Pelt owned a construction
company. He took out a loan for $1.8M to build an apartment building
(along with some partners including Tufts).
The loan was a non-recourse
obligation. That means that Pelt put
up the building as collateral on the debt. If he didn't pay, then the
bank would get the building, but that's all they could get.
Although he spent the $1.8M
building the building, and even spent an extra $44k of his own money,
because of depreciation and losses, when he was done the building only had
an adjusted basis of $1.455M.
The rental market collapsed,
and Pelt couldn't keep up the payments. He sold the building to a guy
named Bayles for the price of what was left on the mortgage (which was
still $1.8M because apparently Pelt made no mortgage payments).
So basically, Pelt walked
away with nothing at all in his pocket, he just gave the building (and
the mortgage) to Bayles.
At the time of the sale the
building had a fair market value
of only $1.4M.
Why Bayles would pay $1.8M
for a building that was only worth $1.4M is a mystery...
The IRS and Pelt disagreed on
how much taxes Pelt had to pay.
Pelt argued that at the time
he sold the building (because of depreciation) his adjusted basis was $1.455M. Since it was only worth $1.4M
when he sold it, he lost $55k.
The IRS argued that Pelt had
given up property with a basis of
$1.455M, but in exchange he
no longer had to pay off a $1.8M mortgage. Therefore he actually made
almost $400k!
The Tax Court found for the
IRS. Pelt appealed.
The Appellate Court reversed.
The IRS appealed.
The US Supreme Court reversed
and found for the IRS.
The US Supreme Court looked
to Crane v. Commissioner (331
U.S. 1 (1947), which said that a taxpayer must incorporate the amount of
mortgage debt liability transferred when calculating "amount
realized" in a property disposition.
The Court noted that the
fair market value of the property at the time of sold is irrelevant.
Basically, this case said that
if you have a loan for more than the property is worth, and you give up
the property in exchange for getting out of paying the loan, then the
amount of money you've earned is the amount of the loan minus your adjusted
basis in the property.
So in this case, that's
$1.8M - $1.455M.
Note that the majority
opinion was that all of the $1.455M is considered 'disposition of
property' which is subject to the capital gain rate, and is not taxed as ordinary
income.
On the other hand, in a
concurrence, it was argued that there should be a complex bifurcated
transaction, where the property transaction should be taxed at the
capital gain rate, and the discharge of debt transaction should be taxed
as ordinary income.
