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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.

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

Part II describes how the Basis Reduction Tax Trap baited and then snapped shut on Beulah. Considering the harsh tax consequences suffered by Beulah were caused by the transformation of useless depreciation deductions into taxable gain, it may seem surprising that Crane did not become a landmark Supreme Court case about the Basis Reduction Tax Trap. Part III submits two possible explanations why this did not occur.

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

The dispute between Beulah and the Government involved the computation, and thus the amount of taxable gain, to be reported from Beulah's sale of the Brooklyn Apartment Building to Avenue C Realty. As discussed below, on her 1938 federal income tax return, Beulah reported the transaction as the sale of a nondepreciable equity interest in the Brooklyn Apartment Building with a zero basis, rather than the physical property itself in exchange for $2,500 (not treating the nonrecourse debt relief as an economic benefit). In the process she disavowed the depreciation deductions she had previously claimed. Because Beulah reported a modest gain of $2,500--none of which, as computed by her, was attributable to depreciation deductions--the minimal tax benefits produced for her by the prior tax years' depreciation deductions were probably of no concern to her. Consequently, the Supreme Court's opinion addressed the merits of her reporting position with no reason to expound on the propriety of the section 1016(a)(2) basis reduction by useless depreciation deductions.

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

Beulah's novel reporting of the taxable gain from the sale of the Brooklyn Apartment Building to Avenue C Realty was based upon the following three components: (a) the property sold was a nondepreciable equity interest in the Brooklyn Apartment Building; (b) the original date-of-death basis and the date-of-sale adjusted basis of the nondepreciable equity interest in the Brooklyn Apartment Building were zero; and (c) the amount realized on the sale included only the net monetary consideration of $2,500 she had received from Avenue C Realty.

a. Nondepreciable Equity Interest in the Brooklyn Apartment Building

On the date of her husband's death, the Brooklyn Apartment Building was encumbered by a nonrecourse mortgage in an amount equal to the fair market value of the property. Consequently, from an equity perspective, the Brooklyn Apartment Building devised to Beulah was worthless. For this reason, Beulah did not perceive the "property" devised to her as being the physical structure of the Brooklyn Apartment Building. Instead, Beulah viewed the devise as a mere equity interest in a property having no value. (68) Moreover, as the next part will discuss, an equity interest with no value was nondepreciable. Based upon that premise, Beulah reported the transaction as the sale of a nondepreciable equity interest in the Brooklyn Apartment Building to Avenue C Realty.

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

Beulah concluded a devise of a worthless, nondepreciable equity interest in the Brooklyn Apartment Building had a date-of-death fair market value--and, thus, a section 1014(a) basis--of zero. Consistent with her view that an equity interest with a zero basis was inherently nondepreciable, Beulah disavowed her right to have previously claimed any depreciation deductions on the property. Consequently, with no basis reductions for nonexistent depreciation deductions, the adjusted basis of her equity interest in the Brooklyn Apartment Building at the time of the sale was also zero. (69)

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

As explained in more detail below, in determining the amount realized from the sale of the Brooklyn Apartment Building, the Government included the relief of the nonrecourse liability ($255,000) remaining as an encumbrance on the property, in addition to the net monetary consideration ($2,500), as economic benefits Beulah received in the exchange. In retrospect, it is highly unlikely that Beulah, in reporting the sale on her 1938 income tax return long before the Government ever challenged it, would have conceived that her transfer of the Brooklyn Apartment Building subject to a nonrecourse liability was debt relief, much less an economic benefit she had received. From Beulah's perspective, it was a liability that she never had a personal obligation to pay and that would simply remain as an encumbrance on the Brooklyn Apartment Building after the property was transferred to the new owner, Avenue C Realty. (70) Beulah more likely viewed the liability as an albatross, since, in spite of her best efforts to cure the delinquency over the seven-year ownership period, the loan remained in default and the interest arrears continued to increase.

So, in arriving at the amount realized, Beulah included the net $2,500 cash in hand as the only economic benefit she received from the sale of the nondepreciable equity interest in the Brooklyn Apartment Building to Avenue C Realty. The following language from the Contract of Sale between Beulah and Avenue C Realty was consistent with Beulah's perception of the sale: "The purchase price is ... $3,000 for the equity conveyed by the seller." (71)

Therefore, Beulah reported her taxable gain as the difference between the amount realized ($2,500) and the adjusted basis of the equity interest ($0), which would have been $2,500. (72) From an economically simplistic perspective, Beulah probably believed the $2,500 of taxable gain was the true measure of her profit from the sale of an initially valueless equity interest in the Brooklyn Apartment Building. Moreover, considering the modest gain from a nondepreciable equity interest with a zero adjusted basis, the minimal tax benefits Beulah received from the depreciation deductions, as well as any adverse tax consequences caused by a section 1016(a)(2) basis reduction by depreciation deductions she had disavowed (and, thus, believed should never have been taken) were of no relevance to her case.

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

Not surprisingly, the Government disputed Beulah's reporting position as to the nature of the property sold, the adjusted basis, the amount realized, and, therefore, the amount of her taxable gain. As to the property sold to Avenue C Realty, the Government considered it to be the depreciable physical structure of the Brooklyn Apartment Building. In determining its adjusted basis, the Government applied section 1016(a)(2) to reduce the original section 1014(a) basis (the date-of-death unencumbered fair market value of approximately $262,000) by all allowable depreciation deductions (approximately $28,000). Finally, as to the amount realized, the Government included the two economic benefits it deemed Beulah to have received in the transaction: the nonrecourse principal debt relief ($255,000) and the net monetary consideration ($2,500). The resulting taxable gain was approximately $23,500. (73)

Based on the Government's computations, the total amount realized was more than 100 times greater than the $2,500 of net monetary consideration Beulah had included on her tax forms. Although the adjusted basis computed by the Government was obviously much higher than Beulah's computation, the differential between the amount realized ($257,500) and the adjusted basis ($234,000) far exceeded the differential between the amount realized ($2,500) and adjusted basis ($0) computed by Beulah. Ultimately, the most significant disparity between the computations was the $23,500 of taxable gain computed by the Government as compared to the $2,500 of taxable gain computed by Beulah.

Even though the large taxable gain computed by the Government was mostly attributable to the section 1016(a)(2) basis reductions by useless depreciation deductions, Beulah's defense of her position did not address that issue. Instead, Beulah attributed the large amount of taxable gain to the inclusion of the nonrecourse liability relief in the amount realized. Her opposition to the Government's position was based on the unconstitutionality of such inclusion and her insistence that the basis of the nondepreciable equity interest in the Brooklyn Apartment Building was zero.

