Copyright (c) 1990 Tax Analysts

Tax Notes

 

APRIL 30, 1990

 

LENGTH: 14140 words 

 

DEPARTMENT: Special Reports (SPR) 

 

CITE: 47 Tax Notes 593 

 

HEADLINE: 47 Tax Notes 593 - THE FRONT END OF THE CRANE RULE. 

 

AUTHOR: Johnson, Calvin H.

 Tax Analysts 

 

TEXT:

 

   Calvin Johnson is a professor at the University of Texas Law School. This article arises from a brief prepared for Tax Advocates as Amicus Curiae in the case of Pleasant Summit Land Corporation v. Commissioner on certiorari to the Supreme Court. Tax Advocates is affiliated with Tax Analysts, the publisher of this magazine. Because the Supreme Court denied certiorari in Pleasant Summit, no brief was filed. 

 

   Under the Supreme Court's 1947 decision in Crane v. Commissioner, nonrecourse liability generally is included in the purchaser's depreciable basis, on the assumption that the liability is a real cost. There has been an explosion of tax shelter cases in recent years, however, in which the nonrecourse liability was dramatically in excess of the fair market value of the collateral property being purchased. The general and correct response of the courts has been to treat such nonrecourse liability as sham, nongenuine debt in full. In Pleasant Summit, however, the Third Circuit held the purchaser was entitled to a fair market value basis for the property purchased, notwithstanding that the nonrecourse liability used to purchase the property was grossly inflated. 

 

   This article argues that Pleasant Summit was wrongly decided. The purchasers and seller there were bargaining with play money that was not expected to be paid. The purchasers were buying tax savings, at a price less their cash cost, and were acquiring no meaningful interest in the underlying property purportedly being sold. The nonrecourse liability represented no investment. The article also argues, beyond the Pleasant Summit case, that seller-provided nonrecourse liability should never be included in the purchaser's basis when the value of the tax savings generated by the purchase is higher than the cash committed to the purchase, because inflation of the liability inevitably arises in such cases out of the bargaining between the parties. 

 

   Inflated nonrecourse liabilities after 1986 are primarily a problem for corporate purchasers. The 'at-risk' and 'passive loss' limitations have contained the damage nonrecourse liability shelters due to individual tax, at least for the time being, although nonrecourse liabilities can do considerable mischief before the limitations take effect. Nothing in the limitations, however, satisfactorily diagnoses the economic characteristics of seller- provided nonrecourse liability and ensures that abuses are prevented.

 

   Johnson expresses his thanks to his fellow teachers, David Shakow, Dick Markovits, and Pat Cain, and to his research assistants, Richard Allen and Julien Smythe, for their invaluable aid and assistance.

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                           Table of Contents

  I. Explosion of the Exceptions to Crane .................... 594

II. The Economics of Seller-Provided

     Nonrecourse Liability ................................... 596

     A. The PSA Shelter ...................................... 596

     B. Liabilities Are Shams if the Tax Savings are

        Worth More Than the Cash ............................. 599

III. Fair Market Value Basis ................................. 600

IV. Collateral Consequences of Nongenuine Debt .............. 603

     A. Treatment of the Cash Costs .......................... 603

     B. Inflated Liabilities Under Tufts ..................... 604

     C. At-Risk and Passive Loss ............................. 604

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   The Third Circuit recently has held, in Pleasant Summit Land Corporation,/1/ that grossly inflated nonrecourse liability would give a tax shelter partnership a fair market value basis in the purchased property. Before Pleasant Summit, the settled doctrine had been that grossly inflated nonrecourse liability was nongenuine, sham debt that was not an investment and not part of depreciable basis,  even in part./2/ But the Third Circuit made and adopted an argument, new to the tax law, that the seller-creditor would settle with the shelter partnership and let the partnership have the purchased garden apartments for their fair market value./3/ The court gave the tax shelter partnership a basis in the apartments equal to their fair market value, to be determined upon remand of the case. The Third Circuit denied rehearing and, notwithstanding the request of the Solicitor General, the Supreme Court now has denied certiorari. 

 

   The settlement posture of the IRS on abusive tax shelters in the past has been to allow deduction of only the investor's out-of-pocket cash./4/ If the IRS is forced to litigate and wins an abusive shelter case, even the deduction of the cash can be lost./5/ Pleasant Summit gives the investors the chance at something better than deduction of out-of-pocket cash, if the investors will litigate fair market value, whatever that might be, and thus rips a hole in IRS' settlement net for tax shelters. For years after 1986, inflated tax shelter debt has been contained, fairly successfully, by the 'passive loss' and 'at- risk' rules./6/ But the 'passive loss' and 'at-risk' rules do not affect widely-held corporations and even for individuals, inflated liabilities can do considerable mischief after 1986. Congress is under constant political pressure, moreover, to find new exemptions and exceptions to the at-risk and passive activity rules that will allow tax shelters to return./7/ Inflated nonrecourse liabilities are the economic explanation of one kind of abusive tax shelter. 

 

   This article looks at the front end of the Crane rule, under which nonrecourse liabilities generally are included in the purchaser's depreciable basis. The article argues that seller- provided nonrecourse liability should not be included in depreciable basis, even in part, if the tax savings generated by including the liability in basis from the seller are worth more than the cash the investors have committed to the shelter. Nonrecourse liability is part of basis only because it is a cost and the liability is not a cost or detriment when the purchaser wants the liability inflated. By the inevitable law of markets, the parties will want the liability inflated when they get more value from tax savings generated by the nonrecourse liability than the tax savings cost them in cash.

 

   This article also argues that Pleasant Summit was wrongly decided -- inflated nonrecourse liability is not a depreciable investment even in part. Pleasant Summit was what the IRS used to call a 'Class III Abusive Tax Shelter,'/8/ in which the shelter investors were buying nothing but tax losses, at a bargain price, and had no investment in the underlying property. This article argues that the IRS should hold its ground -- the high ground -- in opposition to the case.

 

 

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                    I. EXPLOSION OF THE EXCEPTIONS TO CRANE

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   Nonrecourse liability is, in general, included in the purchaser's depreciable basis on the assumption that the liability is a detriment or cost. Basis is defined by section 1012 of the Code as, in general, the cost of the property. In Crane v. Commissioner,/9/ the Court identified nonrecourse liability as a cost like a personal promise, at least when the collateral securing the liability was larger than the liability itself:

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          'We are . . . concerned with the reality that an owner of

     property, mortgaged at a figure less than that at which the

     property will sell, must and will treat the conditions of the

     mortgage exactly as if they were his personal obligations.'/10/

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Identifying nonrecourse liability as similar to a personal obligation meanttreating it as a cost under a tradition going back to the start of double entry bookkeeping. Under standard conservative accounting, a liability must be reported as a reduction in net worth on the balance sheet and if it reduces net worth, there must be an asset (i.e., basis) or expense to complete the double entry. Tax law gives 'advance credit' to a liability in computing cost of property as if the liability already had been paid:/11/

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     'Just as the lender extends credit to the borrower on the

     assumption that the debt will be paid, so the tax law credits

     the taxpayer with the liability on the assumption that it will

     be paid in due course.'/12/

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An arrangement classified as a bona fide obligation is treated by the tax law asif it were payment as good as gold. 

 

   The assumption that the liability is a cost leads in turn to the assumption that the government is protected from overvaluation of depreciation deductions by bargaining between the parties./13/ The standard definition of fair  market value is that it is 'the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell . . . .'/14/ The assumption behind that definition is that the buyer is trying to pay the lowest possible price for the property and that the parties bargaining adversely will come to a price that represents true market value. Paying in debt, moreover, is assumed to give no advantage to the purchaser because of the diligence of the creditor. A creditor protecting itself, it is assumed, will insist on interest payments and other terms sufficient to ensure that the debt has a value at least equal to the cash that it has lent. Some creditors -- my bank, for instance -- even charge such high interest that the debt is less advantageous than the cash payment it replaces. 

 

   The Crane rule has not worked very well, however, for seller- provided nonrecourse liability. The Crane Court stated it was including the nonrecourse liability in basis only because the value of the property was assumed to exceed the debt, and there has been an explosion of reported cases in recent years in which the collateral property was worth less, commonly considerably less, than the debt it was securing. Arm's-length bargaining with two-party nonrecourse liability has not in fact proved to guarantee a fair market value purchase price. 

 

   There is a series of reported cases, for instance, in which the nonrecourse liability has exceeded the fair market value of the purchased property by an order of two to 10 times./15/ There is also a series of cases in which there is essentially no commercial value to the collateral securing the nonrecourse liability because the property had to be made or developed to be worth anything, but it never was./16/ The courts also have found that the liability is too contingent to be fixed and accrued where the liability will be paid only if the project is successful./17/ Closely related are the cases in which there is real and valuable property, but the investor's interest in the property is not large enough to have any significant value./18/ Finally, there is a series of sham-tax-shelter, not-for- profit cases that are explained by inflated seller-provided  nonrecourse liability, although profit motive rather than the nonrecourse liability was the focus of the case./19/ 

 

   Pleasant Summit was just another illustration of nonrecourse debt considerably in excess of the property the debt is purchasing. Pleasant & Summit Associates ('PSA'), the shelter partnership purchasing the property, incurred $7.8 million worth of debt/20/ for garden apartments, Summit House, in West Orange, New Jersey, that were worth somewhere between $1.1 and $4.2 million./21/ Except for the decision of the Third Circuit in Pleasant Summit, it was settled law, routinely applied, that if the principal amount of the nonrecourse note unreasonably exceeds the value of the property, then no 'genuine indebtedness' existed and no investment in the property or tax basis occurs./22/ 

 

   The reported cases are just the tip of the iceberg. According to the government's petition for certiorari in Pleasant Summit, there are almost 2,300 docketed Tax Court cases and more than $630,000,000 in deficiencies that would be affected by Pleasant Summit./23/ More than that has been settled already/24/ and only a fraction of even the large nonrecourse liability shelters were ever audited./25/ Tax shelters were mass-merchandised during the 1970s and 1980s and nonrecourse liability was 'the foundation stone of most tax shelters.'/26/ In any event, the reported cases alone are too common to be aberrations and they prove that bargaining between the parties has not controlled inflated liabilities. While Crane itself contemplated an exception to inclusion in basis when the value of the collateral was insufficient, nothing in the Crane rule explains why the inflated purchase price cases should have happened so routinely. 

