Loans and Cancellation of Indebtedness

In this chapter, we take up various tax consequences of borrowing money. The fact that a taxpayer has borrowed money means that he has more money to spend. However, it also means that he has incurred an obligation to repay the loan. One precisely offsets the other. Hence, there are no tax consequences to taking out a loan. Furthermore, taxpayer is entitled to spend this addition to his “store of property rights” on investment or consumption – and we treat such a taxpayer the same as we would if he had made such a purchase or investment with after-tax income. Taxpayer’s expenditure entitles him to basis in whatever asset he may have purchased.

This does not mean that taxpayer is entitled to income that is not subject to income tax. Consider how taxpayer will meet his obligation to repay the loan. Taxpayer will have to acquire money that is subject to income tax – perhaps by working at a job in exchange for wages – pay income tax on that income, and use what remains after payment of taxes to repay the loan. By taking out a loan, taxpayer has made a future consumption choice, i.e., repayment of the loan. Consistent with the principle that borrowing money is not income to the taxpayer is the rule that repayment of loan principal is not deductible.

All of this assumes that taxpayer will indeed repay the full amount of the loan. Consider now what happens when we no longer make this assumption. Taxpayer does not repay the loan, and for whatever reason, no longer owes it.

• Taxpayer has enjoyed the benefits of an expenditure on consumption without an offsetting reduction to his store of property rights.

• Taxpayer no longer commits his future consumption choices to repayment of the loan.

• Should we regard this as an accession to wealth and treat it as gross income? See § 61(a)(11).

Or: perhaps the assets (e.g., a business venture) that taxpayer purchased with the borrowed funds and upon which taxpayer relies to repay the loan shrink in value so that taxpayer is no longer able to repay the loan.

• Should this excuse a failure to repay the loan because such shrinkage can hardly be regarded as an “accession to wealth?”

• If we deem such a shrinkage not to be an “accession to wealth,” we effectively merge the borrowing transaction and the spending or investing of the loan proceeds into one transaction. Is this appropriate? Or should we account separately for –

• the borrowing and repayment, and

• the fate of the enterprise in which taxpayer spends or invests the loan proceeds?

Or: Perhaps taxpayer can take advantage of market conditions to satisfy his obligation by paying less than the amount that he originally borrowed.

What answers to these questions does this leading case suggest?

MR. JUSTICE HOLMES delivered the opinion of the court.

In July, 1923, the plaintiff, the Kirby Lumber Company, issued its own bonds for $12,126,800 for which it received their par value. Later in the same year, it purchased in the open market some of the same bonds at less than par, the difference of price being $137,521.30. The question is whether this difference is a taxable gain or income of the plaintiff for the year 1923. By the Revenue Act of (November 23) 1921, c. 136, § 213(a), gross income includes “gains or profits and income derived from any source whatever,” and, by the Treasury Regulations authorized by § 1303, that have been in force through repeated reenactments, “If the corporation purchases and retires any of such bonds at a price less than the issuing price or face value, the excess of the issuing price or face value over the purchase price is gain or income for the taxable year.” Article 545(1)(c) of Regulations 62, under Revenue Act of 1921. [citations to more regulations omitted]. We see no reason why the Regulations should not be accepted as a correct statement of the law.

In Bowers v. Kerbaugh-Empire Co., 271 U.S. 170, the defendant in error owned the stock of another company that had borrowed money repayable in marks or their equivalent for an enterprise that failed. At the time of payment, the marks had fallen in value, which, so far as it went, was a gain for the defendant in error, and it was contended by the plaintiff in error that the gain was taxable income. But the transaction as a whole was a loss, and the contention was denied. Here, there was no shrinkage of assets, and the taxpayer made a clear gain. As a result of its dealings, it made available $137,521.30 assets previously offset by the obligation of bonds now extinct. We see nothing to be gained by the discussion of judicial definitions. The defendant in error has realized within the year an accession to income, if we take words in their plain popular meaning, as they should be taken here. Burnet v. Sanford & Brooks Co., 282 U.S. 359, 364.

Judgment reversed.

Notes and Questions:

1. How does it happen that Kirby Lumber Company could buy back its bonds in the open market for less than it obtained when it issued the bond?

2. What is a “shrinkage of assets?” Was the holding in Kerbaugh-Empire wrong? Why (or why not)?

• Evidently, there was a “shrinkage of assets” in Kerbaugh-Empire, but not in Kirby Lumber.

3. What should we make of the “made available” language of the Court?

• Suppose that taxpayer is hopelessly insolvent. Let’s say that taxpayer has assets with a fmv of $152,000, but has liabilities of $379,000. Liabilities exceed assets by $227,000. One creditor settles a $110,000 debt for property worth $18,000. Now the taxpayer has assets with a fmv of $134,000 and liabilities of $269,000. Liabilities now exceed assets by $135,000, i.e., $92,000 less than before this settlement. Has this transaction really “made available” $92,000 to taxpayer?

• No, said the Fifth Circuit in Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 F.2d 95, 96 (5^th Cir. 1934):

There is a reduction or extinguishment of liabilities without any increase of assets. There is an absence of such a gain or profit as is required to come within the accepted definition of income. … [T]he cancellation of the respondent’s past due debt … did not have the effect of making the respondent’s assets greater than they were before that transaction occurred. Taxable income is not acquired by a transaction which does not result in the taxpayer getting or having anything he did not have before. Gain or profit is essential to the existence of taxable income. A transaction whereby nothing of exchangeable value comes to or is received by a taxpayer does not give rise to or create taxable income.

• Reducing the degree by which taxpayer is insolvent from $227,000 to $135,000 is not sufficient to constitute gross income. What if the reduction had been from $227,000 to $100. Where is the line?

4. (note 3 continued) In Lakeland Grocery Co. v. Commissioner, 36 B.T.A. 289, 291-92 (1937), taxpayer was insolvent and had filed a petition for voluntary bankruptcy. Taxpayer’s creditors wrote off $104,000 of debt in exchange for payments totaling $15,000 to keep taxpayer from further pursuing relief through a bankruptcy proceeding. After this exchange, the value of taxpayer’s assets exceeded its liabilities by $40,000. Taxpayer’s

net assets were increased from zero to $39,596.93 as a result of the cancellation of indebtedness by its creditors, and to that extent it had assets which ceased to be offset by any liability. … [T]he cancellation of [taxpayer’s] debts had the effect of making its assets greater than they were before that transaction occurred. It is true that ‘gain’ or ‘profit’ is essential to the existence of taxable ‘income’ … and we believe that ‘gain’, as commonly understood, was realized here when [taxpayer], who was hopelessly insolvent, received by the action of its creditors an increment to its assets clear and free of any claims of the creditors. … [W]e conclude that the assets freed to the [taxpayer] by the composition of creditors had an exchange value. Under such facts …, [taxpayer] realized taxable gain …

Id. at 292.

5. The “making available assets” language meant – practically uniformly among lower courts – that an insolvent debtor realized gross income from cancellation of indebtedness only to the extent that such cancellation made the debtor solvent. In fact, some courts held that the cancellation of debt of an insolvent debtor was not “income” under the Sixteenth Amendment. See Ann K. Wooster, Application of the 16^th Amendment to U.S. Constitution – Taxation of Specific Types of Income, 46 A.L.R. Fed. 2d 301 (2010) § 12 (debt forgiveness income).

6. Back to Kerbaugh-Empire: A loan is a transaction. Taxpayer may use loan proceeds in another transaction. Logically, the loan and the spending or investment of proceeds are two different transactions that taxpayer should have to account for separately. In the absence of any statutory provision governing exclusion of cancellation of indebtedness income, the Code essentially required the Commissioner prior to 1954 to kick a taxpayer when he was down. We see what happened. Dallas Transfer and Lakeland Grocery focused on taxpayer’s insolvency to exclude at least some coi income from taxpayer’s gross income. The holding in Kerbaugh-Empire seemed to permit a court to focus on the success of the enterprise in which taxpayer invested loan proceeds to determine whether taxpayer had to include cancellation of indebtedness in his gross income.

• Section 108 changes this, but § 108 does not convert business losses into excludable cancellation of indebtedness income.

• The court in United States v. Gehl, 50 F.3d 12, 1995 WL 115589 (8^th Cir.), cert. denied, 516 U.S. 899 (1995), chapter 3, supra sorted all this out.

8. Section 108(e)(1) provides that there is no insolvency exception from the general rule that gross income includes income from discharge of indebtedness other than what § 108 provides.

• When the other provisions of § 108 apply, § 108 appears to “preempt the field” – much as §§ 119 and 132 preempt their respective fields. See Boris I. Bittker, Martin J. McMahon, Jr., & Lawrence A. Zelenak, supra at 4-21 to 4-22.

9. Read § 108(b). It implicitly requires a taxpayer who enjoys doi income to determine how much doi income he is not recognizing. What is a “tax attribute?”

• It is a phrase that we use often, but the Code does not define the phrase. We surmise its meaning by reading § 108(b).

• A “tax attribute” is a tax characteristic of a taxpayer. Section 108(b) lists various “tax attributes” that might reduce taxpayer’s tax liability in the future. That list includes: net operating loss, general business credit, minimum tax credit, capital loss carryover, basis reduction, passive activity loss and credit carryovers, and foreign tax credit carryovers.

• What is the effect of § 108(b) on the holdings of cases such as Dallas Transfer & Terminal Warehouse and Lakeland Grocery? Define the “exclusion” from gross income that § 108 provides a taxpayer who is in bankruptcy or insolvent.

• Tax attributes named in § 108(b) reduce a taxpayer’s tax liability at some future time. Does it matter how far into the future the reduction occurs?

• The consequence of reducing a tax attribute is that taxpayer’s future tax liability will not decrease.

• To the extent that a taxpayer has tax attributes, § 108 does not in fact exclude doi income from taxpayer’s gross income, but instead defers the effect of its recognition to the day that a tax attribute would have reduced taxpayer’s tax liability.

10. Section 108(b)(2)(E) provides for basis reductions, and § 108(b)(5) permits the taxpayer to elect to reduce his basis in depreciable property before reducing other tax attributes. Such an election would matter to the taxpayer only if he has attributes listed in § 108(b)(2)(A, B, C, or D) and wants to preserve them.

11. (Note 10 continued): Reduction of tax attributes and reductions of basis: Section 1017 and Reg. § 1.1017-1 provide some rather technical rules governing the sequence of reductions in taxpayer’s basis in his property.

• Read § 1017(b)(2). What rule does it state for basis reductions under 108(b)(2)(E) and under 108(b)(5)?

• Read 1017(a). The reduction is made to the basis of any property held by the taxpayer at the beginning of the tax year following the tax year in which the debt discharge occurs (§ 1017(a)).

• Taxpayer need not reduce (“spend”) his tax attributes upon the discharge of indebtedness but rather may use them to reduce tax liability for the year of discharge.

• Then taxpayer may also reduce basis.

12. Consider:

• 12a. Taxpayer owns real property, fmv = $100,000, ab = $135,000. This is all of taxpayer’s property. Taxpayer also has no other assets, not even cash. Taxpayer has liabilities of $120,000. Is taxpayer insolvent for purposes of § 108? By how much?

• 12b. Taxpayer owns real property, fmv = $135,000, ab = $100,000. This is all of taxpayer’s property. Taxpayer also has no other assets, not even cash. Taxpayer has liabilities of $120,000. Is taxpayer insolvent for purposes of § 108? By how much?

• 12c. Taxpayer owns real property, ab = $80,000, fmv = $125,000. This is all of taxpayer’s property, except that taxpayer also has $5000 of cash. Taxpayer’s real property is subject to a debt of $110,000 that he owes to creditor. Taxpayer did not purchase the property from creditor. Taxpayer was having difficulty making payments, so creditor agreed to reduce taxpayer’s debt to $95,000. How much doi income must taxpayer include in his gross income under §§ 61(a)(11)/108?

