2925 Briarpark, Ltd. v. Commissioner

                    UNITED STATES COURT OF APPEALS
                         For the Fifth Circuit
              __________________________________________

                             No. 97-60850
              _________________________________________

                2925 BRIARPARK, LTD., JAMES C. MOTLEY,
                          TAX MATTERS PARTNER,

                                             Petitioners-Appellants,

                                VERSUS

                   COMMISSIONER OF INTERNAL REVENUE,

                                             Respondent-Appellee.

              __________________________________________

                    Appeal from the Decision of the
                        United States Tax Court
              __________________________________________
                            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

                                 2
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



                                  3
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

                                  4
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),

                                 5
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.

                                 6
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

                                  7
     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).

                                   8
                          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.

                                 9
     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


                                  10
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).

                                11
     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


                                 12
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

                                  13
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).



                                 14
     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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