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The untold story of Crane v. Commissioner reveals an inconvenient tax truth: useless depreciation deductions cause global basis erosion to bait a hazardous tax trap for unwitting taxpayers.

Facts not discussed in the Supreme Court's decision in Crane v. Commissioner (much better known for Footnote 37) reveal an inconvenient tax truth of a hazardous tax trap for unwitting taxpayers (the "Basis Reduction Tax Trap"). For seven years, Beulah Crane operated an apartment building at a loss. For that reason, the substantial amount of allowable depreciation deductions on the building produced minimal tax benefits for her. Notwithstanding the lack of tax benefits, the basis of the apartment building was reduced by the depreciation deductions pursuant to section 1016(a)(2) of the Internal Revenue Code. Under threat of foreclosure, Beulah sold the apartment building for less than its original value. Thus in spite of realizing a loss, she was compelled to recognize phantom gain attributable to those useless depreciation deductions.

In her unsuccessful challenge of the gain she was obligated to recognize, Beulah did not question the propriety of the basis reduction. Yet, even had she done so, there was long-standing judicial precedent holding basis reduction was mandatory even if the corresponding depreciation deduction produced no tax benefits for the taxpayer. The underlying rationale of this judicial precedent, however, was that the mandatory basis reduction is necessary to prevent taxpayer abuse of the depreciation deduction. Conversely, in the context of the Basis Reduction Tax Trap, the abuse goes the other way, as the mandatory basis reduction causes the conversion of useless depreciation deductions into punitive phantom taxable gain.

Thus, the purpose of the article is to expose the inequities of the Basis Reduction Tax Trap and to advocate the amendment of the Code by incorporating tax benefit components to eliminate it without compromising the integrity of the depreciation deduction. This could be accomplished by creating a new Gain Basis to be reduced only by those depreciation deductions that produced tax benefits. By utilizing the Gain Basis as the subtrahend in the gain computation formula, the Basis Reduction Tax Trap would be eliminated as no gain attributable to useless depreciation deductions would ever be triggered. Because current law basis would continue to serve all of its other functions, the integrity of the depreciation would be preserved from taxpayer abuse.
TABLE OF CONTENTS

      INTRODUCTION                                                563

I.    THE FOUR WAYS THE SECTION 1016(A)(2) BASIS REDUCTION        570
      PRESERVES THE INTEGRITY OF THE DEPRECIATION DEDUCTION

      A. Tracking the Declining Balance of Depreciation           570
         Deductions over the Remaining Tax Years of the Recovery
         Period

      B. Precluding a Second Opportunity to Receive the Tax       571
         Benefit of a Depreciation Deduction that Did Not
         Produce a Tax Benefit in Prior Tax Years

      C. Preventing a Taxpayer from Receiving the Tax Benefit of  572
         a Nonexistent Loss when Tax Depreciation Exceeds
         Economic Depreciation

      D. Preventing a Taxpayer Who Claims Excessive Depreciation  574
         Deductions that Produce Tax Benefits from
         Over-Depreciating the Property's Original Cost

II.   HOW THE BASIS REDUCTION TAX TRAP SNARED BEULAH CRANE        574

      A. Step One: Over the Seven Years in Which Beulah Operated  575
         the Apartment Building, the Allowable Depreciation
         Deductions Produced Minimal Tax Benefits for Beulah and
         Her Husband's Estate

      B. Step Two: Sale of the Brooklyn Apartment Building        578
         Triggered the Transformation of Useless Depreciation
         Deductions into Taxable Gain

III.  WHY CRANE HAS NOT EMERGED AS THE PREEMINENT SUPREME COURT   582
      CASE TO SHOW THE HARSH TAX CONSEQUENCES OF THE BASIS
      REDUCTION TAX TRAP

      A. Depreciation Deductions and Corresponding Basis          582
         Reduction Played No Part in Beulah's Creative Reporting
         Position

         1. Beulah Reported the Transaction as the Sale of a      582
            Nondepreciable Equity Interest in the Brooklyn
            Apartment Building for Net Monetary Consideration
            of $2,500

            a. Nondepreciable Equity Interest in the Brooklyn     583
               Apartment Building

            b. The Date-of-Death Pair Market Value and Basis of   583
               the Nondepreciable Equity Interest Was Zero

            c. The Amount Realized Was Limited to the Net         584
               Monetary Consideration Beulah Received from the
               Buyer

        2. Beulah's Defense of Her Reporting Position Did Not     585
           Focus on the Inequity of the Section 1016(a)(2) Basis
           Reduction by Useless Depreciation Deductions

      B. The Double Deduction Myth Becomes Reality                588

         1. The Supreme Court's Disapproval of Beulah's           588
            Reporting Position Created the Double Deduction Myth