• 12d. Taxpayer owns real property, ab = $80,000, fmv = $125,000. This is all of Taxpayer’s property, except that Taxpayer has $20,000 of cash. Taxpayer’s real property is subject to a debt of $150,000 that she owes to creditor. Taxpayer did not purchase the property from creditor. Taxpayer was having difficulty making payments. Creditor agreed to reduce taxpayer’s debt from $150,000 to $130,000 in exchange for an immediate cash payment of $10,000. Taxpayer agreed and made the payment. How much doi income must taxpayer include in her gross income under §§ 61/108?

• 12e. Same facts as 12d, except that taxpayer has filed for bankruptcy. The creditor makes the same arrangement with taxpayer. How much doi income must taxpayer include in her gross income under §§ 61/108? [Disregard the effect of such a payment on the bankruptcy proceeding.]

Now consider a case (and its appeal) in which the very characterization of the transaction(s) generated considerable disagreement. Included here are three opinions from the Tax Court and one from the Third Circuit Court of Appeals. Ultimately, of course, it is the opinion of the Third Circuit that prevails. Be ready to articulate the positions of the different judges as to just exactly what happened.

COHEN, Judge:

Respondent determined deficiencies of $2,466,622 and $58,688 in petitioners’ Federal income taxes for 1980 and 1981, respectively.

In the notice of deficiency, respondent … asserted that petitioners realized … taxable income of $2,935,000 in 1981 through cancellation of indebtedness. The sole issue for decision is whether petitioners had income from discharge of gambling indebtedness during 1981.

….

David Zarin (petitioner) was a professional engineer involved in the development, construction, and management of multi-family housing and nursing home facilities. …

Petitioner occasionally stayed at Resorts International Hotel, Inc. (Resorts), in Atlantic City in connection with his construction activities. … In June 1978, petitioner applied to Resorts for a $10,000 line of credit to be used for gambling. After a credit check, which included inquiries with petitioner’s banks and “Credit Central,” an organization that maintains records of individuals who gamble in casinos, the requested line of credit was granted, despite derogatory information received from Credit Central.

The game most often played by petitioner, craps, creates the potential of losses or gains from wagering on rolls of dice. When he played craps at Resorts, petitioner usually bet the table limit per roll of the dice. Resorts quickly became familiar with petitioner. At petitioner’s request, Resorts would raise the limit at the table to the house maximum. When petitioner gambled at Resorts, crowds would be attracted to his table by the large amounts he would wager. Gamblers would wager more than they might otherwise because of the excitement caused by the crowds and the amounts that petitioner was wagering. Petitioner was referred to as a “valued gaming patron” by executives at Resorts.

By November 1979, petitioner’s permanent line of credit had been increased to $200,000. Despite this increase, at no time after the initial credit check did Resorts perform any further analysis of petitioner’s creditworthiness. Many casinos extend complimentary services and privileges (“comps”) to retain the patronage of their best customers. Beginning in the late summer of 1978, petitioner was extended the complimentary use of a luxury three-room suite at Resorts. Resorts progressively increased the complimentary services to include free meals, entertainment, and 24-hour access to a limousine. By late 1979, Resorts was extending such comps to petitioner’s guests as well. By this practice, Resorts sought to preserve not only petitioner’s patronage but also the attractive power his gambling had on others.

Once the line of credit was established, petitioner was able to receive chips at the gambling table. Patrons of New Jersey casinos may not gamble with currency, but must use chips provided by the casino. Chips may not be used outside the casino where they were issued for any purpose.

Petitioner received chips in exchange for signing counter checks, commonly known as “markers.” The markers were negotiable drafts payable to Resorts drawn on petitioner’s bank. The markers made no reference to chips, but stated that cash had been received.

Petitioner had an understanding with Gary Grant, the credit manager at Resorts, whereby the markers would be held for the maximum period allowable under New Jersey law, which at that time was 90 days, whereupon petitioner would redeem them with a personal check. At all times pertinent hereto, petitioner intended to repay any credit amount properly extended to him by Resorts and to pay Resorts in full the amount of any personal check given by him to pay for chips or to reduce his gambling debt. Between June 1978 and December 1979, petitioner incurred gambling debts of approximately $2.5 million. Petitioner paid these debts in full.

On October 3, 1979, the New Jersey Division of Gaming Enforcement filed with the New Jersey Casino Control Commission a complaint against Resorts and several individuals, which alleged 809 violations pertaining to Resorts’ casino gaming credit system, its internal procedures, and its administrative and accounting controls. Of those 809 violations, 100 were specifically identified as pertaining to petitioner and a gambling companion. Pursuant to a request for a cease and desist order contained in the complaint, a Casino Control Commissioner issued an Emergency Order on October 9, 1979. That order provided, in relevant part:

5. Effective immediately, Resorts shall not issue credit to any patron whose patron credit reference card indicates that the credit now outstanding exceeds the properly approved credit limit. In determining whether a credit limit has been exceeded, all yet undeposited checks received in payment of a counter check or checks shall be included as credits.

After the Emergency Order was issued, Resorts began a policy of treating petitioner’s personal checks as “considered cleared.” Thus, when petitioner wrote a personal check it was treated as a cash transaction, and the amount of the check was not included in determining whether he had reached his permanent credit limit. In addition, Resorts extended petitioner’s credit limit by giving him temporary increases known as “this trip only” credit. Although not specifically addressed by the New Jersey Casino Control regulations in effect during 1979 and 1980, a “this trip only” credit increase was a temporary credit increase for a patron’s current trip to Atlantic City, and was required to be reduced before the patron’s return. Both of these practices effectively ignored the Emergency Order. Petitioner did not understand the difference between “this trip only” credit and his permanent credit line, and he thought that he no longer had a credit limit.

By January 1980, petitioner was gambling compulsively at Resorts. Petitioner was gambling 12-16 hours per day, 7 days per week in the casino, and he was betting up to $15,000 on each roll of the dice. Petitioner was not aware of the amount of his gambling debts.

On April 12, 1980, Resorts increased petitioner’s permanent credit line to $215,000, without any additional credit investigation. During April 1980, petitioner delivered personal checks and markers in the total amount of $3,435,000 that were returned to Resorts as having been drawn against insufficient funds. On April 29, 1980, Resorts cut off petitioner’s credit. Shortly thereafter, petitioner indicated to the Chief Executive Officer of Resorts that he intended to repay the obligations.

On November 18, 1980, Resorts filed a complaint in New Jersey state court seeking collection of $3,435,000 from petitioner based on the unpaid personal checks and markers. On March 4, 1981, petitioner filed an answer, denying the allegations and asserting a variety of affirmative defenses.

On September 28, 1981, petitioner settled the Resorts suit by agreeing to make a series of payments totaling $500,000. Petitioner paid the $500,000 settlement amount to Resorts in accordance with the terms of the agreement. The difference between petitioner’s gambling obligations of $3,435,000 and the settlement payments of $500,000 is the amount that respondent alleges to be income from forgiveness of indebtedness.

On July 8, 1983, Resorts was fined $130,000 for violating the Emergency Order on at least 13 different occasions, 9 of which pertained directly to credit transactions between Resorts and petitioner.

….

Income From the Discharge of Indebtedness

In general, gross income includes all income from whatever source derived, including income from the discharge of indebtedness. [§ 61(a)(11).] Not all discharges of indebtedness, however, result in income. [citation omitted]. The gain to the debtor from such discharge is the resultant freeing up of his assets that he would otherwise have been required to use to pay the debt. See United States v. Kirby Lumber Co., 284 U.S. 1 (1931).

… Petitioner argues that the settlement agreement between Resorts and himself did not give rise to … income because, among other reasons, the debt instruments were not enforceable under New Jersey law and, in any event, the settlement should be treated as a purchase price adjustment that does not give rise to income from the discharge of indebtedness.

Petitioner argues that gambling and debts incurred to acquire gambling opportunity have always received special treatment at common law and in the Internal Revenue Code and that agreeing with respondent in this case would result in taxing petitioner on his losses. Petitioner relies on United States v. Hall, 307 F.2d 238 (10th Cir. 1962), as establishing a rule that the cancellation of indebtedness doctrine is not applicable to the settlement of a gambling debt.

The parties have primarily focused their arguments on whether the debt instruments memorializing the credit transactions were legally enforceable and whether legal enforceability is of significance in determining the existence of income from discharge of indebtedness. Petitioner argues that his debt was unenforceable and thus there was no debt to be discharged and no resulting freeing up of assets because his assets were never encumbered. Petitioner relies on N.J. Stat. Ann. § 5:12-101(f) (West 1988), and Resorts International Hotel, Inc. v. Salomone, 178 N.J. Super. 598, 429 A.2d 1078 (App. Div. 1981), in arguing that the gambling debts were unenforceable.

… We must decide, therefore, whether legal enforceability is a prerequisite to recognition of income in this case.

Enforceability

In United States v. Hall, supra, the taxpayer transferred appreciated property in satisfaction of a gambling debt of an undetermined amount incurred in Las Vegas, Nevada. The Commissioner sought to tax as gain the difference between the amount of the discharged debt and the basis of the appreciated property. Although licensed gambling was legal in Nevada, gambling debts were nevertheless unenforceable. The Court of Appeals concluded that, under the circumstances, the amount of the gambling debt had no significance for tax purposes. The Court reasoned that, “The cold fact is that taxpayer suffered a substantial loss from gambling, the amount of which was determined by the transfer.” 307 F.2d at 241. The Court of Appeals relied on the so-called “diminution of loss theory” developed by the Supreme Court in Bowers v. Kerbaugh-Empire Co., 271 U.S. 170 (1926). In that case, the taxpayer borrowed money that was subsequently lost in a business transaction. The debt was satisfied for less than its face amount. The Supreme Court held that the taxpayer was not required to recognize income from discharge of a debt because the transaction as a whole lost money.

The Court of Appeals for the Tenth Circuit in Hall quoted at length from Bradford v. Commissioner, 233 F.2d 935 (6th Cir. 1956), which noted that the Kerbaugh-Empire case was decided before United States v. Kirby Lumber Co., 284 U.S. 1 (1931), and Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931), and had been “frequently criticized and not easily understood.” Subsequent developments further suggest that Kerbaugh-Empire has lost its vitality. See Vukasovich, Inc. v. Commissioner, 790 F.2d 1409 (9th Cir. 1986) …

….

In the instant case, symmetry from year to year is not accomplished unless we treat petitioner’s receipt of the loan from Resorts (i.e., the markers converted to chips) and the subsequent discharge of his obligation to repay that loan in a consistent manner. Petitioner received credit of $3,435,000 from Resorts. He treated these amounts as a loan, not reporting any income on his 1980 tax return. Compare United States v. Rosenthal, 470 F.2d 837 (2d Cir. 1972), and United States v. Rochelle, 384 F.2d 748 (5th Cir. 1967). The parties have stipulated that he intended to repay the amounts received. Although Resorts extended the credit to petitioner with the expectation that he would continue to gamble, theoretically petitioner could have redeemed the chips for cash. Certainly if he had won, rather than lost, at gambling, the amounts borrowed would have been repaid.

Petitioner argues that he did not get anything of value when he received the chips other than the “opportunity to gamble,” and that, by reason of his addiction to gambling, he was destined to lose everything that he temporarily received. Thus, he is in effect arguing, based on Hall, that the settlement merely reduced the amount of his loss and did not result in income.

….

We have no doubt that an increase in wealth from the cancellation of indebtedness is taxable where the taxpayer received something of value in exchange for the indebtedness. …

We conclude here that the taxpayer did receive value at the time he incurred the debt and that only his promise to repay the value received prevented taxation of the value received at the time of the credit transaction. When, in the subsequent year, a portion of the obligation to repay was forgiven, the general rule that income results from forgiveness of indebtedness, [§ 61(a)(11)], should apply.

