T.C. Memo. 1997-298
UNITED STATES TAX COURT
2925 BRIARPARK, LTD., JAMES C. MOTLEY, TAX MATTERS PARTNER,
Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 22320-94. Filed June 30, 1997.
Alan L. Tinsley and Charles B. Koerth, for petitioner.
Dennis M. Kelly, for respondent.
MEMORANDUM OPINION
HAMBLEN, Judge: Respondent issued a notice of final
partnership administrative adjustment (FPAA) to 2925 Briarpark,
Ltd. (Briarpark), and determined adjustments in Briarpark's
ordinary income, gains derived from dealings in property, and the
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partners' capital accounts for 1989.1 After concessions, the
issue for decision is whether the income realized from the
discharge of nonrecourse loans should be treated as gain derived
from dealings in property includable in gross income under
section 61(a)(3) or as discharge of indebtedness income within
the meaning of section 61(a)(12).
This case was submitted without a trial pursuant to Rule
122.2 The stipulation of facts and the attached exhibits are
incorporated by this reference, and the facts contained therein
are found accordingly.
Background
Briarpark is a Texas limited partnership whose principal
place of business, at the time of filing the petition, was
Houston, Texas. Briarpark is subject to TEFRA provisions
contained in sections 6221 through 6233. During 1989, the
partners in Briarpark were:
Name Type of Partnership Interest
Janet Stein General partner
Robert Husmann General partner
William C. Motley General partner
Billy G. Motley General partner
Jon D. Motley General partner
James H. Motley General partner
1
The FPAA was mailed to the tax matters partner and each of
the partners entitled to notice.
2
Unless otherwise indicated, all section references are to
the Internal Revenue Code as in effect for the year at issue, and
Rule references are to the Tax Court Rules of Practice and
Procedure.
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James C. Motley General partner
David D. Livingston, as trustee Limited partner
James C. Motley (Mr. Motley) was a general partner and the tax
matters partner of Briarpark.
During 1983 and 1984, Briarpark acquired a 3-acre parcel of
land at 2925 Briarpark Road (property) and constructed a 12-story
office building on the property. Around September 27, 1983,
Briarpark borrowed $21,600,000 from InterFirst Bank Houston
(InterFirst) to finance the acquisition of the property and the
construction of the building (original loan). Mr. Motley
executed a guaranty for principal, interest, penalties, expenses,
and fees due on the original loan.
On May 28, 1987, Briarpark and InterFirst modified and
extended the original loan (modified loan) pursuant to a modified
loan agreement. Under the agreement, Mr. Motley's obligation
under the guaranty was limited to $5 million, the original loan
was converted from recourse to nonrecourse, and the accrued but
unpaid interest in the amount of $3,100,000 was capitalized. At
that time, InterFirst estimated that the fair market value of the
property was approximately $17 million. Also on May 28, 1987,
Briarpark obtained a loan in the amount of $1,500,000 for tenant
improvements (build-out loan) on a nonrecourse basis.
On April 15, 1988, Briarpark filed its U.S. Partnership
Return, Form 1065, for taxable year 1987. Briarpark did not
report any income on its 1987 return with respect to the original
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loan or the build-out loan. Briarpark was not subject to an
examination by the IRS for the taxable year 1987.
First Republic Bank Houston (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 build-out loan (the loans) to NCNB
Texas National Bank (NCNB or bank).
During March 1989, Briarpark submitted an application to
NCNB seeking to modify the loans. On March 15, 1989, Mr. Motley
submitted several similar proposals to NCNB regarding the sale of
the property. In NCNB's view, the best proposal was one in which
the property would be sold for $12,700,000.
As of July 1989, Briarpark was in default on the loans. On
July 21, 1989, Briarpark signed a sale agreement to sell the
property to Dan Associates. Dan Associates conditioned its
purchase of the property upon Briarpark'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. Under the amended agreement, Briarpark was
required to arrange the satisfaction of the loans and removal of
the encumbrances for consideration not exceeding $11,036,000. On
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October 11, 1989, Mr. Motley's liabilities exceeded his assets by
$13,497,675. On October 16, 1989, NCNB agreed to allow the cash
sale of the property for $11,600,000 and to settle with Mr.
Motley on his guaranty for $175,000.
On November 3, 1989, Briarpark, Mr. Motley, Dan Associates,
and NCNB entered into a conditional release agreement (November
3, 1989 agreement).3 In the November 3, 1989 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 sale price
of $11,600,000, (2) the assignment of the sale proceeds to the
bank, (3) the transfer of Briarpark's cash reserves, and (4) the
payment of $175,000 by Mr. Motley to the Bank.
