In 1971, a partnership purchased residential property subject to a mortgage insured by the Department of Housing and Urban Development (HUD). The partnership took deductions for interest on the mortgage and real estate taxes on an accrual basis. In 1974 when income from the property was insufficient to cover the mortgage payments, HUD acquired the mortgage. HUD paid real estate taxes as they came due and charged the partnership for interest payments due on the mortgage. Pursuant to the mortgage agreement, HUD added these advances to the mortgage principal as they were made and charged interest thereon. In 1978, the partnership transferred the property in lieu of foreclosure. The outstanding nonrecourse debt to HUD exceeded the fair market value of the property at the time.
86 T.C. 655">*655 Respondent determined deficiencies in petitioners' Federal income taxes for the taxable year 1978 as follows:
Petitioner | Deficiency |
James A. Allan | |
and Eileen M. Allan | $ 82,991 |
Dennis M. Evavold | |
and Joanne L. Evavold | 1,157 |
Lowell J. Gordon | $ 2,487 |
Donald J. Hamm | |
and Beverly J. Hamm | 2,304 |
William D.C. Mattison | |
and Barbara A. Mattison | 17,824 |
Bruce M. Nelson | |
and Doris A. Nelson | 9,286 |
Robert F. Osterbauer | 41,353 |
Daniel R. Vaughan | |
and Roberta E. Vaughan | 419 |
86 T.C. 655">*656 The issues for decision are: (1) What amount, if any, of petitioners' distributive share of partnership income constitutes ordinary income under the tax benefit rule as a result of the partnership transferring property in lieu of foreclosure encumbered by a nonrecourse mortgage; and (2) what amount, if any, of petitioners' distributive share of partnership income constitutes ordinary income under section 1245 11986 U.S. Tax Ct. LEXIS 125">*127 as a result of the property transfer.
Some of the facts have been stipulated and are so found. The stipulation of facts and the attached exhibits are incorporated herein by reference. When the petition in the instant case was filed, all of petitioners resided in the State of Minnesota.
Prior to November 1, 1971, a Minnesota limited partnership was formed with the name Stevens House Co. (hereinafter the partnership). Petitioners in the instant case were partners in this limited partnership.
On November 1, 1971, the partnership agreed to purchase land, a 72-unit apartment building, and related personal property for the amount of $ 989,000 from an unrelated third party. According to the contract for deed, this sale was subject to the seller's acquisition of a nonrecourse note not to exceed the amount of $ 944,000. The mortgage was to be insured under section 221(d)(4) of the National Housing Act,
Paragraph 10 of the mortgage provides as follows:
10. In the event of Mortgagor's failure to pay any sums provided for in this Mortgage, the Mortgagee, at its option, may pay the same. * * * if the Mortgagor shall fail to pay any other governmental or municipal charge, the Mortgagor shall forthwith make good the deficiency or pay the charge before the same become delinquent or subject to interest or penalties and in default thereof the Mortgagee may pay the same. All sums paid by the Mortgagee and any sums which the Mortgagee may be required to advance to pay mortgage insurance premiums shall be added to the principal of the debt secured hereby and shall bear interest from the date of payment at the rate specified in the Note and shall be due and payable on demand. * * *
The partnership paid all expenses associated with the operation of the property through July 1, 1974. In approximately July of 1974, the income from the property was insufficient 1986 U.S. Tax Ct. LEXIS 125">*129 to allow for any payments to be made on the mortgage. The mortgagee, George C. Jones Co., declared the mortgage loan in default and sought recovery of the debt from HUD pursuant to its contract of mortgage insurance with HUD. HUD exercised its rights pursuant to that agreement and acquired the mortgage on December 4, 1974. HUD secured a new management company to manage the property.
After December 4, 1974, HUD paid real estate taxes as the same came due. HUD also charged the partnership for the interest payments due on the mortgage as they came due. HUD added these advances to the mortgage principal as they were made and charged the mortgage interest rate thereon to the partnership.
As a result of the continuing failure of the income from the property to support a payment of the mortgage principal, interest, and taxes, HUD commenced a judicial foreclosure proceeding against the owners of the property. On November 1, 1978, the partnership in lieu of foreclosure transferred all of its right, title, and interest in the property to HUD. The partnership paid $ 56,956 to HUD in conjunction with its transfer of the property. There was no contemporaneous agreement between the parties 1986 U.S. Tax Ct. LEXIS 125">*130 as to the allocation of this payment. The transfer of the property by the partnership 86 T.C. 655">*658 to HUD on November 1, 1978, represented a transfer of all of the property of the partnership.