Legal enforceability of an obligation to repay is not generally determinative of whether the receipt of money or property is taxable. James v. United States, 366 U.S. 213, 219 (1961). …

Here the timing of recognition was set when the debt was compromised. The amount to be recognized as income is the part of the debt that was discharged without payment. The enforceability of petitioner’s debts under New Jersey law did not affect either the timing or the amount and thus is not determinative for Federal income tax purposes. We are not persuaded that gambling debts should be accorded any special treatment for the benefit of the gambler – compulsive or not. As the Court of Appeals in United States v. Hall stated, “The elimination of a gambling debt is * * * a transaction that may have tax consequences independent of the amount of the debt and certainly cannot be used as a tool to avoid a tax incident which is shielded only by the screen of its unenforceable origin.” 307 F.2d at 242.

Disputed Debt

Petitioner also relies on the principle that settlement of disputed debts does not give rise to income. N. Sobel, Inc. v. Commissioner, 40 B.T.A. 1263 (1939), cited with approval in Colonial Savings Assn. v. Commissioner, 85 T.C. 855, 862-863 (1985), aff’d, 854 F.2d 1001 (7th Cir. 1988). Prior to the settlement, the amount of petitioner’s gambling debt to Resorts was a liquidated amount, unlike the taxpayer’s debt in Hall. There is no dispute about the amount petitioner received. The parties dispute only its legal enforceability, i.e., whether petitioner could be legally compelled to pay Resorts the fixed amount he had borrowed. A genuine dispute does not exist merely because petitioner required Resorts to sue him before making payment of any amount on the debt. … In our view, petitioner’s arguments concerning his defenses to Resorts’ claim, which apparently led to Resorts’ agreement to discount the debt, are overcome by (1) the stipulation of the parties that, at the time the debt was created, petitioner agreed to and intended to repay the full amount, and (2) our conclusion that he received full value for what he agreed to pay, i.e., over $3 million worth of chips and the benefits received by petitioner as a “valued gambling patron” of Resorts.

Deductibility of Gambling Losses

….

Purchase Money Debt Reduction

Petitioner argues that the settlement with Resorts should be treated as a purchase price adjustment that does not give rise to income from the discharge of indebtedness. He cites the parties’ stipulation, which included a statement that, “Patrons of New Jersey casinos may not gamble with currency. All gambling must be done with chips provided by the casino. Such chips are property which are not negotiable and may not be used to gamble or for any other purpose outside the casino where they were issued.” Respondent argues that petitioner actually received “cash” in return for his debts.

Section 108(e)(5) was added to the Internal Revenue Code by the Bankruptcy Tax Act of 1980, Pub. L. 96-589, 94 Stat. 3389, 3393, and provides:

(5) Purchase-money debt reduction for solvent debtor treated as price reduction. – If –

(A) the debt of a purchaser of property to the seller of such property which arose out of the purchase of such property is reduced,

(B) such reduction does not occur –

(i) in a title 11 case, or

(ii) when the purchaser is insolvent, and

(C) but for this paragraph, such reduction would be treated as income to the purchaser from the discharge of indebtedness,

then such reduction shall be treated as a purchase price adjustment.

Section 108(e)(5) was enacted “to eliminate disagreements between the Internal Revenue Service and the debtor as to whether, in a particular case to which the provision applies, the debt reductions should be treated as discharge income or a true price adjustment.” S. Rept. No. 96-1035 (1980). Section 108(e)(5) applies to transactions occurring after December 31, 1980. S. Rept. No. 96-1035, supra. The provisions of this section are not elective.

….

It seems to us that the value received by petitioner in exchange for the credit extended by Resorts does not constitute the type of property to which § 108(e)(5) was intended to or reasonably can be applied. Petitioner argued throughout his briefs that he purchased only “the opportunity to gamble” and that the chips had little or no value. We agree with his description of what he bargained for but not with his conclusion about the legal effect.

As indicated above, we are persuaded … that petitioner received full value for his debt. …

Petitioner purchased the opportunity to gamble as he received chips in exchange for his markers. … Upon receipt of the chips, Petitioner immediately proceeded to gamble with these chips. * * *

….

* * *

* * * … Petitioner, in entering into the gaming transactions with Resorts, did not receive any item of tangible value. In fact, Petitioner received nothing more than the opportunity to bet on which of 36 permutations of the dice would appear on a given roll of the dice. * * *

….

While disagreeing with petitioner’s assertion as to the value of what he received, we agree that what he received was something other than normal commercial property. He bargained for and received the opportunity to gamble and incidental services, lodging, entertainment, meals, and transportation. Petitioner’s argument that he was purchasing chips ignores the essence of the transaction, as more accurately described in his other arguments here quoted. The “property” argument simply overemphasizes the significance of the chips. As a matter of substance, chips in isolation are not what petitioner purchased.

The “opportunity to gamble” would not in the usual sense of the words be “property” transferred from a seller to a purchaser. The terminology used in § 108(e)(5) is readily understood with respect to tangible property and may apply to some types of intangibles. Abstract concepts of property are not useful, however, in deciding whether what petitioner received is within the contemplation of the section.

Obviously the chips in this case were a medium of exchange within the Resorts casino, and in that sense they were a substitute for cash, just as Federal Reserve Notes, checks, or other convenient means of representing credit balances constitute or substitute for cash. …

We conclude that petitioner’s settlement with Resorts cannot be construed as a “purchase-money debt reduction” arising from the purchase of property within the meaning of § 108(e)(5).

….

Reviewed by the Court.

Nims, Parker, Körner, Shields, Hamblen, Clapp, Gerber, Wright, Parr, and Colvin, JJ., agree with the majority opinion.

Tannenwald, J., dissenting:

The foundation of the majority’s reasoning is that Mr. Zarin realized income in an amount equal to the amount of the credit extended to him because he was afforded the “opportunity to gamble.” …

….

I think it highly significant that in all the decided cases involving the cancellation of indebtedness, the taxpayer had, in a prior year when the indebtedness was created, received a nontaxable benefit clearly measurable in monetary terms which would remain untaxed if the subsequent cancellation of the indebtedness were held to be tax free. Such is simply not the case herein. The concept that petitioner received his money’s worth from the enjoyment of using the chips (thus equating the pleasure of gambling with increase in wealth) produces the incongruous result that the more a gambler loses, the greater his pleasure and the larger the increase in his wealth. . Under the circumstances, I think the issue of enforceability becomes critical. In this connection, the repeated emphasis by the majority on the stipulation that Mr. Zarin intended to repay the full amount at the time the debt was created is beside the point. If the debt was unenforceable under New Jersey law, that intent is irrelevant.

It is clear that respondent has not shown that the checks Mr. Zarin gave Resorts were enforceable under New Jersey law. New Jersey law provides that checks issued to pay for gambling are enforceable provided that a set of requirements relating to, among other things, proper payees, dating and holding periods, is met. See N.J. Stat. Ann. § 5:12-101 (West 1988).” Any check cashed, transferred, conveyed or given in violation of * * * [those requirements] shall be invalid and unenforceable for the purposes of collection * * *.” N.J. Stat. Ann. § 5:12-101(f) (West 1988). Furthermore, strict compliance with those requirements is mandatory for a check to be enforceable. [citations omitted]. Respondent simply has not shown that the markers given Resorts by Mr. Zarin were drawn and handled in strict compliance with the statute. In fact, the number of violations of the Emergency Order asserted against Resorts by the New Jersey gambling commission, including some betting transactions with petitioner, casts substantial doubt on whether the checks were in fact so handled.

….

… I think it significant that because the debts involved herein were unenforceable from the moment that they were created, there was no freeing up of petitioners’ assets when they were discharged, see United States v. Kirby Lumber Co., supra, and therefore there was no increase in petitioners’ wealth that could constitute income. Cf. Commissioner v. Glenshaw Glass Co., supra. This is particularly true in light of the fact that the chips were given to Mr. Zarin with the expectation that he would continue to gamble and, therefore, did not constitute an increase in his wealth when he received them in the same sense that the proceeds of a non-gambling loan would. [citations omitted].

I am reinforced in my conclusion by the outcome in United States v. Hall, 307 F.2d 238 (10th Cir. 1962). In that case, the court held that there was no income from the discharge of gambling indebtedness because the debt was not enforceable under Nevada law, and observed that such a debt “has but slight potential and does not meet the requirements of debt necessary to justify the mechanical operation of general rules of tax law relating to cancellation of debt.” 307 F.2d at 241. While a gambling debt is not unenforceable under all circumstances in New Jersey, the indebtedness involved herein was unenforceable, and I agree with the court in Hall that an unenforceable “gambling debt * * * has no significance for tax purposes,” 307 F.2d at 242, at least where such unenforceability exists from the moment the debt is created.

I find further support for my conclusion from the application of the principle that if there is a genuine dispute as to liability on the underlying obligation, settlement of that obligation will not give rise to income from discharge of indebtedness. N. Sobel, Inc. v. Commissioner, 40 B.T.A. 1263 (1939), cited with approval in Colonial Savings Association v. Commissioner, 85 T.C. 855, 862-863 (1985), aff’d, 854 F.2d 1001 (7th Cir. 1988). Respondent simply has not met his burden of showing that the dispute between Resorts and Mr. Zarin was not a genuine dispute as to Mr. Zarin’s liability for the underlying obligations, and I believe that, at least as to that debt that was not entered into as required by New Jersey law and was therefore unenforceable, the dispute was in fact genuine. While there is language in Sobel and Colonial Savings indicating that United States v. Kirby Lumber Co., supra, applies when there is a liquidated amount of indebtedness, I do not read that language as requiring that Kirby Lumber must apply unless the amount is unliquidated, where there is a genuine dispute as to the underlying liability.

I would hold for petitioner.

Wells, J., agrees with this dissent.

Jacobs, J., dissenting:

….

Ruwe, dissenting: [Judge Ruwe argued that chips are property and that § 108(e)(5) should apply, thereby making the settlement a purchase price adjustment.]

Notes and Questions:

1. Articulate the different characterizations of the transactions occurring between Zarin and Resorts International of Judges Cohen and Tannenwald.

2. What was the holding of Hall as the majority articulated it? What is wrong with it?

3. What form did Zarin’s consumption take?

• gambling?

• losing at gambling?

• Should it make a difference?

4. The SHS formula defines income to be consumption plus/minus increments/decrements to wealth. Is it correct to focus only on increases to wealth? Do the opinions of any of the judges do that?

5. Notice that the rule that a settlement does not create doi income is that there must be a genuine dispute as to the liability. In this case, the burden of showing that there was not a genuine dispute was on the Commissioner because of the procedural posture (i.e., stipulated facts) of the case.

COWEN, Circuit Judge.

David Zarin (“Zarin”) appeals from a decision of the Tax Court holding that he recognized $2,935,000 of income from discharge of indebtedness resulting from his gambling activities, and that he should be taxed on the income. . … After considering the issues raised by this appeal, we will reverse.

I.

[The court recounts the facts.]

II.

The sole issue before this Court is whether the Tax Court correctly held that Zarin had income from discharge of indebtedness. . Section 108 and [§ 61(a)(11)] of the Code set forth “the general rule that gross income includes income from the discharge of indebtedness.” I.R.C. § 108(e)(1). The Commissioner argues, and the Tax Court agreed, that pursuant to the Code, Zarin did indeed recognize income from discharge of gambling indebtedness.

Under the Commissioner’s logic, Resorts advanced Zarin $3,435,000 worth of chips, chips being the functional equivalent of cash. At that time, the chips were not treated as income, since Zarin recognized an obligation of repayment. In other words, Resorts made Zarin a tax-free loan. However, a taxpayer does recognize income if a loan owed to another party is cancelled, in whole or in part. I.R.C. [§§ 61(a)(11), 108(e)]. The settlement between Zarin and Resorts, claims the Commissioner, fits neatly into the cancellation of indebtedness provisions in the Code. Zarin owed $3,435,000, paid $500,000, with the difference constituting income. Although initially persuasive, the Commissioner’s position is nonetheless flawed for two reasons.

III.