As to the so-called nonrecourse liability relief included in the amount realized, Beulah contended the approximately $24,000 of taxable gain (74) (when she had only received net monetary consideration of $2,500) was not income within the meaning of the 16th Amendment meaning such a calculation violated Article I, Section 9, of the U.S. Constitution, as well as the 5th Amendment. (75) In making this argument in her Supreme Court briefs, Beulah equated the concept of income in the constitutional sense with the receipt of an economic benefit. She asserted she could not receive an economic benefit from the relief of a nonrecourse liability she had no obligation to repay. (76) Accordingly, Beulah argued the inclusion of phantom debt relief in the amount realized created a fictitious gain. Because the resulting gain was not income within the meaning of the 16th Amendment, the tax levied on such income was also unconstitutional. (77)

Ironically, Beulah could have, but did not, advance a similar constitutional argument with respect to the phantom gain triggered by the section 1016(a)(2) basis reduction by useless depreciation deductions. For example, Beulah could have argued that a spurious taxable gain with no corresponding economic benefit was not income in the constitutional sense. (78)

Beulah only referred to the minimal tax benefits from previously claimed depreciation deductions in defense of the apparent hypocrisy of reporting the transaction as the sale of a nondepreciable equity interest in the Brooklyn Apartment Building. As previously discussed, Beulah's reporting of the transaction in this way was inconsistent with having previously claimed depreciation deductions on the physical structure of the Brooklyn Apartment Building throughout the ownership period, including the year of sale. (79) This inconsistency was noted in the Second Circuit's decision against her and in the Government's Supreme Court briefs. (80) In essence, the Second Circuit and the Government accused Beulah of attempting to enjoy the benefit of double deductions--taking depreciation deductions on the Brooklyn Apartment Building to her advantage and then, in reporting her gain from its subsequent sale, disavowing them to eliminate any accountability for those deductions. Moreover, as of the date Beulah filed her Tax Court petition, with the exception of one tax year, (81) the statute of limitations for the disallowance of those depreciation deductions had expired. (82) Even if the Government had acquiesced to her treatment of the sale of a nondepreciable equity interest and disavowal of the previously claimed depreciation deductions, it would have been powerless to make any correlative adjustments for the closed tax years (1932-1937). Therefore, Beulah's "eleventh hour" renunciation of her right to claim depreciation deductions could be viewed as being self-serving and disingenuous.

In a defensive response to the apparent inconsistency of her reporting position, Beulah discounted any impropriety by noting how miniscule the tax benefits were as compared to the claimed depreciation deductions. Thus, in spite of Beulah claiming depreciation deductions she subsequently disavowed and the Government's inability to challenge them, Beulah countered that the Government had not really been harmed by the small amount of tax she had saved from the depreciation deductions. (83) Interestingly, in emphasizing the minimal tax benefits she had received from the depreciation deductions in defense of her reporting position, Beulah failed to link the much higher taxable gain they had morphed into as a result of the Government's inclusion of the nonrecourse liability in the amount realized less an adjusted basis reduced by mostly useless depreciation deductions.

B. The Double Deduction Myth Becomes Reality

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

Another reason why Crane did not become a landmark case to show the Basis Reduction Tax Trap is the myth created by the Supreme Court that Beulah's ultimate purpose was to enjoy the unwarranted benefit of double deductions (the Double Deduction Myth). The Supreme Court's pronouncement of the Double Deduction Myth was made toward the end of the opinion after it had essentially decided the case against Beulah. Basically, it was an after-the-fact admonishment of Beulah's reporting position. It followed the Supreme Court's initial response to Beulah's constitutional challenge of a $24,000 taxable gain when she received only $2,500. (84) As discussed above, Beulah asserted the so-called "relief of a nonrecourse debt she was not obligated to repay was fictitious income so the tax created by its inclusion in the amount realized was unconstitutional. (85)

In response to Beulah's argument, the Supreme Court rejected Beulah's concept of "income in the constitutional sense" as too narrow. (86) Then, as a further criticism of Beulah's reporting position, the Supreme Court made the following infamous pronouncement:
  She was entitled to depreciation deductions for a period of nearly
  seven years, and she actually took them in almost the allowable
  amount. The crux of this case, really, is whether the law permits her
  to exclude allowable deductions from consideration in computing gain.
  We have already showed that, if it does, the taxpayer can enjoy a
  double deduction, in effect, on the same loss of assets. (87)


Clearly, the tone of the Supreme Court's pronouncement was consistent with the criticism of Beulah's reporting position by the Second Circuit and the Government. Moreover, it suggested the following presumptions. During the ownership period of the Brooklyn Apartment Building. Beulah enjoyed the tax benefits from the significant amount of depreciation deductions she had claimed against a section 1014(a) basis of $262,000. Then, in reporting her gain from the sale of the Brooklyn Apartment Building, Beulah manipulated the amount realized and the adjusted basis to eliminate any accountability for those depreciation deductions. Accordingly, the resulting limited amount of gain she recognized enabled her to enjoy the tax benefit of those depreciation deductions a second time.

Of course, as documented in Part II, above, those presumptions were simply not true. In fact, the Double Deduction Myth is wholly unsupportable because, as noted in Beulah's Supreme Court briefs and reflected by the income tax returns that were part of the Record, in the tax years when depreciation deductions were taken, they produced minimal tax benefits for Beulah and the Crane Estate. (88) Moreover, from the text of the entire opinion, however, it is difficult to discern where in it the Supreme Court had "already showed" that Beulah would have enjoyed a double deduction on the same loss of assets. (89) Although the first sentence of the Supreme Court's pronouncement accurately recounted the depreciation deductions Beulah claimed on the Brooklyn Apartment Building, it also erroneously presumed Beulah had actually enjoyed tax benefits commensurate to those deductions.

Thus, the Supreme Court's admonishment of Beulah's reporting position was without merit when considering the ample documentary evidence in the Record demonstrating the depreciation deductions claimed by Beulah produced minimal tax benefits. (90) Accordingly, there was no way the taxable gain Beulah was compelled to recognize could have reversed nonexistent tax benefits from depreciation deductions. For no apparent reason other than its disapproval of Beulah's novel reporting position, the Supreme Court was oblivious to the true facts and created the erroneous myth of her quest for the unwarranted tax benefits of double deductions. (91)

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

Ironically, two courts desperately seeking to find a rationale to deny taxpayers who unlike Beulah were actually attempting to enjoy the unwarranted tax benefit of double deductions further validated the Double Deduction Myth by declaring it to be the rationale for the Crane decision. The potential for this abuse was attributable to the Supreme Court's analysis of whether nonrecourse liability relief was an economic benefit to be included in the amount realized. In determining the amount realized, the first step in the computation of taxable gain, the Supreme Court faced a problematic dilemma of deciding whether in addition to the monetary consideration paid to Beulah by Avenue C Realty, the relief of a nonrecourse liability for which Beulah had no personal obligation to repay could be construed as an economic benefit. (92) If not, the amount realized would have been limited to the $2,500 of cash Beulah had received. In that case, the Supreme Court would have been faced with "the absurdity that [Beulah] sold a quarter-of-a-million dollar property for roughly one percent of its value." (93)

The "absurdity" feared by the Supreme Court did not materialize, however, because the purchase price and fair market value of the Brooklyn Apartment Building ($257,500) exceeded the outstanding balance of the nonrecourse mortgage ($255,000). (94) On that basis, the Supreme Court deemed the economic consideration Beulah received in the exchange for the property to include both the $2,500 of cash plus the nonrecourse debt relief. (95) In other words, the Supreme Court reasoned both elements of the consideration were real economic benefits because Bowery, the mortgagee, would have never permitted Beulah to sell and transfer the Brooklyn Apartment Building encumbered with nonrecourse liability to Avenue C Realty for any monetary consideration unless Avenue C Realty had also agreed to take the property subject to the liability. (96) Accordingly, the Supreme Court viewed the transaction as if Avenue C Realty had purchased the Brooklyn Apartment Building from Beulah by paying off the $255,000 of nonrecourse liability on her behalf (i.e., taking the property subject to it) in addition to paying her net monetary consideration of $2,500. (97)

Then, perhaps as the result of judicial afterthought, in Footnote 37, the Supreme Court pondered whether it might have reached a different conclusion regarding the economic benefit of nonrecourse debt relief if the principal balance had exceeded the fair market value of the property, fn such a scenario, it would be highly unlikely that a mortgagee would permit, and/or a buyer would be willing to pay, any monetary consideration to the seller/mortgagor in exchange for property worth less than the nonrecourse mortgage that encumbered it. Accordingly, in a Footnote 37 scenario, the bootstrapping of the nonrecourse debt relief with the monetary consideration the Supreme Court was able to rationalize in the case before it would be lacking. In spite of the Supreme Court's failure to directly answer the question, it certainly seemed to imply that if presented with a Footnote 37 scenario, it would probably not have treated the nonrecourse debt relief as an economic benefit and would have thus excluded it from the amount realized by the seller.

