UNITED STATES COURT OF APPEALS
For the Fifth Circuit
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No. 97-60850
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2925 BRIARPARK, LTD., JAMES C. MOTLEY,
TAX MATTERS PARTNER,
Petitioners-Appellants,
VERSUS
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.
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Appeal from the Decision of the
United States Tax Court
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January 6, 1999
Before REYNALDO G. GARZA, STEWART, and PARKER, Circuit Judges.
PER CURIAM:
I. FACTUAL AND PROCEDURAL BACKGROUND
In 1981, Briarpark was organized as a Texas limited
partnership (“the partnership”). James C. Motley (“Motley”) was
a general partner. During 1983 and 1984, the partnership
acquired a three-acre parcel of land at 2925 Briarpark Road,
Houston, Texas (“the property”) and constructed a 12-story office
building on it. On September 27, 1983, the partnership borrowed
$21,600,000 from InterFirst Bank Houston, N.A. (“InterFirst”) to
finance the acquisition of the property and the construction of
the building. Motley personally guaranteed the principal,
interest, penalties and fees on the loan.
By December 31, 1986, the outstanding principal and accrued
interest due on the loan was $24,700,000. On May 28, 1987, the
partnership and InterFirst modified and extended the original
loan pursuant to a modified loan agreement. At the time,
InterFirst estimated that the fair market value of the property
was approximately $17,000,000. The original loan was converted
from a recourse to a nonrecourse obligation, and accrued but
unpaid interest in the amount of $3,100,000 was capitalized.
Motley’s personal obligation under his guarantee was limited to
$5,000,000. Also on May 28, 1987, Briarpark obtained a
$1,500,000 loan for tenant improvements (“build-out loan”) on a
nonrecourse basis.
By January 21, 1988, First Republic Bank Houston, N.A.
(“First Republic”) became the successor in interest to
InterFirst. The Federal Deposit Insurance Corporation, as
receiver for First Republic, assigned the modified loan and the
built-out loan to NCNB Texas National Bank (“NCNB”).
During March of 1989, Briarpark submitted an application to
NCNB seeking to modify the loans to allow a cash sale of the
building. In the summer of 1988, at the suggestion of the bank,
Motley placed the building on the market, and in March of 1989,
he brought to the bank several similar proposals for the sale of
the property. At that time, the bank considered as available
options: (1) liquidation in the event of a default (but at that
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time there was no default); (2) refinancing (which was not an
“easily obtained alternative at the level of the debt”); and (3)
a sale/settlement, the loan officer expressing the view that “the
bank will realize the highest value if the building is sold in
1989.” In NCNB’s view, the best proposal was a $12,700,000 cash
sale offer.
As of July 1989, Briarpark was in default on the loans. On
July 21, 1989, the partnership signed a sale agreement to sell
the property to Dan Associates. The gross purchase price for the
property was $12,200,000. Dan Associates conditioned the
purchase of the property upon the partnership’s arranging the
satisfaction or removal of the encumbrances for consideration
paid to NCNB not in excess of $11,490,000. On July 31, 1989,
NCNB agreed to release its liens to allow the sale of the
property to Dan Associates for $12,200,000, with the proceeds
being assigned to NCNB.
On October 5, 1989, Briarpark and Dan Associates amended the
sale agreement, reducing the gross sale price to $11,600,000.
Under the amended agreement, Briarpark was required to arrange
for the satisfaction of the loans and removal of the encumbrances
for consideration not exceeding $11,036,000 plus a $175,000
payment by Motley in settlement of his guarantee.
On October 11, 1989, Motley’s liabilities exceeded his
assets by $13,497,675. On October 16, 1989, NCNB agreed to allow
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the cash sale of the property for $11,600,000 and to settle with
Motley on his guarantee for $175,000.