Initially, we find that §§ 108 and [61(a)(11)] are inapplicable to the Zarin/Resorts transaction. Section 61 does not define indebtedness. On the other hand, § 108(d)(1), which repeats and further elaborates on the rule in [§ 61(a)(11)], defines the term as any indebtedness “(A) for which the taxpayer is liable, or (B) subject to which the taxpayer holds property.” I.R.C. § 108(d)(1). In order to bring the taxpayer within the sweep of the discharge of indebtedness rules, then, the IRS must show that one of the two prongs in the § 108(d)(1) test is satisfied. It has not been demonstrated that Zarin satisfies either.

Because the debt Zarin owed to Resorts was unenforceable as a matter of New Jersey state law , it is clearly not a debt “for which the taxpayer is liable.” I.R.C. § 108(d)(1)(A). Liability implies a legally enforceable obligation to repay, and under New Jersey law, Zarin would have no such obligation.

Zarin did not have a debt subject to which he held property as required by § 108(d)(1)(B). Zarin’s indebtedness arose out of his acquisition of gambling chips. The Tax Court held that gambling chips were not property, but rather, “a medium of exchange within the Resorts casino” and a “substitute for cash.” Alternatively, the Tax Court viewed the chips as nothing more than “the opportunity to gamble and incidental services …” We agree with the gist of these characterizations, and hold that gambling chips are merely an accounting mechanism to evidence debt.

… [U]nder New Jersey state law, gambling chips were Resorts’ property until transferred to Zarin in exchange for the markers, at which point the chips became “evidence” of indebtedness (and not the property of Zarin).

Even were there no relevant legislative pronouncement on which to rely, simple common sense would lead to the conclusion that chips were not property in Zarin’s hands. Zarin could not do with the chips as he pleased, nor did the chips have any independent economic value beyond the casino. The chips themselves were of little use to Zarin, other than as a means of facilitating gambling. …

Although the Tax Court found that theoretically, Zarin could have redeemed the chips he received on credit for cash and walked out of the casino, the reality of the situation was quite different. Realistically, before cashing in his chips, Zarin would have been required to pay his outstanding IOUs. New Jersey state law requires casinos to “request patrons to apply any chips or plaques in their possession in reduction of personal checks or Counter Checks exchanged for purposes of gaming prior to exchanging such chips or plaques for cash or prior to departing from the casino area.” N.J. Admin. Code tit. 19k, § 19:45–1.24(s) (1979) (currently N.J. Admin. Code tit. 19k, § 19:45–1.25(o) (1990) (as amended)). Since his debt at all times equalled or exceeded the number of chips he possessed, redemption would have left Zarin with no chips, no cash, and certainly nothing which could have been characterized as property.

Not only were the chips non-property in Zarin’s hands, but upon transfer to Zarin, the chips also ceased to be the property of Resorts. Since the chips were in the possession of another party, Resorts could no longer do with the chips as it pleased, and could no longer control the chips’ use. Generally, at the time of a transfer, the party in possession of the chips can gamble with them, use them for services, cash them in, or walk out of the casino with them as an Atlantic City souvenir. The chips therefore become nothing more than an accounting mechanism, or evidence of a debt, designed to facilitate gambling in casinos where the use of actual money was forbidden. . Thus, the chips which Zarin held were not property within the meaning of I.R.C. § 108(d)(1)(B). .

In short, because Zarin was not liable on the debt he allegedly owed Resorts, and because Zarin did not hold “property” subject to that debt, the cancellation of indebtedness provisions of the Code do not apply to the settlement between Resorts and Zarin. As such, Zarin cannot have income from the discharge of his debt.

IV.

Instead of analyzing the transaction at issue as cancelled debt, we believe the proper approach is to view it as disputed debt or contested liability. Under the contested liability doctrine, if a taxpayer, in good faith, disputed the amount of a debt, a subsequent settlement of the dispute would be treated as the amount of debt cognizable for tax purposes. The excess of the original debt over the amount determined to have been due is disregarded for both loss and debt accounting purposes. Thus, if a taxpayer took out a loan for $10,000, refused in good faith to pay the full $10,000 back, and then reached an agreement with the lender that he would pay back only $7000 in full satisfaction of the debt, the transaction would be treated as if the initial loan was $7000. When the taxpayer tenders the $7000 payment, he will have been deemed to have paid the full amount of the initially disputed debt. Accordingly, there is no tax consequence to the taxpayer upon payment.

The seminal “contested liability” case is N. Sobel, Inc. v. Commissioner, 40 B.T.A. 1263 (1939). In Sobel, the taxpayer exchanged a $21,700 note for 100 shares of stock from a bank. In the following year, the taxpayer sued the bank for recision [sic], arguing that the bank loan was violative of state law, and moreover, that the bank had failed to perform certain promises. The parties eventually settled the case in 1935, with the taxpayer agreeing to pay half of the face amount of the note. In the year of the settlement, the taxpayer claimed the amount paid as a loss. The Commissioner denied the loss because it had been sustained five years earlier, and further asserted that the taxpayer recognized income from the discharge of half of his indebtedness.

The Board of Tax Appeals held that since the loss was not fixed until the dispute was settled, the loss was recognized in 1935, the year of the settlement, and the deduction was appropriately taken in that year. Additionally, the Board held that the portion of the note forgiven by the bank “was not the occasion for a freeing of assets and that there was no gain …” Id. at 1265. Therefore, the taxpayer did not have any income from cancellation of indebtedness.

Only one other court has addressed a case factually similar to the one before us. In United States v. Hall, 307 F.2d 238 (10th Cir. 1962), the taxpayer owed an unenforceable gambling debt alleged to be $225,000. Subsequently, the taxpayer and the creditor settled for $150,000. The taxpayer then transferred cattle valued at $148,110 to his creditor in satisfaction of the settlement agreement. A jury held that the parties fixed the debt at $150,000, and that the taxpayer recognized income from cancellation of indebtedness equal to the difference between the $150,000 and the $148,110 value affixed to the cattle. Arguing that the taxpayer recognized income equal to the difference between $225,000 and $148,000, the Commissioner appealed.

The Commissioner argues that Sobel and the contested liability doctrine only apply when there is an unliquidated debt; that is, a debt for which the amount cannot be determined. See Colonial Sav. Ass’n v. Commissioner, 85 T.C. 855, 862–863 (1985) (Sobel stands for the proposition that “there must be a liquidated debt”), aff’d, 854 F.2d 1001 (7th Cir.1988). See also N. Sobel, Inc. v. Commissioner, 40 B.T.A. at 1265 (there was a dispute as to “liability and the amount” of the debt). Since Zarin contested his liability based on the unenforceability of the entire debt, and did not dispute the amount of the debt, the Commissioner would have us adopt the reasoning of the Tax Court, which found that Zarin’s debt was liquidated, therefore barring the application of Sobel and the contested liability doctrine. Zarin, 92 T.C. at 1095 (Zarin’s debt “was a liquidated amount” and “[t]here is no dispute about the amount [received].”).

We reject the Tax Court’s rationale. When a debt is unenforceable, it follows that the amount of the debt, and not just the liability thereon, is in dispute. Although a debt may be unenforceable, there still could be some value attached to its worth. This is especially so with regards to gambling debts. In most states, gambling debts are unenforceable, and have “but slight potential …” United States v. Hall, 307 F.2d 238, 241 (10th Cir.1962). Nevertheless, they are often collected, at least in part. For example, Resorts is not a charity; it would not have extended illegal credit to Zarin and others if it did not have some hope of collecting debts incurred pursuant to the grant of credit.

Moreover, the debt is frequently incurred to acquire gambling chips, and not money. Although casinos attach a dollar value to each chip, that value, unlike money’s, is not beyond dispute, particularly given the illegality of gambling debts in the first place. This proposition is supported by the facts of the present case. Resorts gave Zarin $3.4 million dollars of chips in exchange for markers evidencing Zarin’s debt. If indeed the only issue was the enforceability of the entire debt, there would have been no settlement. Zarin would have owed all or nothing. Instead, the parties attached a value to the debt considerably lower than its face value. In other words, the parties agreed that given the circumstances surrounding Zarin’s gambling spree, the chips he acquired might not have been worth $3.4 million dollars, but were worth something. Such a debt cannot be called liquidated, since its exact amount was not fixed until settlement.

To summarize, the transaction between Zarin and Resorts can best be characterized as a disputed debt, or contested liability. Zarin owed an unenforceable debt of $3,435,000 to Resorts. After Zarin in good faith disputed his obligation to repay the debt, the parties settled for $500,000, which Zarin paid. That $500,000 settlement fixed the amount of loss and the amount of debt cognizable for tax purposes. Since Zarin was deemed to have owed $500,000, and since he paid Resorts $500,000, no adverse tax consequences attached to Zarin as a result. .

V.

In conclusion, we hold that Zarin did not have any income from cancellation of indebtedness for two reasons. First, the Code provisions covering discharge of debt are inapplicable since the definitional requirement in I.R.C. § 108(d)(1) was not met. Second, the settlement of Zarin’s gambling debts was a contested liability. We reverse the decision of the Tax Court and remand with instructions to enter judgment that Zarin realized no income by reason of his settlement with Resorts.

STAPLETON, Circuit Judge, dissenting.

[C.J. Stapleton wrote an opinion agreeing with the Tax Court’s majority opinion.]

Notes and Questions:

1. Any other person would have had to pay $3.4M for 3.4M chips. How can the majority conclude that their value is in dispute?

2. Zarin’s gambling attracted crowds, which was good for the business of Resorts International. Could the chips be regarded as compensation?

• Or does it go too far to argue that the “dominant purpose” of Resorts International in transferring chips to Zarin was to benefit itself by attracting such crowds. Cf. Gotcher v. United States (chapter 2, supra).

3. Does a compulsive gambler such as Mr. Zarin realize an accession to wealth or “value” by gambling more?

4. Taxpayer argued that “discharge of his gambling debt was income from gambling against which he may offset his losses.”

• This does not treat the loan and use of the chips as separate transactions.

5. Should borrowing from a casino to purchase the casino’s chips be different than borrowing from a furniture store to buy the store’s furniture or from a car dealership to buy one of the dealership’s cars?

6. Articulate the policies behind state laws that make contracts unenforceable. Do any of these policies suggest anything about whether there was an accession to wealth and so also doi income?

• unconscionable contracts are not enforceable because of unequal bargaining power;

• illegal contracts are not enforceable because the state will not lend its assistance to enforce an illegal bargain;

• some contracts are unenforceable because the state deems normal presumptions about rationality and the ability to know what is beneficial to oneself inapplicable in certain circumstances, e.g., contract with a minor or incompetent.

7. The majority relied heavily on § 108(d)(1). Why? Is this provision applicable to the case at all?

8. What is left of the liquidated debt doctrine?

• What if the debtor reaches a compromise with the creditor, but never actually disputed that he owed the creditor a sum certain? See Melvin v. Commissioner, T.C. Memo 2009-199, 2009 WL 2869816 (2009); Rood v. Commissioner, TC Memo 1996-248, 1996 WL 280899 (1996) (gambling debt).

9. You should be aware of the rule of § 108(e)(5) for purchase price reductions. How does that rule apply when the seller of a service lends money to a customer to purchase the service?

10. For a debt to be cancelled, the creditor must receive nothing in return. The creditor is entitled to a bad debt deduction. § 166. What treatment does § 166 accord non-business bad debts?

11. Consider:

• 11a. Taxpayer engaged the services of Attorney and incurred a bill of $1000. The fmv of taxpayer’s assets is $10,000, and taxpayer has $5000 of cash. Taxpayer has liabilities of $25,000. Taxpayer entered an agreement to do 80 hours of filing and word processing for Attorney. After taxpayer performed these services, Attorney told taxpayer that “you owe me nothing.” Now taxpayer’s liabilities are $24,000, and she has assets with fmv = $10,000 plus $5000 cash. How much doi income must Taxpayer report?

• See Canton v. United States, 226 F.2d 313, 317-18 (8^th Cir. 1955), cert. denied, 350 U.S. 965 (1956).