 

   II. THE ECONOMICS OF SELLER-PROVIDED NONRECOURSE LIABILITY 

 

   The inflated purchase price in cases like Pleasant Summit are best explained by the economics of seller-provided nonrecourse liability. Neither side in PSA had any economic interest in minimizing the amount of the liability. When both sides want a liability to inflate in their own economic interests, then inflated liabilities happen. This section argues that seller-provided nonrecourse purchase liability cannot reasonably be considered to be an economic or tax 'cost' detrimental to the purchaser if the tax savings generated by the purchase are worth more than the cash that the purchaser has committed to put into the shelter.

 

 A. The PSA Shelter 

 

   1. Purchaser's Motives. The PSA partnership was willing to 'incur' liabilities to purchase the Summit House garden apartments that were inflated way beyond the value of the apartments, because the nonrecourse liabilities were essentially free to the PSA investors: If the property went up in value sufficiently, then the liabilities would be paid from out of the proceeds of sale of the property. If the value of the property did not grow in value sufficiently to cover the $7.8 million liability and accrued interest, then the nonrecourse feature would protect the PSA investors from having to pay the liability. In either case, PSA investors would not have to put up cash for Summit House nor divert resources from some other use. Even interest, the usual cost for borrowed money, was payable to the sellers only out of the available cash flow from Summit House./27/ Costs are resources diverted from other uses and the nonrecourse liability entailed none of that. The PSA investors did have to pay good money to become limited partners and gain access to the tax losses generated by the nonrecourse liability, but the big $7.8  million nonrecourse liability at the heart of the shelter was cost- free play money to the PSA investors./28/ 

 

   If the nonrecourse liability were respected for tax purposes, the PSA purchasers were better off the bigger the liability was. A $7.8 million liability would generate larger depreciation and accrued interest deductions over the course of the investment than would a liability of, say, $1.1 million (the appraised value of the Summit House buildings in 1978 for property tax purposes). Real costs are detriments after tax even though they generate deductions. It is a Fool's Shelter, for instance, to lose $100 in cash even if cash is deductible, because the after-tax cost of losing $100 cash is $30 after tax, even in the 70 percent tax bracket, which was the highest tax bracket in 1978. But since the nonrecourse liability was free to the PSA investors, the tax savings, stripped of cost, were bigger the larger the nonrecourse liability was. 

 

   A higher nonrecourse liability generally involves a trade-off for the purchaser between the detriment of losing equity (i.e., value in the property after payment of the liability) and the benefit of greater tax deductions. For PSA, the trade-off was easy: As can be seen from the PSA Offering Memorandum, the PSA investors were acquiring no meaningful chance of acquiring an equity in Summit House, so they were willing to sacrifice their not very valuable chance at an equity in return for a more valuable chance for greater tax deductions. 

 

   According to the PSA Confidential Offering Memorandum, the tax savings PSA investors expected to get were worth considerably more than the cash the investors had to put into the partnership. PSA generated tax losses to be used by its partners because the depreciation and accrued but unpaid interest, both generated by the huge nonrecourse liability, were so much larger than the net operating income from Summit House. Table 1, following, shows, for instance, that a single unit (1/30th interest) in PSA was expected to generate tax savings worth $133,309 to a 60 percent tax bracket taxpayer. The cash committed over a 10-year period for a single unit had a present value of only $88,460. Table 1 uses the Offering Circular's own projections of cash and tax savings from the shelter/29/ and assumes an eight percent discount rate,/30/ and a 10- year duration for PSA's ownership of the Summit House apartments:/31/

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                                Table 1

           Comparison of Present Value Cash and Tax Savings

              Cash       Discounted   Tax Savings   Discounted

          Contribution   Value £ 8%      £ 60%      Value £ 8%

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1978 ....   $ 21,000       $ 19,444       $ 34,400       $ 31,852

1979 ....    17,500        15,003        27,600        23,663

1980 ....    15,000        11,907        24,000        19,052

1981 ....    12,500         9,188        21,800        16,024

1982 ....     9,500         6,466        21,300        14,496

1983 ....     7,500         4,726        20,300        12,792

1984 ....     7,500         4,376        20,400        11,903

1985 ....     7,500         4,052        17,600         9,509

1986 ....     7,000         3,502        17,900         8,954

1987 ....     7,000         3,242        18,400         8,523

                          _______                     _______

Sum ....                  $ 81,907                    $ 156,768

     Less tax on a no-cash-back sale:/32/($ 71,000)    (33,000)

                                                     $ 123,768

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In a 50 percent tax bracket, the tax benefits, computed using the same logic,were worth $141,061, still comfortably in excess of the $88,460 present value of the cash that investors would have to pay. Since the offering was restricted to investors who had at least some 50 percent  tax bracket income,/33/ all investors expected to get tax benefits worth considerably more than the cash they were required to put in. 

 

   A rational PSA investor knew that he was buying nothing but tax savings. The Offering Memorandum as much as promised the PSA investors that they would see no cash from the partnership nor equity in the underlying property. The investors were told that 'expenses of the Partnership will be more than 100 percent or more of the expected net cash receipts from the Property,' even absent adverse variations from the projections/34/ and were told that they could not expect any cash distributions before 2008./35/ By 2008, the useful life of the assets would have expired except for an empty shell of building that represented only 24 percent of the value of the building at the start./36/ Meanwhile, the unpaid liability was projected to increase from an already inflated $7.8 million to $12.54 million within only 10 years, due to accrued but unpaid interest and fees./37/ With a cutoff of Partnership contributions after 10 years, there was no prospect of reversing the direction of the liabilities. In fact, of course, no equity is exactly what happened: PSA and PSLC jointly sold the land and building in 1985 for $7,000,000 and the portion of the sales proceeds attributable to the building was far below the then over $11 million outstanding principal./38/ The PSA investors had no equity in and received no distribution from the 1985 sale of 'their' building./39/ 

 

   Given the value of the tax savings generated by the shelter, it would have been surprising if the PSA investors had been given an interest in Summit House that was worth any meaningful amount. Since the tax savings were so much more valuable than the cash committed to the shelter, no investor would have avoided the investment, even knowing that his nontax interest in Summit House was worthless. No rational shelter promoter, moreover, would have given the investors much of a chance at achieving an equity. Why give the lambs any interest in the property when they already get such excess value from their tax savings? 

 

   PSA thus was what the IRS used to call a 'Class III Abusive Tax Shelter,' that is, a transaction, entered into for tax avoidance, which 'lacks economic reality or viability in its entirety.'/40/ Summit House had real value in 1978 of between $1 and $4 million,/41/ and land and building combined apparently were worth $7,000,000 in 1985./42/ But the PSA investors got no meaningful interest in Summit House, notwithstanding the thick pile of documents involved in the shelter. Except for a trivial amount, the cash that the PSA investors paid, by contribution to the limited partnership, was paid to acquire an indulgence from tax. The PSA partners essentially were just buying naked tax savings, that is, K-1s (Schedule of Partner's Share of Income and Loss) with the line for lots of losses filled in. 

 

   2. Seller Motives. The inflation of seller-provided nonrecourse liability also is explained by the tax treatment of the creditor- seller. Pleasant Summit Land Corporation ('PSLC'), which both sold the property and provided the financing, also was pushing for an inflated liability. 

 

   As seller of Summit House, PSLC of course wanted the liability to be as high as possible. Every seller is better off the higher the sales price. If the property went up in value by enough, then the liability might be paid. If not, PSLC would get Summit House back upon default. In the interim, PSLC got all of the available cash flow from the property and all of the PSA partner's contributions as partial payments of the interest and principal on the nonrecourse liability. Since the PSA partner's contributions depended on the size of their tax savings, the cash that PSLC could expect would increase the higher the liability. 

 

   As the creditor of the seller-financed purchase price, PSLC, like PSA, was using play money. Unlike a bank or other third party lending to buy the property, PSLC was lending not cash, but Summit House. PSLC could increase the loan disbursement just by saying that the garden apartments had a higher purchase price. On that basis, there was no limit on the amount that PSLC was willing to lend. PSLC did not have to divert cash or other resources from outside the project to make the loan, no matter what its size. 

 

   A bank or other outsider lending on a nonrecourse basis could get the loan proceeds back only if the Summit House buildings proved to be sufficient collateral for the loan. But PSLC could get its loan disbursement (i.e., Summit House) back if the liability proved too large, just by reseizing Summit House for nonpayment. 