         2. Two Courts Seize upon the Double Deduction Myth as    591
            Being the Rationale for the Crane Decision

IV.   THE RATIONALE OF THE NO TAX BENEFIT DECISIONS SHOULD BE     595
      LIMITED TO PRESERVING THE INTEGRITY OF THE DEPRECIATION
      DEDUCTION

      A. United States v. Ludey Launches the No Tax Benefit       596
         Decisions

      B. The Second Circuit Explains that Ludey Mandated a Basis  597
         Reduction by Depreciation Deductions Even if they
         Produced No Tax Benefits

      C. Kittredge v. Commissioner and Beckridge Corporation v.   598
         Commissioner: Two Second Circuit No Tax Benefit
         Decisions in Which the Taxpayer Was Snared by the Basis
         Reduction Tax Trap

      D. Virginian Hotel Provides the Final Validation of the     600
         Rationale of the No Tax Benefit Decisions

V.    SEARCHING FOR A TAX BENEFIT PRINCIPLE APPROACH TO           602
      ELIMINATE THE BASIS REDUCTION TAX TRAP

      A. Tax Benefit Components Have Been Incorporated in Code    603
         Sections Relating to Depreciation Deductions

         1. No Harm No Foul--No Basis Reduction for Excessive     603
            Allowed Deductions that Fail to Reduce Tax

         2. Section 1245: Depreciation Recapture from a Tax       604
            Benefit Perspective

      B. The Solution to Ending the Basis Reduction Tax Trap:     607
         Create a New Gain Basis for Purposes of Computing Gain

         1. How Utilizing the Gain Basis Would Have Saved Beulah  609
            from the Clutches of the Basis Reduction Tax Trap

         2. Utilizing the Conventional Current Law Basis for      610
            Purposes of Computing Loss Would Have Prevented
            Beulah from Transforming Useless Depreciation
            Deductions into a Tax Loss

      CONCLUSION                                                  610


INTRODUCTION

The untold story of a legendary vocabulary tax law case reveals an inconvenient tax truth. Pursuant to section 1016(a)(2) (1) of the Internal Revenue Code (Code), (2) the basis of depreciable property is reduced by all depreciation deductions including those that produce no tax benefits for the taxpayer. The following events illustrate the baiting and then the closing of a hazardous tax trap for unwitting taxpayers. Over the course of the ownership period of a depreciable asset, the taxpayer is engaged in a business activity that generates little or no income. Because of the limited income, most or all depreciation deductions the taxpayer is entitled to claim are wasted, as they produce no tax benefits for her. Notwithstanding the lack of tax benefits produced by the depreciation deductions, section 1016(a)(2) requires a basis reduction of the underlying property by the full amount of the allowable depreciation deductions.

Then, perhaps due to economic circumstances beyond the taxpayer's control (such as an imminent foreclosure), the taxpayer is compelled to sell the depreciable property for an amount between its original cost and adjusted basis. So, in spite of realizing no economic gain (if the selling price were equal to the original cost) or possibly an economic loss (if the selling price were less than the original cost), the sale would result in the taxpayer recognizing phantom taxable gain. This is because all the recognized gain would be attributable to the useless tax depreciation deductions that reduced the asset's basis (3) below its original cost (hereinafter referred to as the "Basis Reduction Tax Trap"). (4)

Although Crane v. Commissioner (5) is best known for a footnote that "laid the foundation stone of most tax shelters," (6) facts missing from the Supreme Court's decision divulge that Beulah Crane (Beulah) was a victim of the Basis Reduction Tax Trap. For approximately seven years, Beulah operated an apartment building devised to her by her husband at a loss. At the time of her husband's death, the property was valued at $262,000. (7) Because the apartment building generated minimal rental income over that period, only $3,307 of the $28,000 of allowable depreciation deductions actually produced any tax benefits for Beulah. (8) Notwithstanding the lack of tax benefits, pursuant to section 1016(a)(2), the basis of the apartment building was reduced to $234,000. (9) Faced with imminent foreclosure by the mortgagee, Beulah was compelled to sell the apartment building for $257,500--$4,500 less than its original value. (10) In spite of realizing an economic loss of $4,500 from the sale, reducing the apartment building's basis by the full amount of tax depreciation deductions resulted in Beulah recognizing $23,500 of taxable gain--more than 85% of which was attributable to useless depreciation deductions. (11) Consequently, due to economic circumstances beyond Beulah's control, such as the lack of sufficient income to prevent the foreclosure of the apartment building that led to its inevitable sale, the basis reduction via useless depreciation deductions--as mandated by section 1016(a)(2)--made Beulah a victim of the Basis Reduction Tax Trap.