• 11b. Taxpayer borrowed $25,000 from her uncle to pay for her third year of law school at one of America’s “Best Value Law Schools” (according to preLaw Magazine). Taxpayer and her uncle formalized the arrangement in writing, Taxpayer to pay 6% interest on her declining balance once she began making payments to her uncle after completing law school. At Taxpayer’s commencement day party, her uncle announced to her that “I forgive the loan I made to you. You are free and clear as far as I’m concerned.” At the time, Taxpayer’s liabilities (including the $25,000 owed to her uncle) did not exceed the fmv of her assets. How much doi income must taxpayer report?

• 11c. Taxpayer, a highly skilled craftsman, entered into a contract to produce a custom-made table for Customer’s dining room. Customer paid Taxpayer $2000 on the day they entered the agreement with a promise to pay $2000 more on delivery. Taxpayer was to deliver the table six months after signing. Taxpayer never got around to making the table. At first, Customer patiently waited past the contractual deadline for the table, but finally sued for a refund of the $2000. Customer had waited more than 6 years to bring the suit, so it was dismissed as not having been brought within the limitation period.

• True or false: Taxpayer does not have doi income because the debt is unenforceable.

• See, e.g., Securities Co. v. United States, 85 F. Supp. 532, (S.D.N.Y. 1948).

• 11d. Taxpayer took his automobile to Repair Shop to have some routine maintenance work done. Repair Shop promised to do the work for $300. When Taxpayer returned to pick up his automobile, he told Repair Shop that he only had $250 in cash, but would get the rest by tomorrow. Repair Shop manager responded by saying, “Gimme the $250 and forget the rest.” Taxpayer is solvent throughout. How much doi income must Taxpayer report?

12. Judge Cohen observed that the Taxpayer in Zarin spent the chips he received on consumption, i.e., gambling, and had therefore received value.

Judge Tannenwald observed:

I think it highly significant that in all the decided cases involving the cancellation of indebtedness, the taxpayer had, in a prior year when the indebtedness was created, received a nontaxable benefit clearly measurable in monetary terms which would remain untaxed if the subsequent cancellation of the indebtedness were held to be tax free.

Is consumption, i.e., spending the borrowed money for something, a necessary element to treating a discharge of indebtedness as gross income? Suppose that taxpayer had agreed to pay another’s debt. The creditor subsequently discharged taxpayer from this obligation. Should that discharge be considered gross income? After all, taxpayer received no funds from the “creditor” with which he could exercise any right of consumption.

A “modification” is “any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument …” Reg. § 1.1001-3(c)(1)(i). This does not include alterations that occur by operation of the debt instrument itself, e.g., annual resetting of interest rate based upon an index. Reg. § 1.1001-3(c)(1)(ii). The substitution of a new obligor, the addition or deletion of a co-obligor, or a change in an obligation from recourse to non-recourse (or vice versa) is a modification. Reg. § 1.1001-3(c)(2)(i). An alteration that results in an instrument or property right that is not debt is a modification, unless the alteration occurs pursuant to a holder’s option to convert the debt into equity. Reg. § 1.1001-3(c)(2)(ii). Except for certain unilateral exercises of an option, the exercise of an option by either the issuer or holder that results in change to a term of the debt instrument is a modification. Reg. § 1.1001-3(c)(2 and 3). Neither the issuer’s failure to perform nor the holder’s temporary forbearance to exercise rights upon default is a modification. Reg. § 1.1001-3(c)(4).

A modification is “significant” if “the legal rights or obligations that are altered and the degree to which they are altered are economically significant.” Reg. § 1.1001-3(e)(1). A change in the yield of a debt instrument is “significant” if it varies from the unmodified instrument by more than the greater of 25 basis points or 5% of the annual yield. Reg. § 1.1001-3(e)(2)(ii). A change in the timing of payments is “significant” if it results in the “material deferral of scheduled payments.” Reg. § 1.1001-3(e)(3)(i). With some exceptions, the substitution of a new obligor on a recourse debt instrument is “significant.” Reg. § 1001-3(e)(4)(i)(A). The substitution of a new obligor on a nonrecourse debt instrument is not a significant modification. Reg. § 1.1001-3(e)(4)(ii). A change in the collateral securing a debt obligation that results in a change in payment expectations is “significant.” Reg. § 1.1001-3(e)(4)(iv)(A and B). A change in the priority of a debt instrument relative to other debt instruments is significant if it results in a change in payment expectations. Reg. § 1.1001-3(e)(4)(v). An alteration that results in an instrument or property right that is not debt is significant. Reg. § 1.1001-3(e)(5)(i). A change in an obligation from recourse to non-recourse (or vice versa) is significant. Reg. § 1.1001-3(e)(5)(ii).

Problems:

1. Harry Homeowner borrowed $500,000 to purchase a home from First National Bank at 2% interest. When the prevailing interest rate on home mortgage rose to 8%, First National Bank told Harry that it would accept a cash payment of $350,000 in full satisfaction of the outstanding balance on the loan. Harry paid the bank $350,000. What should be the tax consequences of this restructuring? Why would First National Bank make such an offer?

2. Hillary Carbuyer borrowed $20,000 for five years from Churn ‘n’ Burn Autos, a used car dealership, to buy a used pickup truck. The interest rate on the loan was 6.5%. Her monthly payment was $391.32. After making twenty-four payments, Carbuyer still owed $12,769.89. Carbuyer lost her job, but quickly found another one that did not pay quite as well. She spoke with the credit manager at Churn ‘n’ Burn Autos and obtained an agreement to stretch her remaining payments out over five years, but the interest rate on the loan increased to 7.5%. Her monthly payment would now be $255.88.

• Should there be any tax consequences? What approach would you use to determine what those tax consequences would be?

Section 108(a)(1)(A and B) codifies and limits court-developed rules that govern the discharge of indebtedness of debtors who are in bankruptcy or insolvent. Section 108 also provides rules governing discharge of indebtedness of a (1) taxpayer’s qualified farm indebtedness (§ 108(a)(1)(C)), (2) a non-subchapter C taxpayer’s qualified real property business indebtedness (§ 108(a)(1)(D)), (3) a taxpayer’s qualified principal residence indebtedness discharged before January 1, 2018 (§ 108(a)(1)(D)), (4) a taxpayer’s student loan indebtedness (§ 108(f)), and (5) a taxpayer’s purchase money indebtedness (§ 108(e)(5)). Section 108(i) also provided for deferral of gain resulting from a taxpayer’s reacquisition of a debt instrument as in Kirby Lumber.

• “Qualified farm indebtedness” is debt (but not purchase money debt) that a taxpayer incurred “in connection with” taxpayer’s operation of a farming trade or business, § 108(g)(1). The “qualified farm indebtedness” rules give solvent farmers many of the benefits that § 108 gives to insolvent debtors.

• “Qualified real property business indebtedness” is debt (other than “qualified farm indebtedness”) that taxpayer incurs or assumes “in connection with” real property that secures the debt that taxpayer uses in a trade or business. § 108(c)(3)(A). The amount discharged reduces the bases of taxpayer’s “depreciable real property” to the extent that the loan principal immediately before the discharge exceeds the fmv of such property (less the principal amount of any other loans that the same property secures). § 108(c)(2)(A). This provision should reduce the incentive of a taxpayer to walk away from encumbered property that is (or was) “under water,” despite the fact that a lender has been willing to discharge some of the debt.

• “Qualified principal residence indebtedness” is up to $2M of debt that taxpayer incurred to acquire, construct, or substantially improve taxpayer’s principal residence, which secures the loan. § 108(h)(2), § 108(h)(5). The amount discharged reduces taxpayer’s basis in the home, but not below $0. § 108(h)(1). Congress enacted § 108(a)(1)(E) in response to the financial crisis and to encourage homeowners not to default on their home mortgages when they are “under water.” Notice that unlike the case of “qualified real property business indebtedness,” the amount of permissible basis reduction is the taxpayer’s basis in the home, not the amount by which taxpayer’s basis exceeds the property’s fmv. This provision will not apply to discharges of “qualified principal residence indebtedness” that occur after December 31, 2017.

• the United States (or an instrumentality or agency), § 108(f)(1)(A),

• a state, territory, possession, the District of Columbia, or political subdivision, § 108(f)(1)(B),

• a public benefit corporation exempt from income tax under § 501(c)(3) that has assumed control over a state, county, or municipal hospital and whose employees are deemed to be public employees under state law, § 108(f)(1)(C), OR

• an educational institution when funds are provided by an entity already named OR pursuant to the institution’s program designed to encourage students to serve in occupations with unmet needs or in areas with unmet needs under the supervision of a governmental unit or organization exempt from income tax under §§ 501(a) and 501(c)(3), § 108(f)(1)(D). The discharge may not be for services performed for any of these entities. § 108(f)(3).

Gross income also does not include loan repayments or forgiveness under certain federal and state programs “intended to provide for the increased availability of health care services in underserved or health shortage areas …” § 108(f)(4). Finally, gross income does not include discharge of student loan debt occurring prior to January 1, 2026 and resulting from the death or total and permanent disability of the student. § 108(f)(5).

• “Discharge of Purchase Money Indebtedness” is not excluded from a taxpayer’s gross income but rather is treated as a purchase price reduction. § 108(e)(5). The debt must be owed by the purchaser of property to the seller of the property and arise from the purchase. § 108(e)(5)(A). The debtor must be solvent and not in bankruptcy. § 108(e)(5)(B). The reduction must otherwise constitute discharge of indebtedness income – as opposed to, say, reduction of debt principal in exchange for services. § 108(e)(5)(C). This provision is useful when buyer and seller resolve a dispute over the quality of goods by a reduction in the purchaser’s debt obligation.

Taxpayer may use the proceeds of a loan – perhaps from the seller of property or from a third-party lender – to purchase property and to give the property so purchased as security or collateral for the loan. Such property is “encumbered by” or “subject to” the outstanding principal amount of the loan. Can borrower count the money that he borrowed as part of his basis when in fact taxpayer did not purchase the property with after-tax money?

• Yes. Borrower has an obligation to repay the loan and will repay it with money that has been subject to income tax. It does not matter whether borrower borrowed the money from the seller or a third party.

• When borrower sells the property subject to the loan, the buyer will pay the fmv of the property minus the loan balance. The buyer is treated as having paid the borrower/seller cash equal to the amount of the loan balance. Thus, the seller must include the loan balance in his “amount realized” under § 1001(a).

• Once we permit the borrower to use untaxed borrowed funds to obtain basis in property, the rest of the analysis must follow.

• We assume that the borrower will honor his obligation to repay the loan.

• Consider:

• Taxpayer owns Blackacre. She bought it for $10,000, and its ab = $10,000. At a time when the fmv of Blackacre was $50,000, Taxpayer borrowed $30,000 and put up Blackacre as collateral. Taxpayer sold Blackacre to Buyer who paid her $20,000 cash and assumed the $30,000 loan secured by Blackacre. What is Taxpayer’s taxable gain? May taxpayer treat the amount borrowed as part of his adjusted basis in the property? Why?

• Taxpayer borrows $30,000 from Bank. Taxpayer uses the borrowed money to purchase Whiteacre for $30,000; taxpayer also gives a mortgage to Bank. Taxpayer sold Whiteacre to Buyer for $20,000 cash plus assumption of the $30,000 loan. What is taxpayer’s taxable gain?

• May taxpayer treat the amount borrowed as part of his adjusted basis in the property? Why?

• When do loan proceeds count in basis? When do they not count in basis? What does the Supreme Court say about this in Tufts, infra? Keep track of the amount of gross income on which taxpayer should have paid income tax.

• Now consider the following two arrangements by which lender and borrower might structure a loan:

Recourse obligation: A recourse obligation is one for which the borrower is personally liable. If the borrower defaults and the collateral that the borrower put up to obtain the loan is insufficient to satisfy the borrower’s obligation, the lender may pursue other assets of the borrower to satisfy the debt. The risk that a loss may occur because the fmv of the property decreases prior to default thus falls on the borrower.