 

   The inflated liability did the seller no harm for tax purposes. PSLC recognized the gain on the sale under the installment method of section 453 of the Code, which allows PSLC to pay tax only if and when the liability was paid. On the purchaser's side, the unpaid liability might be treated in calculating basis as if it were payment, but on the seller's side, the liability was ignored for tax purposes until it was actually paid. 

 

   The combination of treating the liability as if it were payment on the purchaser's side, while ignoring the liability on the seller's side, created an asset -- a 'tax float' -- at the expense of the government./43/ The purchase liability saved tax on the purchaser's side through depreciation deductions many years before the seller paid the concomitant tax on the sale proceeds. Even the accrued interest created a tax float, because the accrual method purchaser, PSA, deducted unpaid but accrued interest without the cash method seller, PSLC, paying tax on the interest./44/ The buyers and sellers were strangers to each other, but in creating the tax float, they were acting as a partnership vis-a-vis the government. Like all partners, they would have to negotiate how to split the profits of the tax float: the PSA partners paid cash that went to PSLC to share in PSA's tax benefit from the tax float. But first, as a partnership vis-a-vis the government, both PSA and PSLC wanted as large a liability as possible. 

 

   Cash loans from third parties are different from seller-provided liability in that third party cash loans generally do not save tax on one side before tax is paid on the other. A lender of cash or some predecessor of the lender usually has had to pay tax to get cash to lend. A creditor bank itself pays no tax when it receives cash from depositors or contributing shareholders, but then tax presumably was paid by depositors or contributing shareholders who gave the bank the cash. The creditor bank merely stepped into their shoes for tax purposes. Cash loans to the purchaser, moreover, create immediate tax to the seller when paid over as the purchase price, notwithstanding the cash method and installment method. The tax that a cash borrower saves, in sum, usually is made up by tax paid before or immediately after his borrowing. Cash borrowing does not ordinarily create a tax asset, a tax float, vis-a-vis the government. 

 

   Bargaining with seller-provided nonrecourse liability often is a parody of the sale price negotiations that take place with cash purchase prices. Each round of bids is higher than the last. The buyer and seller may be strangers with no outside economic interests in common, but when they are bargaining with play money, the bargaining leads to million dollar depreciable liabilities for a dog- house. The PSA investors were not bargaining badly for the Summit House apartments: they were bargaining brilliantly, but bargaining with play money that was considered to be like a cash cost only by the blind eye of the tax law. Bargaining with play money explains why buyers willingly 'pay' high prices for nearly worthless or nonexistent coal,/45/ computer programs,/46/ record masters,/47/ or television videos./48/ Inflated liabilities like those for Summit House arise not because the purchasers are especially greedy or unusually tax-phobic. When both the buyer and the seller of Summit House benefit from inflated liabilities, then the inflated liabilities happen. Inflated liabilities are as inevitable as water running down hill once the tax system treats play money as if it were payment.

 

 B. Liabilities Are Shams if the Tax Savings Are Worth More than the Cash 

 

   A fundamental premise of the Crane rule is that a liability is a 'cost.' The statute includes a liability in a purchaser's basis only because the liability is considered to be a cost./49/ A 'cost,' within the 'ordinary, everyday sense' of the word,/50/ needs to be something that the purchaser is trying to minimize. Liabilities like the PSA liabilities, which involve no possibility of resources diverted from other uses and which the investors want to inflate, are not properly 'costs' with a tax status equal to payments in gold, even in part. 

 

   If the tax savings generated by a purchase are worth more than the cash the purchaser must put into the investment whatever the outcome, then it follows by a tight series of links that the purchaser will want the nonrecourse liability to inflate. If the value of the tax savings is more than the cash the purchaser must invest, then no rational seller would also give the purchaser a chance of achieving an equity in the property that has any meaningful value. When the purchaser is given no meaningful chance of achieving an equity in property secured by nonrecourse liability, he will prefer to have higher nonrecourse liability so as to increase the tax savings, even though it means sacrifice of the not very meaningful equity. If the purchaser wants a higher liability, the seller who provides the liability by increasing the sales price for the property will willingly cooperate, even instigate, inflation of the liability. By the inexorable law of the market, if the tax savings are worth more than the cash committed, the nonrecourse liability will be inflated. Liabilities the purchaser wants to inflate are not detriments and cannot reasonably be considered costs. 

 

   The courts, accordingly, should remove seller-provided nonrecourse liability from the purchaser's basis, unless the discounted present value of the cash committed to the shelter is greater than the present value of the projected tax savings. 

 

   Testing whether the tax savings are worth more than the cash committed, under the test proposed in this  article, would be a screen disqualifying seller-provided nonrecourse liability. As a screen, the test would be in addition to, rather than in place of, the traditional test for inflated liabilities. Thus, taxpayers still would be required to show that the value of the collateral was sufficient to exceed the principal amount of the nonrecourse liability, even when they could show that their invested cash was worth more than the tax savings alone. In a market in which all prices on all comparable properties are inflated by play money bidding, however, a screen comparing the net present value of the tax savings with the cash committed would be easier to apply than a test requiring determination of fair market value. Knowing the parties' motives, moreover, would be necessary to evaluate their bargained-for values. 

 

   Testing the relative value of cash and tax savings might be used as merely a presumption that the nonrecourse liability is nongenuine. Taxpayers would then still be able to prove that they, unique among mortals, have adequately secured nonrecourse liability, notwithstanding the economic motives. But even strongly adverse presumptions do not work in a tax system with such low audit rates and in which the taxpayer may report tax relying on positions quite likely to lose if challenged. If the tax system is going to be administrable at all, sometimes prophylactic rules based on normal market reactions must be made to be the dispositive rules. 

 

   As noted, third party borrowing of cash ordinarily is a considerably lesser problem than seller-provided liability. A third party creditor lending on a nonrecourse basis ordinarily will require collateral of sufficient value to ensure that it gets its loan proceeds (cash) back; a seller-creditor, by contrast, will get the lent property back if the collateral is insufficient just by reseizing the property. Third party borrowing, moreover, ordinarily is not a tax float, saving tax before tax must be paid, because the borrower or some predecessor must pay tax to have the cash to lend, and because the seller must pay tax on the cash received. Thus, the test of the relative value of cash and tax savings, proposed here, would not apply to third party cash loans provided at the time of the sale.

 

 

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                         III. FAIR MARKET VALUE BASIS

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   Nonrecourse liability is, by nature, all or nothing. PSA could not retain ownership of the Summit House buildings by paying only their fair market value of $1 or $4 million, or whatever. If PSA paid only what the buildings were worth in 1978, the creditor still would have the right to foreclose on its full lien of $7.8 million plus accrued interest. PSA could not rationally pay the full $7.8 million plus interest to keep the buildings worth so much less, and it does not help PSA to pay anything less than the full lien. PSA thus would be expected to pay nothing to keep the property at the time when the inflated nonrecourse liability must be settled./51/ 

 

   While conceding that PSA had no incentive to pay the inflated liability, even in part, the Third Circuit (Greenberg, J.), under a theory new to the literature, held that PSA would be allowed to have a basis equal to the fair market value of the Summit House buildings. '(T)he creditor holding the debt,' the Third Circuit said, 'had no incentive to take back the property if the taxpayer offers to pay the debt up to the value of the property. For example, if a creditor held a nonrecourse debt of $1,500,000 on a property with a fair market value of $1,000,000, he would have a disincentive to foreclose if his defaulting debtor offered to settle the debt for not less than $1,000,000.'/52/ Because the court believed that the creditor would settle for fair market value, the court remanded the case to the Tax Court to determine the fair market value of Summit House. 

 

   If PSA had paid enough to satisfy the creditor and keep Summit House, it would only have been in a competition with other bidders seeking to own the buildings. PSA had few advantages and many disadvantages in that bidding. The PSA investors were passive outsiders. They did not occupy the property nor have any expertise in its management, nor expect any equity in the property. The major contribution they brought to the project was that they had lots of high bracket taxable income they were willing to pay to shelter. The transaction costs in booting them out were relatively minor. 

 

   Unlike a normal owner, moreover, PSA had no incentive to find the highest and best economic user who would bid the most for the property. PSA could not profit from any sale price less than the inflated nonrecourse liability. PSA thus had no motive to find the highest and best user of the property if that highest and best user was willing to pay something less than the full $7.8 million plus accrued interest lien. 

 

   PSA had no investment in Summit House, in any event, that entitled it to some special status over any other future purchaser. Why not just give depreciation deductions, starting in 1978, to the highest and best user of Summit House, whoever that may be, who will eventually pay for and own Summit House? 

 

   The record is clear, in any event, that PSA did not settle with PSLC by paying the fair market value of the property. In 1985, when PSA and PSLC jointly sold the land and building to a third party, the sale price attributable to PSA's interest in the apartments was far below PSA's outstanding liability./53/ PSA neither paid PSLC enough to own the building nor received any distributions from the sale. How could the Third Circuit have adopted a theory that PSA inevitably was going to keep the property by paying fair market value, in the face of the fact, clear on the record, that PSA did no such thing? The stated rationale for the case is an excuse. 

 

   Upon the Commissioner's petition for rehearing, the Third Circuit (Greenberg, J.), denying the petition, insisted that PSA's basis was the current fair market value upon the purchase in 1978./54/ But the settlement rationale  of the court would require that we look to the value that PSA purportedly would pay to settle the liability when settlement is expected to occur. Under the terms of the purchase, PSA has the right to defer settlement of the nonrecourse liability and accrued interest for 10 years,/55/ and it could ordinarily be expected to take advantage of most of that deferral in order to get most of the depreciation deductions. Thus, although the Court denied it, its rationale, as a matter of logic, is looking to future fair market value of the property. 