On November 3, 1989, Briarpark, Motley, Dan Associates, and
NCNB entered into a conditional release agreement. NCNB agreed
to release the property from all liens and security interests
upon satisfaction of the following conditions: (1) the sale of
the property to Dan Associates for a minimum gross sales price of
$11,600,000; (2) the assignment of the greater of the net sale
proceeds or $11,036,000 sale proceeds to the bank, to be applied
against the partnership’s cash notes; (3) the transfer of the
partnership’s cash reserves to the bank; and (4) Motley’s payment
of $175,000 to the bank.
On December 27, 1989, the outstanding balances of the
modified and the build-out loan were $24,562,763 and $1,019,418,
respectively. Briarpark sold the property to Dan Associates for
$11,600,000. Briarpark incurred selling expenses of $554,901.
Dan Associates paid the net sales proceeds of $10,936,532 to
NCNB. The adjusted basis of the property was $11,105,733.
Also on December 27, 1989, NCNB released the liens against
the property and released Motley from his guarantee of the
modified loan, in return for his payment of $175,000 in cash.
The partnership transferred its cash reserves of $177,495 to
NCNB. As of December 31, 1989, Briarpark had no assets and
ceased business operations.
On its income tax return for 1989, Briarpark reported
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cancellation of indebtedness income for $14,468,154 as a result
of the November 3, 1989, conditional release agreement. The
reported amount was calculated as follows:
Modified loan balance $24,562,763
Build-out loan balance 1,019,418
Total loan Balance $25,582,181
Less sale proceed from
Dan Associates <10,936,532>
Less cash reserves paid to NCNB <177,495>
Net cancellation of indebtedness
income $14,468,154
The partnership also reported a net loss on the sale of the
property in the amount of $61,245.
Upon audit, the Commissioner determined that the property
incorrectly reported discharge of indebtedness income under
I.R.C. § 61(a)(12) on its return. The Commissioner asserts that
the partnership realized a gain from dealings in property under
I.R.C. § 61(a)(3) because the amount of the discharged debt that
had encumbered the property was includable in the amount
realized. The Internal Revenue Service mailed to the partnership
a Notice of Final Partnership Administrative Adjustment (“FPAA”)
proposing adjustments to the partnership’s return to reflect
realized gain from the sale of $13,920,936, rather than the
reported loss of $61,245 and to eliminate the reported
cancellation of indebtedness income.1 Pursuant to the parties’
1
Generally, where the taxpayer is insolvent immediately
after the discharge of a debt, the resulting cancellation of the
indebtedness income, ordinarily taxable under I.R.C. § 61(a)(12),
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stipulation, the Commissioner calculated the partnership’s
capital gain as follows:
Original loan balance $24,562,763.35
Build-out loan balance 1,019,417.65
Total loan balance $25,582,181.00
Less classing proceeds <10,936,531.90>
Less cash reserves <177,495.07>
Total amount of debt discharged $14,468,154.03
Selling price $11,600,000.00
Total amount of debt discharged $14,468,154.03
Total amount realized $26,068,154.03
Total amount realized $26,068,154.03
Adjusted Basis and selling expenses <11,660,633.31>
Capital Gain $14,407,520.72
The Tax Court agreed with the Commissioner that the
partnership had realized gains from dealings in property under
I.R.C. § 61(a)(3) rather than discharge of indebtedness income
under § 61(a)(12). The court noted that, for purposes of §§
61(a)(3) and 1001(b), “the amount realized from a sale or other
is excludable under § 108. Gains from the disposition of
property under §§ 61(a)(3) and 1001, however, are not excludable
under § 108. Generally, debt-discharge income is recognized at
the partnership level, while the exclusion of such income under
I.R.C. § 108(a) and the concomitant attribute reduction under §
108(b) are applied at the partner level. See Gershkowitz v.
