A discussion of sales and exchanges of property secured by recourse and nonrecourse debt brings to mind a court's finding of an "optimist's valhalla," "miraculous dreams of a rising phoenix" and "sophisticated tax legerdemain." The tax consequences inherent in the use of recourse and nonrecourse debt were unsure, became established and are now mixed. This paper will review the tax treatment of the disposition of property which is financed by recourse and nonrecourse financing. The discussion will be mostly chronological and an attempt will be made to discern the tax policy presented by the varying treatment. Examples will be used to demonstratively show the results of the evolution of the tax treatment.

If a taxpayer sold property that was encumbered by a recourse debt, the amount realized or the sales price the taxpayer received was the amount of money received plus the fair market value of property other than money received. If the recourse debt was paid, it was considered that the taxpayer received that amount as money. If the recourse debt was assumed by the buyer, it was deemed that such assumption was the equivalent of the receipt of money by the taxpayer equal to the amount of the liability so assumed.

Since it was properly assumed that no purchasers would pay more than fair market value for an asset, the note assumed or paid plus any other money and other property received equaled the property's fair market value. The amount of gain was then determined by deducting the adjusted basis of the property from the amount realized. This is illustrated as follows (Example 1):

The tax policy surrounding such treatment appeared sound. The taxpayer, being personally liable on the note, either received the cash to pay the note and thus received money or the note was assumed and the taxpayer was relieved of payment, a situation equal to receipt of money. The amount realized by the taxpayer must include the amount he received and this includes the extinguishment of the obligation he was required by law to pay.

A taxpayer does not have a legal requirement to pay a nonrecourse debt. The lender may look solely to the collateral for satisfaction of the obligation. Upon a sale of property and payment by the purchaser of money or other property to the seller equal to the nonrecourse debt, a seller would have an amount realized equal to the consideration, and tax treatment similar to that of recourse debt would ensue. Confusion arose when the property was sold subject to the nonrecourse debt. It was argued that a taxpayer that was never personally liable on the nonrecourse debt could not and did not receive any benefit or consideration as regards the nonrecourse debt upon a sale that was subject to the debt. It was further argued that the basis of such property did not include the nonrecourse debt and upon a sale subject to nonrecourse financing a taxpayer could only sell a "mere equity." Since a taxpayer had no personal obligation to pay the debt it was reasoned that, when the property was sold subject to the debt only, other consideration received would be calculated in the amount realized from a sale. In fact, it was determined to be erroneous for the Commissioner to include the amount of a nonrecourse mortgage in the amount realized for a sale. The tax consequences of a sale subject to nonrecourse debt, prior to 1947, are illustrated in Example 2:

The fair market value of the property is irrelevant to the calculation except that it shows what the property would sell for on an all-cash transaction. The tax policy at this time was simply that a nonrecourse debt was entirely different from a recourse debt. A nonrecourse debt did not give basis, and conveyance of the property subject to the debt was not a factor in the amount realized. Since the taxpayer had no liability for payment of the debt, it was disregarded in all calculations. While this certainly resulted in different tax treatment in the use of recourse and nonrecourse debt (see Examples 1 and 2), such a bifurcated approach fully recognized that there indeed exists a real difference between personal liability obligations and ones from which a taxpayer may walk away with impunity. Since nonrecourse debt is not calculated in the basis of an asset, the amount of depreciation a taxpayer may take is limited to the amount of money or other property with which he actually parted. This policy, in fact, seems sound in light of subsequent legislation to limit basis to debt upon which the taxpayer is personally liable.

In Crane v. Commissioner, the taxpayer sold a mortgaged apartment building, which she had inherited, to a third party. She received $3,000 in cash and the buyer agreed to take the property subject to the mortgage. The property had previously been appraised for estate tax purposes at about one-quarter million dollars. Mrs. Crane had taken $28,045.10 depreciation on the building. Mrs. Crane asserted she had a taxable gain of $2,500 calculated by deducting $500 sales expense from $3,000 received and claiming a zero basis. The IRS asserted Mrs. Crane had a taxable gain of $24,031.45.

The Supreme Court determined that Mrs. Crane inherited not the equity but the property's full value. The Court then addressed the issue of the amount realized from the sale. First, the Court said, it would be an "absurdity" to believe that Mrs. Crane sold property valued at $250,000 for only $3,000 in cash unless she sold only the equity and, secondly, that Mrs. Crane was benefited by being relieved from the mortgage. The Court noted that such a principle was well established as to recourse debt, and made the rule equally applicable to nonrecourse debt having an unpaid balance less than the value of the property:

[A]n 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. 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.

The nonrecourse debt is now to be calculated in all respects as if it were a recourse debt. This may be illustrated as follows (Example 3):

The Supreme Court determined that, as a matter of tax policy, the taxpayer owns the entire property, not just the equity, when the property is encumbered by nonrecourse debt. Therefore, the taxpayer owes the whole debt. Likewise, it was determined that upon sale of property encumbered by nonrecourse debt, a taxpayer transfers the entire value of the property and receives release from the whole debt. The decision was not unanimous by far. Mr. Justice Jackson, joined by Mr. Justice Frankfurter and Mr. Justice Douglas, would have affirmed the tax court. They reasoned, as had the tax court, that the taxpayer never became personally liable for the debt, and when the asset was sold subject to the debt the taxpayer was released from no debt. The dissent concluded that the debt was simply a subtraction from the value of what she did receive and from what she sold, and this left the taxpayer only the cash she actually received when she sold the property. The decision in Crane now allowed a taxpayer to obtain basis in property that would include the debt secured by the property, be it recourse or nonrecourse debt.

While equal treatment of recourse and nonrecourse debt when the sales price (and thus fair market value) is greater than the amount of the debt was mandated by the Court, it was less definitive in the tax treatment afforded upon a disposition of property securing nonrecourse debt when the property's fair market value (thus sales price) is less than the debt. In the now-famous footnote 37, the Court pondered:

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. This is not this case (emphasis added).

