The Story of Tufts: The “Logic” of Taxing Nonrecourse Transactions
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Description
It should come as no surprise to students of the income tax that the presence of liabilities in property transactions can cause enormous complications. In no area is this more true than in the partnership setting, where partnership liabilities are included in the partners' bases in their partnership interests (i.e., their “outside bases”) under the complex set of rules and regulations under Code § 752. Under those rules, each partner is treated as contributing cash in an amount equal to her share of the partnership liabilities. On the other hand, if a partner's share of partnership liabilities decreases, the partner is deemed to have received a cash distribution in that amount. As complicated as these rules are, they draw upon and are consistent with the basic rules learned in income tax: When a taxpayer borrows funds, he does not have income because of his equal and offsetting liability, and when he repays the loan he is not given a deduction. The only time a borrowing transaction generates any taxable income is when the taxpayer is discharged from all or part of his obligation to make repayment.2 If borrowed funds are used to purchase property, they are included in the basis of the purchased property: Taxpayers receive basis credit not only for what they have paid for the property but what they have promised to pay. If the property is depreciable, the owner will compute his depreciation deductions on the full basis so computed: Because we assume that the loan will be paid we assume that any losses represented by those deductions will in fact be borne by the taxpayer when he repays the loan. And when the taxpayer sells the property, he must include in his amount realized from the sale the amounts he uses to repay the loan. To illustrate, assume that A buys a piece of property for $100, borrowing the entire purchase price from a bank. He sells the property two years later for $120 cash. Assume first that the property is not depreciable. A's basis is $100, on sale he includes the full $120 in his amount realized, even though he must use $ 100 to pay back the bank. His gain is $20, representing the increase in the property's value over A's period of ownership. Assume now that the property is depreciable, and during the two years he owns it, A deducts a total of $20 depreciation. A's initial $100 basis will be reduced to $80 by depreciation, and on sale A will report a gain of $40: representing not only the increase in the property's value, but the $20 in depreciation previously taken. It turns out the property did not decline in value as predicted by the depreciation system, and it is appropriate for A to report an offsetting amount of income at the time it becomes clear he will not economically suffer the losses represented by those deductions. All of the foregoing rules apply regardless of whether A uses the purchased property as security for the loan, and if he does, regardless of whether A has personal liability for the loan (recourse), or whether the lender's recourse in the event of foreclosure is limited to the value of the property securing the loan (nonrecourse). In each case, the income tax essentially ignores the loan transaction: Neither the borrowing nor the repayment of the loan are taxable events, and no distinction is made between tax-paid funds taken from A's bank account to purchase property and funds borrowed from the bank, which are untaxed. The rules get a little more complicated if A sells the property for $20 cash to a buyer who either assumes or takes the property subject to the existing $100 loan. In either case, A is in the same economic position as he would have been if he had sold the property for $I20 and paid off the loan himself, and the rule of the Crane case tells us to tax A consistently: His amount realized on the sale includes the debt relief, whether recourse or not. The harder case arises when the value of the property falls below the balance of the outstanding loan. Assume that A's non-depreciable property drops in value to $70, and that the loan is recourse. No sensible buyer will undertake personal liability for A's personal loan for $100, so assume that A transfers the property to the lender in lieu of foreclosure. This is clearly a disposition of the property and A's amount realized is $70, the amount of the liability that is satisfied as a result of the transfer; therefore A has a loss of $30 on the property. In addition, A may have discharge of indebtedness income from the transaction depending on whether the lender pursues A for the $30 shortfall. If the lender does and A pays the outstanding balance as the tax law assumed he would do, then there are no further tax consequences. All appropriate. If, on the other hand, the lender does not force A to pay the $30 shortfall, then A must include that amount in income: Because he was not taxed when he first borrowed the funds, when it turns out he doesn't have to repay them he must have income at that time, income from discharge of indebtedness.
Source Publication
Business Tax Stories
Source Editors/Authors
Steven A. Bank, Kirk J. Stark
Publication Date
2005
Recommended Citation
Cunningham, Laura E. and Cunningham, Noël B., "The Story of Tufts: The “Logic” of Taxing Nonrecourse Transactions" (2005). Faculty Chapters. 1151.
https://gretchen.law.nyu.edu/fac-chapt/1151
