39814
May 7, 1990
Section 61 -- Gross Income Defined
Summary
SERVICE CONCLUDES TRANSFER OF PROPERTY TO BANK FOR CANCELLATION OF DEBT REQUIRES BIFURCATED ANALYSIS.
In GCM 39814, the Office of Chief Counsel has reviewed Rev. Rul. 90-16, 1990-8 I.R.B. 5. A corporation was the owner and developer of two residential subdivisions. The corporation financed the projects through an unrelated bank with nonrecourse debt further backed by a personal guarantee of the corporation.
In 1984, the corporation defaulted on the loans. Although insolvent, the corporation negotiated a settlement with the bank whereby the subdivisions were transferred to the bank in exchange for the corporation's release from liability for the outstanding balance on the loans. When the subdivisions were transferred to the bank, the fair market value of the subdivisions was greater than the corporation's adjusted basis in the subdivisions, but less than the amounts due on the loans. After the exchange, the corporation was still insolvent. Rev. Rul. 90-16
ISSUES. At issue is whether the transfer of two residential subdivisions in exchange for the cancellation of the developer's bank loans on which the developer was personally liable is a sale or other disposition triggering gain recognition. The GCM also involves whether the developer recognizes discharge of indebtedness income if the fair market value of the
transferred subdivisions is less than the amount due on the loan and the developer is insolvent both before and after the transfer.
CONCLUSIONS. The Office of the Chief Counsel has concluded that the transfer of the subdivisions in exchange for the cancellation of the development loans is a sale or other disposition triggering gain recognition. However, the developer will not recognize discharge of indebtedness income when the fair market value of the transferred subdivisions is less than the balance due on the loans and the taxpayer is insolvent both before and after the transfer.
ANALYSIS. The Service explained that the proposed revenue ruling bifurcates the transaction into a sale of the two subdivisions to the bank and the realization of discharge of indebtedness income by the corporation. In analyzing the sale part of the transaction, the revenue ruling provides that the amount realized is the fair market value of the two subdivisions and gain or loss is recognized by the corporation to the extent of the difference between the fair market value of the two subdivisions and their adjusted basis. In analyzing the realization of discharge of indebtedness income by the corporation, the revenue ruling provides that the company will recognize income to the extent that its indebtedness to the bank exceeds the fair market value of the two subdivisions. However, the Service noted that any discharge of indebtedness income realized is excludable by the corporation under section 108(a)(1)(B), because the corporation remained insolvent after the transfer of the subdivisions to the bank.
The Service explained that position taken in the proposed revenue ruling is the same as that taken in regulation section 1.1001-2(c), example 8, and that this position also has support in the case law. The Service concluded that the bifurcation approach is "clearly the approach of the regulation" and that this approach makes sense: "To the extent of the fair market value of the property transferred to the creditor, the indebtedness is satisfied, not discharged. On the other hand, the amount of the cancelled indebtedness in excess of the fair market value of the transferred property is not satisfied, but discharged." The Service noted that the result would be the same if the subdivisions were transferred to the bank pursuant to a foreclosure since it is well established that a mortgage foreclosure, like a voluntary sale, is a "disposition" under section 1001.
a corporation, was the owner and developer of two residential subdivisions, M and R. To finance the projects, X obtained development loans from an unrelated bank, on which X was personally liable. The loans were secured by the subdivisions.
In 1984, X defaulted on the loans. Although X was insolvent, X met with the bank prior to filing for bankruptcy in an effort to negotiate a settlement. The negotiations produced an agreement between the bank and X whereby the M and R subdivisions were transferred to the bank in exchange for the release of X from liability for the outstanding balance on the loans. When the M and R subdivisions were transferred, the fair market value of the subdivisions was greater than X's adjusted basis in the subdivisions but less than the amounts due on the loans. After the exchange X was still insolvent.
ANALYSIS
Section 61(a)(3) provides that except as otherwise provided gross income includes gains derived from dealings in property.
Section 61(a)(12) provides that except as otherwise provided gross income includes income from the discharge of indebtedness.
Section 108(a)(1) provides:
IN GENERAL. -- Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if --..
(B) the discharge occurs when the taxpayer is insolvent. .
Section 100 1(a) provides that the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain.
Section 1001(b) 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) provides that except as otherwise provided under Subtitle A the entire amount of the gain or loss, determined under section 1001, on the sale or exchange of property shall be recognized.