After a pronouncement of the obvious, taxpayers argued that the benefit and amount realized from disposition of property with a fair market value was limited to the property's fair market value. Quite as obviously, the Service took the opposite view. The post- Crane footnote 37 treatment taken by taxpayers is illustrated as follows (Example 4):

The tax policy hereby recognized is that without personal liability the amount realized upon a sale cannot exceed the value of the property when nonrecourse debt is involved, but the amount realized can exceed the value of the property when recourse debt is secured by the property. While this makes some sense, it would seem that either nonrecourse debt should be fully counted in the amount realized or it should be totally disregarded, as was the policy prior to Crane.

Footnote 37 was finally and squarely raised in Commissioner v. Tufts. In Tufts, the property had a value substantially less than the nonrecourse mortgage. The partnership financed an apartment house with a nonrecourse loan, the rental market declined, and the partners sold their interest subject to the debt and $250 in cash. The partners limited the amount they claimed as realized to the fair market value of the property and thereby claimed a loss. The Service, on audit, determined the sale resulted in a partnership capital gain of approximately $400,000.

The Court read Crane "to have approved the Commissioner's decision to treat a nonrecourse mortgage in this context as a true loan." The Commissioner had been on record in his position that the excess of nonrecourse indebtedness cancelled over the adjusted basis of the asset transferred, or the excess of the adjusted basis over the nonrecourse indebtedness cancelled, represents gain or loss from the sale of assets under section 1001 of the 1958 Code. The Commissioner had decided to afford nonrecourse indebtedness the same treatment as he gives a recourse mortgage.

The Commissioner also had chosen not to characterize the transaction as a cancellation of indebtedness. It is important to note at this juncture that the IRS had issued Treasury Regulation section 1.1001-2 (Discharge of Liabilities) shortly before this decision. The Court expressly withheld opinion or dictum regarding the issues of debt forgiveness. The Court did, however, state:

In the context of a sale or disposition of property under section 1001, the extinguishment of the obligation to repay is not ordinary income; instead, the amount of the canceled debt is included in the amount realized, and enters into the computation of gain or loss on the disposition of property. According to Crane this treatment is no different when the obligation is nonrecourse.

Up to this point, one may almost believe that clarity reigns and that "one of the murkiest pools of obscurity in the tax law for the past three decades" has become spring fed. By edict from the high nine on the Potomac, nonrecourse and recourse indebtedness will be treated similarly upon the sale or disposition, and gain or loss will be then easily determined under section 1001 of the Code. Tufts treatment can be analyzed by the following example and, when compared to Example 4, the distinction is apparent (Example 5):

The Tufts decision further established that nonrecourse debt will have all the tax attributes of recourse debt. The fact that recourse and nonrecourse debt are treated significantly differently to all but the taxman is irrelevant and the pre-Crane position of the tax court is fully and completely buried.

That a sale is voluntary or forced (foreclosure) does not result in different treatment. The term "sale" may have many meanings depending on the context. The Supreme Court stated that they could find no basis in the language of the Act, its purpose or legislative history for saying that losses from sales of capital assets were to be treated any differently whether they result from forced sales or voluntary sales. It is the sale, be it voluntary or forced, which finally cuts off the interest of the mortgagor and is the means for determining the amount of deficiency judgment against him and is a means adopted by statute for determining the amount of his capital gain or loss from the sale of the mortgaged property.

Before we explore how the IRS can turn a capital transaction into one generating ordinary income in some instances, we will look at what the sales price really is. Obviously, in a voluntary sale, determination of the sales price, absent chicanery, is not difficult. I will limit this part of the discussion to an involuntary sale of real estate. I will avoid discussion of depreciation recapture, ITC recapture, and the like.

We do not, immediately, need to differentiate between recourse and nonrecourse indebtedness since real estate is excepted from the at-risk requirements. Further, whether or not the mortgagor filed for protection under the Bankruptcy Act or whether the mortgagor is solvent, is not in issue as to the amount realized. One way or another, a trustee's sale is held on the first Tuesday of a month and the mortgagor's property is struck off to a third party or to the debt holder. The amount received or credited at the trustee's sale will be the sales price and amount realized by the mortgagor. But what if that amount is not the fair market value of the property on the date of sale? A secured party has a fiduciary duty to sell the collateral at the highest possible price, but as a purchaser his interest is to buy the collateral at the lowest price. Prior to 1986, the rule in Texas was that a trustee, while having a fiduciary duty to the debtor, could sell or bid on the collateral as long as the price was not grossly inadequate. In 1980 the Fifth Circuit decided the Durrett case. Durrett was a debtor in possession under Chapter XI of the Bankruptcy Act and sought to set aside and vacate a transfer of real property that was foreclosed on by the insurance company nine days before he filed for protection. Durrett's sole issue on appeal was whether a fair equivalent had been paid at the foreclosure sale. The property was sold for 57.7% of its fair market value and the fifth circuit, in voiding the sale, could locate no district court or appellate court decision that dealt with a transfer of real property which had approved the transfer for less than 70% of the market value of the property. Thus sprang up the Durrett Rule or the 70% Rule. Lenders embraced it as if it would absolutely apply to all foreclosures. This belief was strengthened in 1985 by the Willis decision in the Southern District of Texas. Mr. Willis voided the involuntary sale of his residence. The court looked at four different methodologies in determining what percentage of the fair market value the sales price was. The methodologies resulted in 73%, 18%, 41% and 20% as possible percentages. The court rejected the 73% test, did not decide which of the remaining three methods was correct, and voided the sale.

A debtor in bankruptcy could litigate the sales price determined at foreclosure based on these rules. A state court action was still controlled by the grossly inadequate sales price standard of Maxey.

In 1986, the Beaumont Court of Appeals decided Sabine Bank. While the case dealt with the foreclosure upon and sale of personalty, the court used the case to write upon the law of foreclosure, be it of personalty or realty. The court reasoned that:

A lender who has secured collateral, whether personalty or realty, is under a trust arrangement with the borrower, in the event of foreclosure, to make an honest effort to reduce the loan as much as possible by securing a fair price for the collateral.