Despite having all of the components to establish it as a preeminent Supreme Court case showing the harsh punitive tax consequences caused of the Basis Reduction Tax Trap, (12) this aspect of Crane is the case's untold story. One explanation for this phenomenon is that Beulah's novel reporting position (rejected by the Supreme Court) completely nullified the role of depreciation and basis reduction in the computation of her taxable gain. In reporting the sale, Beulah rejected the notion that she actually owned, and thus could sell, the physical structure of an apartment building devised to her completely encumbered by mortgage debt. Instead, Beulah viewed the fully encumbered property she sold as a mere nondepreciable equity interest in the apartment building with a zero basis, for net monetary consideration of $2,500 (not treating the nonrecourse debt relief as consideration). Consequently, in computing her gain on the sale, section 1016(a)(2) was not applicable because there were no depreciation deductions to reduce the basis of the zero basis nondepreciable equity interest. So, none of the $2,500 of gain Beulah reported (the amount realized of $2,500, minus the adjusted basis of $0) was attributable to her previously claimed useless depreciation deductions. (13) Therefore, the Supreme Court's opinion addressed the merits of her reporting position with no reason to delve into the propriety of the section 1016(a)(2) basis reduction by useless depreciation deductions.

Another explanation is that in its disapproval of Beulah's reporting position, though inconsistent with the facts contained in the Record of the case, (14) the Supreme Court cast Beulah as a tax villain creating the myth that her ultimate purpose was to enjoy the unwarranted benefit of double depreciation deductions. (15) More than thirty years after Crane was decided, two prominent court decisions perpetuated this myth by pronouncing the prevention of the double deductions Beulah was seeking as the essence of the Supreme Court's decision. (16) As a result, the myth of double deductions became the face of Crane and obscured the ironic truth of the exact opposite: Beulah's receiving minimal tax benefits from depreciation deductions on the apartment building and her victimization by the Basis Reduction Tax Trap.

Yet, even if Crane had been viewed as a Basis Reduction Tax Trap case, there was long-standing judicial precedent including two landmark Supreme Court cases (17) decided prior to Crane, holding that the section 1016(a)(2) basis reduction was mandatory whether or not the depreciation deductions produced tax benefits (hereinafter the "No Tax Benefit Decisions"). Considering this negative precedent, it is unlikely that the Supreme Court would have been any more sympathetic to Beulah's victimization by the Basis Reduction Tax Trap or that the outcome of the case would have been any different. (18)

On the other hand, notwithstanding the likelihood of an adverse decision against Beulah, a closer examination of the No Tax Benefit Decisions reveals their main focus was to thwart taxpayer attempts to manipulate the timing of the depreciation deduction and the corresponding basis reduction in efforts to achieve the optimal tax benefit from it. For example, in United States v. Ludey, (19) the first of the No Tax Benefit Decisions, the taxpayer chose not to claim depreciation deductions or reduce the cost basis (20) of depreciable equipment used to extract oil. By virtue of the unreduced cost basis, the taxpayer reported a loss upon the subsequent sale of the equipment. (21) Conversely, if the equipment's cost basis had been reduced by the allowable depreciation deductions, the taxpayer would have recognized a gain. In deciding the case against the taxpayer, the Supreme Court declared depreciation was not an optional deduction; regardless of whether the taxpayer claimed it, the corresponding section 1016(a)(2) basis reduction was mandatory. (22) So in Ludey, the Supreme Court correctly recognized the importance of the mandatory section 1016(a)(2) basis reduction in preventing the taxpayer from redirecting the timing of the depreciation deduction by not claiming it in its properly deductible year and, thus, not reducing the basis of the underlying property in order to recognize a tax loss in the subsequent tax year of sale.

In Virginian Hotel Corp. v. Helvering, (23) the other Supreme Court No Tax Benefit Decision decided prior to Crane, the taxpayer claimed depreciation deductions early in the depreciation recovery period that were in excess of the allowable amount. Those excessive depreciation deductions, however, produced no tax benefits. The issue presented was whether, in the absence of corresponding tax benefits, a basis reduction by excessive but wasted depreciation deductions was required. If a basis reduction were required, the aggregate amount of depreciation deductions the taxpayer would be able to claim over the remaining tax years of the depreciation recovery period would be correspondingly less than the amount of otherwise allowable depreciation deductions. Citing Ludey, the Supreme Court emphasized that the section 1016(a)(2) basis reduction was not contingent on whether depreciation deductions produced any tax benefits for the taxpayer. (24) Thus, the excessive depreciation deductions inappropriately claimed in earlier tax years were forever lost and could not be recouped (for example, by not reducing basis) in later tax years.