Commissioner, 88 T.C. 984 (1987). The tax consequences to an
insolvent partner of a partnership’s realizing discharge of
indebtedness income would therefore become apparent only on the
application of such a partnership item to the individual
partner’s circumstances. However, it bears noting that Motley’s
distributive share of partnership income and loss was 83 percent,
and, while there is no snapshot of the financial standing
immediately after the discharge took place in December of 1989,
the record does reflect that he had become insolvent by October
of 1989, before the sale took place.
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disposition of property includes the amount of liabilities from
which the transferor is discharged as a result of the sale or
disposition.” The court found that the sale of the property and
the assignment of sale proceeds and transfer of the partnership’s
cash reserves to NCNB “has the same practical effect as several
other transactions which have been held to be a ‘sale or
exchange.’” According to the court, the transaction at issue “is
the functional equivalent of a foreclosure, reconveyance in lieu
of foreclosure, abandonment, or repossession” because “the
mortgagor in each case is relieved of debt encumbering property
and also is relieved of the obligation to pay taxes and
assessments against the property.”
The court rejected the partnership’s argument that NCNB
should be regarded as having forgiven, independently of the sale,
the excess of the $25,582,181 debt over the $11,114,027 in cash
received. Thus, the court disagreed with the partnership’s
assertion that amount realized on the sale of the property to Dan
Associates was only $10,936,532, or less than the partnership’s
adjusted basis in the property. Far from being “two independent
events,” as the partnership argued, the court found the record to
be “replete with evidence” that the sale and the loan discharges
were the “result of a single transaction involving the sale of
encumbered property.” The court reasoned as follows:
NCNB conditioned the discharge of the loans upon the
sale of the property, and Dan Associates conditioned
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the purchase upon that discharge. At the end of the
day, NCNB had proceeds from the sale, Dan Associates
had the property, and Briarpark was relieved of the
entire balance of the loans. In the foregoing context,
the arrangements among NCNB, Dan Associates, and
Briarpark embodied a single transaction to sell the
property securing the loans.
This appeal followed.
II. STANDARD OF REVIEW
The Tax Court’s fact findings are reviewed for clear error
because they were based on documentary evidence presented to the
court. See Pacific Employers Ins. Co. v. M/V Gloria, 767 F.2d
229, 235 (5th Cir. 1985)(citing Anderson v. Bessemer City, 470
U.S. 564, 574 (1985)). A finding is clearly erroneous when the
reviewing court, upon reviewing all of the evidence, is left with
a firm conviction that a mistake has been committed. Daniels
Towing Service, Inc. v. Nat Harrison Associates, Inc., 432 F.2d
103, 105 (5th Cir. 1970)(citing McAllister v. United States, 348
U.S. 19, 20 (1954)). In reviewing the Tax Court’s
characterization of the transaction, this Court must determine
whether its decision was based on a reasonable interpretation of
“sale or exchange.” Yarbro v. Commissioner, 737 F.2d 479, 483,
486 (5th Cir. 1984). Finding that the transaction constitutes a
sale or exchange would support the Tax Court’s conclusion that
the transaction was a gain from dealing in property under §
61(a)(3).
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III. DISCUSSION
The question on appeal is whether the Tax Court erred by
holding that the partnership realized a gain from dealings in
property in the amount of $14,407,520.72, rather than
cancellation of indebtedness income in the amount of $14,468,154.
A. Internal Revenue Code Section 61.
Gross Income
Section 61(a) of the Internal Revenue Code provides that
gross income includes all income from whatever source derived,
including “gains derived from dealing in property” under
§ 61(a)(3) and “income from discharge of indebtedness” under
§ 61(a)(12). Section 1001(a), which governs the computation of
gains from dealings in property, 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.”
Section 1001(b) defines “amount realized” as “the sum of any
money received plus the fair market value of the property (other
than money) received.” The amount realized on a sale or
disposition of property includes the amount of the liabilities
from which the transferor is discharged as a result of the sale
or disposition. TREAS. REG. § 1.1001-2(a)(1); Commissioner v.