 

   Looking to the future value of the property is not the 'stuff of substance.'/56/ If the future value counts, why not provide for settlement in 100 years, not just 10 years, and then argue in an inflationary economy that every dog-house will be worth $1 trillion? Depreciable costs are supposed to represent investments that have already been made, not investments that might be made 10 years or 100 years hence. 

 

   On petition for rehearing, the Third Circuit also denied that it would allow annual recalculations of the fair market value of the property to determine the portion it would consider genuine. Nonetheless, in looking to the price that the creditor would accept in settlement, the Court's rationale (if coherent) necessarily implies that the basis changes as the settlement price changes. Under the settlement rationale, even without periodic reappraisals of value, basis would rise to exceed the fair market value of the property. As PSA makes payments on the nonrecourse liability (for instance, to keep access to the tax benefits and to prevent recapture of depreciation), PSA still is not entitled to keep the property unless it pays all of the remaining liability. The creditor still would insist on at least the fair market value of the property on settlement in addition to payments that PSA already has made. Thus, PSA's basis would, under the Third Circuit's logic, be payments made plus the fair market value on settlement. 

 

   PSA's outstanding indebtedness, moreover, is increasing by accrued but unpaid interest of almost $700,000 per year/57/ and if any of that interest were really owed, it would be deductible to an accrual method taxpayer like PSA and generate additional tax losses that PSA investors could deduct after 1978. Unfortunately for the theory of the Third Circuit, the shelter did not stay static after 1978 and a theory of legitimate debt based only upon fair market value in 1978 would not dispose of the tax issues the shelter raises. 

 

   Delaying deduction of any losses that PSA might suffer until PSA actually pays the liability would more accurately reflect PSA's true economic income than would giving PSA artificial depreciation deductions. Depreciation deductions, like all deductions, are supposed to represent real costs and real reductions in ability to pay tax. If the liabilities are not in fact paid, as is highly likely, then the depreciation would be deductions of fictional costs. 

 

   If the nonrecourse liability is not paid by the time Summit House is sold or abandoned by PSA, then under Commissioner v. Tufts,/58/ the unpaid amount is gain to the PSA investors arising from the sale. Thus, while PSA partners may have phantom deductions (i.e., deductions without cash outlay) when liability arises, they also have phantom gain (i.e., taxable gain without cash receipt) when the liability disappears from their books. Perhaps we once thought that the phantom gain under Tufts was sufficient to remedy the error of deducting never to be paid amounts, but in fact the phantom gain is not a sufficient remedy, because of the time value of money and the character of the gain. 

 

   Assume, for example, a $100 liability, which is not expected to be paid, that arises and is deducted in full in 1978 on property to be sold in 1987. A 70 percent tax bracket taxpayer would have saved $70 tax in 1978. If the $100 liability was expected to generate capital gain in 1987, the phantom gain would be expected to generate $28 tax since gain is capital gain under Tufts and the maximum tax on capital gain was 28 percent under the Revenue Act of 1978./59/ The present value of the $28 tax in 1987, discounted nine years back to 1978 at, say, eight percent, would be $14 (that is, $28/(1m8%)/9/). The net tax benefit from the deduction of the $100 unpaid nonrecourse liability less the Tufts gain would be $70 less $14, or $56. Thus, even with the phantom gain, a purchaser would expect to come out $56 ahead per $100 liabilities they never expected to pay. The phantom gain does not correct the original error of allowing deductions for never-to-be-paid amounts. 

 

   Even if PSA did pay the debt, allowing a taxpayer to take deductions currently for an amount to be paid only in the future overstates the true cost of the item to the extent that the time value of money is not taken into account. Taken to the extreme, deduction of amounts long enough before payment can yield an absurd result that the present value of the tax savings generated by the future payment will exceed the actual detriment of the payment./60/ 

 

   The Third Circuit, in giving partial credit for the nonrecourse liability, gave too much credence to a liability that the parties treated as play money. PSA is a 'Class III  Abusive Tax Shelter' in which the investors are buying tax deductions without any realistic possibility of achieving any interest in Summit House. The investors were buying naked tax deductions. The Third Circuit seems to assume, contrary to the economics, that 'liabilities' have to be treated as 'costs' because the parties use the magic label 'liability.' But PSA has no investment in this property./61/ No cash or other resources have been or will be diverted from other projects or uses to buy an equity in the property. The nonrecourse liability PSA gave was play money, cost- free debt. PSA had no there, there. If the tax law is going to treat a liability, in any portion, as if it were gold already paid, it should insist on a closer resemblance to gold than this. 

 

   Depreciation deductions are allowed only for costs -- i.e., investments made by the taxpayer. If the taxpayer has no basis in the asset, no depreciation deductions are allowed. A reduction in the fair market value of the taxpayer's assets is not sufficient./62/ Since PSA had no cost or other investment in Summit House, any decline in Summit House would be at best like a decline in untaxed unrealized appreciation or like the loss of an untaxed receivable, both of which appropriately generate no tax loss./63/ 

 

   As a matter of economics, in any event, it is the creditor, PSLC, which will suffer the loss if Summit House declines in value. PSA had no economic interest in the value of Summit House unless it appreciated to a value over the outstanding liability of $7.8 million plus accrued interest. PSA had no concern about any decline in the value of Summit House below the amount of the outstanding liability./64/ 

 

   From a tax planner's perspective, PSA's loss of use of the big nonrecourse liability is a penalty in comparison to optimal tax planning. If PSA and PSLC had not overreached, then they could have achieved a basis and even a tax float for a liability for an amount somewhat in excess of the value of Summit House. For a tax planner, tax savings always should be preserved and maximized, and having to pay some avoidable tax is always a waste. But the courts have no business replacing a taxpayer's failed tax plans with the most aggressive tax plans that the taxpayer could have gotten away with. Questions of taxation are determined not according to what the taxpayer might have done, but by 'what was actually done.'/65/ 'It would be quite intolerable,' as Judge Friendly has said, 'to pyramid the existing complexities of tax law by a rule that the tax shall be that resulting from the form of transaction taxpayers have chosen or from any other form they might have chosen, whichever is less.'/66/ The nonrecourse liability in Pleasant Summit was not an investment, although PSA under some other tax plan might have made an investment in Summit House. 

 

   So long as out-of-pocket cash costs actually incurred by PSA investors are treated according to their true economic nature and without penalty (discussed in the next section), there is no need to give PSA a fair market value basis (without investment) to prevent a penalty. 

 

   Giving a fair market value basis to an inflated liability case, as a consolation prize after the liability is struck down as a sham, will generate an inadministrable tax system, when there is no bargaining between the parties that establish a real fair market value. The 'cost' that the taxpayer reports on his tax return will be like the opening bid in a Persian rug bazaar. High bids will be rewarded because of the tendency of the courts to settle on compromise fair market values between the values suggested by the parties. Even compromises will be difficult to reach, because without bargains there is no objective evidence upon which to judge accuracy. There is, in fact, plausibly no pretax or accounting value out there upon which the Court can build a firm foundation, because the tax advantages of nonrecourse liability have too profoundly corrupted the reported prices of sale. There is no pretax market for comparable properties in West Orange (or in Orange, East Orange, or South Orange), New Jersey/67/ that can provide the 'stuff of substance,' because the market values of all the properties have been inflated by tax. 

 

   Much property has no true fair market value once one can no longer rely on bona fide bargaining. The greatest room for inflated liabilities, as a compliance matter, is for unique or intangible assets like record masters, art, books, or inventions, because our ability to project returns and values beforehand is so weak. A hit record or revolutionary invention indeed may have extraordinary value, but most records and inventions have no substantial commercial worth -- especially where the purchaser does not care whether there is any nontax worth to the property. The shelter promoter will claim that every record might go platinum and that every invention will turn paper into gold. Knowing the purchaser's bargaining incentives may be necessary as a guide to help the courts evaluate what constitutes the fair market value of the collateral.

 

 

________________________________________________________________________________

 

                IV. COLLATERAL CONSEQUENCES OF NONGENUINE DEBT

________________________________________________________________________________

 

   Settling whether the nonrecourse liability can be included in basis, in part, or whole, does not settle all of the issues at the front end of the Crane rule. One still must settle when and if cash outlays by the investors can be deducted, given that the nonrecourse liability is inflated. This section argues that the investors should be able to deduct cash costs funded by rents or other income from the shelter itself, but that the cash provided by the investors from outside the shelter be treated as nondeductible costs. The section also discusses the consequences of inflated liabilities under Tufts, and the at-risk and passive activity loss rules.

 

 A. Treatment of the Cash Costs 

 

   The tax treatment of PSA investors' cash outlays depends upon what is the economic substance of the outlays. The economics of the transaction was that the PSA investors were buying partnership K-1 tax schedules filled out to show lots of tax losses. The price they paid for their tax savings was less than the expected discounted value of the tax savings. PSA investors purchased no meaningful chance of achieving an equity in Summit House./68/ Thus, they could not have rationally incurred the costs with the motive of achieving pretax economic profit. The transaction had no pretax reality that the PSA investors would have undertaken in absence of tax: The nature of the transaction was the tax itself. 