For more than thirty years following the decision, whether the Supreme Court's likely response to its hypothetical query would be followed in subsequent judicial decisions remained an open question. If the Supreme Court's inclination toward noninclusion of nonrecourse liability in the amount realized were followed, it would lead to taxpayer windfalls with devastating consequences to the Government. (98) For example, a taxpayer who utilized nonrecourse acquisition indebtedness to finance the purchase of depreciable property would receive a basis in the property equal to the purchase price. Over the course of the ownership period of the property, the depreciation deductions taken against that basis would provide the taxpayer with a tax benefit by reducing taxable income, resulting in significant tax savings. Then, at a time when the outstanding balance of the nonrecourse debt exceeded the property's fair market value, with no personal obligation to repay the shortfall, the taxpayer could simply abandon the property or "sell" it to a third party subject to the liability for no other consideration. If the amount realized were limited to the fair market value of the underlying depreciable property, (99) the nonrecourse liability in excess of fair market value--never to be repaid by the taxpayer--which had provided the basis for the substantial tax benefits the taxpayer had enjoyed, would be eliminated from the taxable gain consideration. Stated differently, under these circumstances the taxpayer would have reaped the tax benefits of depreciation deductions without ever expending any after tax dollars (i.e., the equivalent of double deductions).

Approximately thirty years after Crane was decided, two analogous Footnote 37 scenarios played out in the Third Circuit (100) and in Tax Court. (101) In Millar, (102) the Third Circuit faced a situation where the taxpayers contributed the proceeds of a nonrecourse loan to the capital of an S Corporation, thereby increasing the basis in their stock from which to take flow-through deductions. (103) Similarly, in Tufts (104) the Tax Court had to decide a case where nonrecourse acquisition debt securing rental real estate owned by a partnership provided the taxpayers with basis in their partnership interests from which to take flow-through depreciation deductions. (105)

In both cases, over a number of tax years, bases in entity interests increased with nonrecourse liability, allowing the taxpayers to enjoy the tax benefit of a corresponding amount of flow through deductions. Subsequently, at the time of the disposition of the underlying property, the outstanding balance of the nonrecourse liability was much greater than the fair market value of the underlying property and the taxpayers' adjusted bases. (106) In computing the potential gain, the taxpayers contended that the amount realized was limited to the fair market value of the property. (107) Relying on Footnote 37, the taxpayers argued that in the absence of any monetary consideration, they could not receive an economic benefit from the relief of nonrecourse liability in excess of the underlying property's fair market value, and, for that reason, it should not be included in the amount realized.

If the taxpayers had prevailed in these cases, the Government would have been severely whipsawed. In Millar, the investment of the $245,000 loan proceeds in the capital of the S Corporation had correspondingly increased the value and bases in the taxpayers' stock by a like amount. (108) Over a number of tax years preceding the lender's foreclosure of the stock that secured the loan, the value of the S Corporation declined by $205,508, reflected in an equivalent amount of deductions that had flowed through to the taxpayers. (109) The outstanding balance of the nonrecourse liability, however, remained at $245,000. If consistent with Footnote 37, the amount realized upon the foreclosure of the taxpayers' stock would have been limited to the much lower fair market value of the stock. (110) Because the fair market value was less than its adjusted basis, the taxpayers would have realized a loss.

Thus, a taxpayer victory would have achieved a huge windfall from the unwarranted tax benefit of double deductions. The $205,508 of operating loss deductions that flowed through to the taxpayers-shareholders would have been the first set of deductions. In addition, the fair market value of the stock and, thus, the amount realized also reflecting the $205,508 loss, would have been the equivalent of a second deduction of the same loss (economically borne by the mortgagee, not the taxpayers). (111) Stated differently, if Millar and the analogous Tufts case had been decided in favor of the taxpayers, the courts would have essentially approved the use of "Monopoly Money"--borrowed nonrecourse proceeds never to be repaid with after-tax dollars and not taxed when forgiven--to generate deductions to offset taxable income and reduce or eliminate a substantial amount of tax liability.

In spite of this potentially devastating result to the Government, the Supreme Court's suggested likely holding in a Footnote 37 scenario appeared to support the taxpayers' position. On the other hand, even though Footnote 37 was dictum having no binding precedential value, a rejection of the Footnote 37 rationale in these cases could have been construed as two lower courts appearing to "overrule" the Supreme Court. Obviously, both courts understood the only way to eliminate the unwarranted tax benefit of double deductions was the inclusion of the full outstanding balance of the nonrecourse liability in the amount realized regardless of the fair market value of the property. Its inclusion in the amount realized would eliminate the possibility of double deductions by triggering sufficient taxable gain to cancel out or offset the tax benefits of the previously claimed deductions.

To solve this dilemma, the two courts seized upon the Double Deduction Myth to reach the desired result without appearing to overrule the Supreme Court. In portraying Beulah as a tax villain who sought the unwarranted tax benefit of double deductions, (112) the courts further perpetuated the Double Deduction Myth by declaring it to be "the rationale of the Supreme Court's principal reasoning, analysis and holding." (113) Spinning the Crane holding in this manner, the Third Circuit and the Tax Court were able to justify the inclusion of the full outstanding liability in the amount realized as a way to eliminate the double deductions by explicitly adopting the Supreme Court's rationale. It was also a judicially correct way to circumvent the devastating consequences a pro-taxpayer Footnote 37 outcome would create for the Government by downplaying the footnote's significance as dictum and as a "hypothetical observation with respect to a hypothetical set of facts not before the Court." (114) In the process of two courts seeking a rationale to reach the correct result without appearing to overrule the Supreme Court, however, the Basis Reduction Tax Trap that victimized Beulah remained an untold story while she was vilified as the archetype of the greedy taxpayer.

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

Part III explains the various reasons why Crane was never viewed as showcasing the inequities of the Basis Reduction Tax Trap. One of those reasons, documented in Part III.A., was Beulah's novel reporting position that eliminated the relevance of depreciation deductions and corresponding basis reductions. Nevertheless, even if the Supreme Court had addressed the inequities of the Basis Reduction Tax Trap, however, the weight of the No Tax Benefit Decisions, including two Supreme Court cases (115) and three cases in the Second Circuit, (116) would not have likely changed the result. Yet, the rationale of the No Tax Benefit Decisions was that the section 1016(a)(2) basis reduction prevented the taxpayer from opting not to claim a depreciation deduction in its properly deductible tax year and, thus, not reducing the basis of the underlying property so as to preserve the tax benefit of that deduction for a subsequent tax year. Conversely, in the Basis Reduction Tax Trap, the taxpayer is the passive victim of the section 1016(a)(2) basis reduction because depreciation deductions that never produced a tax benefit for the taxpayer are transformed into phantom taxable gain. Accordingly, in the course of the following discussion of the development of the No Tax Benefit Decisions, the abuse of the depreciation deduction prevented by the section 1016(a)(2) basis reduction in those cases is distinguished from the harsh lax consequences it visits upon the taxpayer caught by the Basis Reduction Trap.