Noting that the Texas Supreme Court had never spoken precisely on the subject, the court held that a borrower may contest the sale if a significant disparity exists between the sales price and the property's fair market value. The reasoning of the court is in line with other jurisdictions that have reviewed the issue.

Now a taxpayer can at least litigate the sales price that the lender will report to the IRS. A taxpayer may now determine his basis in the real estate that was foreclosed on, accept, negotiate or seek legal recourse of the sales price, go to section 1001 of the Code and determine the amount and recognition of his gain or loss.

A distinction between recourse and nonrecourse financing must now be made. If the property secured nonrecourse financing, Crane and Tufts control, and the fair market value of the property is not in issue when the property has a value less than the debt owed. If, however, the financing was recourse, the determination of the sales price becomes critical.

A related issue is the nature of any gain or loss upon an abandonment of property secured by nonrecourse financing. In 1980 the tax court decided Freeland. Freeland had purchased real estate for $50,000, put $9,000 cash down and gave the seller a $41,000 note secured by a deed of trust on the property. Under the terms of California law, a seller who owner-financed the sale of his property could not seek a deficiency judgment against a purchaser, thus making the note nonrecourse in nature. The market value of the property was reduced to $27,000 and Freeland quitclaimed the property back to the seller when the balance of the note was still $41,000. Freeland claimed an ordinary loss of $9,188 ($188 sales expense) on his tax return for the year in which he abandoned the property back to the seller by quitclaim deed. The amount of the loss was not in dispute, but the Service determined that the loss was deductible only as a loss on the sale or exchange of a capital asset subject to the limitations provided in sections 1211 and 1212. The parties framed the issue in terms of abandonment, and both parties implicitly agreed that a loss sustained on abandonment is an ordinary one. Freeland stated that the issue to be decided is whether a disposition by abandonment constitutes a sale or exchange. The Commissioner, while conceding that abandonment of property is not a disposition by sale or exchange, argued that this disposition was the equivalent of a foreclosure sale rather than an abandonment. The court determined that by reconveying the property to the seller, Freeland had accomplished an abandonment under California law." That a disposition, causing gain or loss to be recognized under section 1001 occurs upon a reconveyance of property in satisfaction of a mortgage obligation is well settled." However, not every taxable disposition of property is a sale or exchange. The court looked at five factors that were given consideration in other decisions, namely:

1. whether the transfer was voluntary or involuntary,

2. whether the mortgage debt was released or not, and whether the transferor received an additional (even minimal) consideration or boot,

3. whether the transferor-mortgagor was personally liable on the mortgage debt,

4. whether the transferor-mortgagor received any tax benefits from including the mortgage debt in his basis while he held the property, and

5. whether the fair market value of the property at the time of reconveyance exceeded or was less than the unpaid balance due on the mortgage debt.

The court then analyzed what the result would be if the mortgage was recourse. "It has been well established that where a taxpayer transfers property to his mortgagee in [satisfaction] of a mortgage obligation for which he is personally liable, any loss sustained by him will be deemed to have resulted from a sale or exchange on the ground that the taxpayer received consideration in return for transferring this property, the consideration being his release from liability." It is important to note that the court, in restating the law as it applied to recourse financing, did not apparently include the concept of debt forgiveness resulting from a reconveyance when the fair market value of the property is less than the outstanding principal balance of the mortgage.

The court reviewed the decision in Hammel wherein the Supreme Court concluded that a foreclosure sale (or involuntary sale) constituted a sale or exchange resulting in a capital loss and reviewed Crane and later decisions and decided that they believed that the holdings of Crane, and subsequent cases decided in light of Crane, mandate the conclusion that relief from indebtedness, even though there is no personal liability, is sufficient to support a sale or exchange.

In 1984 the fifth circuit decided a case directly on point with Freeland. In Yarbro v. Commissioner, the taxpayer formed a joint venture that purchased unimproved real estate. The purchase price was $362,132.08; approximately 10% was paid in cash as a down payment and the balance was represented by four nonrecourse promissory notes secured by deeds of trust on the property. The property was subject to a grazing lease and the joint venture continued to rent the property for grazing during its ownership period. Due to an increase in property taxes and decline in the value of the property, the joint venture decided to abandon the property. Unlike Freeland, the taxpayer notified the lending institution that he was abandoning the property, would not pay the taxes due on it and would not deed it back in lieu of foreclosure, stating that he "had nothing to convey and would have nothing to do . . . with the property from that point on." The bank subsequently foreclosed on the property.

The taxpayer claimed an ordinary loss of approximately $10,000. The Commissioner took the position that the taxpayer's abandonment of the property constituted a sale or exchange within the meaning of sections 1211 and 1212 of the Code. The Commissioner further determined that the taxpayer held the land as an investment and not for use in his trade or business, and concluded that the abandonment was the sale or exchange of a capital asset.

The tax court agreed with the Commissioner and, relying on Freeland, held that an abandonment of property constituted a sale or exchange for purposes of Code sections 1211 and 1212. Further, the tax court relied on Middleton v. Commissioner, a case which was very similar in material aspects to the instant case.

The fifth circuit held the question to be whether a taxpayer can avoid the tax consequences of Hammel by the simple expedient of abandoning the property before the mortgagee can foreclose and stated: "The Freeland court saw no reason, nor do we, to put such a premium on artful timing."

Thus a foreclosure, deed in lieu of foreclosure or simple abandonment of real property secured by a nonrecourse mortgage, will be treated as a sale or exchange and, if held for investment, will create capital gains and losses. If an asset is transferred, the amount realized from disposition is first offset by the adjusted basis of the transferred property in order to determine the transferor's gain or loss from the transaction. Qualifying gains or losses are subject to the capital gain and loss rules which provide for more stringent limitations on deductibility in the case of a net loss for the year. The courts seem to have erased all distinctions between the use of recourse and nonrecourse debt upon the sale or exchange of the asset.

