Does the freeing of assets theory have vitality?

• Author: Orbach, Kenneth N.

Pursuant to Sec. 61(a)(12), a taxpayer generally must include as gross income any income derived from discharge of indebtedness. This rule is of judicial origin. In the seminal case of Kirby Lumber Co., 284 US 1 (1931), the taxpayer corporation issued its own bonds at par. Later in the same year, it purchased some of those bonds on the open market for less than par. The Supreme Court held that the taxpayer had income of the difference. "As a result of its dealings it made available ... assets previously offset by the obligation of bonds now extinct." (Emphasis added.) Thus was born the freeing of assets theory as a rationale for justifying cancellation of debt (COD) income.

The Board of Tax Appeals picked up on the freeing of assets theory in Fulton Gold Corp., 31 BTA 519 (1934). The taxpayer purchased property in 1920, subject to a mortgage that the taxpayer did not assume. Two years later the taxpayer satisfied the nonrecourse debt at less than face value. The taxpayer sold the property in 1929. At issue was the property's basis at the time of sale. The B that the property's basis had to be reduced by the debt discharged. "[P]ayment of the (nonrecourse] mortgage did not result in the liquidation of a personal debt. By it [the taxpayer] merely satisfied an encumbrance on property in which it had an equity and there was no release of assets |previously offset by the obligation' of the notes or bonds evidencing the debt secured by the mortgage." (Emphasis added.)

Practitioners have relied on Fulton Gold in order to reduce the basis of securing property (rather than realize COD income) whenever nonrecourse debt is discharged, at least when, and to the extent that, the debt exceeds the property's fair market value (FMV).

Recently, however, the freeing of assets theory has received a thrashing from both the IRS and the judiciary. For example, in Est. of Newman, 934 F2d 426 (2d Cir. 1991), the Second Circuit specifically stated that the Kirby Lumber freeing of assets rationale was "discredited." Moreover, the court prescribed a modern alternative theory under which the discharge of a debt for less than face is income to the debtor, because the borrowed funds were excluded from the debtor's gross income when first received; on relief from the obligation, "the basis for the original exclusion thus evaporates" (Centennial Savings Bank FSB, 499 US 573 (1991); see also Tufts, 461 US 300 (1983)).

In Gershkowitz, 88 TC 984 (1987), the Tax Court held...