The United States Supreme Court has used its decision in Commissioner v. Tufts to settle a conflict between circuits and to fine tune an ambiguity which it created thirty-six years ago in Crane v. Commissioner. The circumstances focus on a taxpayer who sells his partnership interest by having the purchaser assume nonrecourse debt to which the partnership property is subject

Perkovich, Joseph

English

The University of Akron

The University of AkronIdeaExchange@UAkronAkron Law Review Akron Law JournalsJuly 2015Partnership Sales: When Nonrecourse DebtExceeds Fair Market Value, Commissioner v. TuftsJoseph PerkovichPlease take a moment to share how this work helps you through this survey. Your feedback will beimportant as we plan further development of our repository.Follow this and additional works at: https://ideaexchange.uakron.edu/akronlawreviewPart of the Business Organizations Law Commons, and the Tax Law CommonsThis Article is brought to you for free and open access by Akron Law Journals at IdeaExchange@UAkron, theinstitutional repository of The University of Akron in Akron, Ohio, USA. It has been accepted for inclusion inAkron Law Review by an authorized administrator of IdeaExchange@UAkron. For more information, pleasecontact mjon@uakron.edu, uapress@uakron.edu.Recommended CitationPerkovich, Joseph (1984) "Partnership Sales: When Nonrecourse Debt Exceeds Fair Market Value, Commissionerv. Tufts," Akron Law Review: Vol. 17 : Iss. 1 , Article 10.Available at: https://ideaexchange.uakron.edu/akronlawreview/vol17/iss1/10INCOME TAXATIONPartnership Sales: When NonrecourseDebt Exceeds Fair Market ValueCommissioner v. Tufts, 103 S. Ct. 1826 (1983).T HE UNITED STATES SUPREME COURT has used its decision in Commissionerv. Tufts' to settle a conflict between circuits' and to fine tune an ambiguitywhich it created thirty-six years ago in Crane v. Commissioner.3 The cir-cumstances focus on a taxpayer who sells his partnership interest by havingthe purchaser assume nonrecourse debt" to which the partnership property issubject.The Court addressed the issue of whether the "amount realized" 5 by thetaxpayer on the sale included all of the nonrecourse debt assumed by the pur-chaser or whether such "amount realized" was limited to the fair market valueof the partnership property transferred. In a unanimous decision," the Courtsided with the Commissioner of Internal Revenue and held that the amountrealized by a taxpayer in such a transaction includes the full amount of debtassumed by the purchaser regardless of its nonrecourse characteristic and thelower fair market value of the property transferred.7During 1970, a corporation and five individuals' became partners in ageneral partnership.9 The partnership borrowed $1,851,500 on a nonrecoursemortgage loan from a savings association and used the proceeds to construct'103 S. Ct. 1826 (1983).2The Fifth Circuit had ruled in favor of the taxpayer in Tufts v. Commissioner, 651 F.2d 1058 (5th Cir.1981) and the Third Circuit had ruled in favor of the Commissioner of Internal Revenue in Millar v.Commissioner, 577 F.2d 212 (3d Cir. 1978), cert. denied, 439 U.S. 1046 (1978).'331 U.S. 1 (1947).'The creditor of nonrecourse debt cannot proceed against the debtor personally for collection thereon.The property subject to the debt is the creditor's only security.'The "amount realized" is defined by I.R.C. § 1001(b) (1983). Gain realized on a sale or other dispositionis the excess of amount realized over the adjusted basis. I.R.C. § 1001(a) (1983).'Mme. Justice O'Connor concurred in result but discussed a different analysis. 103 S. Ct. 1826 (1983),O'Connor, J., concurring.7103 S. Ct. 1826, 1836 (1983).'One of whome was respondent Tufts. Id. at 1828.'Id.[155]1Perkovich: Commissioner v. TuftsPublished by IdeaExchange@UAkron, 1984an apartment complex."° During 1971 and 1972, after completion and occupancyof the complex, the partners took total income tax deductions of $439,972."Contributions to capital of $44,212 were also made by the partners during thisperiod, which resulted in an aggregate adjusted basis' 2 in the partnership of$1,455,740.'The apartment complex never reached a sufficient occupancy level, andthe rental income was inadequate to cover expenses. 