Treas. Reg. 1. 1001-2(a)(2) provides:
DISCHARGE OF INDEBTEDNESS. 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 section 61(a)(12).
Certain court cases have held that an insolvent debtor does not realize income upon conveying appreciated property to a creditor in return for release by the creditor of the amount owed to it, provided the debtor remains insolvent after the transaction. See Turney's Estate v. Commissioner, 126 F2d 712 (5th Cir. 1942); Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 F2d 95 (5th Cir. 1934); Brutsche v. Commissioner, 65 TC 1034 (1976), rev'd on other grounds, 585 F2d 436 (10th Cir. 1978); Main Properties, Inc. v. Commissioner, 4 TC 364 (1944), acq., 1945 CB 5; Texas Gas Distributing Co. v. Commissioner, 3 TC 57 (1944), acq. 1944 CB 27, Springfield Industrial Building Co. v. Commissioner, 38 BTA 1445 (1938), nonacq., 1941-2 CB 23. Consider, for example, Main Properties. In that case, the taxpayer exchanged a building and leaseholds for $640,000 of its own bonds, which it then canceled. The fair market value of the property transferred to the taxpayer's creditor exceeded its adjusted basis. Also, the Tax Court found that the taxpayer was insolvent both before and after the transfer of the property to the creditor. The court, relying on Dallas Transfer and Terminal Warehouse, held that the taxpayer did not recognize income upon the exchange. The reasoning of the court in Dallas Transfer and Terminal Warehouse, which is quoted in Main Properties, was that the reduction of a taxpayer's liabilities without any increase of assets does not constitute a gain or profit that comes within the definition of income.
The proposed revenue ruling analyzes the instant transaction differently. It bifurcates the transaction into (1) a sale of the M and R subdivisions to the bank, the amount realized being the fair market value of M and R, with gain or loss being recognized by X to the extent of the
difference between the fair market value of M and R and their adjusted basis and (2) the realization of discharge of indebtedness income by X to the extent that its indebtedness to the bank exceeds the fair market value of M and R. The discharge of indebtedness income realized under "(2)" is excludable by X under section 108(a)(1)(B) because X remained insolvent after the transfer of the subdivisions to the bank.
The position of the proposed ruling is the same as that taken in Treas. Reg. 1.1001-2(c), Example 8, which provides as follows:
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).
The only difference between the facts of the proposed ruling and that of Example 8 of the regulation is that only in the proposed ruling is the debtor stated to be insolvent at the time of the discharge. The solvency of the debtor, or lack thereof, does not, however, affect the characterization of income as being from the sale or exchange of assets or from the discharge of indebtedness. Instead, the debtor's solvency, or lack thereof, is relevant only for purposes of determining whether income from the discharge of indebtedness is excludable from the debtor's gross income under section 108(a)(1)(B).
The position taken in Treas. Reg. 1.1001-2(e), Example 8, has support in the case law. In Bialock v. Commissioner, 35 TC 649 (1961), acq., 1961-2 CB 4, the taxpayer transferred all assets of a business to a creditor, who in turn canceled all indebtedness of the taxpayer owing to it and assumed certain liabilities that the taxpayer owed to third parties. The amount of indebtedness canceled by the creditor exceeded the fair market value of the assets and liabilities transferred to the creditor. The Tax Court stated that it is well established that the transfer of assets in consideration of cancellation of indebtedness is equivalent to a sale upon which gain or loss is recognized in the amount of the difference between the basis of the assets transferred and the amount of the indebtedness which is canceled in consideration of the transfer. Further, the Tax Court held in Bialock that to the extent that the amount of the taxpayer's indebtedness exceeded the value of the property transferred to the creditor, the taxpayer (who was solvent) received income from the discharge of indebtedness.
