Crane and Tufts are foundational cases.

To understand these cases, we need to understand the concept of depreciation. Taxpayer recover cost by taking annual depreciation deductions. These deductions reduce income each year and adjust basis. Depreciation deductions are an exception to the realization requirement.

Assume $300,000 purchase of real estate and a 30-year recovery period. In Year 1, taxpayer takes a deprecation deduction of $10,000 that reduces that year’s income and also reduces basis to $290,000. In Year 2, the taxpayer takes a depreciation deduction of $10,000 that reduces that year’s income and reduces basis to $280,000. If taxpayer sold the building at the beginning of Year 3 for $300,000, taxpayer would have $20,000 gain.

Mrs. Crane inherited a building subject to a nonrecourse mortgage when the FMV the building and the outstanding balance on the mortgage was $250,000.

She owned the building for some time and took depreciation deductions totaling $25,000.

She sold the building for a net amount of $2,500 and subject to the mortgage, which remained at $250,000.

What is her amount realized under section 1001? “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.”

Does her Amount Realized include the outstanding principal on the mortgage to which the property is subject?

Let’s look at the Handout on Crane and Tufts.

The Supreme Court concludes that Mrs. Crane benefited from treating the mortgage as if it were recourse, since the property appreciated.

Tufts raised the question of what happens in the property is worth less than the outstanding nonrecourse mortgage. Is the rule the same?

Yes, says the Supreme Court - AR includes relief of even nonrecourse mortgage greater than the property’s FMV, given that the amount of the mortgage was included in basis.

What about the buyer? The buyer’s initial basis in the property includes the liabilities assumed or to which the property is subject, at least up to the FMV of the property.

Assumption of a mortgage by the buyer or the buyer’s taking property subject to a mortgage is NOT cancellation of indebtedness for the seller.

We treat the transaction AS IF the purchaser had paid the seller cash and the seller had paid off the loan in full.

Borrowing against appreciation in a piece of property neither generates basis in that property nor produces realization of income. (Woodsam Associates)

Example I buy a piece of land for $100k. I used $20k of my savings and borrowed $80k nonrecourse. The property appreciates to $230k and I borrow an additional $120k nonrecourse. I use the money to buy stocks and bonds. My AB in the property remains $100k. If I sell it for $50k in cash, and the buyer takes the property subject to both mortgages, my AR is $250k.

EVEN if amount borrowed nonrecourse against appreciation exceeds basis, we do not recognize gain.

A nonrecourse borrower gets the benefit of any appreciation in the property above the amount of the loan.

Although a loan against appreciation does not in itself generate basis, the amount realized upon disposition of the property includes all debt to which the property is subject.

Example: I buy non-depreciable property for $10K. I pay with $2k of my own funds and borrow $8k nonrecourse. My basis is $10k. My property appreciates in value to $40k and I borrow an additional $20k nonrecourse. I have no gain; my basis remains $10k. I sell the property for $22k and subject to both mortgages, when all principal remains outstanding. My AR is $50K, my AB is $10k, and my GR is $40k.

Some key points so far: Borrowed funds are not income, but we generally get to treat borrowed funds as our own for tax purposes. AR includes relief or assumption of borrowed funds or taking property subject to a mortgage. We can get basis for borrowed funds. Borrowing against appreciation does not in itself generate basis.

I sell property for $500k in cash and use $100k to pay off an unrelated debt. AR is $500k. Buyer’s basis is $500k.

I sell property for $500k in cash and use $100k of it to pay off a recourse debt secured by the property. AR is $500k. Buyer’s basis is $500k.

I sell property for $400k plus the buyer’s assumption of an unrelated recourse debt of $100k. AR is $500k. Buyer’s basis is $500k.

I sell property for $400k and the buyer’s assumption of $100k recourse debt incurred to purchase the property. AR is $500k. Buyer’s basis is $500k.

I sell property for $400k and the property is subject to a $100k nonrecourse debt. AR is $500k. Buyer’s basis is $500k.

In part, the rules of Tufts and Crane are rules of symmetry. I purchase an apartment building in Year 1 for $100k in cash and $900k borrowed as a non- recourse loan. My basis in the building is $1 million. In each of Years 1, 2, and 3, I take $50k in depreciation ($150k total). In Year 3, the rental market collapses and the building declines in value to $850k. I default at the beginning of year 4, when the outstanding balance on the loan is still $900k.

Calculation of gain AR$900k minus AB$850k ($1 million less 150k depreciation) GR $50k

Why? Compare out of pocket loss of $100k with losses of $150k claimed in depreciation deductions. The $50k of gain reconciles this disparity by “giving back” $50k of the losses taken. Economic and tax consequences should eventually match.

WARNING: THERE WOULD BE A DIFFERENT RESULT IF THE BANK HAD TAKEN THE BUILDING IN SATISFACTION OF A RECOURSE LOAN. FORECLOSURE IS AN EXCEPTION TO THE GENERAL RULE TREATING RECOURSE AND NONRECOURE DEBT IN THE SAME WAY.

If the bank does take a building worth $850k in satisfaction of a $900k recourse debt when AB is $850k - AR$850k (FMV of building) minus AB$850k GR $0 BUT there is also $50k of COD income, the difference between the outstanding principal and the value of the property the bank receives.

USUALLY we treat recourse and nonrecourse debt in the same way.

For both, we assume that the amounts will be repaid in full and allow borrowed funds to generate basis.

In a sale, we treat both recourse and nonrecourse debt of which the seller is relieved as part of AR.

It is as if the buyer paid the seller cash and the seller used the cash to pay off the loan.

Example I sell property subject to $100k nonrecourse debt for $300k in cash. It is as if I received $400k in cash and went to the bank to pay off the loan. My AR is $400k. The seller takes a $400k basis in the property.

Is nonrecourse debt as likely to be repaid as recourse debt? If owners of property subject to nonrecourse debt want to retain the property, they must keep up payments and treat the mortgage as if it were a personal obligation. They must keep up the nonrecourse debt to benefit from any appreciation. But if the property is given away or abandoned, the borrower doesn’t care what happens to the debt at maturity.

But debt that is formally recourse may be nonrecourse for all practical purposes. Consider an entity whose only asset is the mortgaged property. Consider an individual who has no significant assets other than the mortgaged property.

Options Make a sharp line between recourse and nonrecourse debt. Engage in a loan by loan consideration as to category. Uniform treatment of both kinds of liability. FOR THE MOST PART, we do the last – uniform treatment of both kinds of liability.

We treat recourse and nonrecourse debt differently in a few cases – at-risk rules, certain partnership rules, AND

As we just saw, in foreclosure of property by the bank. For nonrecourse debt, per Tufts, AR includes the outstanding principal on the loan. For recourse debt, AR includes only the FMV of the property foreclosed. (Gain or loss will likely be capital gain or loss.) For recourse debt, the difference between the outstanding principal on the loan and the FMV of the property is COD income. (COD income is ordinary.)

Review and application. Let’s look at handout “Key Points re Crane and Tufts.” Let’s do handout “Debt Questions.”