Part E. Recognition of Gains and Losses—Selected Issues

• Pages: 357-416
• Author: Marvin A. Chirelstein,Lawrence Zelenak

357

Part E

RECOGNITION OF GAINS AND

LOSSES—SELECTED ISSUES

Enough has been said about the computation of gains and losses

from sales of property to require at this point no m ore than a brief

recapitulation of Code nomenclature. Section 1001(a) provides that

“gain or loss ” shall be the difference between the “amount realized”

from a “sale or other disposition of property” and the taxpayer’s

“adjusted basis” for the property sold. The term “amount re alized” is

defined in § 1001(b) to include not only cash but the “fair market

value” of any other property received, so that by implication the

receipt of consideration in kind is regarded as a realization which

generates gain or loss. Section 1011 states that “adjusted basis”

means “basis”—usually “cost” as provided in § 1012, but capable of a

good many special formulations (see 13.01 nex t following, for

example) depending on the circumstances —as “adjusted” under

§ 1016. Section 1016 contains a lon g list of required additions to or

subtractions from original cost which are designed to give effect to

inclusions, exclusions, deductions or disallowances prescribed by

other substantive Code provisions. Of the adjustments listed in the

section the most important for the discussion below is that contained

in subsection (a)(2), w hich provides that the basis of depre ciable

property (such as buildings and machinery) shall be reduced from

year to year by the amount allowable as a deduction for “exhaustion,

wear and tear, obsolescence, amortization, and depletion.”

Having thu s determined the amount of gain or loss by simple

computation, the next que stion would be whether or not the gain or

loss had been “realized” as a result of the event that occurred.

Although the Code says little directly about the realization

requirement, it is well understood that “mere” property appreciation

or decline is not regarded as a realization of gain or loss. As stated

earlier, the income tax is a tax on transactions, not on income as such.

Largely be cause of its ambiguous and artificial character, the

realization requirement has generated a good many difficult

problems of interpretation. A sampling of these was offered in Section

5, above, and the present Part adds some further illustrations.

Assuming there is a realization in the form of a “sale” of property

for cash or an “exchange” o f one property for another, § 1001(c) then

requires that the realized gain or loss be “recognized” (unless

otherwise provided) and taken into account in determining the

358

RECOGNITION OF GAINS AND

LOSSES—SELECTED ISSUES

PT. E

taxpayer’s tax liability.

1

While “realization” and “recognition”

generally run together, there are a number of transactions which

involve a clear realization of gain or loss but for which the Code

specifically provides non-recognition (sometimes optionally).

Leasehold termin ations (5.03) and “involuntary conversions” (2.04)

are examples that have already been considered. In these and other

instances Congress evidently considered that the realization rule or

the income definition created hardships when rigorously applied, and

it chose instead to protect the gain or the income from immediate

recognition or inclusion. In other situations—li ke-kind exchanges,

for examp le, and certain corporate me rgers—the “exchange” is

regarded as involving no real alteration in the character of the

taxpayer’s investment despite a technical or formal change, and

again immediate recognition of gain or loss is specifically avoided. In

most non-recognition cases, the taxpayer ’s basis in his original

property is carried over to the newly acquired property. The ov erall

effect, then, is a deferral of the gain o r loss, rather than total

forgiveness or permanent disallowance.

Assuming all of these preliminary co nsiderations a re disposed

of—i.e., there is a realization of gain or loss and it is not deferred by

a non-recognition provision of any sort—the next and final question

would be whether the special regime that has been established for

capital gains and losses is applicable because of the nature of the

asset sold. This issue substanti ally overshado ws the others in

importance and complexity, and although closely and curiously

linked to some of the mechanical questions taken up in this Part, it

is simply too extensive to be handled as part of a Part. Hence, our

treatment of property sales is carried out in two steps, with the

present Part E being given over to realization and recognition

questions (largely involving real estate transactions) and Part F

being devoted entirely to capital gains and losses.

13. Transactions in Mortgaged Property

Most real estate purchases are financed by mortgage loans,

whether obtained from a bank or other institutional lender or from

the seller of the property himself if he is willing to hold the

purchaser’s obligation. Th e property acquired stands as security for

the loan, and in the event of a default in payment of interest or

principal by the borrower-mortgagor the lender-mortgagee may

foreclose on the security, dispose of it a t auction, and apply the

proceeds to the debt. Any excess of foreclosure proceeds over the

1

As indicated at 6.06, losses are deductible only if specific authorization can be

found therefor, e.g., in § 165. Losses from the sale of property held for personal use—

say the family car—are not allowed; but see discussion at 15.02, below.

SEC. 13

TRANSACTIONS IN MORTGAGED PROPERTY

359

amount due (there rarely is any) is returned to the debtor. Any

deficiency can be enforced against the debtor’s other assets if (as

would usually be true in the case of a homebuyer) the debtor assumes

personal liability for the loan. If no such personal liability is provided

for (as noted below, commercial property mortgages are often

nonrecourse, meaning that the lender’s sole security is the property

itself), then the deficiency simply becomes the lender’s loss.

The mortgage loan itself i s usually repayable—amortizable—in

equal installments (monthly, quarterly, etc.) over a stated term of

years. As has been noted (2.02), the early payments consist largely of

interest on the outstanding principal, while the later payments

consist largely of principal itself. If the property-owner sells his

property before the mortgage has been fully amortized, the sale

proceeds go first to satisfy the mortgage debt—the mortgagee being

in the status of a senior security-holder—with only the balance going

to the mortgagor, the owner of the equity. In some instances,

especially w here commercial property is concerned, the new

purchaser will simply assume (or take the pro perty subject to) the

outstanding mortgage and carry out the establi shed amortization

schedule, in which event the residual cash component goes entirely

to the equity-owner. The amount received by the equity-owner after

satisfaction or assumption of the mortgage would reflect his initial

cash investmen t in the property plus subsequent payments of

mortgage principal, plus or minus any change in market value during

the period of his ownership.

The subsection that follows raises an important tax question

which relates in particular to mortgages on commercial property. In

brief, the question is whether an investor who purchases real estate

financed by a nonrecourse mortg age can take depreciation in the

same way, and in the same amount, as if the purchase was entirely

self-financed. The answer is affirmative, as will be seen, and on it, to

a considerable degree, rests the phenomenon called the “tax shelter.”

Mortgages are considered further in connection with the

realization requirement at 13.03 and 13.04. The question o f what

constitutes a borrowing is revived with respect to sale-and-leaseback

transactions at 15.01.

13.01 Nonrecourse Debt and the Depreciation

Allowance; the Crane Rule

It may have occurred to the reader at various points that debt

plays a peculiarly controversial role in the tax law, and this is

nowhere truer than in regard to its effect on the depreciation

allowance. As sugg ested just above , many commerc ial real estate

investments—apartment buildings, office buil dings, shopp ing