Consider also Danenberg v. Commissioner, 73 TC 370 (1979), acq., 1980-2 CB 1. In Danenberg, the taxpayer was heavily indebted to a bank. The taxpayer and the bank agreed to an arrangement where the taxpayer would transfer its collateral for the bank loans to third parties, who would remit payment for the collateral directly to the bank. The taxpayer was insolvent both before and after the transaction. The Tax Court stated that case law is clear that when a debt is discharged or reduced upon the debtor's transfer of property to his creditor or a third party, the transaction is treated as a sale or exchange of the debtor's assets, and not as a mere transfer of assets in cancellation of indebtedness. This is in accordance with Treas. Reg. 1.1001-2 and Rialock. Hence the taxpayer in Danenberg was viewed as having sold the collateral to the third parties. The instant case, unlike Danenberg, involves the transfer of property by a debtor directly to the creditor in exchange for a cancellation of indebtedness. The substance of the transactions in this case and Danenberg are the same, since in Danenberg it was agreed that the proceeds from the sale of the collateral to the third parties would be turned over to the creditor in exchange for the cancellation of the indebtedness by the creditor. Given that the substance of the transactions in this case and Danenberg is the same, it would be anomolous for us ta conclude in this case that the transfer of the collateral by X to the bank was not a sale or other disposition.
The Tax Court in Flanenberg also considered whether the taxpayer's insolvency relieved the taxpayer of the requirement of recognizing gain or loss on the disposition of the collateral under section 1001(c) (section 1002 during the tax years at issue in Danenberg). The court held that the taxpayer's insolvency does not provide an exception to the requirement of section 1001(c) that the entire amount of gain on the sale or exchange of property is recognized. The court found that Treas. Reg. 1.61-12(b)(1), which at the time provided that income is not realized by a taxpayer from the discharge of his indebtedness by virtue of an agreement among his creditors not consummated under the Bankruptcy Act, if immediately after the discharge the taxpayer is insolvent, had no bearing on the recognition of gain or loss on the sale or disposition of property by an insolvent taxpayer. Ill Danenberg thus supports the position of the proposed ruling that X's insolvency after the transfer of the subdivisions to the bank does not preclude X from recognizing a gain to the extent that the fair market value of the subdivisions exceeds their adjusted basis. /2/
The bifurcation approach taken in the proposed revenue ruling is clearly the approach of the regulation. We believe that this approach makes sense. To the extent of the fair market value of the property transferred to the creditor, the indebtedness is satisfied, not discharged. On
the other hand, the amount of the canceled indebtedness in excess of the fair market value of the transferred property is not satisfied, but discharged.
We are in agreement with the proposed revenue ruling that the Bankruptcy Tax Act of 1980,
history of the Bankruptcy Tax Act shows Congress' concern in preserving the "fresh start"
after bankruptcy of an insolvent debtor outside of bankruptcy. Specifically, S. Rep. No. 96-
1035, 96th Cong., 2d Sess. 10 (1980), 1980-2 CB 620, 624, states:
To preserve the debtor's "fresh start" after bankruptcy, the bill provides that no income is recognized by reason of debt discharge in bankruptcy, so that a debtor coming out of bankruptcy (or an insolvent debtor outside bankruptcy) is not burdened with an immediate tax liability.
While Congress was concerned with preserving the fresh start of insolvent debtors, the provisions of the Bankruptcy Tax Act are limited in scope to providing nonrecognition of discharge of indebtedness income. /3/ No provision of the Bankrupcty Tax Act relieves a debtor's tax liability arising out of the transfer of appreciated property to a creditor in satisfaction of indebtedness. We believe it is clear that with the exception of discharge of indebtedness income, no relief is given to the insolvent taxpayer. For all other types of income, such as wages, rents, interest, and gain from dealings in property, the solvency of the taxpayer is irrelevant to whether the taxpayer recognizes income. Estate of Delman v. Commissioner, 73 TC 15, 32 (1979).
The question has been raised whether the result in this case would be the same if instead of transferring the subdivisions to the bank pursuant to a negotiated settlement, the transfer occurred as a result of foreclosure proceedings. It is well established that a mortgage foreclosure, like a voluntary sale, is a "disposition" within the scope of the gain or loss provisions of section 1001. See Helvering v. Hammel, 311 US 504 (1941); Electro-Chemical Engraving Co. v. Commissioner, 311 US 513 (1941); Danenberg, 73 TC at 382; ___, GCM 38385, 1-304-79 (May 23, 1930), at 5. Thus, the result in the instant case would be the sane if the subdivisions were transferred to the bank pursuant to a foreclosure.
James F. Malloy
a corporation, was the owner and developer of two residential subdivisions, M and R. To finance the projects, X obtained development loans from an unrelated bank, on which X was personally liable. The loans were secured by the subdivisions.