A. United Stales v. Ludey Launches the No Tax Benefit Decisions

United Stales v. Ludey (117) was the first of the No Tax Benefit Decisions. In that case, the Supreme Court held a taxpayer could not preserve the initial cost basis of depreciable equipment by failing to claim depreciation deductions in their properly deductible tax years and, consequently, recognize a loss upon the sale of the underlying property in a subsequent tax year. (118) In Ludey, the taxpayer sold oil mining properties and equipment with an original cost of approximately $96,000 for approximately $81,000. (119) Although over the course of the ownership period of the equipment the taxpayer claimed approximately 50% of the amount of allowable depreciation deductions, (120) the taxpayer had not reduced the equipment's basis by any amount.

More specifically, the issue presented was whether depreciation deductions were mandatory, and thus whether the cost basis in the equipment had to be reduced by the allowable depreciation deductions. If the basis were reduced, the taxpayer would recognize a gain rather than the loss the taxpayer sought to claim. (121) In this landmark decision, the Supreme Court held that depreciation deductions and a corresponding basis reduction were not optional, denying the taxpayer a loss in the subsequent tax year of sale. (122)

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

Although in Ludey the Supreme Court held that the section 1016(a)(2) basis reduction by allowable depreciation deductions was not optional, the facts before the Court did not specifically address a situation in which the underlying depreciation produced no tax benefit for the taxpayer. In Hardwick Realty Co. v. Commissioner, (123) a Board of Tax Appeals case decided shortly after Ludey, this issue was raised. In that case, the taxpayer argued the depreciation deduction was dependant on income from which it was to be deducted against--thus, without income, the depreciation deduction could not be taken. (124) Accordingly, in the absence of a valid depreciation deduction, no basis reduction of the depreciable asset could be made. Relying on Ludey, the Board of Tax Appeals rejected the taxpayer's position and stated as follows: "Depreciation is not made dependent on income or the lack of it, but is a sum which should be set aside each year, in order that at the end of the useful life of a building, the aggregate sums will provide an amount equal to the original cost."

On appeal to the Second Circuit, the taxpayer attempted to distinguish the case from Ludey by noting that in the latter case, the taxpayer had income from which depreciation could have been deducted. (126) Not swayed by the taxpayer's attempt to distinguish the case, the Second Circuit held that Ludey mandated a basis reduction regardless of whether an allowable depreciation deduction was claimed or provided a tax benefit to the taxpayer in the properly deductible tax year. Thus, consistent with Ludey, depreciation deductions that did not produce a tax benefit for the taxpayer could not be preserved for another tax year by not reducing basis. (127)

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

Kittredge v. Commissioner (128) and Beckridge Corporation v. Commissioner (129) were two significant No Tax Benefit Decisions decided by the Second Circuit between the Ludey and Virginian Hotel Supreme Court decisions. They were hybrid cases because in those cases the section 1016(a)(2) basis reduction not only prevented the taxpayers from resurrecting the tax benefit of unclaimed allowable depreciation deductions in the form of a tax loss (No Tax Benefit Decisions), but also caused the transformation of some of those depreciation deductions into phantom taxable gain (the Basis Reduction Tax Trap). They also demonstrate how the No Tax Benefit Decisions go too far in being punitive to the taxpayer particularly in hybrid cases.

In Kittredge, the taxpayer purchased a winery that, including improvements, had a total cost basis of approximately $37,000. (130) Although the taxpayer initially leased the winery to a tenant who was to operate it as a grape juice plant, for the most part, it remained idle. (131) Because the winery did not generate any income in those tax years, the taxpayer did not claim any of the approximately $25,000 of allowable depreciation deductions or reduce the winery's basis by that amount. (132) As a consequence of not reducing basis, the taxpayer reported a $25,000 tax loss upon the sale of the winery for $12,000. (133) The Commissioner challenged the taxpayer's failure to reduce the winery's basis by the $25,000 of allowable depreciation deductions, and thus disallowed the loss. (134) By reducing the winery's basis by the allowable depreciation deductions, the amount realized exceeded the correspondingly reduced adjusted basis, effectively converting the loss into a taxable gain. (135)

Similarly, in Beckridge, over the entire ownership period of an apartment building, the taxpayer continuously sustained losses and failed to claim any of the allowable but useless depreciation deductions or reduce basis by those deductions. (136) Subsequently, upon the sale of the apartment building, the taxpayer reported a loss because the adjusted basis of the apartment building--unreduced by unclaimed allowable depreciation deductions--exceeded the amount realized. (137) As in Kittredge, the Commissioner's reduction of the apartment building's basis by the full amount of the unclaimed allowable depreciation deductions converted the taxpayer's loss into a taxable gain. (138)

In both cases, the Second Circuit agreed with the Commissioner's application of the mandatory section 1016(a)(2) basis reduction and found in his favor. (139) However, in essence, the mandatory basis reduction had two consequences to the taxpayers. First, to the extent the basis was reduced to the amount realized, the taxpayers were denied a loss. Second, to the extent the basis was reduced below the amount realized, taxpayers had to recognize a phantom taxable gain.

As to the first consequence, by failing to reduce basis, the tax loss the taxpayers sought to recognize was the difference between the original cost basis of the property and the sales price. This spread reflected the economic depreciation of the property unmatched with a basis reduction for the unclaimed allowable depreciation deductions. Therefore, consistent with the rationale of the No Tax Benefit Decisions, the Second Circuit correctly reduced the basis of the underlying property by the unclaimed, albeit useless depreciation deductions so to prevent the taxpayers from recognizing a loss.

In contrast, as to the second consequence, the phantom taxable gain the taxpayers were compelled to recognize was attributable to the basis reduction by an amount of useless depreciation deductions that caused the adjusted basis to fall below the amount realized (the selling price). So, in spite of receiving no tax benefits from the depreciation deductions and realizing an economic loss (and being denied a corresponding tax loss) on the sale of the depreciable property, the taxpayers were saddled with phantom taxable gain.

In the final analysis, this is a clear-cut example of the No Tax Benefit Decisions going too far. Although it was appropriate for the court to deny a tax loss attributable to a basis reduction by unclaimed allowable (but useless) depreciation deductions; it was inappropriate to impose a phantom taxable gain attributable to useless depreciation deductions that reduced basis below the selling price of the depreciable asset. Accordingly, the correct result in both circumstances would have been to deny the taxpayers the loss but not compel the taxpayers to recognize the gain.

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

Into the 1940s, as evident from Kittredge and Beckridge, the rationale of the No Tax Benefit Decisions was broadly applied to mandate basis reductions of all allowable depreciation deductions without regard to whether they provided corresponding tax benefits. In 1943, the Supreme Court's Virginian Hotel Corp. v. Commissioner (140) case served as the final validation of the No Tax Benefit Decisions even though it involved "allowed" rather than "allowable" depreciation deductions.

