Capital gain results when secured property is sold and proceeds are assigned to creditor in satisfaction of debt.

Briarpark Ltd., TC Memo 1997-298, illustrates how a taxpayer may be able to control the taxation of the sale of a secured asset and the assignment of the proceeds to the secured creditor, coupled with a related forgiveness of the nonrecourse debt. Briarpark provides an opportunity to get desired treatment with proper structuring but also creates uncertainty as to how far a court will go in treating two transactions as one.

Typically, a bank does not want to own the property securing a nonrecourse, nonperforming loan that has declined in value. Instead, the bank will request (or require) that the debtor sell the property and assign the sales proceeds to the bank. In return, the bank will release its interest in the property securing the loan.

Example: D owns Blackacre in which it has a $50 basis; its fair market value (FMV) is $20. D owes Bank $100 (a nonrecourse note), secured by Blackacre. D and Bank both want to retire the debt, but the Bank does not want Blackacre. The Bank agrees to release its security interest and forgive the remaining debt when D finds a buyer and assigns the proceeds to the Bank.

Generally, taxpayers have treated this as two separate transactions. First, the sale to a buyer for $20 would result in a $30 capital loss ($50 basis-$20 received). Second, the assignment of the $20 sales proceeds in satisfaction of the $100 note would be treated as $80 of discharge of indebtedness income (DOI), pursuant to Sec. 61(a)(12) (see, e.g., Liberty Mirror Works, 3 TC 1018 (1944)). If, instead, D merely deeded the property to the bank in lieu of a foreclosure, a disposition would occur resulting in a $50 capital gain ($100 received -- $50 basis); see Tufts, 461 US 300 (1983), holding that the amount realized on the disposition of real property subject to a nonrecourse debt included the full amount of the note assumed by the purchaser, even though the note exceeded the property's fair market value. See also Regs. Sec. 1.1001-2(a), which provides that the amount realized from a sale of property includes the liabilities from which the transferor is discharged as a result of the sale.

Briarpark involved a transaction similar to the example. A bank agreed to discharge a nonrecourse loan secured by property only if it were sold and the proceeds of the sale were assigned to it. Specifically, the bank required a minimum sales price, assignment of the proceeds to it, the transfer of Briarpark's cash reserves and a cash payment by one of Briarpark's partners. The buyer agreed to purchase the property only if the creditor bank discharged the debt. Initially, the Tax Court stated that whether a taxpayer recognizes gain from the disposition of property or DOI income depends on the facts and circumstances. The court viewed the sale and discharge of debt as a single, integrated transaction because both the (1) purchase of the property was conditioned on the bank releasing its security interest and (2) discharge of the liability was conditioned on the receipt of sales proceeds. The court stated that any difference between Briarpark's transactions and that described in Tufts was in form only, not substance. Accordingly, the debtor realized an amount equal to its obligation to the bank, and thus had gain under Sec. 61(a)(3) and Regs. Sec. 1.1001-2, not DOI income. In Briarpark, the taxpayer actually wanted DOI income (probably to take advantage of an exclusion under Sec. 108). The taxpayer argued that Regs. Sec. 1.1001-2(a) did not apply because the buyer did not actually assume the liability; in that case, presumably, the debtor would not have had the liability discharged as the result of the sale. However, the court found no need for the buyer to assume the liability; the debt was discharged as a result of the sale because the sale and the discharge were one transaction. Finally, the court distinguished Liberty Mirror Works, stating that in Liberty, the Tax Court decided that the excess amount of discharged debt over the sale price was a gift, not DOI income (as was the issue in Briarpark). Because the court in Liberty found the disputed amount to be nontaxable, the issue of the character of the income of that amount did not arise. This is a somewhat disingenuous argument, because the court in Liberty bifurcated the transaction that would have created DOI income if such income was not found to be a gift.

As stated in Briarpark, the tax treatment of the sale of secured property, assignment of the sales proceeds to the secured creditor and the discharge of the debt secured by the property, is dependent on the facts and circumstances. If the discharge of the loan is contingent on the assignment of the sales proceeds to the secured creditor and the sale is contingent on a subsequent discharge, it should follow that Briarpark will control to characterize the sale and discharge as a single integrated sale and discharge. In addition, one may also obtain DOI income treatment pursuant to the rationale in Briarpark if the discharge is not conditional on the sales proceeds. Capital gain treatment will generally be more favorable if the taxpayer has offsetting capital losses or if an individual taxpayer cannot exclude the DOI income under one of the Sec. 108 exclusions.