• This point may encourage a borrower to pay down a loan, even when its principal amount is greater than the fmv of the property securing the loan. Otherwise, the borrower may lose other assets that he owns.

• If the creditor accepts the collateral as full payment, taxpayer/borrower must recognize gain on the disposition of the collateral as if he had sold it for its fmv.

• If the creditor accepts the collateral as full payment and the fmv of the property is less than the principal amount of the loan, the difference is doi income. Gehl, supra.

Nonrecourse obligation: A nonrecourse obligation is one for which the borrower is not personally liable. Thus, if the borrower defaults, the lender may pursue only the property offered as collateral for the loan. The risk that a loss may occur because the fmv of the property decreases prior to default thus falls entirely on the lender.

• When the fmv of the property is greater than the loan amount, the borrower has an economic incentive to continue making payments on a nonrecourse loan. A borrower should willingly repay a nonrecourse loan of $80 to obtain property whose fmv is $100.

• But: if the fmv of the property is less than the outstanding balance of a nonrecourse loan, the borrower may (should?) profitably “walk away.” After all, why should a borrower pay down a nonrecourse loan of $100 to obtain a piece of property whose fmv is $80?

• This point might encourage lenders to reduce the amount of nonrecourse debt that borrowers owe them when the value of the underlying collateral decreases. Cf. § 108(a)(1)(C, D, E). After all, the property’s fmv is not greater when the lender owns it than it was when the borrower owned it. If the creditor reduces the loan principal to the property’s fmv or less, borrower is more likely to make payments on the loan and not to “walk away.”

• If a nonrecourse borrower defaults on a loan and surrenders the property he put up as collateral whose fmv is less than the loan principal, exactly how much doi results from a freeing of assets?

• This question may arise when a borrower sells or surrenders property subject to a nonrecourse obligation at a time when the fmv of the underlying property is less than the principal of the nonrecourse obligation.

• What would be the rule if the obligation were a recourse obligation?

• Arguably, a taxpayer who sells or surrenders property subject to a nonrecourse obligation should be permitted to deduct loss to the extent § 165 permits. The loss on the sale or surrender of property subject to a non-recourse obligation would be the adjusted basis in the property minus its fmv. Prior to Tufts, this was the position many taxpayers took upon sale or surrender of property subject to a nonrecourse obligation because

[t]he return of a note which represents no personal liability of a taxpayer does not free any assets except those from which the note might otherwise have been paid. Since the underlying theory of income from cancellation of indebtedness is the freeing of the debtor’s assets from liability for the debt, any such income is limited to the amount of assets freed by the cancellation.

Collins v. CIR, T.C. Memo 1963-285, 1963 WL 613 (1963).

• How does the treatment that taxpayers routinely accorded loss property subject to a nonrecourse obligation violate the first guiding principle of the income tax noted in chapter 1, supra?

• Notice the contention of the taxpayer in the following important case.

JUSTICE BLACKMUN delivered the opinion of the Court.

Over 35 years ago, in Crane v. Commissioner, 331 U.S. 1 (1947), this Court ruled that a taxpayer, who sold property encumbered by a nonrecourse mortgage (the amount of the mortgage being less than the property’s value), must include the unpaid balance of the mortgage in the computation of the amount the taxpayer realized on the sale. The case now before us presents the question whether the same rule applies when the unpaid amount of the nonrecourse mortgage exceeds the fair market value of the property sold.

I

On August 1, 1970, respondent Clark Pelt, a builder, and his wholly owned corporation, respondent Clark, Inc., formed a general partnership. The purpose of the partnership was to construct a 120-unit apartment complex in Duncanville, Tex., a Dallas suburb. Neither Pelt nor Clark, Inc., made any capital contribution to the partnership. Six days later, the partnership entered into a mortgage loan agreement with the Farm & Home Savings Association (F&H). Under the agreement, F&H was committed for a $1,851,500 loan for the complex. In return, the partnership executed a note and a deed of trust in favor of F&H. The partnership obtained the loan on a nonrecourse basis: neither the partnership nor its partners assumed any personal liability for repayment of the loan. Pelt later admitted four friends and relatives, respondents Tufts, Steger, Stephens, and Austin, as general partners. None of them contributed capital upon entering the partnership.

The construction of the complex was completed in August, 1971. During 1971, each partner made small capital contributions to the partnership; in 1972, however, only Pelt made a contribution. The total of the partners’ capital contributions was $44,212. In each tax year, all partners claimed as income tax deductions their allocable shares of ordinary losses and depreciation. The deductions taken by the partners in 1971 and 1972 totalled $439,972. Due to these contributions and deductions, the partnership’s adjusted basis in the property in August, 1972, was $1,455,740.

In 1971 and 1972, major employers in the Duncanville area laid off significant numbers of workers. As a result, the partnership’s rental income was less than expected, and it was unable to make the payments due on the mortgage. Each partner, on August 28, 1972, sold his partnership interest to an unrelated third party, Fred Bayles. As consideration, Bayles agreed to reimburse each partner’s sale expenses up to $250; he also assumed the nonrecourse mortgage.

Relying on Millar v. Commissioner, 577 F.2d 212, 215 (CA3), cert. denied, 439 U.S. 1046 (1978), the United States Tax Court, in an unreviewed decision, upheld the asserted deficiencies. The United States Court of Appeals for the Fifth Circuit reversed. That court expressly disagreed with the Millar analysis, and, in limiting Crane v. Commissioner, supra, to its facts, questioned the theoretical underpinnings of the Crane decision. We granted certiorari to resolve the conflict.

II

… Section 1001 governs the determination of gains and losses on the disposition of property. Under § 1001(a), the gain or loss from a sale or other disposition of property is defined as the difference between “the amount realized” on the disposition and the property’s adjusted basis. Subsection (b) of § 1001 defines “amount realized:” “The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.” At issue is the application of the latter provision to the disposition of property encumbered by a nonrecourse mortgage of an amount in excess of the property’s fair market value.

A

In Crane v. Commissioner, supra, this Court took the first and controlling step toward the resolution of this issue. Beulah B. Crane was the sole beneficiary under the will of her deceased husband. At his death in January, 1932, he owned an apartment building that was then mortgaged for an amount which proved to be equal to its fair market value, as determined for federal estate tax purposes. The widow, of course, was not personally liable on the mortgage. She operated the building for nearly seven years, hoping to turn it into a profitable venture; during that period, she claimed income tax deductions for depreciation, property taxes, interest, and operating expenses, but did not make payments upon the mortgage principal. In computing her basis for the depreciation deductions, she included the full amount of the mortgage debt. In November, 1938, with her hopes unfulfilled and the mortgagee threatening foreclosure, Mrs. Crane sold the building. The purchaser took the property subject to the mortgage and paid Crane $3,000; of that amount, $500 went for the expenses of the sale.

Crane reported a gain of $2,500 on the transaction. She reasoned that her basis in the property was zero (despite her earlier depreciation deductions based on including the amount of the mortgage) and that the amount she realized from the sale was simply the cash she received. The Commissioner disputed this claim. He asserted that Crane’s basis in the property, under [what is now § 1014] was the property’s fair market value at the time of her husband’s death, adjusted for depreciation in the interim, and that the amount realized was the net cash received plus the amount of the outstanding mortgage assumed by the purchaser.

In upholding the Commissioner’s interpretation of § [1014] , the Court observed that to regard merely the taxpayer’s equity in the property as her basis would lead to depreciation deductions less than the actual physical deterioration of the property, and would require the basis to be recomputed with each payment on the mortgage. The Court rejected Crane’s claim that any loss due to depreciation belonged to the mortgagee. The effect of the Court’s ruling was that the taxpayer’s basis was the value of the property undiminished by the mortgage.

The Court next proceeded to determine the amount realized under [what is now § 1001(b)]. In order to avoid the “absurdity,” of Crane’s realizing only $2,500 on the sale of property worth over a quarter of a million dollars, the Court treated the amount realized as it had treated basis, that is, by including the outstanding value of the mortgage. To do otherwise would have permitted Crane to recognize a tax loss unconnected with any actual economic loss. The Court refused to construe one section of the Revenue Act so as “to frustrate the Act as a whole.”

In a footnote, pertinent to the present case, the Court observed:

“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. That is not this case.”

331 U.S. at 14, n. 37.

B

This case presents that unresolved issue. We are disinclined to overrule Crane, and we conclude that the same rule applies when the unpaid amount of the nonrecourse mortgage exceeds the value of the property transferred. Crane ultimately does not rest on its limited theory of economic benefit; instead, we read Crane to have approved the Commissioner’s decision to treat a nonrecourse mortgage in this context as a true loan. This approval underlies Crane’s holdings that the amount of the nonrecourse liability is to be included in calculating both the basis and the amount realized on disposition. That the amount of the loan exceeds the fair market value of the property thus becomes irrelevant.

When a taxpayer receives a loan, he incurs an obligation to repay that loan at some future date. Because of this obligation, the loan proceeds do not qualify as income to the taxpayer. When he fulfills the obligation, the repayment of the loan likewise has no effect on his tax liability.

When encumbered property is sold or otherwise disposed of and the purchaser assumes the mortgage, the associated extinguishment of the mortgagor’s obligation to repay is accounted for in the computation of the amount realized. . See United States v. Hendler, 303 U.S. 564, 566-567 (1938). Because no difference between recourse and nonrecourse obligations is recognized in calculating basis , Crane teaches that the Commissioner may ignore the nonrecourse nature of the obligation in determining the amount realized upon disposition of the encumbered property. He thus may include in the amount realized the amount of the nonrecourse mortgage assumed by the purchaser. The rationale for this treatment is that the original inclusion of the amount of the mortgage in basis rested on the assumption that the mortgagor incurred an obligation to repay. Moreover, this treatment balances the fact that the mortgagor originally received the proceeds of the nonrecourse loan tax-free on the same assumption. Unless the outstanding amount of the mortgage is deemed to be realized, the mortgagor effectively will have received untaxed income at the time the loan was extended, and will have received an unwarranted increase in the basis of his property. . The Commissioner’s interpretation of § 1001(b) in this fashion cannot be said to be unreasonable.

C

Respondents received a mortgage loan with the concomitant obligation to repay by the year 2012. The only difference between that mortgage and one on which the borrower is personally liable is that the mortgagee’s remedy is limited to foreclosing on the securing property. This difference does not alter the nature of the obligation; its only effect is to shift from the borrower to the lender any potential loss caused by devaluation of the property. . If the fair market value of the property falls below the amount of the outstanding obligation, the mortgagee’s ability to protect its interests is impaired, for the mortgagor is free to abandon the property to the mortgagee and be relieved of his obligation.

This, however, does not erase the fact that the mortgagor received the loan proceeds tax-free, and included them in his basis on the understanding that he had an obligation to repay the full amount. See Woodsam Associates, Inc. v. Commissioner, 198 F.2d 357, 359 (CA2 1952); Bittker, Tax Shelters, Nonrecourse Debt, and the Crane Case, 33 Tax L. Rev. 277, at 284 n.7 (1978). When the obligation is canceled, the mortgagor is relieved of his responsibility to repay the sum he originally received, and thus realizes value to that extent within the meaning of § 1001(b). From the mortgagor’s point of view, when his obligation is assumed by a third party who purchases the encumbered property, it is as if the mortgagor first had been paid with cash borrowed by the third party from the mortgagee on a nonrecourse basis, and then had used the cash to satisfy his obligation to the mortgagee.

Moreover, this approach avoids the absurdity the Court recognized in Crane. Because of the remedy accompanying the mortgage in the nonrecourse situation, the depreciation in the fair market value of the property is relevant economically only to the mortgagee, who, by lending on a nonrecourse basis, remains at risk. To permit the taxpayer to limit his realization to the fair market value of the property would be to recognize a tax loss for which he has suffered no corresponding economic loss. . Such a result would be to construe “one section of the Act … so as … to defeat the intention of another or to frustrate the Act as a whole.” 331 U.S. at 13.

