Ms. Crane inherited all her
husband's property when he died. Unfortunately for Ms. Crane, she also
inherited all of his debt.
Mr. Crane owned a building
that had a $255k mortgage on it, plus $7k in interest.
It was a non-recourse
obligation, which means that if Ms.
Crane didn't pay, they could take the building back, but they couldn't
go after any of Ms. Crane's other assets.
The building was assessed to
be worth exactly the amount of the mortgage, so in a way you could argue
that Ms. Crane acquired $0. She got $262k of building and also $262k of
debt to go with it.
Ms. Crane couldn't keep up with
the payments, and eventually sold the building for the price of the
mortgage plus $2500.
Ms. Crane reported the $2500
on her taxes (half as gross income
and half as capital gains
but don't worry about that). The IRS claimed that Ms. Crane owed a lot more
than that.
The IRS argued that while
the building was originally worth $262k there had been depreciation (and Ms. Crane had taken credit for that depreciation on her taxes), so when Ms. Crane sold it, the
building had lost $28k of value, so Ms. Crane really made a gain of about
$30k.
The Tax Court found for Ms.
Crane. The IRS appealed.
The Tax Court found that
what Ms. Crane had inherited was equity, which is the difference in value of the land and building in
excess of the value of the mortgage. That was $0.
The Appellate Court reversed.
Ms. Crane appealed.
The Appellate Court found
that Ms. Crane didn't inherit equity,
she inherited property.
When the property was sold, she received income equal to the amount of
debt assumed by the purchaser that was in excess of the value of the
building and land.
The US Supreme Court affirmed
and found for the IRS.
The US Supreme Court agreed
with the IRS that what Ms. Crane inherited was property and not equity.
The Court found that when
Ms. Crane sold the house, she made a gain because she sold the property
for more than it was worth.
So Ms. Crane made a profit
even though she didn't actually get any of the money.
When Ms. Crane previously
calculated depreciation on her
taxes, she basically had said that she lost $28k of value on the property
(because she only counted the fair market value of the property in the calculations, not her
equity (which was $0)). So it was inconsistent for her to later say that
she had no equity in the property.
This case stands for the idea
that non-recourse liability will
occupy the same posture for tax purposes as full recourse
liability does.
Basically, a taxpayer is
treated as having realized proceeds from the elimination of a debt even
if that taxpayer had no personal liability for the debt.
