AuthorKahn, Douglas A.

    The transfer of property subject to a nonrecourse liability (1) is treated for tax purposes essentially as if the transferor received cash from the transferee in the amount of the liability. (2) In the context of transfers to corporations that are subject to a nonrecognition provision in the Code, a nonrecourse liability to which the transferred property is subject is treated as boot, (3) which, unless a statute provides otherwise, can cause the recognition of gain or a reduction of basis in the property received by the shareholder in exchange. As to the recognition of gain, it would frustrate the purpose of many nonrecognition provisions to require recognition when transferred property is subject to a debt. To prevent that from occurring in specific transactions, Congress included several provisions in the Code to prevent the recognition of gain. (4) In such cases, the liability is not ignored; instead of causing gain however, it reduces the basis of certain properties. (5) It is still treated as cash received by the transferor, but it does not usually cause the recognition of gain. Instead, the basis of properties received by the transferor in the exchange is reduced.

    The Code provision dealing with liabilities in the context of a reorganization (6) or a transfer to a controlled corporation is [section] 357. (7) The reference to a transfer to a controlled corporation is to an exchange described in [section] 351. Section 351 provides nonrecognition for a transfer by one or more persons to a corporation in exchange solely for stock of that corporation if immediately afterwards the transferors are in control (8) of the corporation. If, in addition to stock, a transferor receives other property (9) (i.e., boot), any realized gain is recognized but only to the extent of the amount of the boot. (10) For purposes of that provision, nonqualified preferred stock (11) is not treated as stock and so can cause gain recognition. Subject to a few exceptions, the basis of the property transferred to the controlled corporation is the same as the transferor's basis in that property increased by any gain recognized by the transferor. (12)

    This Article explores the tax treatment of cross-collateral nonrecourse debt. There has been little written on such treatment by either the Service or academics. When using the term cross-collateral debt, we are referring to nonrecourse debt that is connected with more than one piece ofproperty. (13) While tax issues concerning cross-collateralized properties can arise in several circumstances, the focus of this Article is on the tax treatment of a transfer of property subject to a cross-collateralized nonrecourse liability to a controlled corporation in exchange for stock that qualifies for some or all nonrecognition under [section] 351. For convenience, we refer to those exchanges as "[section] 351 exchanges." The Article also discusses two other tax issues involving cross-collateralized nonrecourse liability--namely, cancellation of debt and determination of basis issues.


    In a [section] 351 exchange, the transferor's basis in the stock received is equal to the basis of the assets transferred to the corporation increased by income recognized by the transferor and reduced by the amount of boot received. (14) For this purpose, the transferee's "assumption" (15) of a liability is treated as cash received by the transferor and so reduces the basis the transferor has in the corporation's stock. (16)

    Section 357(a) provides that, subject to two exceptions, (17) for the purpose of gain recognition a transferee corporation's "assumption" (18) of a liability in a [section] 351 exchange is not treated as cash. Instead, the liability will reduce the basis of the stock that the transferor received in exchange. The operation of those provisions is shown in the illustrations below.