On December 27, 1989, the outstanding balances of the
modified loan 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 $10,936,532 of the proceeds to
NCNB. The adjusted basis of the property was $11,661,245. Also
on December 27, 1989, NCNB released the liens against the
property and released Mr. Motley from his guaranty of the
modified loan. Mr. Motley paid $175,000 in cash to the bank.
3
The complete terms of the conditional release agreement
were not available, for a page of the agreement was missing from
the joint exhibit provided to the Court.
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Briarpark transferred its cash reserves of $177,495 to NCNB. As
of December 31, 1989, Briarpark had no assets and ceased business
operations.
On its 1989 Federal partnership income tax return, Briarpark
reported cancellation of indebtedness income (COI income) of
approximately $14,468,154 as a result of the November 3, 1989,
agreement. The reported amount is calculated as follows:
Modified loan balance $24,562,763
Build-out loan balance 1,019,418
Total loan balance 25,582,181
Less sale proceeds from Dan Associates (10,936,532)
Less cash reserves paid to NCNB (177,495)
Net COI income 14,468,154
===========
Discussion
The parties do not dispute that the loans were nonrecourse
during 1989. The issue before us is whether the income realized
from the discharge of the loans should be treated as gains
derived from dealings in property includable in gross income
under section 61(a)(3) or as cancellation of indebtedness (COI)
income within the meaning of section 61(a)(12).
Petitioner contends that the discharge of $14,468,154 of
Briarpark's modified and build-out loans (loans) by NCNB should
be characterized as COI income under section 61(a)(12).
Respondent argues that the entire balance of the loans must be
included in the amount realized and that the resulting gain is
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taxable under section 61(a)(3). Ultimately, we agree with
respondent.
Petitioner bears the burden of proof on this issue. Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); Freytag v.
Commissioner, 904 F.2d 1011, 1017 (5th Cir. 1990), affg. 89 T.C.
849 (1987), affd. 501 U.S. 868 (1991). For the first time on
brief, respondent increased Briarpark's amount realized by
$485,973, decreased its adjusted basis by $555,512, and deducted
its selling expenses of $554,901, thereby increasing Briarpark's
gains derived from dealings in property by $486,584.4 These
modifications result in an increased deficiency and are new
matters under Rule 142. See Cox v. Commissioner, T.C. Memo.
1982-667. Respondent did not assert an increased deficiency in
his answer. Additionally, respondent did not move to conform the
4
In the notice of deficiency, respondent calculated the gain
derived from dealings in property as follows:
Amount realized $25,582,181
Less adjusted basis (11,661,245)
Gain 13,920,936
==========
On opening brief, respondent calculated the amount realized
and the resulting gain as follows:
Cash proceeds from Dan Associates $11,600,000
Debt discharged as a result of the sale 14,468,154
Total amount realized 26,068,154
Less adjusted basis (11,105,733)
Less selling expenses (554,901)
Gain 14,407,520
==========
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pleadings to the proof. Id. If we were to allow respondent to
claim the increased deficiency for the first time on brief,
petitioner would be deprived of the opportunity to present
evidence to controvert whatever evidence respondent relies upon
to sustain his burden of proving the new matter. Respondent is,
therefore, limited to the determination of gain contained in the
notice of deficiency. Commissioner v. Transport Manufacturing &
Equip. Co., 478 F.2d 731 (8th Cir. 1973), affg. Riss v.
Commissioner, 56 T.C. 388 and 57 T.C. 469 (1971); Fox Chevrolet,
Inc. v. Commissioner, 76 T.C. 708 (1981); Rubin v. Commissioner,
56 T.C. 1155, 1163 (1971), affd. 460 F.2d 1216 (2d Cir. 1972).
Gross income includes discharge of indebtedness, sec.
61(a)(12), and gains derived from dealings in property, sec.
61(a)(3). Under section 61(a)(12), a taxpayer realizes income
when a creditor discharges nongratuitously all or a portion of a
taxpayer's debt. Sec. 61(a)(12); sec. 1.61-12(a), Income Tax
Regs.