 

   Costs are allowed as nonitemized deductions only if they are costs of business transactions or transactions entered with the motive of achieving a pretax accounting profit. The Courts repeatedly have held that the out-of-pocket costs incurred in a transaction with inflated nonrecourse liability are not profit motivated costs, but rather 'hobby loss' expenses that can be deducted only to shield income from the same property./69/ The costs, though actually expended, are not deductible if they are incurred solely to avoid tax./70/ 

 

   Costs that are the purchase price of tax savings are not deductible, moreover, because they are costs related to tax-exempt benefits. Federal income tax is not deductible in computing taxable income and savings or reductions in Federal tax are not an income item./71/ The PSA investors' out-of-pocket costs were made to avoid tax, so the costs should be accounted for by netting the cash costs against the tax savings. Since tax savings have no recognized tax effects, so the costs of the tax savings have no recognized tax impact./72/ Alternatively stated, the out-of-pocket costs are in lieu of Federal tax and they should not be deductible because the Federal taxes they replace are not deductible. The tax character of payments generally is determined by what they were in lieu of./73/ 

 

   Shelter investors who lose their case and have their liability treated as nongenuine, turn out not to have saved tax as intended. There is a lovely little paradox under which the investors should lose their tax deductions for cash costs, if they are not audited or win and achieve their tax savings, but they could get their tax deductions for cash costs, if they lose their tax savings from the nonrecourse liability. The solution to the paradox is that tax treatment is determined according to the facts as they are known at the end of the taxable year./74/ If the 'facts' upon which tax is based are allowed to change because of audit of tax returns, there would be a perpetual 'renvoi' that would automatically frustrate the collection of revenue./75/ It is appropriate to deny tax deductions for the cash costs of shelter investors who lose their cases as a proxy for denying the tax deductions of the tax shelter investors who never were audited. Wholly apart from the computation of income, moreover, there is a public policy concern: a respectable tax law should not be forced to fund the rope that hangs itself. 

 

   Cash from the rents from tenants of Summit House, however, are not appropriately taxed to PSA investors. PSLC sold tax savings and not Summit House, so PSLC in substance retained the full rents from Summit House. The hobby loss or not-for-profit doctrine traditionally has allowed the taxpayer a deduction for expenses up to the amount of the income from the property./76/ That result is appropriate because the rent that PSA received from Summit House was passed over to PSLC in the form of interest. If the interest that PSA paid on the inflated liability was in some sense nongenuine because the underlying debt was nongenuine,/77/ still so was PSA's receipt of the rents that went to pay that interest. 

 

   Even if PSA's payments had been for a meaningful interest in Summit House and for profit, the payments would have been nondeductible because they were capital expenditures./78/ Capital expenditures are investments and they are not deductible until the costs expire and cease to be investments./79/ One helpful way to test whether cash payments have expired or not is according to whether the total cash invested exceeds the appropriate adjusted basis in the property. The appropriate adjusted basis might be computed, under this proposal, under a phantom depreciation schedule that started with the stated purchase price and went down by the amount of depreciation that would have been allowed under the statutory schedule had the liability been real. If the purchaser already had made cash payments equal to that adjusted basis, further cash would be deductible as an expired cost when made. But a purchaser would capitalize cash payments if the payments made so far are less than the adjusted basis under the phantom depreciation schedule. Cash not deducted when paid then would be deducted when the phantom adjusted basis schedule drops below the taxpayer's cash investment. Using such a phantom schedule will prevent a taxpayer from putting a nongenuine liability on the property just to get a more accelerated depreciation schedule than he would have achieved had he paid all cash for the property. 

 

   It would be inappropriate to characterize PSA cash payments as payments for an option. The cash payments paid by PSA investors were made to buy tax benefits and were too big to be payments for an option with such a trivial chance of being exercised. A trivial fraction of the cash would have covered the option value. Treating the cash paid by a buyer as a payment for an option would suspend the tax recognition of the cash until the buyer completes or abandons the transaction; symmetrically, the seller would have a windfall because payments for an option are cash receipts without tax until the option is exercised or lapses./80/ For long-term nonrecourse liabilities, 30-40 years might go by before the cash is taxable. The cash received by a tax shelter promoter for selling tax losses should be taxable to the promoter as ordinary income immediately when received, and not only 30-40 years later.

 

 B. Inflated Liabilities Under Tufts 

 

   Liabilities treated as nongenuine for the purposes of computing depreciation should not be included as amounts realized when the taxpayer disposes of the property or otherwise gets out of the gain. The basic purpose of the phantom gain in Tufts/81/ was to reverse into income depreciation deductions never really paid for. If a liability is not included in basis, because it is inflated, but the liability is nonetheless treated as an amount realized, there would be artificial gain where none existed: Assume, for instance, inflated liability of $100,000 secured by depreciable property worth only $50,000 and that the investor was not entitled to include the inflated liability in depreciable basis. If, on disposition of the property, the liability is treated as part of the amount realized for the property, without being included in the basis, the taxpayer would be treated as having had $100,000 gain on the entire transaction when in fact there was no gain (or loss) on the liability. The amount realized on sale must be consistent with the decision as to basis.

 

 C. At-Risk and Passive Loss

 

   After the PSA investment in 1978, Congress attempted to contain losses generated by tax shelters such as PSA  by the 'at-risk' of IRC section 469 and 'passive activity loss' limitations of section 465. The limitations restrict the scope within which losses from nonrecourse liability can be used, without affecting the computations of depreciation or depreciable basis./82/ Sections 465 and 469 presuppose, however, that they are limiting excess use of basically legitimate tax losses./83/ Neither the at- risk nor the passive loss limitation apply, for instance, to widely held corporations; widely held corporations thus can use losses generated by nonrecourse liabilities without limitation./84/ Even for individuals, moreover, the at-risk rules allow losses from a shelter to be used up to the amount of all cash invested in the project,/85/ including cash borrowed to invest in the activity,/86/ The passive activity loss limitations allow the losses from an activity to be used to shelter income from any other passive activity the taxpayer has invested in./87/ 

 

   Congress would not have allowed losses to be used so broadly except on the assumption that they were dealing with basically genuine liabilities. If the losses are shams, such as the PSA losses, they still can do a lot of damage within the scope allowed by the at- risk and passive activity limitations. Nothing in either 'at-risk' or 'passive activity,' in any event, helps legitimate what otherwise would be nongenuine debt. The at-risk and passive activity rules, at least temporarily, have contained the economic damage caused by abusive tax shelters. So we are learning about play money debts only after the peak of their economic damage. The Owl of Wisdom, it is said, flies only at dusk. 

 

   Still, Congress is under constant and considerable political pressure to exempt taxpayers and transactions from the at-risk and passive activity loss rules./88/ Thus, unless Congress and the courts understand the fundamental economics of seller-provided nonrecourse liability and identify sham debts as such, the inflated nonrecourse shelters, with all their horror, may well rise again.

 

 

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                                   FOOTNOTES

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   /1/ 863 F.2d 263 (1989) rehearing denied id. at 277, aff'g T.C. Memo. 87-469, 54 T.C.M. 566, cert. denied sub nom. Prussin v. Commissioner, 58 U.S.L.W. 3241 (October 10, 1989). 

 

   /2/ See infra notes 15-17 and accompanying text. 

 

   /3/ 863 F.2d at 276. 

 

   /4/ See, e.g., IRS Commissioner Egger, Testimony Before Subcommittee on Oversight of the House Ways and Means Comm., IR 82- 111 at 11 (Sept. 28, 1982 (Tax Notes Microfiche Doc 82-9767) (Settlement offers on pre-1981 tax shelters authorized that would allow deduction of the cash investment in the initial year and disregard nonrecourse loans). The IRS' current public position is just that settlement offers will be based on the merits of each shelter, with the IRS' best offer given at the outset. IR 87-56 (April 1987) (Tax Notes Microfiche Doc 87-2446). 

 

   /5/ See cases cited infra notes 71 and 72. IRS Commissioner Roscoe Egger, for instance, assessed the IRS' litigation success:

________________________________________________________________________________

 

 

     '(I)n only two decided cases have taxpayers recovered their full

     out-of-pocket or actual cash expenditures. In fact, in the

     majority of its opinions, the Tax Court has denied all of the

     claimed deductions. In recent opinions, the Court has sent out a

     clear message that even out-of-pocket costs will not be allowed

     where the shelter transaction lacks economic substance.' Speech

     before AICPA (Oct. 4, 1983) quoted in Graetz, Federal Income

     Taxation: Principles and Policies 1034 (2d Ed. 1988).

________________________________________________________________________________

 

   /6/ I.R.C. sections 465 (at-risk rules); and 469 (passive activity loss limitations). 

 

   /7/ The House-passed version of the Revenue Reconciliation Act of 1989, H.R. 3299, section 11965, for instance, exempts timber from the passive activity loss provisions (by amending IRC section 469(c) to provide that timber investments are not passive activities, even though the investor does not materially participate in the investment). 

 

   /8/ IRS, Examination Tax Shelters Handbook Para. 361(2) (Nov. 6, 1979). 

 

   /9/ 331 U.S. 1 (1947). 

 

   /10/ Id. at 14. 

 

   /11/ Mayerson v. Commissioner, 47 T.C. 340, 352 (1966). 

 

   /12/ B. Bittker, 3 Federal Taxation of Income Estates and Gifts 85-36 (1981). 