In Virginian Hotel, over a number of years the taxpayer claimed depreciation deductions in excess of the allowable amount. The excessive depreciation deductions, however, did not produce any tax benefits for the taxpayer. In any event, within the applicable limitations period, the Commissioner did not contest the taxpayer's excessive depreciation deductions. (141) Subsequently, in an examination of other tax years, the Commissioner reduced the taxpayer's basis in the underlying property by the excessive allowed depreciation deductions. (142)

At stake in the case was the amount of depreciation deductions the taxpayer would be entitled to claim over the remaining tax years of the recovery period. If the adjusted basis of the underlying property were "over" reduced by the excessive depreciation deductions that should have never been claimed, there would be a lower resulting adjusted basis from which subsequent legitimate allowable depreciation deductions could be taken. On the other hand, if the basis reduction were limited to the allowable depreciation deductions, the taxpayer would be entitled to claim the full, undiminished amount of remaining allowable depreciation deductions over the balance of the recovery period.

The resolution of the issue turned on the meaning of the phrase "to the extent allowed (but not less than the amount allowable)" in the predecessor of section 1016(a)(2), as it applied to a basis reduction of depreciation deductions. (143) According to the Commissioner's interpretation of the phrase, an excessive depreciation deduction not successfully challenged during the limitations period was "allowed" within the meaning of the phrase. (144) Therefore, section 1016(a)(2) mandated a basis reduction by the full amount of the depreciation deductions (both "allowed" and "allowable").

In disputing the Commissioner's interpretation of the phrase, the taxpayer contended the word "allowed" connoted the receipt of a tax benefit. (145) In other words, an excessive "allowed" deduction could only harm the Government if it produced a tax benefit for the taxpayer. In that case, a basis adjustment would be appropriated because if not, the taxpayer would be in a position to "over" depreciate the cost of the asset or receive an unwarranted tax benefit of a loss from the subsequent sale of the asset. Conversely, in this case, the excessive amount of allowed depreciation deductions taken in the earlier tax years that produced no tax benefits were a tax nullity. Therefore, lacking the receipt of an unwarranted tax benefit, the taxpayer contended the Commissioner's basis reduction inappropriately limited the depreciation deductions it could take over the remaining tax years of the recovery period.

In an opinion written by Justice Douglas, (146) the Supreme Court refused to read a tax benefit concept into the word "allowed." Citing the Beckridge case, (147) the Supreme Court held the basis reduction of the predecessor of section 1016(a)(2) was mandatory for allowed and allowable depreciation deductions alike, even if the deductions produced no tax benefits for the taxpayer. (148) So, in light of the Supreme Court's emphatic holding in Virginian Hotel just four years prior to the Crane decision, as well as its obvious approval of the holding in Beckridge, it is highly unlikely the Supreme Court would have been receptive to an argument based on the inequitable transformation of depreciation deductions into taxable gain.

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

As demonstrated in Parts I and IV of this article, the mandatory section 1016(a)(2) basis reduction achieves the desired result of preserving the integrity of the depreciation deduction by limiting its deductibility to the proper tax year. That, however, is not the case in the Basis Reduction Tax Trap. In Kittredge and Beckridge, the Second Circuit would have achieved an equitable result by denying the taxpayer a second opportunity to receive the tax benefit of unclaimed allowable depreciation deductions in the form of a tax loss without compelling the taxpayer to recognize phantom taxable gain attributable to useless depreciation deductions. Yet, without statutory authority, no court would have the power to make this equitable distinction. (149) Amendment of the applicable Code sections, by implementing tax benefit components into their application, would provide the statutory authority to achieve the desired result.

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

In current tax law, several Code sections involving depreciation deductions have prudently incorporated tax benefit components into their application. The presence and effectiveness of these Code sections provides precedence for Congress to implement similar tax benefit components into the amendment of other Code sections so as to eliminate the punitive harsh tax consequences of the Basis Reduction Tax Trap. In this Subpart A, two such Code sections are discussed.

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

Ironically, section 1016(a)(2) itself incorporates tax benefit components into the basis reduction for allowed depreciation deductions. As discussed in Part V.D., above, the Virginian Hotel case held that section 1016(a)(2) mandated a basis reduction by allowed deductions in excess of the amount of allowable deductions regardless of whether they produced corresponding tax benefits. (150) In 1952, nine years after the case was decided, however, Congress reversed the Virginian Hotel holding by amending section 1016(a)(2) to allow for an upward adjustment to basis with respect to excessive depreciation not resulting in a tax benefit. (151) Then, in 1954, Congress modified its prior amendment of section 1016(a)(2) to its current version by simply not requiring a basis adjustment for excessive depreciation deductions that did not reduce the taxpayer's taxes. (152)

By reversing Virginian Hotel, Congress must have recognized the inequity and unnecessary punitive consequences caused by a basis reduction of excessive but useless allowed depreciation deductions. Accordingly, there is no reason why Congress should not extend the same relief to prevent useless allowable depreciation deductions from being transformed into phantom taxable gain.

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

Section 1245 is another Code section that incorporates a tax benefit component in the characterization of taxable gain attributable to depreciation deductions as ordinary income. Specifically, the purpose of section 1245 is to require a taxpayer who enjoyed the tax benefit of ordinary depreciation deductions from section 1245 property (153) to "recapture" the gain attributable to those deductions as ordinary income ("Recapture Income") upon the disposition of such property. (154)

Sequentially, if the disposition of section 1245 property results in recognized gain, section 1245 is then applied to determine the characterization of all or part of such gain as Recapture Income. Recapture Income is the difference between the "recomputed basis" and the adjusted basis of the section 1245 property. (155) Simply stated, the recomputed basis is the adjusted basis increased by the amount of all previously taken depreciation deductions. (156)

For example, assume that a taxpayer acquires section 1245 property with an original basis of $1,000. Further assume that during the first tax year in which the section 1245 property is placed in service, the taxpayer claims a $200 allowable depreciation deduction. Pursuant to section 1016(a)(2), the original basis of the section 1245 property would be reduced to $800. If the taxpayer were to sell the section 1245 property for $1,000, the taxpayer's recognized gain of $200 would be attributable to the previously taken depreciation deduction that reduced the section 1245 property's basis. (157) For purposes of characterizing all or part of the taxable gain as Recapture Income, the recomputed basis would be $1,000 (the adjusted basis of $800 plus the previously claimed depreciation deduction of $200). Then, subtracting the adjusted basis of $800 from the recomputed basis of $1,000, the entire $200 of taxable gain would be characterized as Recapture Income. (158)

In the big picture, due to the valuable tax benefit that a depreciation deduction taken against ordinary income provides for the taxpayer, there is a need for symmetry so any gain attributable to those deductions is also characterized as ordinary income. To illustrate this point, consider the following fact pattern. Assume a taxpayer acquires section 1245 property for $1,000. Further assume in the first two tax years, the taxpayer claims $400 of depreciation deductions offsetting a like amount of ordinary income. Assuming a marginal tax bracket of 35%, the tax savings produced by the ordinary depreciation deductions offsetting ordinary income would be $140. Then, assume that in the third year the taxpayer sells the section 1245 property for $1,000 (meaning the asset did not decline in value). The entire recognized gain of $400 would be attributable to the previously claimed depreciation deductions that had reduced ordinary income in a like amount.

If, instead of being characterized as ordinary income, the $400 gain were characterized as long-term capital gain taxed at 15%, the resulting tax liability would be $60. Thus, an overly taxpayer favorable differential of $140 tax savings to $60 tax liability would whipsaw the Treasury. By characterizing the taxable gain as Recapture Income, however, the playing field is level, as the tax savings of a deduction against ordinary income is offset by the tax liability of ordinary gain.