In contrast to the No Tax Benefit Decisions, in which the taxpayer seeks to defer the depreciation deduction, in the Basis Reduction Tax Trap scenario the taxpayer is the passive victim of the harsh tax consequences of phantom taxable income. Moreover, unlike the No Tax Benefit Decisions in which the taxpayer acted affirmatively to manipulate the depreciation deduction and/or basis reduction to her tax advantage, the taxpayer has no control over the sequence of events leading to the baiting and ultimate closing of the Basis Reduction Tax Trap. For example, Beulah had no control over the limited amount of rental income generated by the apartment building or that most of the much larger amount of allowable depreciations would produce no tax benefits. Yet, the Basis Reduction Tax Trap was baited by the reduction of the basis of the apartment building by those useless depreciation deductions. When Beulah was compelled to sell the apartment building as a last resort to avoid foreclosure, the Basis Reduction Tax Trap snapped shut on her because most of her taxable gain was attributable to those useless deductions. Accordingly, the mandatory section 1016(a)(2) basis reduction that prevents taxpayer abuse of the depreciation deduction in the No Tax Benefit Decisions goes too far when it causes the transformation of useless depreciation deductions into phantom taxable gain for an unwitting taxpayer.

This article fully exposes the inconvenient tax truth and the Basis Reduction Tax Trap's punitive nature by retelling the Crane story from that perspective, relying on relevant facts from the Record of the case that were missing from the Supreme Court's opinion. Because of the punitive tax consequences it causes, the article advocates the elimination of the Basis Reduction Trap by incorporating tax benefit components into the amendment of the basis-related provisions of the Code. Recognizing the importance of the mandatory section 1016(a)(2) basis reduction to prevent taxpayer abuse, however, any such amendments must not compromise the integrity of the depreciation deduction protected by the No Tax Benefit Decisions.

The article begins with a discussion in Part I of the four ways (other than the Basis Reduction Tax Trap) in which the section 1016(a)(2) basis reduction effectively protects the integrity of the depreciation deduction; and, thus, to which no change to the basis rule should be made. Part II explains the two-step process that ultimately led to Beulah falling victim to the Basis Reduction Tax Trap. Subpart A delves behind the numbers to reveal the minimal tax benefits produced by the allowable depreciation deductions and the corresponding basis reduction of Beulah's apartment building by mostly useless depreciation deductions that baited the Basis Reduction Tax Trap. Subpart B then explains how the Basis Reduction Tax Trap snapped shut on Beulah when she was compelled to sell the apartment building to avoid foreclosure, only to endure the adverse tax consequences of a mostly phantom gain attributable to useless depreciation deductions.

Part III discusses two reasons why Crane has never been considered a preeminent Supreme Court case to show the punitive tax consequences of the Basis Reduction Tax Trap. Subpart A analyzes Beulah's novel reporting of the transaction as the sale of a zero-basis, nondepreciable equity interest in the apartment building, devoid of any depreciation deductions and basis reductions. Because the reduction of the basis was not relevant in Beulah's computation of gain, there was no reason for the Supreme Court to consider the propriety of the section 1016(a)(2) basis reduction by Beulah's previously claimed, useless depreciation deductions in its opinion. Subpart B explains how the Supreme Court's disapproval of Beulah's reporting position created the myth of her so-called quest for the unwarranted benefits of double deductions and tracks the perpetuation of this myth in two subsequent court holdings. The myth of double deductions has obscured the reality of Beulah's minimal tax benefits from depreciation deductions, as well as her victimization by the Basis Reduction Tax Trap.

Part IV tracks the judicial development of the No Tax Benefit Decisions. In the course of this discussion, it demonstrates how the mandatory section 1016(a)(2) basis reduction that appropriately prevents taxpayer abuse of the depreciation deduction goes too far when it causes the transformation of useless depreciation deductions into phantom taxable gain for the unwitting taxpayer.

Part V recommends that a tax benefit principle approach be implemented in the Code amendments to eliminate the Basis Reduction Tax Trap without compromising the integrity of the depreciation deduction. In doing so, Subpart A examines two examples of current Code sections dealing with depreciation deductions that successfully incorporate tax benefit components. The proposed amendments to the Code would involve the creation of a new gain basis to be used as the subtrahend in the computation of gain on the sale of depreciable property. Unlike the current law's adjusted basis, however, the new gain basis would be reduced by only those depreciation deductions that produce tax benefits. Accordingly, no portion of the gain recognized upon the sale of the underlying asset would be attributable to useless depreciation deductions. Subpart B.1 explains how using the new gain basis would have saved Beulah from the clutches of the Basis Reduction Tax Trap. Finally, Subpart B.2 shows how continuing unaltered use of the current law's adjusted basis--for purposes of tracking the declining balance of depreciation deductions and of serving as the minuend in loss computation--would preserve the integrity of the depreciation deduction.

I. THE FOUR WAYS THE SECTION 1016(a)(2) BASIS REDUCTION PRESERVES THE INTEGRITY OF THE DEPRECIATION DEDUCTION

As alluded to in the introduction, this article does not wholly dismiss the rationale of the No Tax Benefit Decisions or advocate the wholesale repeal of section 1016(a)(2). Whereas the article advocates an amendment to the Code in order to eliminate the Basis Reduction Tax Trap, it also recognizes the important functions the codependency of depreciation deductions and the section 1016(a)(2) basis reduction serve in preserving the integrity of the depreciation deduction. Specifically, the section 1016(a)(2) reduction of basis by depreciation deductions serves the vital functions of (1) tracking an asset's declining balance available for depreciation deductions over the remaining tax years of the recovery period; (2) precluding the taxpayer from having a second opportunity to receive the tax benefit of a depreciation deduction that did not produce a tax benefit in a prior tax year(s); (3) preventing the taxpayer from enjoying the tax benefit of a nonexistent loss; and (4) preventing the taxpayer from claiming depreciation deductions in excess of the underlying asset's original cost.