For purposes of section 61(a)(3), section 1001 and the
regulations thereunder govern the method by which the amount of
gain or loss realized upon a sale or disposition of property is
calculated. The amount of gain realized is the excess of the
amount realized over the taxpayer's adjusted basis in the
property, and the amount of loss realized is the excess of the
adjusted basis over the amount realized. Sec. 1001(a). The
"amount realized" is defined by section 1001(b) as the sum of any
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money received plus the fair market value of the property
received. Section 1.1001-2(a)(1), Income Tax Regs., further
defines "amount realized":
Except as provided in paragraph (a)(2) and (3) of this
section, 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.
Various methods exist by which indebtedness may be satisfied,
each method producing a different tax consequence. Danenberg v.
Commissioner, 73 T.C. 370, 381 (1979). Whether the realized
income is gain on the disposition of property or COI income
depends on the particular facts. Id.
In the instant case, the sale of the property, the transfer
of cash of $177,495, and the assignment of the sale proceeds to
NCNB has the same practical effect as several other transactions
which have been held to be a "sale or exchange". Helvering v.
Hammel, 311 U.S. 504 (1941) (holding that an involuntary
foreclosure sale of real estate was a sale or exchange); Allan v.
Commissioner, 856 F.2d 1169 (8th Cir. 1988) (treating the
taxpayer's reconveyance of property subject to nonrecourse debt
as a sale or exchange), affg. 86 T.C. 655 (1986); Yarbro v.
Commissioner, 737 F.2d 479, 483-485 (5th Cir. 1984) (holding that
an abandonment of real property subject to a nonrecourse debt was
an exchange; i.e., an act of giving one thing in return for
another thing regarded as equivalent), affg. T.C. Memo. 1982-675;
Laport v. Commissioner, 671 F.2d 1028 (7th Cir. 1982) (holding
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the taxpayer's conveyance of property subject to nonrecourse debt
to the mortgagee by quitclaim deed in lieu of foreclosure was a
sale or exchange), affg. T.C. Memo. 1980-355; Middleton v.
Commissioner, 77 T.C. 310, 321 (1981) (holding the taxpayer's
abandonment of real property subject to nonrecourse debt was a
sale or exchange), affd. 693 F.2d 124 (11th Cir. 1982); Freeland
v. Commissioner, 74 T.C. 970 (1980) (holding the taxpayer's
conveyance of property encumbered by nonrecourse debt to the
mortgagee was a sale or exchange); Estate of Delman v.
Commissioner, 73 T.C. 15, 28 (1979) (holding repossession of
property subject to a nonrecourse obligation is to be treated as
a sale or exchange).
The transaction before us is the functional equivalent of a
foreclosure, reconveyance in lieu of foreclosure, abandonment, or
repossession. The same consequences flow from the November 3,
1989, agreement as in the cases cited supra p. 9: 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. Yarbro v. Commissioner, supra at 483; Laport v.
Commissioner, supra at 1032-1033; Freeland v. Commissioner,
supra.
Any differences between the above transactions and the
transaction in the instant case are not in substance, but in
form. For example, the fact that NCNB did not directly take
title to the property is immaterial. See Sands v. Commissioner,
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T.C. Memo. 1997-146 (holding that the discharge of nonrecourse
debt and release of ownership in the property that secured the
debt is a sale or exchange even though the mortgagee did not take
title to the property).
Petitioner argues that the discharge of the loans by the
mortgagee falls under the purview of Gershkowitz v. Commissioner,
88 T.C. 984 (1987), and Rev. Rul. 91-31, 1991-1 C.B. 19. In
Gershkowitz, several partnerships were involved in two identical
transactions. Each partnership satisfied $250,000 of nonrecourse
loans with a cash payment of $40,000 but retained the property
securing the loans. Each partnership obtained the funds to
settle the above loans by borrowing the $40,000 from another
lender on a nonrecourse basis and ultimately satisfying the
latter loan by transferring the encumbered property to the
lender.
We held that the cancellation of the $250,000 of nonrecourse
loans without the surrender of the property securing those loans
resulted in COI income under section 61(a)(12) to the extent that
the canceled debt exceeded the cash payment. Gershkowitz v.
Commissioner, supra at 1014. With respect to each nonrecourse
loan of $40,000, we held that the entire outstanding balance of
the loan must be included in the amount realized in the
calculation of gain under section 1001. Id. at 1016.