Tufts, 461 U.S. 300, 306 (1983); Cox v. Commissioner, 68 F.3d
128, 134 (5th Cir. 1984); Yarbro, 737 F.2d at 484.
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In the case of a property encumbered by nonrecourse
indebtedness, the amount realized on disposition includes the
entire amount of the mortgage on the property. Tufts, 461 U.S.
at 312; Yarbro, 737 F.2d at 484; See also TREAS. REG. §§ 1.1001-
2(c)Example(7). The fact that the fair market value of the
security at the time of sale or disposition is less than the
amount of the liabilities it secures “does not prevent the full
amount of these liabilities from being treated as money received
from the sale or other disposition of the property.” TREAS. REG. §
1.1001-2(b); Tufts, 461 U.S. at 310.
There is a distinction between what constitutes income
realized from the “discharge of indebtedness” under § 61(a)(12)
and income realized from “gains derived from dealing in property”
under § 61(a)(3). Under § 61(a)(12), a debtor may realize income
from the discharge of indebtedness where his debt is canceled,
forgiven or otherwise discharged for less than the full amount of
the debt. The Supreme Court has held that when a nonrecourse
debt is forgiven, the debtor’s basis in the securing property is
reduced by the amount of debt canceled, and realization of income
is deferred until the sale of the property. United States v.
Kirby Lumber Co., 284 U.S. 1, 3 (1931); Fulton Gold Corp. v.
Commissioner, 31 B.T.A. 519, 520 (1934). This interpretation
attributes income only when assets are freed, therefore, an
insolvent debtor realizes income just to the extent his assets
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exceed his liabilities after the cancellation. Tufts, 461 U.S.
at 310 n. 11.
Section 61(a)(3) applies when a taxpayer agrees to surrender
the property in exchange for the cancellation of a debt. Under
this scenario, the transaction may be characterized as a sale or
exchange of property giving rise to income under § 61(a)(3) with
the whole amount of the canceled nonrecourse indebtedness being
includable in the amount realized under § 1001. Therefore, §
61(a)(3) applies if the court determines that the transaction:
(1) relieved the tax payer-owner of his obligation to repay the
debt2; and (2) the tax payer is relieved of title of the
property. Yarbro 737 F.2d at 486.
B. Whether Briarpark’s Transaction Constitutes a
Sale or Exchange for Tax Purposes.
2
An essential point to remember is that the debt herein is
“nonrecourse debt.” Nonrecourse debt and recourse debt are
treated differently by certain sections of the Code. Case law
firmly establishes that when a taxpayer is relieved of
nonrecourse debt, his obligation is canceled and he realizes a
value. Tufts, 461 U.S. at 312. Determining whether that value
falls under § 61(a)(3) or § 61(a)(12) will further determine
whether the insolvent petitioner herein will have to pay taxes on
that value or be absolved under § 108. With a recourse debt, a
debtor remains liable for the unpaid balance after a foreclosure
sale. Therefore, the unpaid portion is not used to calculate
“amount realized” under § 1001(b). Furthermore, if the recourse
debt is subsequently forgiven, or the judgement is permitted to
lapse uncollected, the recourse debt would then fall under §
61(a)(12). Therefore, if this Court determines that the
transaction constituted a “sale or exchange,” the value from the
nonrecourse debt herein would be governed by § 61(a)(3) and
included to calculate “amount realized” under § 1001(b).
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The Commissioner of Internal Revenue asserts that “Congress
intended the words ‘sale or exchange’ to have a broad meaning,
not to be limited to the standard transfer of property by one
person to another in exchange for a stated consideration in money
or money’s worth.” Freeland v. Commissioner, 74 T.C. 970, 980
(1980); see Helvering v. Hammel, 311 U.S. 504 (1941). For
example, it has long been established that a foreclosure sale
constitutes a “disposition of property” within the meaning of §
1001(b). Id. at 506-511; Cox, 68 F.3d at 133. A nonjudicial
foreclosure sale is also a transaction that triggers taxable
gain. Chilingirian v. Commissioner, 918 F.2d 1251, 1253 (6th
Cir. 1990). It is also well settled that the transfer of
property by deed in lieu of foreclosure is the functional
equivalent of a “sale or exchange” for federal income tax
purposes. Allan v. Commissioner, 856 F.2d 1169, 1172 (8th Cir.