A. Tracking the Declining Balance of Depreciation Deductions over the Remaining Tax Years of the Recovery Period

Section 167(a) (authorizing the depreciation deduction) and section 1016(a)(2) (requiring a basis reduction for depreciation deductions) are codependent Code sections. In a landmark case, the Supreme Court defined depreciation as follows:
  Depreciation is an accounting device which recognizes that the
  physical consumption of a capital asset is a true cost, since
  the asset is being depleted. As the process of consumption continues,
  and depreciation is claimed and allowed, the asset's adjusted income
  tax basis is reduced to reflect the distribution of its cost over
  the accounting periods affected. (25)


Simply stated, depreciation is a means of deducting the cost of an asset utilized to generate taxable income over the multiple years the asset is used up or consumed. (26) The initial cost of the depreciable asset (27) or the taxpayer's after-tax investment (28) is the starting point from which to claim depreciation deductions over the recovery period of the asset. (29) Pursuant to section 1016(a)(2), basis is reduced by each tax year's depreciation deduction. The declining balance of basis reflects the total amount of allowable depreciation deductions over the remaining tax years of the recovery period. Once the adjusted basis reaches zero, depreciation deductions and the corresponding basis reduction cease because the taxpayer has then recovered her entire after-tax investment in the asset. (30)

B. Precluding a Second Opportunity to Receive the Tax Benefit of a Depreciation Deduction that Did Not Produce a Tax Benefit in Prior Tax Years

Another important function of the section 1016(a)(2) basis reduction by all allowable depreciation deductions is to prevent a taxpayer from having a second chance to receive the tax benefit of a depreciation deduction that did not produce a tax benefit in the tax year it was properly deductible. Consistent with the rationale of the No Tax Benefit Decisions, the allowable depreciation deduction in a given year must be taken in that year or be lost forever. (31)

So if a depreciation deduction would not produce a tax benefit in its properly deductible tax year, the taxpayer does not have the option of skipping the deduction for that year; thus, not reducing the underlying asset's basis. Otherwise, that tax year's unclaimed depreciation deduction would be preserved for later deductibility in the unreduced adjusted basis.

To illustrate this point, assume a taxpayer acquires a depreciable asset for $100. Further assume that in the first year, the taxpayer is entitled to an allowable depreciation deduction of $20. Because the taxpayer lacks income from which to offset the depreciation deduction, she decides not to claim it in that lax year. Subsequently, in the second year, the taxpayer sells the asset for its fair market value of $80. If the asset's basis was not reduced by the $20 unclaimed depreciation deduction, the taxpayer would recognize a $20 loss (adjusted basis $100 minus amount realized $80). (32) In essence, the depreciation deduction that did not produce a tax benefit in the first year would re-emerge as a $20 loss in the subsequent tax year of sale. Although Congress has enacted a Code section allowing the depreciation deduction, there is no corresponding guarantee the taxpayer will receive a tax benefit commensurate to the deduction. (33) So, whether or not the depreciation deduction produces a tax benefit, section 1016(a)(2) requires a basis reduction to preclude a second opportunity to enjoy the tax benefit of an otherwise lost deduction.

C. Preventing a Taxpayer from Receiving the Tax Benefit of a Nonexistent Loss when Tax Depreciation Exceeds Economic Depreciation

Unlike the harsh punitive tax consequences of the Basis Reduction Tax Trap, if tax depreciation deductions that produce corresponding tax benefits exceed the economic depreciation of the underlying depreciable asset, the section 1016(a)(2) basis reduction precludes the taxpayer from enjoying the unwarranted tax benefit of a deduction for a nonexistent economic loss. Although tax depreciation is a means to account for the declining value of an asset through wear and tear, there is no necessary correlation between the tax depreciation and the economic depreciation of the asset. (34) Even if the tax depreciation of an asset exceeds its economic depreciation, for as long as the asset is used in a trade or business, the taxpayer is nonetheless entitled to claim the full amount of the tax depreciation deductions with a corresponding basis reduction by the same amount. (35) The ultimate reckoning of the correlation between tax depreciation and economic depreciation is determined when the underlying asset is sold or exchanged for a gain, a loss, or no gain or loss.

