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[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:

FMV: $262,000

Mortgage: $262,000

Equity: $0

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.]

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I’m like Randall from Clerks, only the exact opposite: I like people, but I hate gatherings. Particularly dinner parties. Oh, how I hate dinner parties.

This is largely due to the fact that I’m awful at small talk, which in turn is largely due to the fact that I’m only well-versed on two things in life: sports and The Simpsons. And while this may make me a hit with the 14-21 year old demographic, most adults seem largely unimpressed with my ability to list 20 people who’ve worked alongside Homer at the Springfield Nuclear Power Plant.

No, the majority of my contemporaries prefer to talk about grown-up topics like mortgage rates and lawn care and the various pros and cons of the local school systems. Now, call me immature, but when I get stuck talking about any of this stuff, it makes my brain want to flee my body, sort of like this:

As my wife constantly reminds me, however, I am now a husband and a father, and by extension, a grown-up. I can no longer avoid uncomfortable conversations by stuffing my pockets with cocktail shrimp and waiting out a party in an upstairs guest bathroom. I’ve got to grin and bear it, which means I’ve got to be prepared.

And you should be too. Whether you’re socially challenged like me or not, as CPAs, new acquaintances expect us to be experts on all things finance. It matters little if you’ve spent your entire career preparing consolidated corporate tax returns, your neighbor Bill will inevitably look to you for advice on funding little William’s 529 plan.

That’s why I’ve put together the following FAQ. As you may have heard, our nation has been dealing with a bit of a debt problem. On Tuesday, legislation was passed as part of a “deficit reduction deal,” allowing the U.S. to narrowly avoid defaulting on its obligations and preventing us from becoming the largest province in the Chinese empire.

It’s only a matter of time before someone asks you what the deal is about the deal. So read on, and you can thank me after your next dinner party.

Wait…what happened?

The U.S. almost defaulted on its outstanding debt. The U.S. Treasury is no different then MC Hammer or Mike Tyson; it can’t cover its expenses strictly from the revenue it earns. As a result,  it looks to borrow.  However, the Treasury can only borrow money as long as the total debt doesn’t exceed a ceiling stated by law.  As of July 2011, the U.S. had maxed out its $14.3 trillion borrowing limit, meaning unless the President found some serious loose change under his couch cushions, we would have to either increase the debt limit or risk becoming unable to service our obligations, potentially leading to default.

So how did we avoid default?  

To change the debt ceiling, new legistlation must be passed. This was accomplished mere hours before default was likely, when lawmakers agreed to increase the amount the U.S. could borrow from its lenders, while simultaneously requiring the government to cut its spending in an effort to reduct the deficit. This may seem counterintuitive — akin, if you will,  to trying to curb your wife’s shopping habit by handing her a shiny new VISA but advising her to take it easy at Ann Taylor Loft —  but it accomplished the task of keeping us out of default.

How much additional cash can we borrow?

The legislation will raise the debt ceiling by $400 billion today, then another $500 billion in September. It will then be increased by another $1.2 trillion to $1.5 trillion. That’s a total debt ceiling increase of $2.4 trillion, or just enough to cover Albert Pujols next contract.

What kind of budget cuts are we facing? 

Much of the first $900 billion of spending cuts will likely come from our defense budget. So while we may become a more fiscally responsible nation,  in ten years there will be nothing to prevent the King of England from marching right through your front door and pushing you around. So there’s that to consider.

Where are the tax increases?

Despite an abundance of rhetoric over the past few months, the current proposal doesn’t account for any additional revenue raisers — tax or otherwise. Only reduced spending.

Can you really reduce a deficit by merely cutting spending and not raising additional revenue?

Sure you can, but as Chris Rock once said, you can also drive a car with your feet, but that don’t make it a good idea. It’s extremely likely that when the bipartisan committee assigned to reducing the deficit puts their heads together later this year, tax reform will be on the menu.

What kind of tax reform might we see?

In light of these recent developments, I would wager a guess that any reform may well be sweeping, the likes of which we haven’t seen since 1986. I just wouldn’t expect to see any major changes in 2011, since the bipartisan committee has a tight window to work with in meeting its November 2011 deadline for recommending additional deficit reduction strategies.

From a long-term standpoint, however, several proposals are currently on the table, including the following:

Obama’s Plan:

  • Includes an extension of the Bush tax cuts after 2012 for only those earning less than $200,000 ($250,000 for MFJ).
  • Eliminating tax breaks for big oil and corporate jets.
  • A permanent extension of the R&D credit.
  • Keeping the 3.8% Medicare contribution tax on certain unearned income after 2012.

These proposals keep with Obama’s theme of targeting the wealthy and demanding that they pay their “fair share.”

The Gang of Six Plan

White House Deficit Commission

  • Reducing tax rates, but eliminating or reducing many current tax incentives, including the deduction for home mortgage interest, accelerated depreciation, lower rates on capital gains and the earned income credit.
  • Individual rates would drop to a range from 8-23%, though dividends and capital gains would be taxed as ordinary income.
  • Eliminating the AMT.
  • Repealing the state and local tax itemized deduction and reducing the charitable contribution deduction.
  • A single corporate rate of 26% and elimination of the Section 199 deduction.

That should give you everything you need to handle any unsolicited questions with aplomb. You’ll notice I’ve only provided facts; no opinion. It’s been my experience that in a social setting, one should never offer their views on politics, religion, or just how overrated Lady Gaga is. It can never end well.

Instead, just drop some deficit reduction deal knowledge. You’ll be a bigger hit at parties than this dude. 

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