The partnership accrued, but did not itself pay, the following amounts of interest on the mortgage and real estate taxes which were claimed as deductions on the partnership's income tax returns:
Years | Interest | Taxes |
1974 | $ 38,064 | $ 137,950 |
1975 | 74,982 | 52,397 |
1976 | 64,580 | 61,885 |
1977 | 65,376 | 27,480 |
1978 | 54,480 | 31,222 |
Total | 297,482 | 310,934 |
HUD payment from Stevens House escrow | 1 (35,714) | |
FHA reserve escrow | 21986 U.S. Tax Ct. LEXIS 125">*149 (15,215) | |
260,005 |
All amounts owed for interest and real estate taxes were nonrecourse obligations.
HUD had an appraisal made of the property by Fritz Brandberg Appraisals which was completed on August 5, 1977. The appraisal estimated the fair market value of the property at $ 540,000. The parties agree that as of November 1, 1978, the fair market value of the real property did not exceed this amount. To establish the fair market value of the personal property located on the real estate, petitioner presented the testimony 1986 U.S. Tax Ct. LEXIS 125">*131 of Mr. Fritz Brandberg who had prepared the appraisal. Mr. Brandberg has been in the real estate business since 1949 and has been a full-time appraiser for more than 20 years. He is qualified with the American Society of Appraisers as a senior appraiser, as to real property of all kinds including attachments and fixtures of real property. His estimate of the fair market value of the personal property consisting of room air conditioners, electric ranges, and refrigerators was $ 14,000 as of August 5, 1977. Mr. Brandberg viewed the appliances in a few of the apartment units, primarily those that were vacant and in the worst condition. In his opinion, the value of the personal property would decline after August 5, 1977. Using a 10-year life, the most optimistic estimate, the value would 86 T.C. 655">*659 decline 10 percent and using a 5-year life, it would decline by 20 percent.
The partnership reported on its return a capital gain of $ 700,633 as a result of the transfer of the deed in lieu of foreclosure. This amount was computed by taking the difference between the entire amount of the debt outstanding to HUD ($ 1,455,941) minus the adjusted basis ($ 650,653). (A portion of this difference ($ 1986 U.S. Tax Ct. LEXIS 125">*132 104,655) was reported as ordinary income pursuant to section 1250 and is not in dispute.) The notice of deficiency issued to petitioners determined that the portion of the $ 700,633, which represented the amount of previously deducted interest and real estate taxes, to wit $ 572,562, constituted ordinary income pursuant to section 61 and section 111. In addition, the notice determined that $ 77,950 of the $ 700,633 was ordinary income pursuant to the recapture provisions of section 1245.
OPINION
The first issue for decision is whether petitioners are required to recognize ordinary income in an amount equal to the previously deducted interest and taxes. This issue in turn depends upon what amount was realized when the partnership transferred the property. Petitioners argue that the entire amount of outstanding nonrecourse debt to HUD, including the original mortgage, the interest payments due, and the real estate taxes paid, (which is greater than the fair market value of the property) is includable in the amount realized pursuant to
It is now well settled that the transfer of property by deed in lieu of foreclosure constitutes a "sale or exchange."
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. [
The parties in the instant case agree that the fair market value is not the 1986 U.S. Tax Ct. LEXIS 125">*135 relevant factor in determining the amount realized. Respondent argues that the amount realized does not include that part of the nonrecourse debt which represents the interest and taxes but rather is limited to the mortgage principal. Respondent points to the fact that petitioners did not consistently treat these amounts as mortgage principal in that the partnership did not add the amounts to the basis of the property. The partnership instead took current deductions as these expenses accrued. 86 T.C. 655">*661 In respondent's view, the exclusion of these expenses from basis of the property requires the exclusion of the discharged liability to pay these expenses from the amount realized.
Petitioners rely on paragraph 10 of the mortgage to support their position that HUD added to the mortgage principal the real estate tax payments paid and the interest payments due. HUD charged the mortgage interest rate to the partnership for these advanced moneys.
We agree with petitioners. The advances were considered mortgage principal by the terms of the mortgage agreement and as such were subject to the mortgage interest rate. Only by adding these advances to the mortgage principal could interest on the advances 1986 U.S. Tax Ct. LEXIS 125">*136 be charged. The nonrecourse obligation was satisfied when the partnership paid the $ 56,000 payment and transferred the property securing that obligation. Therefore, the amount realized includes the amount of the nonrecourse debt in accordance with
In making its determination in
Respondent seems to read
86 T.C. 655">*662
(a)
Paragraph (a)(2) provides that the amount realized from the disposition of property that secures a recourse liability does not include amounts that are income from the discharge of indebtedness. Paragraph (a)(3) excludes liabilities incurred by reason of the acquisition of the property which are not taken into account in determining the transferor's basis. Neither of these exceptions applies to the instant case. The outstanding debt to HUD was satisfied as a result of the disposition of the property.