    Ex. (1): Helen formed the X corporation. In exchange for 100 shares of X stock, Helen transferred Blackacre to X. Helen had a basis of $250,000 in Blackacre, which had a fair market value of $600,000. Blackacre was subject to a mortgage of $130,000, and X took Blackacre subject to that mortgage. Helen had no personal liability for the mortgage debt which therefore was a nonrecourse debt. While Helen realizes a gain of $350,000, the $130,000 mortgage liability does not cause Helen to recognize any of that gain. Instead, it reduces her basis in the X stock that she receives. Helen's basis in the 100 shares of X stock is $120,000 (her $250,000 basis in Blackacre less the $130,000 mortgage debt). (19) Ex. (2): The same facts as those stated in Ex. (1) except that Helen's basis in Blackacre was only $100,000. The $130,000 mortgage debt is greater than Helen's basis in Blackacre. If the liability did not cause Helen to recognize a gain, she would have a negative basis of ($30,000) in the X stock. Congress frowns upon a negative basis, and to prevent it occurring in a [section] 351 exchange, Congress added [section] 357(c) to the Code. (20) That provision requires a transferor to recognize income to the extent that the sum of the liabilities assumed by the corporation exceed the total adjusted basis of the properties transferred by that transferor. So, Helen will recognize income in the amount of $30,000. Helen's basis in the X stock will be zero (Helen's $100,000 basis in Blackacre plus $30,000 income recognized minus the $130,000 liability). In 1999, Congress made several amendments to the Code that changed the treatment of both recourse and nonrecourse liabilities for purposes of a number of provisions, including [section] 351 exchanges. (21) Section 357 was changed to require that a liability be "assumed" to be taken into account under that section and specified other provisions. (22) The term "assumed" was given a special definition in [section] 357(d) that is not the same as the usual meaning of that term. In this Article, we will focus only on the treatment given to nonrecourse liabilities. (23)

    Section 357(d)(1)(B) provides that, for purposes of that section, a nonrecourse liability secured by a transferred asset will be treated as assumed by the transferee. So, that liability will be treated in accordance with the treatment described above--i.e., in general, it will not cause gain recognition but will reduce the transferor's basis in the stock received in the exchange. Where two or more properties are security for the same debt, and where only one of the properties is transferred in a [section] 351 exchange, the amount of liability assumed by the corporation is subject to a reduction under [section] 357(d)(2). If the provision for a reduction does not apply, the entire amount of the debt is treated as assumed by the transferee corporation. So, the default rule is that the entire amount of the liability is deemed to be assumed. The reduction of assumed liability applies only if there is an agreement between the party owning the other property and the transferee corporation. The statute does not spell out the conditions for making a valid agreement. The cross-collateralization problem at which [section] 357(d)(2) is aimed is illustrated in the following two examples.

    Ex. (3): Randolph owned Blackacre with a fair market value of $400,000 and a basis of$180,000. Randolph also owned Whiteacre with a fair market value of $400,000 and a basis of $80,000. Randolph borrowed $200,000 from the Friendly Bank on a nonrecourse loan which was secured by both Blackacre and Whiteacre. Randolph subsequently created the X corporation and transferred Blackacre to X in a [section] 351 exchange for stock. Randolph retains ownership of Whiteacre. Blackacre was transferred subject to the outstanding $200,000 debt to the Friendly Bank. There was no agreement between Randolph and X as to how much of that debt Randolph agreed, and is expected, to pay. Ex. (4): The same facts as those in Ex. (3) except that Randolph created both the X and Y corporations. Randolph transferred Blackacre to X and Whiteacre to Y in [section] 351 exchanges for stock. The properties were transferred subject to the outstanding $200,000 debt to the Friendly Bank. There was no agreement between Randolph and X as to how much of that debt Randolph agreed, and is expected, to pay. The questions posed by Ex. (3) are how much of the $200,000 debt should be deemed to have been assumed by the X corporation that acquired Blackacre and how much remains with Randolph since he continues to hold Whiteacre. The same issue arises in Ex (4) where the questions are how much of the liability has been assumed by X corporation that acquired Blackacre and how much has been assumed by Y corporation that acquired Whiteacre. In a 1987 Private Letter Ruling, (24) the Service ruled that the debt is to be divided between the two properties, but the Service did not indicate how the amount allocated to each property is to be determined. A 1990 Private Letter Ruling (25) revoked the 1987 ruling and stated that it was incorrect. The 1990 ruling did not explain how the cross-collateralized debt was to be treated. A strong inference from that revocation is that each property is deemed to be subject to the entire amount of the $200,000 debt.

    The amendment to [section] 357(d) that was made by the 1999 Act makes it certain that unless the exception in that provision applies, the entire amount of the debt will be treated as assumed. (26) Section 357(d) (1)(B) states "except to the extent provided in paragraph (2), a nonrecourse liability shall be treated as having been assumed by the transferee of any asset subject...

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