[Ed Note: This is the first of what will be a recurring series of posts by WS+B Tax Partner Steve Talkowsky addressing the seminal tax cases in our country's tax history. Why do something like this?
Because unless you happen to be this chick, the tax law is considerably older than you are. As a result, no matter how diligent and dutiful you may be in absorbing current events, the reality is that much of the current law was established long before you were a twinkle in your daddy's eyes.
To speed up your learning curve, Mr. Talkowsky will stop by from time to time to reintroduce and dissect those landmark decisions that have had a far-reaching impact on the tax law as we know it.
First up: The Supreme Court's decision in CRANE v. COMMISSIONER. Now on to Steve…]
My esteemed colleague likes to blog about current events, but as they say, in order to understand the present you must understand the past. So I have taken on the task of blogging about Crane v. Commissioner, 331 U.S. 1 (1947).
Crane is widely considered the landmark Supreme Court decision in the tax world, as it created the law we have today - that if nonrecourse debt is assumed by a buyer upon a sale of property, that assumption is equivalent to receiving cash proceeds by the seller and must be used in the calculation of taxable gain or loss.
Mrs. Crane (Crane) inherited all of her husband’s property upon his death; unfortunately, she also inherited all of his debt as well. At this time of his death, the building’s FMV and related mortgage were as follows:
The mortgage was nonrecourse – meaning that if Crane could not pay the mortgage, the building could be used to satisfy the mortgage but the lender could not go after Crane’s other assets.
Crane could not keep up the building and the mortgage went into default. In order to avoid foreclosure, Mrs. Crane sold the building for $2,500 in cash plus an assumption of the mortgage balance of $255,000 by the purchaser.
Mrs. Crane – taking a rational, non-tax approach – reported gain of $2,500 on her tax return. In her mind, when she inherited the property from her husband, her basis in the property was $0, as the mortgage fully offset the FMV of the property. In other words, she viewed the value of the property as being synonymous with her equity in the property. Because Crane believed she had no basis in the property, she took no depreciation, and the sale of the property for $2,500 generated gain of $2,500 ($2,500-$0).
The IRS disagreed, arguing that:
1. Crane’s basis in the inherited property was the FMV of the property of $262,000, rather than the net equity of $0. The Service then reduced her basis by $28,000 of allowable depreciation to come to a net adjusted basis of $234,000; and
2. Crane’s proceeds from the sale of the property included not only the $2,500 of cash received, but also the relief of the $255,000 nonrecourse mortgage assumed by the buyer, for a total sales price of $257,500.
Thus, according to the IRS, Crane recognized a gain of $23,500 on the sale of the property ($257,500 – $234,000).
The Tax Court decided both issues in favor of Crane, but the Second Circuit Court of Appeals reversed the decision. In its seminal decision, the Supreme Court sided with the IRS and affirmed the Appellate Court with a 6-3 decision, establishing two fundamentals of tax law in the process:
1. When basis is determined in reference to the “fair market value of the property” — as it is in the case of an inheritance under I.R.C. § 1014 — the word “property” refers to the actual physical object being acquired, not the net equity of the object being acquired; and more importantly,
2. Even when a taxpayer is not personally liable on a debt — as is the case with a nonrecourse mortgage — the amount realized upon any sale or disposition of the mortgaged property must include any portion of the nonrecourse debt that is assumed by the buyer. The Supreme Court reasoned that the economics were no different than if the buyer had simply paid cash equal to the mortgage balance to the seller who used the proceeds to pay off the mortgage simultaneous to the sale. While a litany of cases had already established this to be the case when the borrower was personally liable on a debt or mortgage (i.e., recourse debt), this was an issue of first impression with regards to nonrecourse debt.
[Ed note: For a case with a very basic, understandable set of facts, Crane has grown into the most impactful tax case ever decided by the Supreme Court. It spawned widespread abuses during the tax-shelter era of the 80's by allowing a taxpayer to take depreciation deductions on the cost of acquired property -- unreduced by any debt encumbering the property. To understand how, consider this: the Crane decision permitted a taxpayer to borrow $100,000 from a bank on a nonrecourse basis and then acquire and depreciate machinery, even though the taxpayer's economic investment in the acquired machinery was $0 ($100,000 cost - $100,000 debt). Smart, inventive people looking to save on taxes can do wonders with facts like that.
Crane also indirectly gave birth to the passive activity rules, as they were largely enacted to curb these abusive tax shelters. In turn, the passive activity rules played a large role in the savings and loan crisis of the late 1980's.
More recently, Crane has returned to the public consciousness with the string of real estate foreclosures that have defined the previous half decade. The economic downturn has left many taxpayers unable to pay their mortgages. In situations where those mortgages are nonrecourse, a transfer of the property by the borrower to the lender in lieu of foreclosure and in satisfaction of the nonrecourse mortgage is treated as a sale of the property for the amount of the nonrecourse mortgage under the principles established 60 years ago by the Supreme Court in Crane.]