To illustrate this point, consider the following fact pattern: a taxpayer acquires a depreciable asset for $100 and claims in the first year a $20 depreciation deduction that reduces her taxable income by a like amount; in the second year, the taxpayer sells the asset for its original cost of $100. In retrospect, the $20 tax depreciation deduction was not economically justified because there was no decline in the asset's monetary value. If the basis of the asset were not reduced to account for the tax depreciation deduction, however, the taxpayer would not recognize any taxable gain. (36) Consequently, the taxpayer would have enjoyed the tax benefit of a $20 depreciation deduction for a nonexistent economic loss.

The section 1016(a)(2) basis reduction prevents the taxpayer, however, from enjoying such a windfall. Because the asset's basis was reduced by the $20 tax depreciation deduction, the subsequent sale of the asset resulted in a taxable gain of $20 (37) Thus, the unwarranted tax benefit of a depreciation deduction for a nonexistent economic loss would be effectively reversed or offset by a corresponding amount of gain triggered by the sale of the depreciable asset.

D. Preventing a Taxpayer Who Claims Excessive Depreciation Deductions that Produce Tax Benefits from Over-Depreciating the Property's Original Cost

A taxpayer who claims depreciation deductions in excess of the allowable amount that reduces taxable income receives an unwarranted tax benefit. In spite of the impropriety of the deductions, any excessive depreciation deductions unchallenged by the Government within the applicable limitations period are treated as being "allowed." (38) Accordingly, if basis were not reduced to account for such allowed depreciation deductions, the aggregate amount of depreciation claimed by the taxpayer over the recovery period would be greater than the cost of the property.

To illustrate the point, assume the taxpayer acquires an asset for $100 depreciable over a five-year recovery period. (39) Further assume that in the first four years of the recovery period, the taxpayer claimed an aggregate amount of $100 of depreciation deductions (all of which reduced taxable income by a like amount) or $20 more than the allowable amount of $80 over that period. If the basis reduction of the asset were limited to the amount of the allowable depreciation deductions, its adjusted basis entering the final year of the recovery period would be $20--even though the total amount of depreciation deductions claimed by the taxpayer had to this point already equaled the asset's original basis ($100). Moreover, with a remaining adjusted basis of $20, the taxpayer could also claim the final year's allowable depreciation deduction of $20. If this were permitted, the aggregate amount of depreciation deductions claimed by the taxpayer ($120) over the recovery period would have exceeded the asset's original basis ($100) by the $20 of excessive allowed depreciation deductions.

To prevent this abuse, section 1016(a)(2) also requires a basis reduction for all allowed depreciation deductions that produce tax benefits. In the above illustration, as of the end of the fourth year of the recovery period, the original basis of $100 would have been reduced by the $80 of allowable depreciation deductions plus the $20 of allowed depreciation deductions. Consequently, entering the final year of the recovery period, the asset's basis would be zero. No further depreciation deductions could be claimed. Therefore, even if the Government was barred by the expiration of the applicable limitations period from challenging the excessive depreciation deductions taken in any of the first four recovery years, it could nonetheless challenge an "allowable" depreciation deduction claimed in the final recovery year. (40)

II. HOW THE BASIS REDUCTION TAX TRAP SNARED BEULAH CRANE

As discussed in Part I, with the exception of the Basis Reduction Tax Trap, the codependency of the depreciation deduction and the section 1016(a)(2) basis reduction is vital to protecting the integrity of the depreciation deduction. Part II, however, discusses the circumstances by which the basis reduction of useless depreciation deductions made Beulah Crane a victim of the Basis Reduction Tax Trap.

A. Step One: Over the Seven Years in Which Beulah Operated the Apartment Building, the Allowable Depreciation Deductions Produced Minimal Tax Benefits for Beulah and Her Husband's Estate

On January 11, 1932, William M. Crane died and was survived by his wife, Beulah. (41) His will named Beulah as the executrix of his estate (42) (the Crane Estate) and devised the residuary estate to her, including an apartment building located at 395 Clinton Avenue in Brooklyn, New York (the Brooklyn Apartment Building). (43) The Brooklyn Apartment Building's date-of-death unencumbered fair market value was $262,000. (44) It was secured, however, by a nonrecourse mortgage in an equivalent amount, comprised of the principal amount of $255,000 plus interest arrears of approximately $7,000. (45)

Also, because the nonrecourse mortgage was in default at the time of William Crane's death, the mortgagee. Bowery Bank (Bowery) was seriously considering foreclosure. (46) Beulah, however, wanted to retain the Brooklyn Apartment Building in the Crane Estate, and, ultimately, to acquire it outright. Taking swift action the day after her husband's will was admitted to probate, (47) Beulah persuaded Bowery to allow the Crane Estate to retain ownership of the Brooklyn Apartment Building subject to the outstanding debt. She also promised to pay all of the net rental income it generated (computed without taking into account the depreciation deduction) to Bowery to be applied to the delinquent loan. (48)

On December 31, 1936, the Crane Estate terminated, and the Brooklyn Apartment Building was transferred to Beulah. (49) Thereafter, until November 29, 1938, (50) when she sold the property, Beulah continued to operate the Brooklyn Apartment Building in her individual capacity. Moreover, true to Beulah's earlier promise, she honored her commitment to pay whatever net rental income was generated to Bowery.