Assuming a foreclosure or abandonment of property secured by recourse debt and assuming the lender declares a deficiency, which year does the taxpayer take into account in determining his loss and/or income from any debt forgiveness? Ordinarily the taxpayer would account for the transaction on his tax return in the year of foreclosure or abandonment. This is the transaction approach. However, if the taxpayer challenges the amount determined by the lender as not being the fair market value, the event could take place in one year and the amounts be determined in a later year. Further, as to any debt forgiveness, the lender has four years from date of default to bring a deficiency action. Until the statute of limitations has run or other indicia of forgiveness is apparent, it would seem the taxpayer is free to choose the year of inclusion. The taxpayer can elect a year that may be more beneficial from a tax standpoint than others. For instance, in the year of foreclosure the taxpayer may be solvent but in the next year other property declines in value and the taxpayer may now be insolvent in an amount equal to or greater than the claimed deficiency. In year two the taxpayer includes the income on his tax return and may exclude the income that the deficiency has generated.

Upon the death of a taxpayer, if the decedent's executor does not intend to satisfy a debt of the decedent and it is apparent either due to the failure to file a claim or otherwise that the creditor is not going to seek to enforce the claim, the decedent's estate will realize debt forgiveness income.

Up to this point, it would seem that the tax treatment on disposition of an asset encumbered by a recourse or nonrecourse debt will be treated similarly. The amount realized on sale or exchange includes the amount of the debt even if it is nonrecourse and the property has a fair market value less than the debt.

While Tufts was pending before the Court of Appeals for the Fifth Circuit, the Treasury promulgated Regulation section 1.1001- 2(b) which states that the fair market value of an asset at time of sale is not relevant for purposes of determining the amount realized nor the amount of liability from which a taxpayer is discharged. Along with that section of the regulation, the Treasury promulgated Regulation section 1.1001-2(a)(2): "Discharge of indebtedness. The amount realized on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness under section 61(a)(12). . . ."

The Service was required by the Crane/Tufts reasoning to include the entire amount of the principal debt owed in the amount realized when the debt was nonrecourse. The lesson of these cases seemed to be one of equal treatment for recourse and nonrecourse debt. Now, however, the Service has bifurcated the treatment of recourse and nonrecourse debt when the fair market value of the asset is less than the amount owed. Prior to the Treasury taking this approach, the courts had, as a rule, treated income realized by a debtor from the transfer of property in discharge of nonrecourse debt in the same manner as such income from recourse debt - as gain from sale of the transferred property. Almost uniformly the taxable event has been characterized as a sale of the transferred property resulting in gain to the extent that the liability discharged exceeded the property's adjusted basis. The same result was reached even in some cases in which the Service attempted to characterize the transaction as producing cancellation of indebtedness income. The problem before Crane and Tufts was the treatment of nonrecourse indebtedness upon a sale or exchange (voluntary or involuntary), not how to treat a sale or exchange of property securing recourse debt. The tax consequences of the latter were well understood:

If an owner sells property for more than its basis, the assumption that there has been a taxable gain follows almost inevitably. This is as true where the consideration received is property as where it is cash. Sometimes the transaction involves an atypical sort of consideration such as a release of the transferor's indebtedness. That does not prevent the transfer from being a sale or exchange resulting in capital gain or loss. So where an owner pledges his property for a loan, the proceeds of which are greater than his basis, and subsequently succeeds in transferring the property for a cancellation of debt, the excess of what is received over the basis of the property is gain, taxable in the year which the property is disposed of and the debt discharged.

In each case the transaction is treated as if the mortgagor had sold the property for cash equivalent to the amount of the debt and had applied the cash to the payment of the debt.

As stated above, Regulation section 1.1001-2(a)(2) was promulgated at the time the Supreme Court decided Tufts. A portion of the regulation was cited in the case. Further, in discussing the issue that nonrecourse financing gave rise to most tax shelters and that Congress enacted at-risk rules but exempted real estate from them, the Court states in a footnote, "[a]lthough this congressional action may foreshadow a day when nonrecourse and recourse debts will be treated differently, neither Congress nor the Commissioner has sought to alter Crane's rule of including nonrecourse in both basis and amount realized." The Court goes on to state in another footnote:

In the context of a sale or disposition of property under section 1.1001, the extinguishment of the obligation to repay is not ordinary income; instead, the amount of the cancelled debt is included in the amount realized, and enters into the computation of gain or loss on the disposition of the property. According to Crane, this treatment is not different when the obligation is nonrecourse: the basis is not reduced as in the cancellation of indebtedness context and the full value of the outstanding liability is included in the amount realized (emphasis added).

To be sure, the Supreme Court could have decided Tufts differently. Justice O'Connor, in her concurring opinion, indeed bemoaned the fact that she felt compelled to follow the teachings of Crane, "[i]ndeed, were we writing on a clean slate except for the Crane decision, I would take quite a different approach. . . ." The court did not take a different approach but affirmed the Crane reasoning. Does Regulation section 1.1001-2(a)(2) conflict with the Crane/Tufts decisions?

The Service has found no conflict and has applied the two-step analysis set forth in the regulation for treatment of recourse debt upon sale or exchange of the asset. To demonstrate the Treasury's approach to nonrecourse and recourse indebtedness upon a sale or exchange of an asset, the regulation includes two examples. First, nonrecourse debt:

In 1974 E purchases a herd of cattle for breeding purposes. The purchase price is $20,000, consisting of $1,000 cash and a $19,000 note. E is not personally liable for repayment of the liability and the seller's only recourse in the event of default is to the herd. In 1977 E transfers the herd back to the original seller, thereby satisfying the indebtedness. . . . At the time of the transfer the fair market value of the herd is $15,000 and the remaining principal balance on the note is $19,000. At that time E's adjusted basis in the herd is $16,500. . . . As a result of the indebtedness being satisfied, E's amount realized is $19,000. . . . E's realized gain is $2,500 ($19,000-$16,500);

Second, recourse debt:

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).

Since the promulgation of the regulation, the Service has been consistent in its application of the bifurcated or two-step approach upon a sale or exchange of an asset securing a recourse debt when the fair market value of the asset is less than the amount of the debt. Ordinary income will result from the cancellation of indebtedness. Tax treatment after Regulation section 1.1001-2(b) may be further illustrated by the following example:

The changes in tax treatment are dramatic. The deemed amount realized is now the opposite of what would have been determined under post-Crane footnote 37 treatment. Other examples can show even greater disparity in tax treatment between disposition of property secured by recourse and nonrecourse financing.