4 On August 28, 1972,each of the six partners sold their partnership interests to the same individual.' 5The consideration provided by the purchaser was basically the assumption ofthe nonrecourse debt. '6 At the time of sale, the fair market value of the prop-erty was determined to be $1,400,000.1The partners reported a loss on each of their 1972 federal income tax returnswhich aggregated to $55,740.'s The Commissioner of Internal Revenue reviewedthe transaction and concluded that the partners had realized a gain on the saleof $395,760.'" The difference in the two proposed treatments focused on theamount realized. The partners argued that section 752(c) of the Internal RevenueCode,"° read in conjunction with footnote thirty-seven of Crane v.Commissioner,2' limited the amount realized on the sale to the fair market valueof the partnership property. The Commissioner argued that this transactionwarranted no departure from the general rule of section 1001(b) of the Code 3'Old."Id. Deductions were attributed to ordinary losses and depreciation. Id."Adjusted basis is defined by I.R. C. § 1012 to be cost which is then increased by capital contributionsand earnings and decreased by distributions and losses. I.R.C. § 1012 (1983)."103 S. Ct. 1826, 1829 (1983)."Id.I"Id. Fred Bayles, who was not related to any of the six partners, acquired 100% of the partnership interests.Id."Id. Fred Bayles also reimbursed each partner for their selling expenses up to $250. Id.17d."Id. Amount is calculated by subtracting the fair market value of $1,400,000 from the adjusted basisof $1,455,740. Id."Id. at 1829, n.2. Amount is calculated by subtracting the adjusted basis of $1,455,740 from the full liabilityassumed of $1,851,500."I.R.C. § 752(c) provides: "For the purpose of this section, a liability to which property is subject shall,to the extent of the fair market value of such property, be considered as a liability of the owner of theproperty." I.R.C. § 752(c) (1983)."331 U.S. 1, 14 (1947). Footnote 37 reads:Obviously, if the value of the property is less than the amount of the mortgage, a mortgagor whois not personally liable cannot realize a benefit equal to the mortgage. Consequently, a differentproblem might be encountered where a mortgagor abandoned the property or transferred it subjectto the mortgage without receiving boot. That is not the case. 331 U.S. 1 at 14 n.37."Commissioner v. Tufts, 103 S. Ct. 1826 (1983)."3.R.C. § 1001(b) provides in relevant part that "The amount realized from the sale or other dispositionof property shall be the sum of any money received plus the fair market value of the property (other thanmoney) received." I.R.C. § 1001(b) (1983).AKRON LAW REVIEW [Vol. 17:12Akron Law Review, Vol. 17 [1984], Iss. 1, Art. 10https://ideaexchange.uakron.edu/akronlawreview/vol17/iss1/10and the now applicable Treasury Regulation2 ' thereunder, which includes allliabilities assumed by a purchaser in the amount realized by the seller. 5The case was first heard in the Tax Court 26 where the partners sued fora refund based on the alleged loss. The Tax Couit held that the fair marketvalue of the propety was irrelevant in determining the amount realized, whichincluded the full amount of nonrecourse liability assumed.27 The Fifth Circuitreversed the Tax Court's decision and held that the fair market value of thepartnership property limited the amount realized on the sale.2"Just before the Tax Court's decision in Tufts, the Third Circuit decidedthe case of Millar v. Commissioner29 where it held that the fair market valueof the property did not affect the amount realized.3"The Supreme Court had to reconcile these apparently conflicting lines ofthought. In doing so, the Court first turned to the case of Crane v.Commissioner.3 The taxpayer in Crane acquired rental property which wassubject to a mortgage for which the taxpayer was not personally liable.3 2 Thetaxpayer's basis in the property included, however, the full amount of