Concepts of federal income tax
1) ESSAY (30%): Several years ago, Courtney borrowed $100,000 of recourse debt from the Friendly Local Bank and used it to buy some equipment to start up a business. Courtney’s business results have been disappointing and she has not made any principal payments on the loan, but she has paid all of the interest due. Courtney has fallen on hard times and her only asset is the equipment, which is now worth $75,000 and in which she now has an adjusted basis of $50,000. Courtney has no other assets and no other liabilities. If the bank cancels the debt in exchange for the apartment building, what are the income tax consequences to Courtney?
a) Primary authorities relied on in answering (b):
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1) Peter Piper purchased a parcel of land for $20,000 and constructed an apartment building on it at a cost of $380,000 (total basis in land and building = $400,000). He paid the entire purchase price and construction costs with the proceeds of a nonrecourse loan that was secured by a mortgage on the property. Two years later, when Peter’s basis in the land and apartment building was $360,000 (due to $40,000 of depreciation on the building), the fair market value of the land and building was $500,000 and the outstanding balance on the mortgage was still $400,000, Peter sold the land and building, subject to the mortgage, to Betty Boop for $100,000 in cash. As part of the transaction, Betty assumed the mortgage.
a) How much gain or loss must Peter recognize? What is its character? What is Betty’s basis in the property?
The original mortgage holder (Peter) has been relieved of a duty to pay. However, because the mortgage was not forgiven by the bank, this is not a cancellation of debt issue (neither Code section 61(a)(12) nor 108 apply), rather, this is a sale transaction.
Peter’s Gain: Amount realized = $500,000 ($100K cash + $400K mortgage relief per Treas. Reg. section 1.1001-1 and – 2) less adjusted basis of $360,000 = $140,000. Also, see Tufts and Code section 7701(g) regarding the requirement that debt relief be included in amount realized, even if the debt is nonrecourse.
Character: Because the building and land was held for more than a year in a trade or business (and the building was subject to depreciation), the $100,000 gain is generally Code section 1231 gain. Although there was depreciation, neither Code section 1250 nor Code section 291 applies to recharacterize the gain as ordinary. Code section 1250 applies only if depreciation is “accelerated” and applies only to real property purchased before 1987. Peter purchased the property two years ago. Code section 291 applies to corporations, and Peter is a person.
Betty’s basis = $500,000. Per Code section 1012, basis is cost. Betty paid $100,000 in cash and took the property subject to a $400,000 mortgage. As discussed above, debt relief is treated as sales proceeds under Code section 1001 and its Regulations. As such, the debt assumption by the buyer creates basis.