Debt and Property

• Author: Deborah A. Geier
• Pages: 324-349

Chapter 11: Debt and Property

The primary focus of this chapter is to explore the tax consequences of (1) the purchase of

property with debt, (2) the transfer of property (other than by gift) subject to debt, and (3) the

reduction of debt secured by property without a transfer of that property. Before we proceed to

consider those issues, however, let’s set the stage by considering the more straightforward tax

consequences of debt repayment with property in kind, instead of with cash.

Suppose that Kent borrows $10,000 in cash from Kathy for five years at market-rate interest

and that this debt is a bona fide debt. When the $10,000 principal repayment is due, Kathy agrees

to accept Blackacre with a fair market value (FMV) of $10,000 from Kent rather than $10,000 in

cash. Blackacre is not encumbered by any debt. Rather, Kent is simply using Blackacre to repay

his $10,000 debt, rather than using cash to repay it. Assume that Kent’s basis in Blackacre is

$7,000. The $3,000 built-in gain in Blackacre was ignored under the realization requirement while

Kent owned the property, but now he is disposing of that property in satisfaction of a debt.

You learned in Chapter 8 in connection with Davis v. Commissioner1 that the transfer of

property in satisfaction of a debt is a realization event under § 1001. Therefore, when Kent transfers

Blackacre to Kathy in satisfaction of his $10,000 debt, Kent realizes a $3,000 gain under § 1001,

equal to the difference between the $10,000 FMV of the property that he transfers in satisfaction

of his debt and his $7,000 basis in that property. If Blackacre is a capital asset, this realized gain

is capital gain under § 1222.

This outcome ensues notwithstanding the language in § 1001(b), which provides that the

“amount realized” on the transfer of property (from which adjusted basis is subtracted to reach

either “gain” or “loss”) is equal to the “sum of money received plus the fair market value of the

property (other than money) received.” In form, Kent does not receive “money” or “property” from

Kathy in exchange for Blackacre. Yet, in substance, the transaction is treated as though he (1) sells

Blackacre for cash equal to its $10,000 FMV—comfortably producing an “amount realized” of

$10,000 under the language in § 1001(b)—and (2) uses that $10,000 in deemed cash to repay the

$10,000 that he owes to Kathy (with no tax consequences for either party on the debt repayment).

The transfer of property in s atisfaction of a debt is recast as a sale for cash for purposes of § 1001(b)

because of the “economic benefit” that Kent enjoys by having his $10,000 debt retired with

Blackacre’s $10,000 FMV (unlike a transfer by gift, which is not a realization event).

This construct also governs the analysis of Kathy’s cost basis in Blackacre under § 1012. She

is treated as having taken that $10,000 in cash deemed received from Kent in repayment of his

debt to her and using it to purchase Blackacre, which she now owns, for $10,000, producing a

$10,000 cost basis under § 1012.

Now suppose that Blackacre is worth only $8,000, which means that Kent must transfer $2,000

of cash, in addition to Blackacre, to repay his $10,000 debt. The repayment of $2,000 of his debt

with cash has no tax consequences for either party, but Kent realizes a $1,000 gain under § 1001,

equal to the difference between his $7,000 property basis and its $8,000 FMV because he repays

$8,000 of his $10,000 debt with that property. If Blackacre is a capital asset, Kent’s $1,000 realized

1 370 U.S. 65 (1962). Davis led to the enactment of § 1041, but that provision applies only to transfers between spouses

or former spouses incident to divorce.

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gain is capital gain. Kathy takes an $8,000 cost basis in Blackacre, as she is treated as having taken

$8,000 of the $10,000 in actual and deemed cash received from Kent and using it to purchase

Blackacre for its $8,000 FMV. (Kathy also has $2,000 in cash, which always has a basis equal to

face amount.)

Next iteration: Blackacre is again worth $10,000 (the full amount owed to Kathy), but Kent’s

basis in Blackacre is $14,000 instead of $7,000. Kent realizes a $4,000 loss under § 1001 on the

transfer of Blackacre to Kathy in satisfaction of his $10,000 debt to her, as though he receives

$10,000 in cash on a deemed sale and uses that cash to repay Kathy. Only if Blackacre is business

or investment property would Kent’s loss be deductible under §§ 165(c)(1) or (2). If the loss is

deductible and Blackacre is a capital asset in Kent’s hands, Kent’s loss is a capital loss, subject to

the § 1211(b) capital loss limitation rule applicable to otherwise deductible capital losses. Kathy,

as before, takes a $10,000 cost basis in Blackacre under § 1012.

Finally, suppose that Kent, in severe financial distress, transfers Blackacre, worth only $8,000

but with a $7,000 basis in Kent’s hands, to Kathy in satisfaction of his $10,000 debt, and Kathy

agrees to cancel the remaining $2,000 debt. As before, Kent is treated as selling Blackacre for

$8,000 in cash (Blackacre’s FMV) and using that $8,000 in deemed cash to fully settle his debt

with Kathy. The deemed sale for $8,000 in cash again produces a $1,000 realized gain under §

1001, which is capital gain if Blackacre is a capital asset in Kent’s hands. In addition, Kent also

realizes $2,000 of § 61(a)(12) debt-discharge income, as you learned in Chapter 10, which is

ordinary income because it does not arise on the sale or exchange of a capital asset. Generally,

Kent could exclude this § 61(a)(12) income only if he is either insolvent or in bankruptcy court,

with tax attribute reduction equal to $2,000 under § 108(b) resulting in effective deferral only. If

the debt satisfies the “worthlessness” standard, Kathy is entitled to a $2,000 bad-debt deduction

under § 166.

In the above scenarios, Kent did not purchase property with debt. Nor did he transfer property

to another subject to debt. What if he did? Part A. explores the purchase of property with borrowed

money. Part B. considers the tax consequences of transferring property subject to encumbering

debt to another. Finally, Part C. considers the tax consequences of a reduction in debt encumbering

property without a transfer of the property.

A. The purchase of property with

borrowed money—the front-end rule in Crane

Suppose that Cain, who owns Blackacre, lists it for sale for $100,000. Connie, who wishes to

purchase Blackacre, borrows $80,000 from National Bank and, together with $20,000 of her own

previously saved (after-tax) cash, purchases Blackacre for its $100,000 purchase price in Year 1.

What is Connie’s basis in Blackacre in Year 1? We know for certain that it should be at least

$20,000, as Connie spent $20,000 of her own cash—a nondeductible capital expenditure. The

denial of a deduction for her $20,000 outlay (because it is a capital expenditure) clearly creates

basis to that extent. We also know, however, that Connie is entitled to exclude from her Gross

Income the $80,000 of borrowed cash under the borrowing exclusion. Thus, $80,000 of the

purchase price represents pre-tax dollars, instead of after-tax dollars. Should that $80,000 of

untaxed dollars create basis?

In Chapter 1, you learned that basis generally is a running record of previously or concurrently