Petitioner maintains that the facts are similar to those of
Gershkowitz in that NCNB agreed to discharge $25,582,181 of
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nonrecourse debt in exchange for a cash payment of $11,114,027 of
which only $177,495 was from petitioner's own funds and the
remaining $10,936,532 was the proceeds from the sale to Dan
Associates. We disagree. We recognized in Gershkowitz that the
tax consequences from the discharge of nonrecourse debt depend
upon whether the mortgagor transfers or retains the property
securing the debt and, accordingly, analyzed the tax consequences
of each debt separately. The taxpayers in Gershkowitz discharged
the two loans in independent settlements, in one of which the
taxpayers retained the encumbered property and in the other of
which they did not.
Petitioner would have us treat the cash sale and the
discharge of the loans as two independent events. The record
before us, however, is replete with evidence that both loans were
discharged as a result of a single transaction involving the sale
of encumbered property. NCNB conditioned the discharge of the
loans upon the sale of the property, and Dan Associates
conditioned the purchase upon that discharge. At the end of the
day, NCNB had the 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. Accordingly, we must
conclude that Gershkowitz is not dispositive in the instant case.
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Petitioner's reliance on Rev. Rul. 91-31, supra, is also
flawed. In Rev. Rul. 91-31, supra, the taxpayer purchased an
office building for $1 million. In obtaining the purchase funds
from a third-party lender, the taxpayer executed a nonrecourse
note. When the building's value dropped to $800,000, and the
outstanding principal on the note was still $1 million, the
lender agreed to modify the terms of the note's principal amount
to $800,000. The Commissioner concluded that Commissioner v.
Tufts, 461 U.S. 300 (1983), and Gershkowitz v. Commissioner,
supra, required COI income to be recognized, pursuant to section
61(a)(12), to the extent the lender reduced the principal of the
undersecured, nonrecourse debt. Rev. Rul. 91-31, supra, is
distinguishable because the facts therein did not involve the
sale or exchange of the encumbered property.
Petitioner maintains that NCNB agreed to the discharge and
cash sale because it was in the bank's best interests rather than
as an accommodation to Briarpark. The fact that NCNB, as a
profit-oriented entity, acted for economic reasons and agreed to
the transaction herein is not a sufficient basis for altering the
character of the gain realized by Briarpark on the transaction.
Petitioner argues that the amount realized includes
nonrecourse debt only if the purchaser assumes that debt. In
support of his position, petitioner relies upon Commissioner v.
Tufts, supra; section 1.1001-2(a), Income Tax Regs; and section
1.1034-1(b)(4), Income Tax Regs. In Tufts, the Supreme Court
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held that when a taxpayer sells or disposes of property subject
to nonrecourse debt in an amount in excess of its fair market
value, it must include in the amount realized the balance of the
nonrecourse debt even if such amount exceeds the fair market
value of the transferred property. Even assuming that Dan
Associates did not take the property subject to the modified and
build-out loans, we do not agree that Tufts was intended to limit
the liabilities included in the amount realized to only those
assumed by a third-party purchaser. The holding in Tufts focused
on the amount, not the character, of the gain or loss. Moreover,
its rationale supports respondent's position in the instant case
to the extent that the concept of "amount realized" for computing
gain or loss may be equated with the concept of consideration for
"sale or exchange" purposes. Commissioner v. Tufts, supra;
Yarbro v. Commissioner, 737 F.2d at 484.
Moreover, we are not persuaded that the regulations cited by
petitioner include nonrecourse debt in the amount realized only
if the purchaser assumes such debt. Section 1.1001-2(a), Income
Tax Regs., provides that the amount realized includes
"liabilities from which the transferor is discharged as a result
of the sale or disposition." There is no mention of a
requirement that the purchaser must assume the debt for the debt
to be discharged as a result of a sale or disposition.
Petitioner's argument under section 1.1034-1(b)(4) Income Tax
Regs., is equally unpersuasive. Section 1034 requires a taxpayer
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to defer recognition of gain realized on the sale of the
taxpayer's principal residence in certain circumstances. We are
not concerned with a residence in the case before us. Section
1.1034-1(b)(4), Income Tax Regs., is simply not relevant to
petitioner in this case.
Additionally, petitioner argues that Liberty Mirror Works v.