liabilityon the property. The taxpayer took depreciation and other deductions againstthe adjusted basis for approximately seven years.33 When the property was sold,the purchaser took over payments on the mortgage debt.3 ' Even though thepurchaser did not become personally liable for the debt, the taxpayer (seller)was completely discharged from making any further payments thereon.35 Themortgage debt which the taxpayer had been paying off was less than the fairmarket value of the property.3 6 The Supreme Court held that the taxpayer hadto include the full amount of the liability discharged in the amount realizedupon the sale.37 The Court's rationale focused on the fact that the taxpayer2 Treasury Regulation § 1.100 1-2(a)(1) provides:Except as provided in paragraph (a)(2) and (3) of this section, the amount realized from a saleor other disposition of property includes the amount of liabilities from which the transferor isdischarged as a result of the sale or disposition. Treas. Reg. § 1.1001-2(a)(1) (1980)."Commissioner v. Tufts, 103 S. Ct. 1826 (1983)."Tufts v. Commissioner, 70 T.C. 756 (1978)."1d. at 769."Tufts v. Commissioner, 652 F.2d 1058 (5th Cir. 1981), reh' denied (October 19, 1981), cert. granted,456 U.S. 960, No. 81-1536 (May 1, 1982).29577 F.2d 212 (3d Cir. 1978), cert. denied, 439 U.S. 1046 (1978)."Id. at 215."331 U.S. 1 (1947)."The taxpayer acquired the property by devise from her deceased husband. The record was not clear asto whether or not he was personally liable for the mortgage debt. Nevertheless, the mortgagee allowedthe taxpayer to continue to use the debt without becoming personally liable thereon. Id. at 3-4.33Id.3"Id.35Id.3'Id. The property sold for $257,000 while the outstanding principal balance of the mortgage debt was$255,000. Id.3'Id. at 13-14.RECENT CASESSummer, 1983]3Perkovich: Commissioner v. TuftsPublished by IdeaExchange@UAkron, 1984had received the benefit of including the liability in the adjusted basis of theproperty,3" and therefore must also include it in the amount realized when theliability was discharged. The Court then entered into a hypothetical discussionin which it articulated footnote thirty-seven.3"It is the dictum in this footnote which appears to cause the confusion today.The Tufts Court refused to give any recognition to the dictum contained infootnote thirty-seven. "We are disinclined to overrule Crane, and we concludethat the same rule applies when the unpaid amount of the nonrecourse mortgageexceeds the value of the property transferred.''4 Thus, the Court reaffirmedthe general rule of Crane and expressly overruled any application of footnotethirty-seven.The Crane Court's analysis of adjusted basis versus amount realized withregard to a liability is now supported by Treasury Regulation section 1.1001-2."Except as provided in paragraph (a)(2) and (3) of this section, the amountrealized from a sale or other disposition of property includes the amount ofliabilities from which the transferor is discharged as a result of the sale ordisposition."," Furthermore, paragraph (a)(4)(i) makes it clear that whenproperty subject to a nonrecourse debt is disposed of and such debt remainssecured by the property, the discharge referred to in paragraph (a)(1) does in-deed occur."2 Finally, paragraph (a)(3) provides "In the case of a liability in-curred by reason of the acquisition of the property, this section does not applyto the extent that such liability was not taken into account in determining thetransferor's basis for such property." 