 

   /13/ Brountas v. Commissioner, 73 T.C. 491, 541 (1979), appropriately rev'd 692 F.2d 152 (1st Cir. 1982) explicitly relied on bargaining between the parties to legitimate a nongenuine, nonrecourse liability. Diggs v. Commissioner, 87 T.C. 759, 773 (1986), for instance, rejects the argument. 

 

   /14/ Treas. reg. section 20.2031-1(b) (1963) cited with approval United States v. Cartwright, 411 U.S. 546, 551 (1973). 

 

   /15/ Bryant v. Commissioner, 790 F.2d 1463 (9th Cir. 1986) ($400 purchase price for beavers worth $3.25 each; while liability was not in form nonrecourse, it could be satisfied by return of beavers at stipulated inflated value); Odend'Hal v. Commissioner, 748 F.2d 908 (4th Cir. 1984) cert. denied 471 U.S. 1143 (1985) ($4 million largely nonrecourse liability purchase price for real estate exceeded value 'by a factor of two'); Thompson v. Commissioner, 631 F.2d 642, 647 (9th Cir. 1980) cert. denied 452 U.S. 961 (1981) (promoter purchased property for $700,000 and sold to investors for $6,800,000 nonrecourse liability three months later); Brannen v. Commissioner, 722 F.2d 695 (11th Cir. 1984) ($1,400,000 nonrecourse liability secured by $85,000 movie); Estate of Franklin v. Commissioner, 544 F.2d 1045 (9th Cir. 1976) ($1.2 million liability for motel worth no more than $660,000); Hulter v. Commissioner, 91 T.C. 371, 392 (1988) (apartments and motels worth $14.5 million purchased for $24.5 million); West v. Commissioner, 88 T.C. 152, 160 (1987) ($180,000 purchase price for movie print worth $150); Zirker v. Commissioner, 87 T.C. 970, 976-977 (1986) ($39,000 nonrecourse debt for cattle worth $9,600 per head); Law v. Commissioner, 86 T.C. 1065, 1100-1101 (1986) ($5,040,000 nonrecourse liability secured by $560,000 movie); Waddell v. Commissioner, 86 T.C. 848, 906 (1986) aff'd 841 F.2d 264 (9th Cir. 1987) ($25,000 in substance nonrecourse liability for medical computer terminal worth $2,500-$4,000); Hagler v. Commissioner, 86 T.C. 598 (1986) ($2,800,000 nonrecourse liability for computer rights worth no more than $900,000); Falsetti v. Commissioner, 85 T.C. 332, 335, 340 (1985) ($2.85 million nonrecourse liability for condominiums worth $1.96 million); Dean v. Commissioner, 83 T.C. 56, 71 (1984) ($742,500 nonrecourse liability for book worth $58,500); Siegel v. Commissioner, 78 T.C. 659, 690 (1982) ($900,000 purchase price for $190,000 movie); Fox v. Commissioner, 80 T.C. 972, 983 (1983) aff'd sub nom Barnard v. Commissioner, 731 F.2d 230 (4th Cir. 1984) ($660,000 purchase price for book having $85,000 cash cost); Hager v. Commissioner, 76 T.C. 759, 764 (1981) (cattle bought by promoter for $1,000 a head and sold for nonrecourse liability of $10,000 a head); Narver c. Commissioner, 75 T.C. 53, 98 (1980) aff'd 670 F.2d 855 (9th Cir. 1982) (nonrecourse liability of $1,800,000 for property worth $412,000); Beck v. Commissioner, 75 T.C. 1534, 1552 (1980) (property of $186,000; liability of $1,008,000); Del Guercio v. Commissioner, T.C. Memo. 1989-354 ($100,000 purchase price for $50,000 construction crane); Goldman v. Commissioner, T.C. Memo. 1988-355 (nonrecourse note of $5.9 million for patents worth $1.5 million); Tolson v. Commissioner, T.C. Memo. 1987-578 (nonrecourse notes of $66,700 for cattle worth $27,000); Bizub v. Commissioner, T.C. Memo. 1983-280 ($1.2 million purchase price for $150,000 value movie); Hunter vs. Commissioner, T.C. Memo. 1982-126 (purchase price: $7,200 per cow; value: $230 per cow). 

 

   /16/ Helba v. Commissioner, 87 T.C. 983, 1014 (1986) (video tapes); Hagler v. Commissioner, 86 T.C. 598, 617 (1986) ($1,200,000 note secured by rights under computer programs that were yet to be developed); Moore v. Commissioner, 85 T.C. 72, 101 (1985) (diamond distributorships); Surloff v. Commissioner, 81 T.C. 210, 235 (1983) aff'd 788 F.2d 695 (11th Cir. 1986) (coal mines); Flowers v. Commissioner, 80 T.C. 914, 944 (1983) (record master); Brountas v. Commissioner, 692 F.2d 152 (1st Cir. 1982) rev'g 73 T.C. 491 (1979) cert. denied 462 U.S. 1106 (1983) (oil drilling shelter: debt would be paid only if oil was found); Gibson Products v. Commissioner, 637 F.2d 1041 (5th Cir. 1981) (oil); CRC v. Commissioner, 693 F.2d 281 (3d Cir. 1982) cert. denied 462 U.S. 1106 (1983) (oil); Saviano v. Commissioner, 80 T.C. 955 (1983) aff'd 765 F.2d 643 (7th Cir. 1985) (note to be paid from sale of gold); Wing v. Commissioner, 81 T.C. 17, 41 (1983) (note to be paid from sale of coal). 

 

   /17/ Crane basis is a subset of accrual accounting (although available for cash method taxpayers too); if the liability is not fixed so as to be accrued, it cannot be included in basis. Brountas v. Commissioner, 692 F.2d 152 (1st Cir. 1982) rev'g 73 T.C. 491 (1979) (oil drilling shelter: debt would be paid only if oil was found); Gibson Products v. Commissioner, 637 F. 281 (3d Cir. 1982) (follows Brountas and Gibson Products); Wing v. Commissioner, 81 T.C.17, 41 (1982) (note to be paid from sale of coal); Graf v. Commissioner, 80 T.C. 944, 947 (1983) (Panamanian dredging shelter with note to be paid only out of sale of lots to be created by dredging); Saviano v. Commissioner, 80 T.C. 955, 962 (1982) aff'd 765 F.2d 643 (7th Cir. 1985) (note to be paid from sale of gold). 

 

   /18/ Bailey v. Commissioner, 90 T.C. 558, 617 (1988) (shelter partnership's rights in movies were too insubstantial to qualify as ownership); Coleman v. Commissioner, 87 T.C. 178, 204, 209 (1986) (computer leasing); Dukin v. Commissioner, 87 T.C. 1329, 1389 (1986) aff'd 872 F.2d 1271, 1277 (7th Cir. 1989) (movie); Green v. Commissioner, T.C. Memo. 1989-436 (movie). 

 

   /19/ Rose v. Commissioner, 88 T.C. 386, 415 (1987) (lithographs; the liability, while not recourse in form, could be satisfied by return of the lithographs at stipulated value); Porreca v. Commissioner, 86 T.C. 821, 843 (1986) (television video masters); Herrick v. Commissioner, 85 T.C. 237, 255 (1985) (tire gauges); Driggs v. Commissioner, 87 T.C. 759, 774 (1986) (computer translation program); Elliot v. Commissioner, 84 T.C. 227, 236 (1985) aff'd 782 F.2d 1027 (3rd Cir. 1986) (gothic novel); Sutton v. Commissioner, 84 T.C. 210, 221 (1985) (truck trailers); Est. of Baron v. Commissioner, 83 T.C. 542, 553 (1984) aff'd 798 F.2d 65 (2d Cir. 1986) (master recording); Dean v. Commissioner, 83 T.C. 56, 73 (1984) (rights to paperback book); Surloff v. Commissioner, 81 T.C. 210, 232 (1983) aff'd 788 F.2d 695 (11th Cir. 1986) (coal mines); Fox v. Commissioner, 80 T.C. 972, 1010 (1983) aff'd 742 F.2d 1441 (2d Cir. 1984) (book); Flowers v. Commissioner, 80 T.C. 914, 940 (1983); Brannan v. Commissoner, 78 T.C. 471, 512 (1982) (movie); Deegan v. Commissioner, T.C. Memo. 1985-219 aff'd 787 F.2d 825 (2d Cir. 1986) (movie); Snyder v. Commissioner, T.C. Memo. No. 1985-9 (master recording). 

 

   /20/ There is some ambiguity in the record as to whether PSA paid or merely owed the $500,000 stated down payment. 863 F.2d at 277. The $7.8 million figure assumes that PSA did not pay the $500,000 down payment, but if they did, the initial outstanding liability was only $7.3 million. 

 

   /21/ The Third Circuit put a cap on the fair market value that could be found on remand of $4.2 million because that was the price that the promoter paid for the land and building (with nonrecourse liability) shortly before it sold the building alone to the shelter partnership. 863 F.2d at 277 n.18. The appraised value of the building, separate from the land, for property tax, was $1.1 million in 1978. 54 T.C.M. at 571. The projected rent roll from the apartments was $612,000 for the first full year, 1979, less operating expenses of $282,000(!), so that net operating income was projected to be $330,000 (before depreciation and interest) (Appendix to the Record in the Third Circuit at 332a), which would put the real value of the apartments (using a 20 percent interest multiplier) at $1.65 million. 

