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Does the freeing of assets theory have vitality?

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 that the extinguishment of a $250,000 nonrecourse debt, secured by property with a value of $2,500 and an adjusted basis of $50,000, for $40,000 cash (creditor released its security interest in the property), resulted in COD income of $210,000 ($250,000 debt minus $40,000 cash). The Gershkowitz court did not explicitly overrule Fulton Gold; however, its conclusion is clearly contrary to Fulton Gold and the freeing of assets theory, but is consistent with the modern alternative theory.

The Service, in turn, has taken the position that Tufts and Gershkowitz have rejected Fulton Gold. In Rev. Rul. 91-31, a $1 million nonrecourse debt was secured by property with an $800,000 FMV. The creditor (who was not the seller of the property) agreed to modify the note terms by reducing its principal to $800,000. Since the amount of the nonrecourse debt that had been discharged reduced the obligation to the value of the securing property, no assets had been "freed." Rejecting Fulton Gold, the IRS ruled that the debtor realized $200,000 of COD income under See. 61(a)(12). This result is consistent with the modem alternative theory. (Nor does the debt reduction under these facts result in a purchase price adjustment that reduces the property's basis under Sec. 108(e)(5), "in the absence of an infirmity that clearly relates back to the original sale;" see Rev. Rul. 92-99.) Of course, once it is determined that Sec. 61(a)(12) applies, the applicability of Sec. 108 must be considered. In particular, the new qualified real property business indebtedness rule of Sec. 108(a)(1)(d) and (c) may be relevant.

Recently, the Tax Court in Gehl, 102 TC No. 37 (1994), added another wrinkle (or reaffirmed an old wrinkle) to the freeing of assets theory. The taxpayer transferred property to a creditor in satisfaction of a recourse obligation. The principal amount of the indebtedness exceeded the transferred property's FMV, which in turn exceeded the property's adjusted basis. The taxpayer was insolvent both before and after the transfer (and thus the discharge did not free assets).

In light of Regs. See. 1.1001-2(a)(2) and (c), Example (8), the IRS conceded that the excess of debt over the transferred property's FMV constituted COD income, excludible under Sec. 108. Furthermore, it is well settled that the property transfer is a sale or exchange and that the excess of the property's FMV over the property's adjusted basis is taxable gain. The issue was whether the taxable gain should be treated as Sec. 61(a)(3) gain derived from property dealings (and therefore includible as gross income) or as Sec. 61(a)(12) COD income (excludible under Sec. 108 due to the taxpayer's insolvency). In holding that the taxable gain was includible in gross income under Sec. 61(a)(3), the court "rejected the test of lack of economic gain because of insolvency ... or, in other words, the absence of any freeing of [the taxpayer's] assets."

Put another way, the freeing of assets theory, to the extent it has any vitality, applies only to COD income and not to other types of income.

It is important to point out that the freeing of assets rationale of Kirby Lumber and Fulton Gold has not explicitly been judicially overruled. However, subsequent cases and administrative pronouncements have put the theory's remaining vitality into serious question. In its stead, a modern alternative theory has been espoused.
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Author:Orbach, Kenneth N.
Publication:The Tax Adviser
Date:Sep 1, 1994
Words:999
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