Up to this point in the section 1245 analysis, the computations of Recapture Income and gain on the disposition of depreciable property pursuant to section 1001(a) are seemingly identical. Conceptually, the recomputed basis and the amount realized are similar. Both amounts are utilized as the minuend from which the adjusted basis of the underlying property is subtracted. If, for example, the underlying section 1245 property were to be sold for an amount equal to its original basis, the difference between the respective minuends and the adjusted basis of the underlying property accounts for the total amount of prior tax years' depreciation deductions in the computation of gain and Recapture Income, respectively. The two computations part ways, however, with respect to the tax benefit component built into the computation of the recomputed basis that is not factored into the section 1016(a)(2) reduction of the adjusted basis.

More to the point, in the computation of taxable gain, section 1016(a)(2) requires a basis reduction by all allowable depreciation deductions including those that did not produce tax benefits. This means the resulting taxable gain accounts for all depreciation deductions including those that produced no tax benefits for the taxpayer. Conversely, although in the computation of Recapture Income, the same adjusted basis is utilized as the subtrahend, in arriving at the recomputed basis, the minuend of the formula only depreciation deductions actually claimed are added to the adjusted basis. The flush language of section 1245(a)(2) adds this tax benefit component as follows: "[I]f the taxpayer can establish by adequate records or other sufficient evidence that the amount allowed for depreciation ... for any period was less than the amount allowable, the amount added for such period shall be the amount allowed."

Thus, due to the tax benefit component incorporated in section 1245(a)(2), only depreciation deductions actually claimed by the taxpayer are transformed into Recapture Income. (159) For example, assume a taxpayer sold section 1245 property with an adjusted basis of $500 for $1,500. Further, assume over the period in which the taxpayer utilized the section 1245 property in her trade or business, the allowable depreciation deductions were $1,000 of which she claimed only $800. (160)

In spite of recognizing $1,000 of taxable gain from the sale of the 1245 property, the amount characterized as Recapture Income would be limited to depreciation deductions actually claimed by the taxpayer. Here, the recomputed basis of the section 1245 property would be $1,300, the taxpayer's adjusted basis ($500) plus only the depreciation deductions actually claimed by the taxpayer ($800). Finally, subtracting the adjusted basis ($500) from the recomputed basis ($1,300) would result in $800 of Recapture Income. (161) Thus, the remaining taxable gain of $200 could potentially be characterized as capital gain. (162)

The above example demonstrates how section 1245(a)(2) achieves tax symmetry, without causing punitive tax consequences, because only the portion of gain attributable to previously claimed depreciation deductions is characterized as Recapture Income. In this case, the taxpayer claimed only $800 of the $1,000 of allowable depreciation deductions. Obviously, an unclaimed depreciation deduction cannot reduce ordinary income and, with a tax benefit component built into its application, section 1245 never causes the harsh tax consequences of transforming unclaimed depreciation deductions into ordinary income.

Unfortunately, the computation of gain upon the disposition of depreciable property does not invoke a similar tax benefit component. So, if in the above example, the facts were modified to assume the taxpayer actually claimed allowable depreciation deductions of $1,000. of which only $800 produced tax benefits, the taxpayer would nonetheless be compelled to recognize the entire realized gain of $1,000. This would include the amount attributable to the $200 of depreciation deductions that produced no tax benefits. This is because unlike section 1245(a)(2), section 1016(a)(2) requires a dollar for dollar depreciation basis reduction with no consideration of whether those deductions produced equivalent tax benefits.

As a matter of tax policy, there is no rational reason why a tax benefit component similar to that built into the computation of Recapture Income should not also be incorporated into the computation of taxable gain upon the disposition of depreciable property. Both computations are intended to prevent the taxpayer from enjoying unwarranted tax benefits. Although section 1245 achieves this purpose with tax equity, the rigid, no exception depreciation basis reduction of section 1016(a)(2) creates a Basis Reduction Tax Trap for the unwitting taxpayer. In all instances, the ultimate result should be an equal match of the tax benefits of the depreciation deductions with the tax detriment of the taxable gain. For purposes of computing gain, unless and until the gain attributable to useless depreciation deductions are excluded from gross income, tax symmetry will never be achieved.

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

One way to incorporate a tax benefit component to eliminate the Basis Reduction Tax Trap would be to create a new "Gain Basis" to be utilized solely for purposes of computing taxable gain upon the disposition of depreciable property. For purposes of tracking depreciation deductions over the recovery period and computing loss on the disposition of depreciable property, the current law adjusted basis would continue to be utilized as it is today.

The creation of a gain basis and a loss basis is not a novel concept in tax law. Section 1015(a) provides that if the fair market value of gifted property is less than the donor's basis in the property, for purposes of computing loss, the donee's basis in the property is the date of gift fair market value. Conversely, for purposes of computing gain, the donee's basis in the property is the same as the donor's basis. The purpose of a separate loss basis is to prevent the donee from taking advantage of the donor's basis in order to claim the donor's pre-gift transfer loss on a subsequent sale of the gifted property. (163) On the other hand, for purposes of computing gain, the carryover gain basis provides the donee with the full benefit of the donor's basis as an offset against the amount realized, and thus resulting gain, from the subsequent disposition of the gifted property. (164)

In an analogous way, the new Gain Basis would assure that no gain attributable to useless depreciation deductions would ever be triggered upon the sale of the underlying property. Each tax year, unlike the current version of section 1016(a)(2), the Gain Basis would be reduced only by those depreciation deductions that produced tax benefits for the taxpayer. Therefore, utilizing the Gain Basis as the subtrahend in the gain computation formula would eliminate any potential gain attributable to depreciation deductions that did not produce tax benefits for the taxpayer.

Conversely, the current law adjusted basis would be utilized for purposes of tracking the declining balance available for depreciation deductions over the remaining years of the recovery period as well as in the computation of loss. By reducing basis by the full amount of allowable depreciation deductions (as well as allowed depreciation deductions that produce tax benefits for the taxpayer), the integrity of the depreciation deduction would be preserved. So, just as it does today, utilizing the current law basis as the minuend in the computation of loss would prevent the taxpayer from having a second opportunity to receive the tax benefit of unclaimed allowable depreciation deductions in the form of a tax loss whether or not they provided tax benefits.

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

Under current law, the basis of depreciable property is reduced by all depreciation deductions including those that produced no tax benefits for the taxpayer. So, even if the taxpayer were to realize an economic loss (if the selling price were less than the original cost), the disposition of depreciable property would trigger the recognition of phantom taxable gain, all of which would be attributable to those useless tax depreciation deductions that reduced the asset's basis. This is exactly what happened to Beulah. Although she realized a $4,500 economic loss from the sale of the Brooklyn Apartment Building and had received minimal tax benefits from the allowable depreciation deductions, she was compelled to recognize $23,500 of gain attributable to useless depreciation deductions that reduced the basis of the property.