1988); see Laport v. Commissioner, 671 F.2d 1028 (7th Cir. 1982);
see Millar v. Commissioner, 67 T.C. 656 (1977), aff’d, 577 F.2d
212 (3d Cir.), cert denied, 439 U.S. 1046 (1978).
The Commissioner asserts that the Tax Court followed the
teaching of Yarbro and similar cases by considering the
“practical effect” of Briarpark’s transaction. Under the
conditional release agreement, the bank agreed to release the
property from all liens and security interests upon satisfaction
of the following conditions: (1) the sale of the property to Dan
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Associates for a minimum gross sales price of $11,600,000; (2)
the assignment of the sale proceeds to the bank; (3) the transfer
of Briarpark’s cash reserves to the bank; and (4) the payment of
$175,000 by Motley to the bank. There was no indication that the
bank was willing to forgive any part of the partnership’s debt
except as a condition of sale to Dan Associates. At the end of
the transaction NCNB released all liens against the property,
released Motley from his guarantee, and Briarpark had no assets
and ceased business operations. Unlike § 61(a)(12) cases, where
debt forgiveness occurs as a single transaction and the
realization of the property income occurs in a later and separate
transaction, the debt forgiveness in the case herein was closely
intertwined with the terms of the agreement. Therefore, this was
a single transaction governed by § 61(a)(3). See Fulton, 31
B.T.A. at 519.
The partnership correctly asserts that the determination of
whether a transaction is governed by § 61(a)(3) or § 61(a)(12)
depends on the particular facts of the case. Danenberg v.
Commissioner, 73 T.C. 370, 381 (1979). The petitioners assert
that in Gershkowitz v. Commissioner, 88 T.C. 984 (1987), the
taxpayer’s nonrecourse debt settlement was characterized as §
61(a)(12) income and that the divestment of the property, just
three months later, was characterized separately as § 61(a)(3)
income. The partnership argues that the fact that Briarpark,
NCNB, and Dan Associates accomplished both tasks in a single
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transaction, rather than in two transactions, should not cause
the entire transaction to be categorized as § 61(a)(3) income.
The partnership also argues that because the purchaser did not
assume the debt, the partnership must be treated as having
received discharge of indebtedness income.
The Tax Court properly distinguished Gershkowitz from this
case. In Gershkowitz, the debts were not discharged in
connection with the disposition of the property. Since there was
no disposition of property upon the discharge of the debts, the
Tax Court held that there was no amount realized upon disposition
that could be regarded as flowing from the discharge of
indebtedness, and, hence, no gain or loss on disposition to be
computed. Id. at 1016. The Tax Court properly found that the
partnership’s disposition of the property was conditioned upon
the relief of its debt and was therefore the functional
equivalent of a foreclosure sale. See Yarbro, F.2d at 485-86.
The partnership’s argument, that the purchaser did not
assume the debt, is also without merit. The language of § 1001-
2(a)(1) provides that “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,” and does not consider for its purposes whether the
purchaser assumes the debt or not. See also § 1001-2(c)
Example(7).
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Congress has determined that different tax consequences
shall flow from different methods by which the shareholders of a
closely held corporation may dispose of corporate property.
United States v. Cumberland Public Service Co., 338 U.S. 451, 456
(1959). Also, it is for the trial court, upon consideration of
an entire transaction, to determine the factual category in which
a particular transaction belongs. Id.
IV. CONCLUSION
Upon reviewing the factual findings of this case, this Court
agrees with the Tax Court’s characterization of this transaction.
Therefore, we AFFIRM the Tax Court’s decision.
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