3 The converse of this regulation sug-gests that when a liability was taken into account in determining the transferor'sbasis, such liability should also be included in the amount realized upondisposition.In Millar v. Commissioner," the taxpayers had $500,000 of debt, for whichthey were not personally liable, discharged in a foreclosure action."5 The debthad been borrowed by a corporation which had elected Subchapter S status.4 6The court of appeals noted that even though the taxpayers were not personallyliable on the loan, they did use the money borrowed to increase the basis of3 Id. at 9-10."Id. at 14, n.37."Commissioner v. Tufts, 103 S. Ct. 1826 (1983), supra n. 39."Treas. Reg. § 1.1001-2(a)(1) (1980).4'Treasury Regulation § l.1001-2(a)(4)(i) states that "[tihe sale or other disposition of property that securesa nonrecourse liability discharges the transferor from the liability." Treas. Reg. § 1.1001-2(a)(4)(i) (1980)."3Treas. Reg. § 1.1001-2(a)(3) (1980)."577 F.2d 212 (3d Cir. 1978)."See Millar v. Commissioner, 540 F.2d 184 (3d Cir. 1976) for full recital of facts in this case where thecourt of appeals had earlier remanded to the Tax Court."I.R.C. §§ 1361 through 1399 provide an election whereby corporate income or loss is not taxed at thecorporate level, but rather passed through to the individual shareholders and taxed along with their otherincome and losses under I.R.C. § 1.AKRON LAW REVIEW [Vol. 17:14Akron Law Review, Vol. 17 [1984], Iss. 1, Art. 10https://ideaexchange.uakron.edu/akronlawreview/vol17/iss1/10their stock. The taxpayers were then able to take deductions for losses thatpassed through from the corporation to the extent of their adjusted basis inthe stock. When the taxpayers surrendered their stock and had their liabilitydischarged in the foreclosure action, the Tax Court considered the transactionto be the same as selling the stock for the amount of the outstanding liabilityand then paying off the liability with the proceeds of the sale,"7 and the courtof appeals agreed. 8 Thus, the liability would be included in the amount realizedon the sale. Failure to include the liability in the amount realized would resultin a "double deduction."4 "The Supreme Court then turned to section 752 of the Internal RevenueCode. The purpose of sections 752(a) and 752(b) is to cause the partner's basisin his partnership interest to be adjusted for liabilities of the individual partnerthat are assumed by the partnership or liabilities of the partnership that areassumed by the individual partner.5" The adjusted basis determines the maximumamount of partnership loss that a partner is entitled to deduct on his individualtax return. Section 752(c) then limits this adjustment to the basis, due to theassumption of a liability, to the fair market value of the property that is sub-ject to the liability.5 ' Section 752(d) provides that liabilities will not be givenany special treatment when a partnership interest is sold or exchanged. 2 Onthe face of the statute, there is an apparent conflict between subsections (c)and (d). The Supreme Court resolved this conflict by reviewing legislativehistory" and holding that section 752(c) applied only to transactions betweena partner and his partnership." ' Thus, in a transaction between a partner anda third party, section 752(c) was inapplicable, and section 752(d) could beinvoked without conflict.The Supreme Court has clearly eliminated any uncertainty that existed inthis area of the tax law. "When a taxpayer sells or disposes of property encum-"'67 T.C. 656, 660-662 (1970)."577 F.2d 212 (3d Cir. 1978)."Id. at 215."I.R.C. § 752(a) and § 752(b) provide as follows:(a) Any increase in a partner's share of the liabilities of a partnership, or any increase in apartner's individual liabilities by reason of the assumption by such partner of partnershipliabilities, shall be considered as a contribution of money by such partner to the partnership.(b) Any decrease in a partner's share of the liabilities of a partnership, or any decrease in a partner'sindividual liabilities by reason of the assumption by the partnership of such individual liabilities,shall be considered as a distribution of money to the partner by the partnership. I .R.C. § 752(a),(b) (1983)."I.R.C. § 752(c) provides:For purposes of this section, a liability to which property is subject shall, to the extent of the fairmarket value of such property, be considered as a liability of the owner of the property. I.R.C.