On the other hand, if the Gain Basis had been utilized, Beulah would have been saved from the Basis Reduction Tax Trap, as no gain from the sale of the Brooklyn Apartment Building would have been recognized. Starting with $262,000 as the original Gain Basis of the Brooklyn Apartment Building and limiting the basis reduction of the Gain Basis to the $3,307 of tax productive depreciation deductions, the "adjusted" Gain Basis of the Brooklyn Apartment Building at the time of the sale would have been $258,693 ($262,000 minus $3,307). Thus, because the amount realized ($257,500)--i.e., the total consideration Beulah was deemed to have received from the sale of Brooklyn Apartment Building--did not exceed her Gain Basis ($258,693), no gain would have been recognized. Thus, the utilization of Gain Basis would have prevented Beulah from falling victim to the Basis Reduction Tax Trap. (165)

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

Just as utilizing the Gain Basis would have prevented Beulah from falling into the Basis Reduction Tax Trap, utilizing the conventional current law adjusted basis as the minuend in the computation of loss would have prevented her from transforming those useless depreciation deductions into a tax loss. In other words, although Beulah's Gain Basis would have been $258,693, her conventional adjusted basis would have been $234,000 ($262,000 minus $28,000, the amount of all allowable depreciation deductions). Because loss is the excess of the adjusted basis over the amount realized, (166) there would have been no loss because the conventional adjusted basis of $234,000 would not have exceeded the amount realized of $257,500.

Consistent with the rationale of the No Tax Benefit Decisions, this is the correct result. Although over the course of the ownership period of the Brooklyn Apartment Building Beulah and the Crane Estate received the tax benefit of only $3,307 of the $28,000 allowable depreciation deductions, she was not entitled to a second chance to receive the tax benefit of those unproductive depreciation deductions. Because the conventional current law basis would function as the minuend in the computation of loss, it could never exceed the amount realized and result in the recognition of a tax loss. Thus, had the Gain Basis been in effect during the Crane years, Beulah would have escaped the recognition of phantom gain upon the disposition of the Brooklyn Apartment Building without a second opportunity to transform depreciation deductions that did not produce tax benefits for her and the Crane estate in the tax year of sale.

CONCLUSION

The untold story of Beulah Crane reveals an inconvenient tax truth of the Basis Reduction Tax Trap. The combination of economic circumstances beyond the taxpayer's control, such as little or no income generated from her trade or business, unproductive wasted depreciation deductions and the mandatory section 1016(a)(2) basis reduction resulting from those useless depreciation deductions, bait this hazardous trap for unwitting taxpayers. The trap snaps shut if the taxpayer were to sell the underlying depreciable property for an amount between the property's adjusted basis and original cost. All gain triggered by the sale would be attributable to useless depreciation deductions that reduced the basis of the property. So, in spite of realizing no economic gain, or perhaps realizing an economic loss, the taxpayer is compelled to recognize phantom taxable gain.

In the vocabulary tax law case, Crane v. Commissioner, (167) facts not discussed in the Supreme Court's decision reveal that Beulah was the victim of the Basis Reduction Tax Trap. In that case, Beulah operated the Brooklyn Apartment Building at a loss for seven years. Because she was entitled to claim a substantial amount of allowable deductions, the basis of the Brooklyn Apartment Building was reduced by a like amount. Due to the limited income generated by the Brooklyn Apartment Building, however, only a small portion of those allowable depreciation deductions actually produced tax benefits for her. Subsequently, when she was compelled to sell the Brooklyn Apartment Building for less than its original value in order to avoid foreclosure, the large amount of phantom gain triggered by the sale was attributable to the useless depreciation deductions that had reduced the basis of the building.

In unsuccessfully challenging the gain she was obligated to recognize, Beulah did not question the propriety of the section 1016(a)(2) basis reduction by useless deductions. Even had she done so, the result would have surely been the same. This is because of the long-standing judicial precedent of the No Tax Benefit Decisions, holding the section 1016(a)(2) basis reduction was mandatory even if the corresponding depreciation deductions produced no tax benefits to the taxpayer.

A closer examination of the No Tax Benefit Decisions, however, reveals the purpose of the mandatory section 1016(a)(2) basis reduction is to preserve the integrity of the depreciation deduction. For the most part, those cases involved taxpayers attempting to manipulate the timing of the depreciation deduction. The mandatory basis reduction prevented the taxpayer from effectively deferring a depreciation deduction from its properly deductible year by not reducing the basis of the underlying property in order to receive the tax benefit of the deduction in a subsequent tax year of sale. Conversely, in the Basis Reduction Tax Trap, the mandatory basis reduction is punitive because it causes the transformation of depreciation deductions that would never provide a tax benefit for the taxpayer into phantom taxable gain. In many instances, economic circumstances beyond the taxpayer's control (such as the imminent foreclosure Beulah faced) compel the taxpayer to dispose of a depreciable asset. Consequently, perhaps after experiencing multiple tax years of generating little or no income in which the depreciation deductions provided no tax benefits, a fire sale might trigger substantial and unexpected taxable income.

Thus, incorporating tax benefit components in amending the Code would be a prudent way to eliminate the Basis Reduction Trap without compromising the integrity of the depreciation deduction. This could be accomplished by creating a new Gain Basis, utilized solely as the subtrahend in the computation of gain from the disposition of depreciable property. Unlike the current law basis, the Gain Basis would be reduced only by those depreciation deductions that produced tax benefits. That way, no gain attributable to useless depreciation deductions would ever be triggered.

On the other hand, the current law basis would continue to serve its functions of tracking the balance of an asset's basis available for depreciation deductions over the remaining tax years in the recovery period as well as being the minuend in the computation of loss. Because basis would be reduced by all allowable deductions for purposes of computing loss, (168) a taxpayer would never have a second opportunity to resurrect a depreciation deduction that did not produce a tax benefit in the given tax year, when it was properly deductible, and take a tax loss in the subsequent tax year of sale.

In the final analysis, the best of both tax worlds would be achieved. The basis reduction rules should protect the integrity of the depreciation deduction without triggering punitive tax consequences for the unsuspecting taxpayer.

(1) I.R.C. [section] 1016(a)(2)(A)-(B) provides in pertinent part:
  General rule. Proper adjustment in respect of properly shall
  in all cases be made ... (2) in respect of any period since
  February 28, 1913, for exhaustion, wear and tear, obsolescence,
  amortization ... to the extent of the amount (A) allowed as
  deductions in computing taxable income ... and (B) resulting
  (by reason of the deductions so allowed) in a reduction for any
  taxable year of the taxpayer's taxes ... but not less than the amount
  allowable under this subtitle. ...


(2) Unless otherwise indicated, all citations to provisions codified in Title 26 of the United States Code and sections from prior law comparable to the current law version are cited herein as sections of the Internal Revenue Code (Code).

(3) I.R.C. [section] 1001(a) (staling that the gain is the difference between the amount realized and the adjusted basis). In this case, the spread between the amount realized and the adjusted basis is attributable to allowable depreciation deductions.

(4) Of course, some of the gain could be potentially offset with a net operating loss deduction from prior tax years. The magnitude of the offset would depend on the amount of the net operating loss available for carryover from those prior tax years. For example, if the depreciable asset were commercial or residential real estate much of the net operating deduction might have been incurred in tax years well prior to the carry forward tax years.

(5) Crane v. Commissioner, 331 U.S. 1 (1947).

(6) Boris I. Bittker, Tax Shelters, Nonrecourse Debt, and the Crime Case, 33 Tax L. Rev. 277, 283 (1978).

(7) Id. at 3. This was the unencumbered fair market value of the apartment building. It was secured by a nonrecourse mortgage in the principal amount of $255,000 plus approximately $7,000 of interest arrears.

(8) See Tax Court Petition at 7, Crane v. Commissioner, 153 F.2d 504 (2d Cir. 1946) (No. 110361).

(9) Crane, 331 U.S. at 4.

(10) Id. at 3. The purchase price included the buyers taking the property subject to the principal balance of the nonrecourse mortgage ($255,000) plus net monetary consideration ($2,500).