 

   /22/ See, e.g., cases cited at supra notes 15-19. The Third Circuit miscited Odend'Hal v. Commissioner, 748 F.2d 908 at 912-914 (4th Cir. 1984) cert. denied 471 U.S. 1143 (1985) as authority for a fair market value basis. At the pages cited, however, the court merely held that Commissioner v. Tufts, 461 U.S. 300 (1983) reh. den. 463 U.S. 1215 (1983) would not help a taxpayer with sham nongenuine debt and held that deductions could prevent the taxpayer from having fictive income from the property. See discussion in text accompanying supra notes 78-79. The Third Circuit in any event managed to ignore all of the cases in the Tax Court and many of the cases in the Court of Appeals. 

 

   /23/ Petition for Writ of Certiorari in Commissioner v. Prussin at 20. 

 

   /24/ Audits closed between October 1982 and December 1985, for instance, generated $7.4 billion of contested liabilities from tax shelter issues. General Accounting Office, Tax Administration: IRS' Backlog of Tax Returns With Tax Shelter Issues Awaiting Settlement (Sept. 1985). 

 

   /25/ The IRS audit coverage of even high loss partnership returns approximated only 24 percent in 1978, the year of the Pleasant Summit investment. Commissioner of Internal Revenue, 1978 Annual Report at 28. 

 

   /26/ B. Bittker, Tax Shelters, Nonrecourse Debt, and the Crane Case, 33 Tax L. Rev. 277, 283 (1978).

 

   /27/ Note (7) to Projected Financial Schedules, Appendix to the Record in the 3d Cir. at 336a. 

 

   /28/ Cf. Levin v. Commissioner, 832 F.2d 403, 407 (7th Cir. 1987) (Easterbrook, J.) (tax shelter investors paid for investment with 'confetti debt'). 

 

   /29/ 54 T.C.M. 566, 570 (1987). 

 

   /30/ The discount rate used here is a conservative rate, adverse to the conclusions reached. See Moody's Munic. & Gov. Manual at a10 (1989) (Long term municipal bonds averaged a yield of 6.3 percent in December 1978). Higher discount rates, taking account of more risk, would improve the relative value of the tax savings by reducing the impact of the tax on sale. 

 

   /31/ PSA would default by the end of 10 years because actual payments of principal and interest, ground rent, and fees could be deferred for 10 years, but no more, and partnership contributions from which to make payments would end after 10 years. Notes (1), (4), and (6) to Projected Financial Schedules, Appendix to the Record in the 3d Cir. at 334a-335a. There was no prospect of keeping up with outstanding liabilities after the partner contributions and the right to defer ended at 10 years. 

 

   /32/ PSA's financial projections given to potential investors in the Offering Circular were misleading because they ignored the tax on sale. The projections also gave figures, however, which, with some analysis, yield the proper expected amount of tax on sale. Of PSA's total $7.8 million basis in Summit House, $2.3 million was allocated to property that would expire in less than 10 years, $1.86 million was allocated to building shell (40 year useful life and 125 percent declining balance depreciation), and $3.6 million to building components (30 year useful life and 125 percent declining balance depreciation). Confidential Offering Memo., Note (8) on Depreciation, Projected Financial Schedules, Appendix in the 3d Cir. at 336a. The adjusted basis after 10 years would be $3.73 million (i.e., $1.36 million for the building shell and $2.37 million for the building components). Meanwhile, the outstanding liability of PSA, starting at $7.76 million, would be increased by accrued but unpaid interest (roughly $700,000 per year), ground rent ($10,000 per year), and management fees (roughly $20,000 per year), and decreased by 'Mortgage Amortization' (starting at $462,000, but trailing off to $189,000 per year) to reach an outstanding principal of $12.54 million at the end of 1987. Projected Schedule of Cash Flows, Id. at 333a). There would be gain of the $12.54 million amount realized less the $3.73 million adjusted basis or $8.81 million upon disposition at the end of 1987. The recapture (ordinary) gain would be $93,000 due to depreciation in excess of straight line. Thus, $8.72 million would be capital gain. Under the Revenue Act of 1978, 60 percent of capital gain was excluded, yielding tax at 60 percent rates of $2.09 million on the capital gain. Adding the $56,000 tax (at 60 percent) on the recapture (ordinary) gain yields a total of $2.15 million tax on sale. Discounting the $2.15 million at eight percent for nine years yields a discounted present value of the tax of $1.076 million. A single unit (1/30th) share of the tax would be $36,000. 

 

   While Table 1 includes the expected tax on sale, adversely to the conclusions reached here, the tax was absent from the financial projections and might well have been ignored in the investor's calculations. Possibly, the promoters were planning to report no tax on sale (see, e.g., Tufts v. Commissioner, 651 F.2d 1058 (5th Cir. 1981) (amount realized cannot exceed fair market value on sale) rev'd 461 U.S. 300 (1983)), although the text of the Offering Circular did warn that the unpaid mortgage amount would be amount realized, without, however, quantifying the economic impact on the investors. Confidential Offering Memorandum at 50, Appendix to the Record (3d Cir.) at 736a. 

 

   /33/ Id. at 882a-883a. 

 

   /34/ Confidential Offering Memorandum 47, Id. t 733a. 

 

   /35/ Confidential Offering Memorandum Para. 62, Id. at 748a. 

 

   /36/ Only the building shell ($1.9 million of the total/$7.8 million) had a claimed life of over 30 years. Confidential Offering Memorandum, Note (8) on Depreciation to Projected Financial Schedules, Id. at 336a. Pleasant Summit Land Corporation, the seller of Summit House, kept the fee to the underlying land.  

 

   /37/ See supra note 32. 

 

   /38/ Under the projections, PSA's outstanding principal was optimistically expected to be $11.41 million by the end of 1985 (see supra note 32 for the logic of the calculation), so that even if all of the sales proceeds had been for PSA's interest, and none for PSLC's landlord interest, PSA investors would have received zero cash. The record does not tell what PSA's outstanding liabilities in fact were in 1985 on the sale, but undoubtedly they were higher than the optimistic projections would indicate. 

 

   /39/ In their Brief in Opposition to the Petition for Certiorari in Pleasant Summit (sub nom. Prussin v. Commissioner), the taxpayers argued that the sale for $7,000,000 implied thment. 

 

   /40/ IRS, Examination Tax Shelters Handbook Para. 361(2) (Nov. 6, 1979). 

 

   /41/ See supra note 21. 

 

   /42/ The buyer was another shelter partnership, however, which might also have been buying Summit House with play money liabilities. 

 

   /43/See Johnson, A New Way to Look at the Tax Shelter Problem, 30 Tax Notes 765 (1984) (explaining tax floats). 

 

   /44/ If PSA defaulted on the liability, PSLC never would pay tax on the liability, but PSA then would have gain from the unpaid liabilities. Commissioner v. Tufts, 461 U.S. 300 (1983) reh. den. 463 U.S. 1215 (1983). From the government's point of view, the analysis is the same whether or not payment occurs: the nonrecourse liability generates ordinary deductions from the time it first arises and there is capital gain tax on someone when the liability is later settled by payment or by nonpayment. 

 

   /45/ Surloff v. Commissioner, 81 T.C. 210, 232 (1983). 

 

   /46/ Hagler v. Commissioner, 86 T.C. 598, 617 (1986). 

 

   /47/ Flowers v. Commissioner, 80 T.C. 914, 927 (1983).

 

   /48/ Porreca v. Commissioner, 86 T.C. 821, 846-849 (1986). 

 

   /49/ IRC section 5012. 

 

   /50/ Crane v. Commissioner, 331 U.S. 1, 6 (1947). 

 

   /51/ PSA would rationally pay amounts to allow its investors continued access to the big depreciation deductions from the play money debt, to defer the Tufts phantom gain from the debt when the property is foreclosed, and to keep the investor's options open. But none of these reasons for payment, i.e., to acquire or retain tax savings and to buy an option to the property, justify any depreciable basis for PSA. See Section IV, infra. 

 

   /52/ 863 F.2d at 276. 

 

   /53/ See supra note 38. 

 

   /54/ 863 F.2d at 278. 

 

   /55/ See supra note 31. 

 

   /56/ Estate of Franklin, 544 F.2d 1045, 1048 (9th Cir. 1976); Odend'Hal v. Commissioner, 80 T.C. 588, 619 (1983) aff'd 748 F.2d 908 (4th Cir. 1984) cert. denied 471 U.S. 1143 (1985) (rejecting taxpayer's offer of proof of the future value of property securing a liability). 

 

   /57/ The net increase in outstanding liabilities was less than $700,000 per year because the partnership was scheduled to reduce the mortgage (starting at $462,000 in 1979 and trailing off to $189,000 in 1987) from out of partnership contributions. Projected Schedule of Cash Flows, Appendix in the 3d Cr. at 333a. 

 

   /58/ Tufts v. Commissioner, 651 F.2d 1058 (5th Cir. 1981) rev'd 651 U.S. 300 (1983) reh. den. 463 U.S.1215. 

 

   /59/ Revenue Act of 1978, P.L. No. 95-6000, section 402 amending IRC section 1202 to exclude 60 percent of capital gain from tax, applicable to tax years ending after November 1, 1978. The maximum tax rate on capital gains in 1987 turned out in fact to be 28 percent, notwithstanding all the changes in tax rates between 1978 and 1985(?)). Tax Reform Act of 1986, P.O. 99-514, section 302(a), adding IRC section 1(j). 

 

   /60/ Johnson, Silk Purses from a Sow's Ear: Cost Free Liabilities Under the Income Tax, 3 Amer. J. of Tax Pol'y 231 (1984). 

