Debt and Property Purchases         Chapter 13

What is the effect of debt on the income tax basis of an acquired property?

Acquisition debt is to be included in the buyer’s tax basis for acquired property.

This can include “seller financing” debt.

Also, property can be acquired with debt attached, i.e., either (1) assumed debt, or (2) non-recourse debt, with property subject to debt (but no personal liability).

Cf., post-acquisition debt (i.e., borrowing with existing property as collateral).

 

Computing Gain Upon Property Disposition

Do the proceeds of sale also include relief from the debt, either (1) assumed by the purchaser, or (2) being nonrecourse debt which is attached to the property transferred to another?

Crane case supports inclusion of the debt in tax basis for the property owner.

What would occur if no inclusion in tax basis occurred:(1) upon purchase? (2) when sold?

Reduction in Acquisition Debt
p. 328

§108(e)(5) provides that a reduction in purchase money debt is a purchase price reduction, not debt discharge income (under §61(a)(12)).

This provision applies only to a property purchase, not to a debt owed to a service provider.

This purchase price reduction concept is also not applicable to “third party debt.” 

Rev. Rul. 91-31               p. 331
Debt Reduction - No Transfer

Lender agreed to reduce the nonrecourse debt when the value of the building ($800,000) was less than the outstanding mortgage debt ($1 million). No insolvency.

Reduction of the principal amount of the undersecured non-recourse debt was made by the holder of debt who was not the seller.

This debt reduction constitutes realization of COD income  (even in the non-recourse  debt context) - since no disposition of the collateral has occurred.   200x COD income.

 Or, should a tax basis reduction result?

 

Alternative Approach –
Debt Discharge Situation

Reduce the tax basis for the purchased property by the amount of the debt forgiven?

Rather than COD income (which is currently included in gross income).

See Code §108(e)(3) re exclusion of discharge of “qualified real property business indebtedness” (at taxpayer’s election), to the extent of the  negative equity amount.

But, reduction in tax basis of the taxpayer’s depreciable real property.

 

 

Treatment of Disposition of Property Encumbered by Debt

Crane case rule states that purchase debt is included in the tax basis of an acquired property & in the proceeds received when debt relief occurs upon asset disposition.

See §1001(b) identifying the amount realized.

Relief from recourse debt is included in the amount realized.  The exclusion of borrowed funds from gross income should cause inclusion when property sale occurs.

Problem 1                        p.336
Liability exceeds basis

1)  Equipment purchase for $10,000:

    $1,000 cash; $9,000 note – nonrecourse debt, but mortgage on the equipment.

    $3,000 deduction for depreciation claimed.

2)  Debtor sells the equipment to a 3rd party for $1,000 cash, subject to the nonrecourse debt of $9,000.

Amount realized: $10,000; tax basis is $7,000;   Gain realized:   $3,000.

 

Problem 2                        p.336
Liability exceeds basis

1)  Purchase for $10,000 - $1,000 cash; $9,000 note - nonrecourse, but nonrecourse mortgage on the purchased equipment.

    $3,000 deduction claimed for depreciation.

2)  Donor sells the equipment (FMV $9,000) to a 3rd party for $1,000, subject to the debt of $8,000 ($1,000 principal payment on debt was previously made). 

Gain realized: $2,000 ($9,000 amount realized less $7,000 remaining basis).

Problem 3                        p.336
After-acquired debt

Bought property for    $30,000

Appreciated to             $80,000

Mortgage loan for       $40,000 (non-recourse)

Further appreciated to $100,000 and sale for $60,000 cash and $40,000 debt assumption (amount realized is $100,000).

Basis is $30,000;   gain is $70,000 (but cash received on sale is only $60,000; previously $40,000 cash was received in the non-recourse “after-acquired” borrowing).

 

Problem 4a                      p.336
Purchase Debt Reduction?

Purchase for $10,000  (business equipment).

    $1,000 cash; $9,000 note to the seller - nonrecourse, but mortgage on equipment.

    $3,000 deduction for tax depreciation.

Basis - $7,000;  Property FMV is $6,900.

Debt principal is reduced by $2,500 from $9,000 to $6,500.

Tax basis is reduced from $7,000 to $4,500 (assuming Code §108(e)(5) is applicable). 

Problem 4b                     p. 336
Bank Financing

Purchase for $10,000  (business equipment).

    $1,000 cash; $9,000 loan from a bank; nonrecourse mortgage on the equipment.

    $3,000 deduction for tax depreciation.

3rd party debt reduced from $9,000 to $6,500.

Property FMV is $6,900;  basis is $7,000.