In the specific circumstances of Crane, the economic benefit theory did support the Commissioner’s treatment of the nonrecourse mortgage as a personal obligation. The footnote in Crane acknowledged the limitations of that theory when applied to a different set of facts. Crane also stands for the broader proposition, however, that a nonrecourse loan should be treated as a true loan. We therefore hold that a taxpayer must account for the proceeds of obligations he has received tax-free and included in basis. Nothing in either § 1001(b) or in the Court’s prior decisions requires the Commissioner to permit a taxpayer to treat a sale of encumbered property asymmetrically, by including the proceeds of the nonrecourse obligation in basis but not accounting for the proceeds upon transfer of the encumbered property. [citation omitted].

III

….

IV

When a taxpayer sells or disposes of property encumbered by a nonrecourse obligation, the Commissioner properly requires him to include among the assets realized the outstanding amount of the obligation. The fair market value of the property is irrelevant to this calculation. We find this interpretation to be consistent with Crane v. Commissioner, 331 U.S. 1 (1947), and to implement the statutory mandate in a reasonable manner. [citation omitted].

The judgment of the Court of Appeals is therefore reversed.

It is so ordered.

JUSTICE O’CONNOR, concurring.

I concur in the opinion of the Court, accepting the view of the Commissioner. I do not, however, endorse the Commissioner’s view. Indeed, were we writing on a slate clean except for the decision in Crane v. Commissioner, 331 U.S. 1 (1947), I would take quite a different approach – that urged upon us by Professor Barnett as amicus.

Crane established that a taxpayer could treat property as entirely his own, in spite of the “coinvestment” provided by his mortgagee in the form of a nonrecourse loan. That is, the full basis of the property, with all its tax consequences, belongs to the mortgagor. That rule alone, though, does not in any way tie nonrecourse debt to the cost of property or to the proceeds upon disposition. I see no reason to treat the purchase, ownership, and eventual disposition of property differently because the taxpayer also takes out a mortgage, an independent transaction. In this case, the taxpayer purchased property, using nonrecourse financing, and sold it after it declined in value to a buyer who assumed the mortgage. …

The logical way to treat … this case … is to separate the two aspects of these events and to consider, first, the ownership and sale of the property, and, second, the arrangement and retirement of the loan. Under Crane, the fair market value of the property on the date of acquisition – the purchase price – represents the taxpayer’s basis in the property, and the fair market value on the date of disposition represents the proceeds on sale. The benefit received by the taxpayer in return for the property is the cancellation of a mortgage that is worth no more than the fair market value of the property, for that is all the mortgagee can expect to collect on the mortgage. His gain or loss on the disposition of the property equals the difference between the proceeds and the cost of acquisition. Thus, the taxation of the transaction in property reflects the economic fate of the property. If the property has declined in value, as was the case here, the taxpayer recognizes a loss on the disposition of the property. The new purchaser then takes as his basis the fair market value as of the date of the sale. [citations omitted].

In the separate borrowing transaction, the taxpayer acquires cash from the mortgagee. He need not recognize income at that time, of course, because he also incurs an obligation to repay the money. Later, though, when he is able to satisfy the debt by surrendering property that is worth less than the face amount of the debt, we have a classic situation of cancellation of indebtedness, requiring the taxpayer to recognize income in the amount of the difference between the proceeds of the loan and the amount for which he is able to satisfy his creditor. 26 U.S.C. § [61(a)(11)]. The taxation of the financing transaction then reflects the economic fate of the loan.

The reason that separation of the two aspects of the events in this case is important is, of course, that the Code treats different sorts of income differently. A gain on the sale of the property may qualify for capital gains treatment, §§ 1202, 1221, while the cancellation of indebtedness is ordinary income, but income that the taxpayer may be able to defer. §§ 108, 1017. Not only does Professor Barnett’s theory permit us to accord appropriate treatment to each of the two types of income or loss present in these sorts of transactions, it also restores continuity to the system by making the taxpayer-seller’s proceeds on the disposition of property equal to the purchaser’s basis in the property. Further, and most important, it allows us to tax the events in this case in the same way that we tax the economically identical hypothesized transaction.

Persuaded though I am by the logical coherence and internal consistency of this approach, I agree with the Court’s decision not to adopt it judicially. We do not write on a slate marked only by Crane. The Commissioner’s longstanding position, Rev. Rul. 76-111, is now reflected in the regulations. Reg. § 1.1001-2 (1982). In the light of the numerous cases in the lower courts including the amount of the unrepaid proceeds of the mortgage in the proceeds on sale or disposition [citations omitted], it is difficult to conclude that the Commissioner’s interpretation of the statute exceeds the bounds of his discretion. As the Court’s opinion demonstrates, his interpretation is defensible. One can reasonably read § 1001(b)’s reference to “the amount realized from the sale or other disposition of property” (emphasis added) to permit the Commissioner to collapse the two aspects of the transaction. As long as his view is a reasonable reading of § 1001(b), we should defer to the regulations promulgated by the agency charged with interpretation of the statute. [citations omitted]. Accordingly, I concur.

Notes and Questions:

1. Notice that taxpayers’ allowable depreciation deductions reduced their adjusted basis in the property. Why is it necessary that this be the rule?

• Aside from computation of gain under § 1001, what significance is there in the fact that taxpayer includes borrowed money in determining his adjusted basis in property?

2. What was in this for Fred Bayles? How was he going to profit by assuming a nonrecourse obligation that was greater than the fmv of the property?

3. Does this case unmoor cancellation of indebtedness income from the necessity of establishing a “freeing of assets” or a “shrinking of assets?”

• The Court’s opinion does not treat any of the loan as having been cancelled. It is all included in “amount realized.”

4. Read Reg. § 1.1001-2(a)(2). It seems to apply Justice O’Connor’s/Professor Barnett’s theory to discharge of recourse liability when the fmv of the property is less than the outstanding principal of the loan. Why the difference?

• Did the lender in Tufts discharge any indebtedness?

5. Property that is subject to depreciation is not a capital asset. § 1221(a)(2). A special wartime measure, § 1231, allows taxpayer to treat such property held for more than one year as a capital asset if a sale or disposition produces gain.

Rev. Rul. 90-16, 1990-1 C.B. 12

….

Property transfer by insolvent taxpayer in satisfaction of debt secured by property. A transfer of property to a bank in satisfaction of a debt on which the taxpayer is personally liable and which is secured by the property is a disposition upon which gain is recognized under §§ 1001(c) and 61(a)(3) of the Code to the extent the fair market value of the property exceeds the taxpayer’s adjusted basis in the property.

ISSUE

A taxpayer transfers to a creditor a residential subdivision that has a fair market value in excess of the taxpayer’s basis in satisfaction of a debt for which the taxpayer was personally liable. Is the transfer a sale or disposition resulting in the realization and recognition of gain by the taxpayer under §§ 1001(c) and 61(a)(3) of the Internal Revenue Code?

FACTS

X was the owner and developer of a residential subdivision. To finance the development of the subdivision, X obtained a loan from an unrelated bank. X was unconditionally liable for repayment of the debt. The debt was secured by a mortgage on the subdivision.

X became insolvent (within the meaning of § 108(d)(3) of the Code) and defaulted on the debt. X negotiated an agreement with the bank whereby the subdivision was transferred to the bank and the bank released X from all liability for the amounts due on the debt. When the subdivision was transferred pursuant to the agreement, its fair market value was 10,000x dollars, X’s adjusted basis in the subdivision was 8,000x dollars, and the amount due on the debt was 12,000x dollars, which did not represent any accrued but unpaid interest. After the transaction X was still insolvent.

LAW AND ANALYSIS

Sections 61(a)(3) and [61(a)(11)] of the Code provide that, except as otherwise provided, gross income means all income from whatever source derived, including (but not limited to) gains from dealings in property and income from discharge of indebtedness.

Section 108(a)(1)(B) of the Code provides that gross income does not include any amount that would otherwise be includible in gross income by reason of discharge (in whole or in part) of indebtedness of the taxpayer if the discharge occurs when the taxpayer is insolvent. Section 108(a)(3) provides that, in the case of a discharge to which § 108(a)(1)(B) applies, the amount excluded under § 108(a)(1)(B) shall not exceed the amount by which the taxpayer is insolvent (as defined in § 108(d)(3)).

Reg. § 1.61-6(a) provides that the specific rules for computing the amount of gain or loss from dealings in property under § 61(a)(3) are contained in § 1001 and the regulations thereunder.

Section 1001(a) of the Code provides that gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in § 1011 for determining gain.

Section 1001(b) of the Code provides that the amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.

Section 1001(c) of the Code provides that, except as otherwise provided in subtitle A, the entire amount of the gain or loss, determined under § 1001, on the sale or exchange of property shall be recognized.

Reg. § 1.1001-2(a)(1) provides that, except as provided in § 1.1001-2(a)(2) and (3), the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition. Section 1.1001-2(a)(2) provides that 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 [§ 61(a)(11)]. Example (8) under § 1.1001-2(c) illustrates these rules as follows:

Example (8). 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).

In the present situation, X transferred the subdivision to the bank in satisfaction of the 12,000x dollar debt. To the extent of the fair market value of the property transferred to the creditor, the transfer of the subdivision is treated as a sale or disposition upon which gain is recognized under § 1001(c) of the Code. To the extent the fair market value of the subdivision, 10,000x dollars, exceeds its adjusted basis, 8,000x dollars, X realizes and recognizes gain on the transfer. X thus recognizes 2,000x dollars of gain.

To the extent the amount of debt, 12,000x dollars, exceeds the fair market value of the subdivision, 10,000x dollars, X realizes income from the discharge of indebtedness. However, under § 108(a)(1)(B) of the Code, the full amount of X’s discharge of indebtedness income is excluded from gross income because that amount does not exceed the amount by which X was insolvent.

If the subdivision had been transferred to the bank as a result of a foreclosure proceeding in which the outstanding balance of the debt was discharged (rather than having been transferred pursuant to the settlement agreement), the result would be the same. A mortgage foreclosure, like a voluntary sale, is a ‘disposition’ within the scope of the gain or loss provisions of § 1001 of the Code. See Helvering v. Hammel, 311 U.S. 504 (1941); Electro-Chemical Engraving Co. v. Commissioner, 311 U.S. 513 (1941); and Danenberg v. Commissioner, 73 T.C. 370 (1979), acq., 1980-2 C.B. 1.

HOLDING

The transfer of the subdivision by X to the bank in satisfaction of a debt on which X was personally liable is a sale or disposition upon which gain is realized and recognized by X under §§ 1001(c) and 61(a)(3) of the Code to the extent the fair market value of the subdivision transferred exceeds X’s adjusted basis. Subject to the application of § 108 of the Code, to the extent the amount of debt exceeds the fair market value of the subdivision, X would also realize income from the discharge of indebtedness.

Notes and Questions:

1. What would have been the result if the adjusted basis of the property had been $7000x?

2. Why is it so important to this revenue ruling that taxpayer is insolvent?

3. You should recognize that the holding in Gehl is in exact accord with the IRS’s position in this revenue ruling.

4. Read Reg. § 1.1001-3(b). You might have to get this regulation on Westlaw or Lexis. A “material modification” of a debt instrument results in an exchange for purposes of § 1001(a). What is the effect of this treatment?

5. Would the result have been the same if the loan had been without recourse? Read on.

Rev. Rul. 91-31, 1991-C.B. 19-1

DISCHARGE OF INDEBTEDNESS

…

ISSUE

If the principal amount of an undersecured nonrecourse debt is reduced by the holder of the debt who was not the seller of the property securing the debt, does this debt reduction result in the realization of discharge of indebtedness income for the year of the reduction under [§ 61(a)(11)] of the Internal Revenue Code or in the reduction of the basis in the property securing the debt?