The tax court has adopted the Commissioner's position. In Michaels v. Commissioner, the court held that a discount that the taxpayer received on the prepayment of a recourse mortgage that was made in connection with the sale of her residence is not included in the amount realized for purposes of computing gain. The taxpayers included the discount as part of the gain they realized on the sale of their residence which they deferred. The court in interpreting Regulation section 1.1001-2(a)(2) stated:

This Regulation effectively bifurcates the instant transaction by removing the amount of the discount from the computation of the amount realized and recognizing it as a separate income item.

While section 108 allows a reduction in basis for the reduction of a debt held by the seller, no such allowance is made for reduction in a mortgage held by a third party.

Since a taxpayer may recognize debt forgiveness income, a determination of what is and is not such income is required. A taxpayer realizes and recognizes ordinary income if he is relieved of payment of a debt. If, for example, an individual performs services for a creditor, who in consideration thereof cancels the debt, the debtor realizes income in the amount of the debt as compensation. A taxpayer does not realize income when money is borrowed due to the corresponding obligation to repay the amount borrowed. If, however, the taxpayer is for some reason not required to repay the borrowed money, income will result. In 1931, the U.S. Supreme Court held that if a corporation repurchases its own bonds for an amount less than the price for which it sold those bonds, the difference between the sale or issue price and the repurchase price constitutes taxable income to the corporation. The Court based its decision on the theory that the reduction in outstanding liabilities (the difference between the issue and repurchase prices) resulted in a freeing of assets and an accession to income.

This position is now statutorily embodied in section 61(a)(12) which states, "[e]xcept as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items: . . . Income from discharge of indebtedness."

In order for a taxpayer to have income from discharge of indebtedness, there must in fact be a debt that is in some manner cancelled. There is no discharge of indebtedness income if there is no obligation to repay the funds that were advanced. In Millar v. Commissioner the taxpayers signed nonrecourse notes and invested the proceeds into the capital of a corporation they owned. Upon default the note holder foreclosed upon the taxpayers' stock in the corporation. The Commissioner took the position that the taxpayers had realized cancellation of indebtedness income on the surrender of their stock in the amount of their discharged nonrecourse obligations. The issue as stated by the court was whether the taxpayers had an obligation to repay the funds advanced to them and if not then no cancellation of indebtedness could arise. Not surprisingly, one of the taxpayers took the position that the cash advances made to them were intended as gifts, not loans. The court remanded for a factual determination of gift or loan, the tax court found a loan, and that finding was affirmed on appeal. Without a repayment obligation a transaction cannot be elevated to indebtedness and, therefore, cannot result in discharge of indebtedness income.

The discharge of a debt that is contingent may not result in income. If an obligation is so contingent that it does not constitute a debt of the taxpayer then a discharge of that debt does not give rise to income. Mere bookkeeping entries, though of some evidentiary value, are not determinative. They cannot alter the legal effects of transactions, nor create income where none in fact exists. If the debt is too contingent at the creation of the debt so as to allow it to be included in an asset's basis for Federal income tax purposes, then the taxpayer cannot realize income upon the release of the obligation to repay. Repayment that is highly contingent, such as upon the discovery of recoverable amounts of oil and gas, will not allow a nonrecourse note amount to be included in basis, and the forgiveness of such indebtedness will not give rise to income.

Income from discharge of indebtedness requires that the debt be cancelled. The absolute cancellation of a debt, while easy of concept, occurs infrequently. Cancellation of debt also occurs where a creditor accepts property that has a value less than the debt or an amount of money less than the debt in complete satisfaction of that debt. This may occur when the creditor is convinced that the debtor can pay no more than what is being offered or when the debt instrument carries an interest rate significantly below the now prevailing rates. However, a cancellation of debt can also occur if the creditor fails to act timely, and his claim is barred by an applicable statute of limitations or other rule of law. If there exists a reasonable expectation of repayment of the debt, a cancellation of the debt will not generally be found. If the expectation of repayment vanishes in a subsequent year, then a taxpayer may realize income.

The cancellation of a debt may not be, in and of itself, the source of income but may simply be the method by which a creditor makes a payment to the debtor. Whether such payment is ordinary income to the debtor depends upon the nature of payment. For example, a discharge of indebtedness may constitute a payment for services or a constructive dividend. A discharge of indebtedness can also constitute a contribution to capital or a gift, in which case the forgiveness of indebtedness is not income to the debtor. The discharge of a debt may also represent a payment for property, in which case the gain, if any, is derived from dealings in property, not the discharge of indebtedness. The discharge of indebtedness may also constitute a payment for the settlement of a litigated claim. Where a payment is made in settlement of litigation, the nature of the claims involved and the basis of the recovery determine the tax treatment of the settlement proceeds. The Senate Finance Report accompanying the passage of section 108 of the Code states that "debt discharge that is only a medium for some other form of payment, such as gift or salary, is treated as that form of payment rather than under the debt discharge rules."

Discharge of debt is not realized where there is a modification of the debt or if the taxpayer substitutes a new obligation for the original debt. A taxpayer will, however, recognize income on an exchange of an old obligation for a new debt instrument to the extent that the face amount of the new debt is less than the old.

A taxpayer who is primarily liable for a debt may wish to substitute a guarantee agreement for joint and several primary liability on a debt. Under tax law, no immediate tax consequences result from the execution of a guarantee agreement. While refinancing of a debt may preclude income realization, the substitution of a guaranty that is contingent and which has no ascertainable value vis-a-vis a true debt is not a substitute for the debt nor is it refinancing of the debt. There is no real continuation of the indebtedness when a highly contingent obligation is substituted for a true debt. Therefore, upon such a substitution, income is realized to the extent the taxpayer is discharged from the initial indebtedness.

