that amount must be included in the amount realized.Under its reasoning, IRS showed the partners with a capital gain of roughly $400,000.
The agency also noted that the partners had used the full amount of the loan in computing their tax deductions during ownership -- which totaled more than $400,000.
The Tax Court agreed with the IRS, but the 5th Circuit took the taxpayers' side.
In finding for the IRS, the Supreme Court noted in an unsigned opinion, that under a 1947 decision, it is plain that, when a borrower is relieved of his obligation under a nonrecourse loan that is less than the value of property, the loan balance is included in the amount realized in computing tax.
However, the 1947 decision left open the question of what would happen if the loan balance exceeded fair market value, and "this case presents that unresolved case," the court said.
The taxpayers argued that it would be unrealistic to tax them on a gain when, in fact, their property had lost value. They also argued that the tax code specifically allows the approach they took on their returns.
But the court concluded that, because the taxpayers are entitled to tax and other benefits from the loan in recognition of their obligation to repay it, it would create an "asymmetrical" situation if removal of that obligation were not counted in full.
"Nothing in either [the code] or in the court's prior decisions requires the commissioner to permit a taxpayer to treat a sale of encumbered [mortgaged] property asymmetrically, by including the proceeds of the nonrecourse obligation in basis but not accounting for the proceeds upon transfer of the unencumbered party," the court said.
The court conceded that the code is "ambiguous" on the question, but concluded from its reading of the legislative history that the IRS" interpretation of the law was correct.
"When a taxpayer sells or disposes of a property encumbered by a nonrecourse obligation, the commissioner properly requires him to include among the assets realized the outstanding amount of the obligation. The fair market value is irrelevant to this calculation," the court said.
"We find this interpretation to be consistent with [the 1947 case] and to implement the statutory mandate in a reasonable manner," it added.
Justice Sandra Day O'Connor, in a concurring opinion, expressed reservations about the court's reasoning, but said that she would accept it in view of the judicial history. She indicated that it would make more sense in such situations "to separate the two aspects of these events and to consider, first, the ownership and sale of the property, and, second, the arrangement and retirement of the loan."
"The reason that separation . . . is important is, of course, that the code treats different sorts of income differently," she said. "A gain on a sale of the property may qualify for capital-gains treatment, while cancellation of indebtedness is ordinary income, but income that the taxpayer may be able to defer."