FACTS

In 1988, individual A borrowed $1,000,000 from C and signed a note payable to C for $1,000,000 that bore interest at a fixed market rate payable annually. A had no personal liability with respect to the note, which was secured by an office building valued at $1,000,000 that A acquired from B with the proceeds of the nonrecourse financing. In 1989, when the value of the office building was $800,000 and the outstanding principal on the note was $1,000,000, C agreed to modify the terms of the note by reducing the note’s principal amount to $800,000. The modified note bore adequate stated interest within the meaning of § 1274(c)(2).

The facts here do not involve the bankruptcy, insolvency, or qualified farm indebtedness of the taxpayer. Thus, the specific exclusions provided by § 108(a) do not apply.

LAW AND ANALYSIS

Section [61(a)(11)] of the Code provides that gross income includes income from the discharge of indebtedness. Reg. § 1.61-12(a) provides that the discharge of indebtedness, in whole or in part, may result in the realization of income.

In Rev. Rul. 82-202, a taxpayer prepaid the mortgage held by a third party lender on the taxpayer’s residence for less than the principal balance of the mortgage. At the time of the prepayment, the fair market value of the residence was greater than the principal balance of the mortgage. The revenue ruling holds that the taxpayer realizes discharge of indebtedness income under [§ 61(a)(11)] of the Code, whether the mortgage is recourse or nonrecourse and whether it is partially or fully prepaid. Rev. Rul. 82-202 relies on United States v. Kirby Lumber Co., 284 U.S. 1 (1931), in which the United States Supreme Court held that a taxpayer realized ordinary income upon the purchase of its own bonds in an arm’s length transaction at less than their face amount.

In Commissioner v. Tufts, 461 U.S. 300 (1983), the Supreme Court held that when a taxpayer sold property encumbered by a nonrecourse obligation that exceeded the fair market value of the property sold, the amount realized included the amount of the obligation discharged. The Court reasoned that because a nonrecourse note is treated as a true debt upon inception (so that the loan proceeds are not taken into income at that time), a taxpayer is bound to treat the nonrecourse note as a true debt when the taxpayer is discharged from the liability upon disposition of the collateral, notwithstanding the lesser fair market value of the collateral. See § 1.1001-2(c), Example 7, of the Income Tax Regulations.

In Gershkowitz v. Commissioner, 88 T.C. 984 (1987), the Tax Court, in a reviewed opinion, concluded, in part, that the settlement of a nonrecourse debt of $250,000 for a $40,000 cash payment (rather than surrender of the $2,500 collateral) resulted in $210,000 of discharge of indebtedness income. The court, following the Tufts holding that income results when a taxpayer is discharged from liability for an undersecured nonrecourse obligation upon the disposition of the collateral, held that the discharge from a portion of the liability for an undersecured nonrecourse obligation through a cash settlement must also result in income.

The Service will follow the holding in Gershkowitz where a taxpayer is discharged from all or a portion of a nonrecourse liability when there is no disposition of the collateral. Thus, in the present case, A realizes $200,000 of discharge of indebtedness income in 1989 as a result of the modification of A’s note payable to C.

In an earlier Board of Tax Appeals decision, Fulton Gold Corp. v. Commissioner, 31 B.T.A. 519 (1934), a taxpayer purchased property without assuming an outstanding mortgage and subsequently satisfied the mortgage for less than its face amount. In a decision based on unclear facts, the Board of Tax Appeals, for purposes of determining the taxpayer’s gain or loss upon the sale of the property in a later year, held that the taxpayer’s basis in the property should have been reduced by the amount of the mortgage debt forgiven in the earlier year.

The Tufts and Gershkowitz decisions implicitly reject any interpretation of Fulton Gold that a reduction in the amount of a nonrecourse liability by the holder of the debt who was not the seller of the property securing the liability results in a reduction of the basis in that property, rather than discharge of indebtedness income for the year of the reduction. Fulton Gold, interpreted in this manner, is inconsistent with Tufts and Gershkowitz. Therefore, that interpretation is rejected and will not be followed.

HOLDING

The reduction of the principal amount of an undersecured nonrecourse debt by the holder of a debt who was not the seller of the property securing the debt results in the realization of discharge of indebtedness income under § [61(a)(11)] of the Code.

Notes and Questions:

1. Compare Gershkowitz (summarized in Rev. Rul. 91-31) and Tufts. When and why does it matter whether taxpayer is relieved of a nonrecourse obligation through doi or through realization of the amount of the obligation?

2. What is the rule of Rev. Rul. 82-202, as stated in Rev. Rul. 91-31?

• We’ve asked about this before.

3. If the creditor is the seller of the property – i.e., the debt was purchase money debt – the revenue ruling implies that the holding might be different.

• What do you think should be the result in such a case?

• No doi income, but a reduction of basis?

• A purchase price (and basis) reduction if taxpayer is solvent?

• No doi income, and amount of debt included in debtor’s “amount realized” – as in Tufts?

• See Reg. § 1.1001-2(c), Example 7 (which the IRS cites in connection with its discussion of Tufts).

4. To what extent should taxpayer take account of nonrecourse debt in determining whether he is insolvent for purposes of applying § 108? In Rev. Rul. 92-53, 1992-2 C.B. 48, the IRS stated that

the amount by which a nonrecourse debt exceeds the fair market value of the property securing the debt is taken into account in determining whether, and to what extent, a taxpayer is insolvent within the meaning of § 108(d)(3) of the Code, but only to the extent that the excess nonrecourse debt is discharged.

Nonrecourse debt up to the fmv of the property is taken into account. Why shouldn’t the full excess of the amount of the nonrecourse debt over the fmv of the property – even that which is not discharged – be taken into account? How does the IRS’s treatment of nonrecourse debt preserve taxpayer’s “fresh start” – but no more?

The use of borrowed money for a term is not free, just as the use of a “borrowed” apartment is not free. A person pays for the use of another’s money by paying interest. The payment and receipt of interest have certain tax consequences. Payment of interest might be deductible from a taxpayer’s ordinary income. See § 163. The recipient of interest realizes gross income. See 61(a)(4). Lenders and borrowers usually create loans with another transaction in mind, e.g., purchase of property, investment. Those transactions generate certain tax consequences that may differ from the tax consequences of payment of interest, e.g., taxation of capital gains at a rate lower than the tax rate on ordinary income (see chapter 10, infra), realization of gain or loss only upon sale or exchange of the underlying asset rather than on an annual basis (see chapter 9, infra). When parties to a transaction combine a loan with another transaction (e.g., a seller-financed purchase), the Code’s rules may create and carve out an interest element. The Code also provides some timing rules that govern transactions in which the parties fail to specify when interest is paid.

Consider: (1) Clifton Corporation issued $10M worth of bonds on January 1, 2016. For each $10,000 bond that an investor purchased, Clifton Corporation promised to pay $15,007.30 on January 1, 2022. Taxpayer Linda invested $10,000 on January 1, 2016 in Clifton Corporation bonds. She held the Clifton Corporation bonds until their maturity on January 1, 2022 at which time Clifton Corporation paid her $15,007.30. Obviously, Linda realized $5007.30 of interest income. When? Obviously, Clifton Corporation paid $5007.30 in interest. When?

(1a) Suppose that Linda had sold the Clifton Corporation bond on January 1, 2019 for $13,000. Obviously (?) Linda realized a total of $3000 of income. When? How much of it was interest income and how much of it was gain derived from dealing in property? The Buyer would have a $13,000 basis in the bond. How should Buyer treat his eventual receipt of $15,007.30? When?

(2) Seller agreed to sell Blackacre to Buyer for $3,500,000. Seller’s basis in Blackacre was $2,500,000. The terms of the agreement were that Buyer would pay Seller $350,000 every year for ten years. The parties stated no other terms of their agreement. Assume that Buyer made all the required payments. Upon fulfillment of all his obligations, what is Buyer’s basis in Blackacre? How much interest income must Seller recognize in each of years 1 through 10? How much must Seller recognize as gain derived from dealing in property?

The terms of these arrangements all required performance of obligations at different times and thereby raised time value of money issues. The Code sections create an interest rate and prescribe a certain compounding period – essentially semi-annual. We will note the compounding period that the sections relevant to this discussion requires, but we will borrow from the tables in chapter 2 that follow the Bruun case. Those tables reflect compounding interest on an annual basis.

Examples (1) and (1a:) Section 1272(a)(1) provides for inclusion of interest income in the gross income of a holder of a debt instrument as the interest accrues, i.e., taxpayer Linda in Example (1) must include in her gross income interest as if Clifton had paid it and it was compounded semi-annually (§ 1272(a)(5)).

• Section 1273(a)(1) defines “original issue discount” to be the redemption price at maturity minus the issue price.

• By using table 1, we learn that Linda should include $700 in her gross income one year after making her investment. Because she has paid income tax on $700, Linda’s basis in the bond increases to $10,700. § 1272(d)(2).

• Section 163(e)(1) provides for the same measurement of any allowable interest deduction for the Clifton Corporation.

After three years, Linda would have paid tax on a total of $2250 of interest income. She must include $801 of interest income in her gross income for year 3 – again, more than her interest income in year 2. The basis in her bond would be $12,250. She would realize $750 of gain from dealing in property upon its sale for $13,000. See Example (1a).

• Buyer paid a “premium,” i.e., Buyer paid $750 more than Linda’s adjusted basis in the bond. Buyer will step into Linda’s shoes and recognize interest income on the bond. However, Buyer will reduce the interest based upon a similar calculation of the $750 premium spread over the time remaining to maturity of the bond. § 1272(a)(7).

Example 2: Section 1274 provides that when a debt instrument is given in exchange for property (§ 1274(c)(1)), the interest must be at least the “applicable federal rate” (AFR). If it is not, then the debt payments are structured as if the interest rate is the AFR.

• The AFR depends on the term of the debt instrument – whether short-term, mid-term, or long-term. The Treasury Department determines AFRs monthly. § 1274(d).

• The imputed principal amount of a debt instrument is the sum of the present values of all future payments. The present value is determined by using the AFR compounded semi-annually. § 1274(b)(1 and 2).

• Since Seller will receive a total of $3,500,000, the difference between that amount and $2,458,260 must be interest, i.e., $1,041,740. The parties will allocate it on the same yield-to-maturity principles of § 1272 applicable to OID.

• Even though Seller will have $1M of income from the transaction, Seller actually lost money on the sale. Seller will realize substantial interest income – which is subject to a higher tax rate than long-term capital gain.

1. What is wrong with the shrinkage of assets doctrine? Why should a loan and the use of loan proceeds be treated as separate transactions?

2. What should be the applicability of the “disputed debt doctrine” to cases where the amount of a debt is fixed and determined, but its enforceability (in a court) is highly unlikely? Taxpayer borrows money to engage in an illegal transaction.

3. The Bankruptcy Code, 11 U.S.C. § 523(a)(8) makes discharge of a student loan quite difficult, i.e., bankrupt must show “undue hardship on the debtor and the debtor’s dependents.” Section 108(f)(1) of the I.R.C. excludes doi income from a taxpayer’s gross income when “discharge was pursuant to a provision of such loan under which all or part of the indebtedness of the individual would be discharged if the individual worked for a certain period in certain professions for any of a broad class of employers.” What should be the effect of these provisions?

4. What reasons might support treating receipt of loan proceeds as gross income and treating repayment of the loan as deductible? What would be the effects on the economy?

5. You have seen that various types of loans fall within § 108 and are therefore subject to the favorable treatment that that section provides. Are there others? Some argue that any forgiveness of a student loan should be excluded from gross income. Do you agree?

Can you explain or define –

• Why a taxpayer does not in fact exclude the proceeds or a loan from his gross income

• What is § 108’s treatment of doi income if taxpayer is in a bankruptcy proceeding

• What is § 108’s treatment of doi income if taxpayer is insolvent

• When a taxpayer is insolvent

• What are the conditions of excludability of a purchase money debt reduction under § 108(e)(5)

• What a recourse loan is; what a non-recourse loan is

• Why the buyer’s assumption of a loan to which property is subject must be included in the seller’s “amount realized”