As we have seen, a sale or exchange of an asset securing a nonrecourse debt that has a fair market value less than the debt will result in the amount realized being the amount of the debt. But when a taxpayer sells or disposes of property encumbered by an obligation involving accrued interest as well as principal, then, assuming the accrued interest was neither previously deducted nor included in basis, the amount realized under section 1001(B) does not include the accrued interest. Only the outstanding principal is included. However, if the accrued interest became a part of the principal pursuant to the terms of the mortgage then it is included in the amount realized even though the taxpayer may have previously deducted these amounts.

In Allan v. Commissioner, the taxpayers were partners in a limited partnership which purchased residential property subject to a mortgage insured by the Department of Housing and Urban Development (HUD). The partnership deducted interest on the accrual basis of accounting. The partnership defaulted and HUD acquired the mortgage. HUD paid the real estate taxes and charged the partnership for interest payments when they fell due on the mortgage. Four years after HUD acquired the mortgage, the partnership transferred the property to HUD in lieu of foreclosure. The amount of the outstanding nonrecourse debt to HUD exceeded the fair market value of the property at the time the deed in lieu of foreclosure was given. The issue presented was whether the partnership was required to recognize ordinary income in an amount equal to the previously deducted interest and taxes. The mortgage provided that the advances that HUD made to pay the real estate taxes and interest payments due were to be added to the principal and were subject to the mortgage interest rate. As such the Court determined it was required by Tufts to include in the amount realized the full principal amount of the nonrecourse debt which by its own terms included the advances for real estate taxes and interest.

If a taxpayer realizes ordinary income upon the voluntary or involuntary sale of an asset at a price less than the recourse debt owing against it, the nonrecognition provisions of section 108 and the ordering provisions of section 1017 become important. Section 108 provides that if a taxpayer would otherwise recognize discharge of indebtedness income, the income will be excluded under certain circumstances. A taxpayer must first realize discharge of indebtedness income in order to qualify for the exclusions allowed in section 108. Section 108 applies to indebtedness incurred or assumed either by a corporation or by an individual in connection with property used in a trade or business for which the corporation or individual taxpayer is liable or subject to which the taxpayer holds the property.

Income from discharge of indebtedness income will be excluded if the discharge occurs in a Title 11 case or if the discharge occurs when the taxpayer is insolvent. A Title 11 exclusion takes precedence over the insolvency exclusion.

The Code defines insolvency to mean the excess of liabilities over the fair market value of assets immediately before the discharge of indebtedness occurs. Bankruptcy or a Title 11 case means solely that a bankruptcy court has jurisdiction over the taxpayer and that the discharge of indebtedness is granted by the court or pursuant to a plan approved by the court.

The debt from which a taxpayer may be discharged includes that for which he is liable (recourse) and that which encumbers his property and for which he is not personally liable. Since the Supreme Court has made no distinction between recourse and nonrecourse debt in determining the amount realized, and has considered nonrecourse debt to be real debt for tax purposes, the inclusion of nonrecourse debt in the definition of indebtedness of a taxpayer is mandated.

The Tax Reform Act of 1986 repealed a third category for discharges of indebtedness after December 31, 1986. The now-defunct third category provided that cancellation or discharge of indebtedness income would not be recognized if the indebtedness discharge was "qualified business indebtedness." This exception was repealed because Congress believed that the prior law treatment of the discharge of qualified business indebtedness was too generous in that income from such a discharge generally was deferred by reducing the basis of depreciable assets, regardless of the economic ability of the taxpayer to currently pay the tax. Moreover, the exclusion produced disparate results among taxpayers depending upon the makeup of their depreciable assets.

The question of whether a debt is discharged in a Title 11 proceeding or not depends solely upon whether the taxpayer has filed for protection under Title 11 and whether the debt has been all or partially discharged pursuant to a court order or pursuant to an approved plan of arrangement under court supervision. The Internal Revenue Code provides that a taxpayer who meets these criteria does not have income from the cancellation or discharge of indebtedness.

The insolvency exception applies to the extent the taxpayer is insolvent before the debt is discharged and solvent afterwards with income realized to the extent the taxpayer is made solvent. Insolvency is defined to mean the excess of a taxpayer's liabilities over the fair market value of the taxpayer's assets. The determination of insolvency is made on the basis of the taxpayer's assets and liabilities immediately before the discharge.

The insolvency provisions of section 108 are tested at the partnership, not the partner, level, and the insolvency exception applies only for discharge of indebtedness income, not for other types of income, such as the cancellation of a wage claim or of rents that are due.

The insolvency exception, while a needed provision, only applies to the extent the taxpayer is insolvent before the debt is discharged. Income is realized to the extent the taxpayer is made solvent. Further, as stated above, in determining the extent of liabilities, there apparently is no authority for counting contingent or contested liabilities within the scope of the term liability as used to define insolvency in section 108.

As with most matters, a taxpayer is rarely given a free lunch. The price of a section 108 exclusion is that the taxpayer's tax attributes will be reduced to the extent the amount of income from discharge of indebtedness is excluded from gross income under section 108(a)(1). Thus the exemption is not totally free, but lunch is paid for in a different manner. The taxpayer is given a deferral (except as noted below) on the discharge income by offsetting such amounts against the taxpayer's tax attributes. The taxpayer's tax attributes must be reduced in the following order:

• The net operating loss for the taxable year of discharge (if any), and any net operating loss carryover to that year;

• Any carryover of the general investment tax credit under Section 38;

• Any net capital loss generated in the taxable year of discharge and any capital loss carryover to that year;

• The basis of the taxpayer's assets (depreciable and nondepreciable); and

• Foreign tax credit carryovers.

Before application of section 108 attribute reductions, the taxpayer must first determine his tax for the taxable year of the discharge, applying the general rules of the Code. The reduction in net operating loss carryovers and capital loss carryovers applies to the loss (if any) for the taxable year of the discharge and then applies to reduce the loss carryovers in the order in which they arose. Tax credits are now reduced at the rate of 33 1/3 cents for each dollar of indebtedness discharged.