To support the contention that the portion of capital 1986 U.S. Tax Ct. LEXIS 125">*138 gain reported by petitioners representing the unpaid taxes and interest should be treated as ordinary income, respondent primarily relies on a series of cases which apply the tax benefit rule. This rule requires the recognition of income when a subsequent event occurs which is "fundamentally inconsistent with the premise on which [an earlier] deduction was initially based. That is, if that event had occurred within the same taxable year, it would have foreclosed the deduction."
In the context of a sale or disposition of property under
86 T.C. 655">*663 In invoking the tax benefit rule, respondent relies on
Respondent also relies on
This Court in determining that the refunded escrow accounts constituted receipt of income recited the following factors:
The factors reflected therein fatal to petitioner's case are (1) that the original escrow payments made to the mortgagee upon purchase, were considered separate from cost, and were taken as a current expense deduction against rental income for that period; (2) that the further payments made on his behalf 1986 U.S. Tax Ct. LEXIS 125">*142 by the agencies managing the projects were not a duplication of those originally made but were a continuation of the monthly payment requirements which were also treated as current expense deductions in preparing the net cash rental (or deficit) statements supplied to petitioner and upon which his tax returns were prepared; (3) that the refunded escrow amounts were not treated as part of the selling price of the property, did not enter into any calculation of net gains upon such sale * * * and were excluded from calculations of income by the accountants. [
The escrow payments were considered separate and apart from the selling price of the property. Here, the advances for the interest and taxes were added to the mortgage principal, and the liability for the mortgage was extinguished when the property was transferred.
Respondent contends that the failure to consistently treat expensed items as capital assets under a recognized method of depreciation prevents the later characterization of these expensed items as the sale of property subject to capital gain rates. Instead, in respondent's view, the application of the tax benefit rule 1986 U.S. Tax Ct. LEXIS 125">*143 requires the inclusion of the items in ordinary income. Respondent relies on
Subsequent to
If the taxpayer * * * sells the [expensed] asset rather than consuming it in furtherance of his trade or business, it is quite clear that he would lose his deduction, for the basis of the asset would be zero, * * * so he would recognize the full amount of the proceeds on sale as gain. [
We agree with petitioners that
Respondent seeks, through the tax benefit rule, to recharacterize capital gain as ordinary income. Here, in essence, petitioner borrowed money from a third party, took the cash and paid expenses connected with the property, i.e., interest and taxes. The debt was secured only by the property. The partnership later transferred the property in lieu of foreclosure in a transaction considered the equivalent of a sale or exchange. The amount realized includes the outstanding amount of the mortgage. Under respondent's analysis, we should then trace the mortgage proceeds and, if used for deductible expenses, subtract that portion of the debt from amount realized and recharacterize it as ordinary income under the tax benefit rule. We believe this recharacterization is an improper application of that rule.
Respondent cites a series of cases dealing with the tax consequences to the mortgagee, apparently for the proposition that symmetry requires that if no interest income is recognized by the mortgagee then the mortgagor must include amounts previously deducted as income. These cases held that where a debtor voluntarily surrenders 1986 U.S. Tax Ct. LEXIS 125">*146 mortgaged property to the mortgagee, the mortgagee realizes income in the form of accrued interest if the value of the property is more than the amount of the principal amount of the loan.
Respondent is attempting to bifurcate the disposition of the property into two separate events: (1) Relief from the mortgage principal, and (2) relief from the liability for the accrued interest and taxes. Yet there is only one mortgage, one note, and one property transfer. Under
The second issue for decision involves recharacterization of capital gain as ordinary income as provided in section 1245(a).
The authority respondent cites in support of the contention that the regulation is inapplicable is
Based 1986 U.S. Tax Ct. LEXIS 125">*150 on the only testimony presented at trial, which we found credible, we find the value of the section 1245 property as of August 5, 1977, was $ 14,000. Recognizing that the value of this property would decline during the year before disposition and accepting Mr. Brandberg's estimate of 10-percent decline, we find the value of the personal property to be $ 12,600. This amount is 2.3 percent of the fair market value of the entire property ($ 12,600/$ 540,000). Accordingly, the amount realized from the section 1245 property is 2.3 percent of the total amount realized ($ 1,455,941) or $ 33,486.
To reflect the foregoing,
1. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954 as amended and in effect for the year in issue.
1. These payments were made to HUD during the years 1974-78 and credited toward the payment of real estate taxes.↩
2. SEC. 1245. GAIN FROM DISPOSITIONS OF CERTAIN DEPRECIABLE PROPERTY.
(a) General Rule. -- (1) Ordinary income. -- Except as otherwise provided in this section, if section 1245 property is disposed of during a taxable year beginning after December 31, 1962, the amount by which the lower of -- (A) the recomputed basis of the property, or (B)(i) in the case of a sale, exchange, or involuntary conversion, the amount realized, or (ii) in the case of any other disposition, the fair market value of such property, exceeds the adjusted basis of such property shall be treated as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231. Such gain shall be recognized notwithstanding any other provision of this subtitle.↩