Throughout the entire ownership period of the Brooklyn Apartment Building (between 1932 and 1938), Beulah claimed depreciation deductions in the aggregate amount of $25,200 (51) on the Crane Estate's and her own federal income tax returns. Apparently, in claiming those depreciation deductions on the Brooklyn Apartment Building, Beulah utilized the date-of-death unencumbered fair market value as her original section 1014(a) basis. (52)

Although absent from the Supreme Court's opinion, the Record (53) reveals that the relatively large amount of allowable depreciation deductions produced only minimal benefits for the Crane Estate and Beulah. This is because the Brooklyn Apartment Building generated little income to be offset by those depreciation deductions. For example, in 1932 and 1933, the first two years the Brooklyn Apartment Building was held by the Crane Estate, the property generated pre-depreciation deduction net rental income of approximately $3,439 and $1,570, respectively. (54) Of the $7,000 depreciation deductions claimed on the estate's income tax returns for those years, only $3,113 was needed to eliminate all of the Crane Estate's tax liability. Then, from 1934 through 1936, the final three years the Crane Estate held the Brooklyn Apartment Building, the property generated zero or negative net rental income, even without considering the depreciation deductions. (55) So, for the final three years, none of the depreciation deductions produced any tax benefits for the Crane Estate. In total, over the five year period the Crane Estate held the Brooklyn Apartment, only $3,113 of the $18,500 depreciation deductions actually produced any tax benefits for the estate. (56) This means most of the estate's allowable depreciation deductions were wasted.

Similarly, in 1937 and 1938, the two years Beulah operated the Brooklyn Apartment Building in her individual capacity, she claimed the aggregate amount of $6,700 of depreciation deductions on her personal income tax returns. For those years, the Brooklyn Apartment Building generated pre-depreciation deduction net rental income of $1,294 and $1,036, (57) respectively. Only a nominal amount of approximately $194 of the $6,700 of depreciation deductions was needed to reduce the net rental income to achieve zero tax liability. (58) The balance of the depreciation deductions, $6,506, produced no tax benefits.

In summary, due to the limited amount of net rental income generated by the Brooklyn Apartment Building, of the $25,200 of depreciation deductions claimed by the Crane Estate and Beulah, only $3,307 of those deductions was needed to reduce net rental income to eliminate all tax liability. (59) Consequently, the balance of the depreciation deductions, $21,893, produced no tax benefits. With the addition of $2,800 of allowable depreciation deductions Beulah did not claim, (60) the total amount of wasted depreciation deductions was $24,693. For reasons explained in Part III, none of these facts detailing the minimal tax benefits enjoyed by Beulah and the Crane Estate contained in the Record were addressed--and, in fact, they were misrepresented--in the Supreme Court's decision.

B. Step Two: Sale of the Brooklyn Apartment Building Triggered the Transformation of Useless Depreciation Deductions into Taxable Gain

The minimal tax benefits Beulah and the Crane Estate received from the allowable depreciation deductions did not, on their own, cause Beulah's harsh tax consequences. Because the depreciation deductions were more than enough to wipe out the entire tax liability of Beulah and the Crane Estate, the wasted depreciation deductions were simply lost with no other tax significance. It was the second part of the equation, the sale of the Brooklyn Apartment Building with an adjusted basis reduced by those wasted depreciation deductions, however, that caused Beulah to be snared by the Basis Reduction Tax Trap.

Approaching the end of the second year of her individual ownership of the Brooklyn Apartment Building, it was clear Beulah had failed in her efforts to cure the default on the nonrecourse mortgage. In October 1938, Bowery notified Beulah of its intention to bring a foreclosure action against the Brooklyn Apartment Building. Beulah responded by offering to execute a deed in lieu of foreclosure in favor of Bowery. Bowery, however, refused Beulah's offer. (61) Ultimately. Beulah managed to avoid foreclosure by entering into a "Contract of Sale" (62) with Avenue C Realty, pursuant to which the title of the Brooklyn Apartment Building was transferred from Beulah to Avenue C Realty subject to the outstanding balance of the nonrecourse mortgage and interest arrears in exchange for Beulah's receipt of net monetary consideration of $2,500. (63)

In the computation of Beulah's gain upon the sale of the Brooklyn Apartment Building, the Supreme Court (agreeing with the Government's position) determined the amount realized to be the sum of the principal balance of the nonrecourse mortgage ($255,000 remaining as an encumbrance on the property) treated as liability relief plus the net monetary consideration ($2,500)--at total of $257,500. As to the Brooklyn Apartment Building's adjusted basis, the Supreme Court applied section 1016(a)(2) and reduced the original section 1014(a) basis of $262,000 by the $28,000 of allowable deductions, arriving at a final adjusted basis of $234,000. Thus, the difference between the amount realized and the adjusted basis resulted in a taxable gain of $23,500. (64)