After reduction in operating losses, capital losses, and tax credits, the remainder of the amount of indebtedness that was discharged is applied to the taxpayer's assets (depreciable and nondepreciable). An important note is that the basis of a taxpayer's assets may not be reduced below the amount of the taxpayer's remaining undischarged liabilities. Therefore, if the taxpayer sells all of his assets after debt discharge occurs but prior to the end of the tax year in which the debt discharge occurred, for an amount equal to the outstanding and nondischarged liabilities of the taxpayer, no income is recognized by the bankrupt or insolvent taxpayer.

A very important provision found in the Committee Report is the fresh start or free lunch provision. That provision states that any amount of debt discharge that is left after the attribute reduction under section 108 is disregarded. Such excess amount of debt discharge is not income nor does it have other tax consequences. By allowing this excess to disappear, the taxpayer has obtained a fresh start and a free lunch.

In a case under Title 11 involving an individual debtor, the attribute reduction required under section 108(b) of the Code applies to the attributes of the bankruptcy estate which succeeded to the tax attributes of the individual debtor. The attribute reduction does not apply to the tax attributes of individual taxpayers which were generated after the filing of the bankruptcy petition. Property of an individual debtor that is exempt such as a homestead, automobile and furnishings will not be subject to basis reduction rules. The Code also provides that a reduction in the basis of assets pursuant to section 108 is not considered a disposition for tax purposes and there is no recapture of investment tax credit. The Code specifically states that a taxpayer under Title 11 will not have a basis reduction in exempt property. It is silent as to insolvent taxpayers who do not require bankruptcy court protection. If silence is construed to mean a nonbankrupt taxpayer will be required to reduce his basis in all other property, including exempt property, then a large disparity exists. An insolvent taxpayer may well want to and be able to avoid filing a bankruptcy petition, but may be well advised to do so in order to retain the tax basis on his homestead, automobile and exempt furnishings. For example, if taxpayer A is insolvent in the amount of $500,000 due to a bad real estate investment and has as his sole asset a residence with a basis of $375,000, he would reduce his basis in the residence to zero. A subsequent sale for $500,000 would produce $500,000 of ordinary income (unless a section 121 exclusion is allowed). Taxpayer B, with the same amount of insolvency and the same asset and basis, files for bankruptcy protection. The debt is discharged pursuant to a court-approved plan. A subsequent sale of the residence results in a gain of $125,000 ($500,000 sales price less adjusted basis of $375,000) which may be excluded under section 121 resulting in no gain and no tax. Taxpayer A may have tax to pay of $144,000 ($500,000 x 28%).

Prior case law looked to state law to determine whether a taxpayer's assets were exempt from the claims of creditors. To the extent assets were exempt from creditor claims they were not considered in a determination of whether a taxpayer was solvent. Section 108(d)(10) provides a cross reference to section 1017(c)(1) for a provision which states that no reduction is to be made in the basis of exempt property of an individual debtor. The referenced section, while entitled "Reduction Not To Be Made In Exempt Property," provides that no basis reduction will occur in property which the debtor treats as exempt under the Bankruptcy Code. The section does not state that no basis reduction will occur in property which a taxpayer owns that is exempt from the claims of creditors under applicable state law. The term "debtor" has a specific definition in bankruptcy law: "[a] person or municipality concerning which a case under this title has been commenced." This construction would overrule prior case law and treat insolvent taxpayers and Title 11 debtors in a very different manner. It should not be the policy of tax law to encourage the filing of bankruptcy petitions in order to obtain more favorable tax treatment, and it would seem the better interpretation is to allow both bankrupt and insolvent taxpayers to retain basis in exempt property and have an equal fresh start.

An alternative to the ordering of the reduction of tax attributes is available to a bankrupt or insolvent taxpayer. In lieu of the normal ordering set forth above, a taxpayer may elect (but only up to the amount of insolvency) to first reduce the basis of depreciable property by all or any portion of the income from discharge of indebtedness excluded under section 108(a)(1). The general rule that prohibits a taxpayer from reducing the basis of his depreciable assets below the amount of the taxpayer's remaining undischarged liabilities is not applicable. If the taxpayer elects, the Code permits the taxpayer to elect to reduce the entire basis of the taxpayer's depreciable assets, but not below zero.

A taxpayer makes an election to reduce basis in depreciable property on his return for the year in which the discharge of indebtedness occurs. Once the election is made, the election can be terminated only with the Commissioner's consent. Temporary Treasury Regulations provide that the election must be made on a statement attached to a completed Form 982, or on that form itself if the form provides a space for the election. Failure to file the basis adjustment form can result in the full amount of the income from debt forgiveness being recognized fully in the year in which the statute of limitations for instituting suit to collect on the taxpayer's notes expires.

The operational rules for reducing the basis in assets are contained in section 1017 of the Code, which controls for reducing basis under section 108(b)(2)(D) or under the election in section 108(b)(5). Section 1017(b)(1) states that the order of reduction of the basis of the particular assets will be determined pursuant to Treasury Regulations. The Regulations require that basis reduction will first apply only to property used in a trade or business in the following order:

• In the case of indebtedness used to purchase a particular asset (other than inventory, notes or accounts receivable) that is discharged, the cost or other basis of such property will be decreased by the amount excluded from gross income under IRC section 108(a) which is attributable to the discharged debt used to purchase that property. This is so even if a lien is placed against the property securing payment of the debt;

• In the case of property that has a nonpurchase money lien against it (other than inventory, notes or accounts receivable), the cost or other basis of such property will be decreased by an amount equal to the amount excluded from gross income under IRC section 108(a) and attributable to the discharge of indebtedness secured by such lien;

• Any remaining excess will next be applied proportionately to other property of the taxpayer (other than inventory, notes and accounts receivable); and

• Any remaining excess will next be applied proportionately to inventory, notes and accounts receivable.

If after application of the above, nontaxable income from discharge of indebtedness remains, a taxpayer looks to the basis of property he holds for the production of income. In the case of an individual the cost or other basis in property held for the production of income is reduced on a proportionate basis. Any excess nontaxable income from discharge of indebtedness after application of the above is then applied against basis in property other than property used in any trade or business and property held for the production of income, with such reductions also being made on a proportionate basis.