§ 752(c) (1983)."I.R.C. § 752(d) provides:In the case of a sale or exchange of an interest in a partnership, liabilities shall be treated in thesame manner as liabilities in connection with the sale or exchange of property not associated withpartnerships. I.R.C. § 752(d) (1983).1"H.R. REP. No. 1337, 83d Cong., 2d Sess., 236 (1954); S. REP. No. 1622, 83d Cong., 2d Sess., 405 (1954)."1103 S. Ct. 1826, 1835-1836 (1983).Summer, 19831 RECENT CASES5Perkovich: Commissioner v. TuftsPublished by IdeaExchange@UAkron, 1984bered by a nonrecourse obligation, the Commissioner properly requires himto include among the assets realized the outstanding amount of the obligation.The fair market value of the property is irrelevant to this calculation." 5 Theamount realized on the sale of a partnership interest to a third party will bedetermined under the general rule of the Internal Revenue Code56 and the relatedTreasury Regulation." The Supreme Court has unequivocally decided thatneither footnote thirty-seven in Crane v. Commissioner," nor section 752(c)were intended to interfere with the application of the general rule in this con-text. When a nonrecourse liability is incurred, and the adjusted basis of theproperty subject thereto has been accordingly increased, the discharge of theliability in a disposition of the property must be fully reflected in the amountrealized upon the disposition regardless of the fair market value of the property.In conclusion, the result reached by the high Court is obviously unfavorableto the taxpayer, but it is also one that is supported by the greater weight ofauthority.59 The basis for the result is logical and understandable. When a tax-payer has received the benefit of including loan proceeds in the adjusted basisof his property, he must correspondingly include the amount of a loan obliga-tion which is discharged upon a disposition of such property in the amountrealized. "Nothing in either section 1001(b) or in the Court's prior decisionsrequires the Commissioner to permit a taxpayer to treat a sale of encumberedproperty asymmetrically, by including the proceeds of the nonrecourse obliga-tion in basis but not accounting for the proceeds upon transfer of the en-cumbered property.""0 Enforcing a consistent treatment on both sides of the''section 1001 coin''61 in this context should not be regarded as the downfallof another significant tax shelter. Banks and other creditors typically do notlend money on a nonrecourse basis in amounts that are in excess of the fairmarket value of the property which secures the loan. Furthermore, investorstypically do not acquire limited partnership interests in real estate with the ex-pectation of a decline in the fair market value of the property. For those tax-payers, however, who find themselves selling a limited partnership interest byhaving the purchaser assume nonrecourse debt which is in excess of the fairmarket value of the partnership property, it will now take an act of the Con-gress to afford them special tax relief.JOSEPH PERKOVICH, C.P.A.1103 S. Ct. 1826, 1836 (1983).'6.R.C. § 1001(b) (1983). See supra note 23 and accompanying text."Treas. Reg. § 1.1001-2(a)(1) (1980). See supra note 24 and accompanying text.58331 U.S. 1, 14 n.37 (1947). See supra note 21 and accompanying text."See, e.g., Millar v. Commissioner, 577 F.2d 212 (3d Cir. 1978), cert. denied, 439 U.S. 1046 (1978); Bittker,Tax Shelters, Nonrecourse Debt, and the Crane Case, 33 TAX. L. REV. 277 (1978); Tufts v. Commissioner:Amount Realized Limited to Fair Market Value, 15 U.C. D. L. REV. 577 (1981); The Resurgence ofFootnote 37: Tufts v. Commissioner, 18 WAKE FOREST L. REV. 1 (1982).60103 S. Ct. 1826, 1834 (1983)."One side of the coin is the amount realized as defined in I.R.C. § 1001(b) and the other side is adjustedbasis as defined in I.R.C. § 1012. The difference between the two is gain or loss realized under I.R.C.§ 1001(a).[Vol. 17:1AKRON LAW REVIEW6Akron Law Review, Vol. 17 [1984], Iss. 1, Art. 10https://ideaexchange.uakron.edu/akronlawreview/vol17/iss1/10

Partnership Sales: When Nonrecourse Debt Exceeds Fair Market Value, Commissioner v. Tufts

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Partnership Sales: When Nonrecourse Debt Exceeds Fair Market Value, Commissioner v. Tufts

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