 

   /61/ See, e.g., Epstein, The Application of the Crane Doctrine to Limited Partnerships, 45 U. So. Calif. L. Rev. 100, 103 (1972) (nonrecourse liability is not an 'economic investment.'). 

 

   /62/ See, e.g., United States v. Chicago, Burlington & Quincy Railroad, 412 U.S. 401, 412 (1973) (Railroad has no depreciable basis for highway underpasses, bridges, crossings, etc., paid for by various governmental units, even though the railroads bore the burden of decline in value of the assets, because governments were not making contributions to the railroad and the railroad had no cost for the assets); Detroit Edison Co. v. Commissioner, 319 U.S. 98, 103 (1943) (utility had no basis in electrical lines paid for by distant customers because the utility's basis did not include an 'investment it refused to make'). 

 

   /63/ A taxpayer who has no basis in amounts owed to him, for instance, has no deduction when the amount owed is lost or stolen. Collin v. Commissioner, 1 B.T.A. 305, 308 (1925) (explaining why a cash method taxpayer has no tax loss when accrued interest was never in fact received); Alsop v. Commissioner, 34 T.C. 606 (1960) (cash method taxpayer has no tax loss upon discovery of embezzlement of income never taxed). 

 

   /64/ The tax treatment of PSLC, the seller of Summit House, was not before the court in Pleasant Summit, but economic substance, which determines all good tax law, is a consistent and cogent reality for all parties. The economic reality of this transaction is that PSLC is selling partnership K-1 tax schedules to the PSA investors, much like forged records of tax deductions, and selling no meaningful interest in Summit House. Thus the cash contributed by PSA investors that ended up in PSLC's hands should have been ordinary income, as from the sale of a tax avoidance service to customers. Since PSLC in substance continued to own Summit House, the cash originating from tenant apartment rents also should be ordinary income to PSLC, albeit as offset by depreciation deductions appropriate to PSLC's continued ownership of Summit House. None of PSLC receipts were properly treated as capital gain from sale of Summit House because PSLC did not sell Summit House or any part of it. 

 

   There would be no injustice in denying PSLC depreciation deductions, however, notwithstanding the economic substance of its continued ownership. Depreciation is merely a method by which the taxpayer recovers its cost basis and PSLC, like all creditors, has a perfectly fine cost recovery method of its own choosing. PSLC recovered its costs under the installment method as payments are made on the note, which prorates the seller's basis across payments received. The proration of basis if anything tends to be overly generous to seller because the straight line depreciation of basis, usual under the installment method, tends to be faster than the real economic declines in the value of the seller's investment. See, e.g., Chirelstein, Federal Income Taxation: A Law Student's Guide to the Leading Cases and Concepts Para. 6.08, 136-139 (5th edition 1988) (explaining how straight line proration of basis is faster than economic declines). PSLC also recovered its remaining basis when it sold its interest in Summit House in 1985. 

 

   As an administrative matter, moreover, PSLC should not be allowed to impeach its own documents and deny the form chosen after the fact. Under the form of the transaction chosen by the parties, PSA had the depreciable interest in the Summit House buildings. That freely chosen form has to exclude any other party but PSA from claiming the depreciation deductions on the buildings. The ownership of real property, under modern transactions, is so fractionalized that there can be a large number of different kinds of interests in the same land and building, each with some colorable claim to having the depreciable interest. See, e.g., Kronovet, Characterization of Real Estate Leases: An Analysis and Proposal, 32 Tax Lawyer 737 (1979) (arguing that it is impossible to determine the 'true owner' of complexly owned property other than as the parties designate an owner). Either the form the parties choose will exclude everyone but PSA or else all the cacophony of interests will be reporting tax losses as if they each had the depreciable interest. 

 

   /65/ Weiss v. Stearn, 265 U.S. 242, 254 (1924).

 

   /66/ Television Industries v. Commissioner, 284 F.2d 322, 325 (2d Cir. 1960) (Friendly, J.). 

 

   /67/ There is no North Orange, New Jersey. 

 

   /68/ See text accompanying supra notes 29-33 & 37-41. 

 

   /69/ IRC section 183(a). See,e.g., Dean v. Commissioner, 83 T.C. 56, 78 (1984); Elliot v. Commissioner, 84 T.C. 227, 246 (1985) (aff'd 782 F.2d 1027 (3rd Cir. 1986); Surloff v. Commissioner, 81 T.C. 210, 241-243 (1983) Est. of Baron v. Commissioner, 83 T.C. 542, 560 (1984) aff'd 798 F.2d 65 (2d Cir.1986); Flowers v. Commissioner, 80 T.C. 914, 943 (1983); Brannan v. Commissioner, 78 T.C. 471, 513 (1982). See also supra note 5. 

 

   /70/ Est. of Melcher v. Commissioner, 476 F.2d 398 (9th Cir. 1973); Knetsch v. United States, 348 F.2d 932, 938 (Ct. Cl. 1965) (follow-up of the Supreme Court's Knetsch decision holding the leverage in the transaction was a sham); Rev. Rul. 70-333, 1970-1 C.B. 38). 

 

   /71/ Rev. Rul. 57-47, 1957-1 C.B. 23. The status of Federal income tax as a 'tax exempt' sector that means that related costs are nondeductible is illustrated, for instance, by Temp. Treas. reg. section 1.163-9T(b)(2) (1987), which provides that interest paid on underpayments of individual Federal income tax or on indebtedness used to pay such tax is nondeductible 'personal' interest (after phase-out in 1991), regardless of the source of the income generating the tax liability. 

 

   /72/ See, e.g., Page v. Commissioner, 524 F.2d 1149 (9th Cir. 1975) and cases cited therein (corporation's costs of liquidation sale are not deductible because liquidation sale was not taxable). 

 

   /73/ See, e.g., Sager Glove Corp. v. Commissioner, 36 T.C. 1173, 1180 (1961) aff'd 311 F.2d 210 (7th Cir.) cert. denied 373 U.S. 910. 

 

   /74/ See, e.g., Baltimore Transfer Co. v. Commissioner, 8 T.C.1, 7 (1947) (propriety of deduction determined by facts taxpayer knew or had reason to know on last day of the year). 

 

   /75/ See, e.g., Commissioner v. Proctor, 142 F.2d 824 (4th Cir. 1944) cert. denied 323 U.S. 756 (1944) (gift rescinded if subject to gift tax was not validly rescinded). 

 

   /76/ IRC section 183(b)(2). 

 

   /77/ See, e.g., Estate of Franklin v. Commissioner, 544 F.2d 1045, 1049 (9th Cir. 1976). 

 

   /78/ See, e.g., Porreca v. Commissioner, 86 T.C. 821, 847 (1986) (payments characterized as interest were not interest because underlying debt was sham, so payments were treated as capital expenditures). 

 

   /79/ See, e.g., Johnson, Soft Money Investing Under the Income Tax, 1989 Ill. L. Rev. -- (forthcoming 1989) for an explanation of the norm under the income tax, that adjusted basis equal fair market value because the fair market value is an investment that has not been lost.

 

   /80/ Commissioner v. Dill, 294 F.2d 291 (3d Cir. 1961); Virginia Iron Coal & Coke Co. v. Commissioner, 140 F.2d 954 (5th Cir. 1944). 

 

   /81/ Commissioner v. Tufts, 461 U.S. 300 (1983) reh. den. 463 U.S. 1215 (1983). 

 

   /82/ See, e.g., Sen. Fin. Comm., Report on Tax Reform Act of 1976, Sen. Rep. No. 94-938, 94th Cong., 2d Sess. at 49 (1976) (at- risk rules do not affect computation of basis). On passive losses generally, see, e.g., Peroni, Policy Critique of the Section 469 Passive Loss Rules, 62 S. Cal. L. Rev. 1 (1988); Shaviro, Passive Loss Rules, 454 (BNA) Tax Management Portfolios (1989).On at-risk rules generally, see, e.g., Martin & McCrawley, At Risk Rule -- Sections 465 and 46(c)(8), 455 (BNA) Tax Management Portfolios (1989). 

 

   /83/ See, e.g., Schapiro, Sheltering the Revenue from Shelters: A Legislative Proposal Involving the Minimum Tax and Accounting Provisions, 22 Tax Notes 811, 815 (1984) proposing what would become the passive loss limitations by arguing that individuals should pay significant tax on their principal source of income irrespective of their shelters, no matter how nonabusive their tax shelters might be. 

 

   /84/ IRC sections 465(a)(1)(A) & (B) (at risk limited to individuals and closely held corporations); IRC section 469(a)(2) (passive activity loss limitations applied only to individuals, estates, trusts, closely held C corporations, and personal service corporations). 

 

   /85/ IRC section 465(b)(1)(A). 

 

   /86/ IRC section 465(b)(2), subject to section 465(b)(3) (excluding certain borrowing from related parties from at-risk amount). 

 

   /87/ IRC section 469(d)(1). 

 

   /88/ See, e.g., the House passed version of the Revenue Reconciliation Act of 1989, H.R. 3299, section 11965 amending IRC section 469(c) to provide that timber investments are not passive activities even though the investor does not materially participate in the investment. See also IRC sections 465(b)(6)(B)(ii), (D)(ii) (exempting certain seller-provided and government guaranteed loans for real estate from at-risk limitations); section 469(c)(3) (exemption from passive activity rules for certain oil and gas investments), (i)(6) (exemption from passive activity rules for rehabilitation credit and low-income housing credit). 

 

 

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