As can be seen, all the property of a taxpayer can realize a basis reduction. But here the bankrupt taxpayer appears to have the advantage. As stated above, property which is treated by the debtor as exempt in a bankruptcy case will not be subject to the basis reduction rules. If the Code gives disparate treatment to debtor and nondebtor insolvent taxpayers in this area, then a bankruptcy filing may serve to save a considerable amount of basis and attendant tax upon disposition of those exempt assets.

To the extent the taxpayer has had a free lunch on debt forgiveness, the case is closed. To the extent the taxpayer paid for lunch with a postponement via a basis reduction in his property, the taxman waiteth. A taxpayer will report debt forgiveness basis adjustments as ordinary income upon disposition of the asset. The Committee Report states: "This rule operates to ensure that the taxpayer has only obtained a postponement of the recognition of the income and not a complete exemption from recognition." If the basis of property is reduced under the general attribute rule of section 108(b)(2)(D) or the special election under section 108(b)(5), any gain realized on a subsequent sale or disposition of non-sections 1245 and 1250 property will be treated as the recapture of depreciation under section 1245 to the extent of basis reduction under section 108. A special rule for section 1250 property applies. The recapture rules imposed by section 1017(d) apply to all assets whether depreciable or nondepreciable. Since an insolvent taxpayer who does not file for bankruptcy protection may be treated differently than one who has filed under Title 11, do these rules control over section 1034 dealing with the nontaxable exchange of a residence, and how does a taxpayer treat the over age 55 exemption on sale of a residence? The smarter policy, one would hope, would be one of equal tax treatment and preservation of the special treatment afforded a taxpayer on the sale or exchange of a residence.

Not all reductions in indebtedness will activate discharge of indebtedness rules. If a taxpayer purchases property which is financed by the seller of the property and the seller subsequently reduces the amount of the purchase money debt, the reduction will be treated as a purchase price adjustment and not income to the payor if the reduction does not occur in a bankruptcy case or when the purchaser is insolvent. Further, the amount of the reduction must otherwise qualify as discharge of indebtedness income. Since discharge of indebtedness income cannot arise with use of nonrecourse debt this provision is inapplicable to nonrecourse debt. Section 108(e)(5) will apply only if the seller and buyer have retained the same position vis-a-vis each other (buyer has not conveyed property nor seller assigned note) and section 108(e)(5) will not apply where the debt is reduced other than by a direct agreement between the seller and buyer such as the running of the statute of limitations on a portion of the debt. While the other basis reduction rules do not treat the reduction as a disposition, a purchase price adjustment will trigger the recapture of business credits.

The voluntary or involuntary conveyance of an asset is a sale or exchange of that asset under section 1001. If the asset secured nonrecourse debt the amount realized upon that sale will never be less than the amount of that debt. The amount of the gain will be the difference between the adjusted basis of the property and the debt secured by it. There can be no debt forgiveness.

If, however, the property secures payment of a recourse debt, the fair market value of the property, if less than the debt, enters the equation. The gain is the difference between the adjusted basis in the property and its fair market value. The remaining amount of the debt will be categorized as debt forgiveness and ordinary income.

A taxpayer may litigate the amount of debt forgiveness by putting in issue the amount for which the property was sold or bid on at foreclosure sale in state court.

Since the definition of liabilities for purposes of determining insolvency under section 108 precludes the addition of contingent claims, can a taxpayer include the amount he is being sued for on a deficiency judgment if he contests the entirety of the claim?

The insolvency exception should not be available to exclude gain realized on the disposition of an asset secured by a nonrecourse note if that asset has a fair market value less the debt since a taxpayer will have no change in his net worth after disposition. The exception is limited to cancellation of indebtedness income. The exceptions under section 108 offer a taxpayer some ability to defer the tax on the recognized ordinary income and can even result in the true forgiveness of the debt and attendant tax consequences. The perceived disparity in treatment on exempt assets between a debtor taxpayer and an insolvent taxpayer who does not file for bankruptcy protection can cause very divergent final results.

What was confusing and allowed for various theories of tax treatment, namely the manner of treatment of nonrecourse liabilities upon a sale or exchange of an asset, was settled with Tufts. We could then treat nonrecourse and recourse alike for this purpose. What appeared settled before the issuance of Treasury Regulation section 1.1001-2(a)(2), namely treatment of recourse debt on the sale or exchange of an asset with a fair market value less than the debt, is now confusing and may allow for different theories of tax treatment. The inability to get basis in seller- financed nonrecourse indebtedness on real estate due to the change to section 465 means that a greater amount of real estate sales will have attendant recourse loans. A decline in value will leave the solvent taxpayer with the prospect of a large amount of ordinary income if payment on the deficiency has not been made.

The insolvency exception under section 108 and the basis reduction ordering rules under section 1017, while appropriate, seem to offer divergent treatment on the basis reduction of exempt property. This is particularly important in Texas where a residence may be claimed as exempt irrespective of the taxpayer's basis in it. Bankruptcy, in this instance, may give rise to the phoenix rising from the ruins.

The growth of tax shelters and the cost to the taxpayers in policing and legislation related to tax shelters may have been spared had the Supreme Court declined to give nonrecourse debt the status of recourse debt. We would truly have a bifurcated approach but one that has more basis in the realities of the difference in personal liability and nonpersonal liability debt. That Justice O'Connor would like to treat both types of debt again in the identical manner only seems to further distance tax treatment in this area from what the taxpayer perceives to be reality. The present bifurcated approach that can result in ordinary income from debt forgiveness and capital loss by use of recourse financing, but never ordinary income from debt forgiveness (and rarely loss) by use of nonrecourse financing, does not seem justified. The introduction of passive gain and loss and, in particular, section 469(e)(1)(A)(ii) of the 1986 Act will further produce disparate tax treatment regarding the disposition of property securing recourse and nonrecourse debt.

That a judge should accuse tax practitioners of financial fantasies constructed of gossamer wings and of sophisticated tax legerdemain can only mean that he, too, has tried to read the Code and tax cases and failed to comprehend the distinctions without difference that become differences with distinction.

Published in the Baylor Law Review, Volume 41, Number 2

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