$2,500 COD income?   Rev. Rul. 91-31.

Cf., §108(a)(1)(D) which applies to qualified real property business debt.

 

 

Problem 5                      p. 336
Debt Exceeding Basis

Transfer by gift of property with FMV of 100x, basis of 20x, nonrecourse debt of 30x. 

Treat as “part gift/part sale” transaction.

Reg. §1.1015-4:  allocate entire 20x basis to the “sale” portion of transaction, resulting in 10x gain.  Transferee takes a 30x basis.

Option:  treat as 3/10th sale and 7/10ths gift.

3/10ths of 20x basis = 6x allocated to the 20x sale and gain of 24x (30x less 6x), not 10x.

Tufts case                       p.338
Debt Exceeds Property FMV

Property purchase for $1.85 million nonrecourse debt & tax basis of $1.85 mil.

$400,000 tax depreciation claimed.

Tax basis is reduced to $1.45 million (§1016).

Property FMV at disposition was $1.4 million - $1.850 debt exceeds tax basis and the FMV of the property.

Tax issues:  Gain or other income? Loss? Tax character?  How much?

 

Tufts choices for decision
One or Two Transactions?

Integrated transaction

1.850 debt

Less 1.450 basis

Equals: 400 gain

(capital gain?)

Two transactions

1)  1.850 debt relief

Less: 1.400 value

= 450 COD income.

2)  1.450 basis

Less: 1.400 value

Equals: 50 capital loss.

Treasury Regulations & Nonrecourse Debt

Reg. §1.1001-2(a)(1) - the amount realized includes the amount of liabilities from which the transferor is discharged.

Reg. §1.1001-2(a)(4)(i) - the sale of property that secures a nonrecourse liability discharges the transferor from the liability.

Reg. §1.1001-2(b) - the fair market value of the security is not relevant for determining the amount of liabilities being discharged.

Revenue Ruling 90-16  
p. 345

Acquisition of property with recourse liability, i.e., personal liability.

Property was transferred to lender and borrower was released from liability.

Debt                   12x

Property FMV  10x   (2x COD income?)

Basis                   8x    (2x property gain?)

Foreclosure proceeding:  same result.

Problem 1a                      p.347
Liability Exceeds FMV

Purchase for $10,000:         $1,000 cash &

    $9,000 note - non-recourse debt, but mortgage on the equipment;

    $3,000 deduction claimed for depreciation.

Adjusted tax basis for property:   $7,000.

Transfer of property to the buyer for no cash since the property was only worth $8,500.

$2,000 sales gain - similar to Tufts situation.

Problem 1b                      p.347
Foreclosure Proceeding

Purchase for $10,000:         $1,000 cash &

    $9,000 note - non-recourse debt, but mortgage on the equipment;

    $3,000 deduction claimed for depreciation.

Adjusted tax basis for property:   $7,000.

Foreclosure on the property when the property was only worth $8,500.

$2,000 gain – (9,000 debt less 7,000 basis)

Tufts situation whether voluntary or involuntary transfer.

 

Problem 1c                      p.347
Recourse Debt  & Foreclosure

Purchase of property for $10,000:

    $1,000 cash; $9,000 note - recourse.

    $3,000 deduction for depreciation

     Adjusted basis: $7,000.

Foreclosure when property FMV is $8,500.

$1,500 gain;  $500 COD income (since deficiency not pursued).

(Recourse debt - not an integrated result as in the Tufts non-recourse situation).

Problem 1d                      p.348
Foreclosure & Deficiency

Purchase of property for $10,000:

    $1,000 cash; $9,000 note - recourse.

    $3,000 deduction for depreciation

     Adjusted basis: $7,000.

Foreclosure when the property FMV is $8,500.

$1,500 gain; Deficiency judgment is obtained.

No $500 COD income (since deficiency judgment can be pursued).

Problem 2                        p.348
Low FMV Property

FMV of property is worth 10x, less than basis (50x) and less than nonrecourse debt (200x).

Abandon the property (a realization event of 150x gain, under Tufts;  not deferrable (capital) gain under §108); or

Negotiate a debt discharge with the lender: (1) pay, e.g.,  15x to cancel the debt, and

   (2)  borrower keeps the property;  §108 COD income of 185x is excludable since borrower is insolvent (basis adjustment).

 

Summary of Tax Treatment

Recourse Debt

1) FMV exceeds debt  -  §1001.

 

2) Debt exceeds FMV - §61(a)(12).

COD income.

Nonrecourse debt

 1) FMV exceeds debt - §1001.

 

2) Debt exceeds FMV - §1001 (Tufts).