In 1984, X defaulted on the loans. Although X was insolvent, met with the bank prior to filing for bankruptcy in an effort to negotiate a settlement. The negotiations produced an agreement between the bank and X whereby the M and R subdivisions were transferred to the bank in exchange for the release of X from liability for the outstanding balance on the loans. When the M and R subdivisions were transferred, the fair market value of the subdivisions was greater than X's adjusted basis in the subdivisions but less than the amounts due on the loans. After the exchange, was still insolvent.
LAW AND ANALYSIS
Section 61(a)(3) of the Code provides that, except as otherwise provided, gross income means all income from whatever source derived, including gain from dealings in property. Section 1.61-6(a) of the Income Tax Regulations provides that gain from dealings in property under section 61(a)(3) is computed under section 1001 and the regulations thereunder.
In addition to gain from dealings in property under section 61(a)(3) of the Code, gross income also includes income from discharge of indebtedness under section 61(a)(12).
Under section 108(a)(1)(B) of the Code, gross income does not include any amount which 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 section 108(a)(1)(B) applies, the amount excluded under section 108(a)(1)(B) shall not exceed the amount by which the taxpayer is insolvent.
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 section 1011 for determining gain.
Section 100 1(c) of the Code provides that, except as otherwise provided in title A, the entire amount of the gain or loss, determined under section 1001, on the sale or exchange of property shall be recognized.
Section l.l001-2(a)(1) of the regulations provides that, except as provided in sections 1.100 1- 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) of the regulations provides, in part, 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 section 61(a)(12). Example 8 under section 1.1001- 2(c) of the regulations illustrates this rule 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 the fair market value ($6,000). In addition, F has income from the discharge of indebtedness of $1,500 ($7,ShO - $6,000).
"It is well established that the transfer of assets in consideration of cancellation of indebtedness is equivalent to a sale upon which gain or loss is recognized." Bialock v. Commissioner, 35 T.C. 649, 640 (1961), supra, 1961-2 C.B. 4. See also Danenberg v. Commissioner, 73 T.C. 370 (1979), acq., 1980-2 C.B. 1. The statement from Bialock is consistent with Example (8) of section 1.1001-2(c) of the regulations. example (8) further provides that the amount realized on the disposition of an asset is its fair market value.
Although Congress under the Bankruptcy Tax Act of 1980, Pub. L. 96-589, 1980-2 C.B. 607, intended to eliminate a debtor's tax liability with respect to discharge of indebtedness income under section 61(a)(12) of the Code in bankruptcy cases (or in cases of insolvent debtors outside of bankruptcy), see S. Rep. No. 96-1035, 96th Cong., 2d Sess. 9 (1980), 1980-2 C.B. 620, 624, there is no provision under the Bankruptcy Tax Act eliminating tax liability on gain on assets transferred in satisfaction of indebtedness. Accordingly, sections 61(a)(3) and 100 1(c) of the Code require recognition of such gain.
In the present case, X transferred the M and R subdivisions to the bank in exchange for cancellation of the development loans. The transfer of the subdivisions is treated as a sale or disposition upon which gain is recognized under section 1001(c) of the Code. X recognizes gain to the extent that the fair market value of the subdivisions transferred exceeds their adjusted basis determined under section 1011.
Example (4) in section 1.1001-2(c) of the regulations further illustrates that a debtor has income from discharge of indebtedness to the extent that the amount of the debt discharged exceeds the fair market value of the assets transferred. The amount that is treated as discharge of indebtedness income, in the present case, is that portion of the debt that exceeds the fair market value of the subdivisions. X's discharge of indebtedness income, however, is excluded from gross income because X is insolvent. Section 108(a)(1)(B).
HOLDINGS
Under the circumstances described above
(1) The transfer of the M and R subdivisions by X in exchange for the cancellation of the development loans is a sale or disposition in which gain is recognized under sections 61(a)(3) and 1001(c) of the Code.
(2) X does not recognize discharge of indebtedness income under section 61(a)(12) when the fair market value of the M and R subdivisions is less than the amount due on the loans and X is insolvent both before and after the transfer.
FOOTNOTES
/1/ Section 108(a)(1)(B), quoted above, currently treats discharge of indebtedness of an insolvent taxpayer.
/2/ We note that Estate of Delman v. Commissioner, 73 TC 15, 31 (1979), is in agreement with Danenberg that insolvency is pertinent only as an exception to discharge of indebtedness income, and not to gain from dealings in property.
/3/ See section 2(a) of the Bankruptcy Tax Act, which amended section 108, quoted above, to read as it presently does.