Commissioner, 3 T.C. 1018 (1944), supports his contention that a
mortgagor realizes COI income when a lender agrees to discharge a
debt encumbering property and to release the accompanying debt in
exchange for the assignment of the proceeds from the sale of the
property. Petitioner's reliance on Liberty Mirror also is
misplaced. In Liberty Mirror, the bank held a mortgage on the
taxpayer's property to secure a loan. As part of its settlement
with the bank, the taxpayer agreed to forward the proceeds from
the sale of the property to the bank. Because the taxpayer's
debt exceeded the proceeds from the sale, the bank agreed to
cancel the taxpayer's remaining indebtedness. This Court held
that the cancellation of the taxpayer's remaining indebtedness
constituted a gift5 and that, consequently, the taxpayer realized
no income. Although the facts there bear some similarity to
those of the instant case, it does not help petitioner because in
5
The precedential value of the gift rationale, as
articulated by the Supreme Court in Helvering v. American Dental
Co., 318 U.S. 322 (1943), and followed by this Court in Liberty
Mirror Works v. Commissioner, 3 T.C. 1018 (1944), has been
curtailed by subsequent authority, including Commissioner v.
Jacobson, 336 U.S. 28 (1949).
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Liberty Mirror we did not consider the character of the
nonexistent income. Danenberg v. Commissioner, 73 T.C. at 383.
Thus, we are satisfied that the discharge of the loans, the
transfer of the property, and the assignment of the sale proceeds
constitute a single integrated sale or exchange.
Alternatively, petitioner argues that Briarpark realized
$9,200,000 of COI income in 1987 when InterFirst and Briarpark
agreed to convert the outstanding balance of the original loan,
which exceeded the fair market value of the property, from
recourse to nonrecourse debt.
Whether a debt has been discharged is dependent upon the
substance of the transaction. Cozzi v. Commissioner, 88 T.C.
435, 445 (1987). A debt is considered to be discharged at the
point when it becomes clear that the debt will never have to be
paid. Id. In deciding when such a moment occurs, we must
consider the actions of the parties together with other facts and
circumstances relating to the likelihood of payment. Id. Any
identifiable event that fixes with certainty the amount to be
discharged may be taken into consideration. Id. (citing United
States v. S.S. White Dental Manufacturing Co., 274 U.S. 398
(1927)).
The existence of a faint possibility that a debt may be
collected does not prevent the recognition of COI income.
Exchange Sec. Bank v. United States, 492 F.2d 1096, 1099 (5th
Cir. 1974); cf. Fidelity-Philadelphia Trust Co. v. Commissioner,
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23 T.C. 527, 531 (1954). The fact that a creditor has failed to
remove a debt from its books does not mean that the debt has not
been canceled. Exchange Sec. Bank v. United States, supra.
Based upon the principles set forth above, we must conclude
that an identifiable event fixing with certainty the discharge of
part of the original loan did not occur in 1987. At the same
time they modified the original loan, InterFirst agreed to
provide Briarpark the additional build-out loan in the amount of
$1,500,000 for tenant improvements.
We are not convinced that converting the undersecured
original loan from a recourse to a nonrecourse debt constitutes
an identifiable event. See Zappo v. Commissioner, 81 T.C. 77, 87
(1983). Petitioner has not established that the conversion of
the debt made it highly unlikely, or impossible to estimate,
whether and when the debt would be repaid. Commissioner v.
Tufts, 461 U.S. 300 (1983); Gibson Prods. Co. v. United States,
637 F.2d 1041, 1047 (5th Cir. 1981). In our view, InterFirst's
willingness to make the build-out loan indicates its belief that
the tenant improvements would increase the value of the property.
Moreover, InterFirst increased the lien securing the original
loan according to the agreed modifications. Such actions are not
consistent with discharging the loan. The totality of the
circumstances leads us to believe that InterFirst still intended
to enforce its rights in 1987. In addition, petitioner does not
point to any identifiable event indicating Briarpark's
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abandonment of the property in 1987. Accordingly, we are
satisfied that Briarpark did not realize COI income of $9,200,000
in 1987.
Having found that Briarpark discharged the loans as a result
of the sale in 1989, we turn to consider the effect of that
determination upon the characterization of Briarpark's income.
The amount realized on the sale, exchange, or disposition of
property encumbered by nonrecourse debt includes the entire
balance of the obligation. Commissioner v. Tufts, supra; Crane
v. Commissioner, 331 U.S. 1 (1947); Lockwood v. Commissioner, 94
T.C. 252 (1990). In this case, section 61(a)(12) has no
application to a sale or exchange of property subject to
nonrecourse liabilities. Estate of Delman v. Commissioner, 73
T.C. 15 (1979).
In sum, we hold that the disposition of the property
constitutes a sale or exchange for purposes of section 1001 and
the regulations thereunder and that the income Briarpark realized
must be characterized as gain derived from dealings in property
under section 61(a)(3). We have considered all of the other
arguments and, to the extent we have not addressed them, find
them to be without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.