Although the Supreme Court correctly applied all relevant Code sections in the computation of Beulah's taxable gain, it is inconceivable from an equitable perspective that Beulah should have been compelled to recognize such a large amount of taxable gain. First, assuming the amount realized was also the fair market value of the Brooklyn Apartment Building, (65) over the seven-year ownership period the property actually lost $4,500 of its date-of-death value (from $262,000 to $257,500). Second, virtually all of the taxable gain Beulah was compelled to report was attributable to useless depreciation deductions that reduced the basis of the Brooklyn Apartment Building. In total, there was $28,000 of allowable depreciation deductions on the Brooklyn Apartment Building. Because the amount realized ($257,500) was also $4,500 less than the original basis of the Brooklyn Apartment Building ($262,000), that portion of the allowable deductions on the Brooklyn Apartment Building did not factor into her taxable gain. All of Beulah's taxable gain of $23,500 (amount realized $257,500 minus $234,000), however, was attributable to the section 1016(a)(2) basis reduction of depreciation deductions. Only $3,307 of those depreciation deduction produced tax benefits for Beulah and the Crane Estate. Thus, $20,193 ($23,500 less $3,307) of Beulah's taxable gain was the consequence of the basis reduction of useless depreciation deductions.

The following charts set forth a year-by-year breakdown of: net rental income generated by the Brooklyn Apartment Building, the amount of depreciation deductions claimed by the Crane Estate and Beulah, the net income as reduced by depreciation deductions, the section 1016(a)(2) basis reductions, the tax savings the depreciation deductions produced, and the amount of the useless depreciation deductions transformed into taxable gain upon the sale of the Brooklyn Apartment Building. (66)
TABLE 1. THE SEVEN-YEAR OWNERSHIP PERIOD OF THE BROOKLYN APARTMENT
BUILDING (1932-1938) (67)

Year                       Net Rental     Claimed     Net Income as
                             Income     Depreciation   Reduced by
                            Excluding     Deduction   Depreciation
                          Depreciation                 Deduction
                            Deduction

1932                         $3,439        $3,500        ($61)

1933                         $1,570        $3,500       ($1,930)

1934                          -0-          $3,800       At least
                                                        ($3,800)

1935                          -0-          $3,800       At least
                                                        ($3,800)

1936                          -0-          $3,900       At least
                                                        ($3,900)

1937                         $1,294        $3,500       ($2,206)

1938                         $1,026        $3,200       ($2,464)

Plus Unclaimed Allowable      N/A          $2,800          N/A
Depreciation Deductions
All Years

Total                        $7,329       $28,000

Year                        [section]     Depreciation  Depreciation
                            1016(a)(2)      Deduction    Deductions
                             Brooklyn     Necessary to  Producing No
                            Apartment     Achieve Zero  Tax Benefit
                          Building Basis      Tax
                            Reduction       Liability

1932                          $3,500         $2,243        $1,257

1933                          $3,500          $870         $2,630

1934                          $3,800          -0-          $3,800

1935                          $3,800          -0-          $3,800

1936                          $3,900          -0-          $3,900

1937                          $3,500          $194         $3,306

1938                          $3,200          -0-          $3,200

Plus Unclaimed Allowable      $2,800          -0-          $2,800
Depreciation Deductions
All Years

Total                        $28,000         $3,307       $24,693


In summary, despite suffering an economic loss of $4,500, Beulah was compelled to recognize a taxable gain of $23,500 on the sale of the Brooklyn Apartment Building. As demonstrated above, $20,193 of Beulah's $23,500 taxable gain was attributable to the indiscriminate section 1016(a)(2) basis reduction that included depreciation deductions producing no tax benefits for Beulah and the Crane Estate. Ultimately, the Basis Reduction Tax Trap snared Beulah because of her misfortune in lacking sufficient taxable income to absorb all of the allowable depreciation deductions, most of which were transformed into taxable gain.
TABLE 2. COMPUTATION OF TAXABLE GAIN UPON SALE OF THE BROOKLYN
APARTMENT BUILDING

Amount      Allowable        Economic         Adjusted Basis as
Realized  Depreciation  Depreciation That      Reduced by All
           Deductions      Reduced the     Allowable Depreciation
                         Amount Realized         Deductions

$257,500    $28,000           $4,500               $234,000

Amount    Taxable Gain    Depreciation      Useless Depreciation
Realized                Deductions That  Deductions Transformed Into
                          Produced Tax           Taxable Gain
                            Benefits

$257,500    $23,500          $3,307                 $20,193
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Title Annotation:part 1
Author:Katz, I. Jay
Publication:Virginia Tax Review
Date:Jan 1, 2011
Words:6668
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