(11) Id. at 4. The selling price was actually allocated between the building and the land. With respect to the building, there was a taxable gain of approximately $24,000. As to the land, there was a capital loss of approximately $264. The net effect was a taxable gain of approximately $23,500. For purposes of this article, however, the allocation between the building and the land is ignored and $23,500 is deemed to be the taxable gain from the sale of the entire property.

(12) There were ample facts throughout the record of the ease indicating Beulah's enjoyment of minimal tax benefits from the apartment building's depreciation deductions. None of those facts, however, were discussed or even mentioned in the Supreme Court decision. Transcript of Record, Crane v. Commissioner, 331 U.S. 1 (1947) (No. 68).

(13) See infra Part III.A.

(14) See supra note 12.

(15) See infra Part III.B.1.

(16) See infra Pan III.B.2.

(17) See United States v. Ludey, 274 U.S. 295 (1927) (holding that taxpayer could not preserve the initial cost basis of depreciable equipment and recognize a loss upon sale of the underlying property); Virginian Hotel Corp. v. Commissioner, 319 U.S. 523 (1943) (holding basis reduction was mandatory for allowed and allowable deprecation deductions). See infra Part IV.A. and Part IV.D. for a detailed discussion of these two cases.

(18) See Kittredge v. Commissioner, 88 F.2d 632 (2d Cir. 1937); Beckridge Corp. v. Commissioner, 129 F.2d 318 (2d Cir. 1942). These are two Second Circuit cases (the circuit in which Beulah resided) in which the taxpayer was snared by the Basis Reduction Tax Trap. Although not specifically raised in the decisions, in both cases useless depreciation deductions were transformed into taxable gain. See infra Part IV.C. for a detailed discussion of these two cases.

Also, in the Crane decision, without directly referencing the mandatory section 1016(a)(2) basis reduction, the Supreme Court stated as follows: "The crux of this case, really, is whether the law permits her to exclude allowable deductions from consideration in computing gain. We have already showed that, if it does, the taxpayer can enjoy a doable deduction, in effect, on the same loss of assets." Crane, 331 U.S. at 15-16 (emphasis added). This quote is very similar to the following statement made by the Supreme Court in Ludey in which it held that the depreciation deduction and corresponding basis reduction were not optional. "The amount of the depreciation must be deducted from the original cost of the whole in order to determine the cost of that disposed of in the final sale of properties. Any other construction would permit a double deduction from the same capital assets." Ludey, 274 U.S. at 301 (emphasis added). So even though the Supreme Court in Crane did not directly address the propriety of the section 1016(a)(2) basis reduction by useless depreciation deductions, its paraphrasing of the Ludey quote provides an indication of its reaching a similar conclusion had the issued been raised in the case.

(19) Ludey, 274 U.S. 295 (1927).

(20) Although the facts in the case are not entirely clear, it appears that the taxpayer claimed approximately 50% of the allowable depreciation deductions, but totally failed to reduce basis by any amount. In any event, the primary position of the taxpayer was that depreciation deductions were not mandatory.

(21) Ludey, 274 U.S. at 296.

(22) Id. at 300.

(23) Virginian Hotel Corp. v. Helvering, 319 U.S. 523 (1943).

(24) Id. at 525-26.

(25) Commissioner v. Idaho Power Co., 418 U.S. 1, 10 (1974) (footnote OMITTED).

(26) See Liddle v. Commissioner, 103 T.C. 285, 289 (T.C. 1994) ("The primary purpose of allocating depreciation to more than 1 year is to provide a more meaningful matching of the cost of an income-producing asset with the income therefrom; this meaningful match, in turn, bolsters the integrity of the taxpayer's periodic income statements.") (citations OMITTED).

(27) Section 1012(a) defines basis as its cost.

(28) See Philadelphia Park Amusement Co. v. United States, 126 F. Supp. 184, 188 (Ct. Cl. 1954) (noting that basis represents the taxpayer's after-tax investment in property).

(29) Section 167(c)(1) provides "the basis on which exhaustion, wear and tear, obsolescence are to be allowed in respect of any properly shall be the adjusted basis provided in section 1011." Section 1011 is the adjusted basis of property, i.e., the section 1012 basis as reduced by depreciation deductions per section 1016(a)(2). Section 168(a) sets forth the three essential components necessary in the computation of depreciation deductions, i.e., the applicable depreciation method, the applicable recovery period, and the applicable convention.

(30) Obviously, at that point, there is no more basis from which to take any further depreciation deductions.

(31) See United States v. Ludley, 274 U.S. 295, 304 (1927).

(32) Section 1001(a) defines a loss as the excess of the adjusted basis over the amount realized.

(33) See Commerce Co. v. United States, 171 F.2d 189, 192 (5th Cir. 1948).

(34) See Fribourg Navigation Co. v. Commissioner, 383 U.S. 272, 277 (1966) ("In so defining depreciation, tax law has long recognized the accounting concept that depreciation is a process of estimated allocation which does not take account of fluctuations in valuation through market appreciation.") (footnotes OMITTED).

(35) See Simon v. Commissioner, 103 T.C. 247, 262 (T.C. 1994) (slating that violin bows that were treasured works of art used in taxpayer's trade or business were depreciable regardless of whether they actually lost value over the recovery period); Liddle v. Commissioner. 103 T.C. 285. 293-94 (T.C. 1994) (noting a similar holding in case involving the depreciation of a 17th-century Ruggeri bass viol used by a full time musician).

(36) This is because the amount realized ($100) would be offset by the adjusted basis ($100) resulting in no gain or loss.

(37) Section 1001(a) provides that "[t]he gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain. ..."

(38) See Virginian Hotel Corp. v. Helvering, 319 U.S. 523, 527 (1943).

(39) For purposes of the illustration, the half-year convention is ignored. See I.R.C. [section] 168(a)(3).

(40) This assumes, however, the final year was an open year for examination.

(41) Crane v. Commissioner, 331 U.S. 1.3 (1947).

(42) Id.

(43) Transcript of Record at 5, Crane v. Commissioner, 331 U.S. 1 (1947) (No. 68). Sometime in 1924, William Crane purchased the Brooklyn Apartment Building for approximately $1,000,000. George K. Yin, The Story of Crane: How a Widow's Misfortune Led to lax Shelters, in TAX STORIES 251, 251 (Paul L. Caron 2d ed., 2009).

(44) Although the unencumbered fair market value of (he Brooklyn Apartment Building was appraised at $55,000.00 for the land and $207,042.00 for the building, for purposes of this article, the apportionment of the fair market value to the land is ignored. Thus, it is always assumed that the fair market value of the building was the full $262,000. Transcript of Record at 15, Crane v. Commissioner, 331 U.S. 1 (1947) (No. 68).

(45) These amounts appeared on Schedule A and J of the Federal estate tax return, respectively. Id.

(46) Id. at 8.

(47) William's will was probated on January 31, 1932. Id. at 6.

(48) See Crane v. Commissioner, 331 U.S. 1, 3 (1947).

(49) See Transcript of Record at 6, Crane v. Commissioner, 331 U.S. 1 (1947) (No. 68).

(50) See Crane, 331 U.S. at 3.

(51) See Transcript of Record at 15-16, Crane v. Commissioner, 331 U.S. 1 (1947) (No. 68). For some unexplained reason, the Supreme Court slated the depreciation deductions claimed by the Crane Estate and Beulah was $25,500. See Crane, 331 U.S. at 3, n. 2.

(52) Although the Record is silent on the point, considering the large amount of the depreciation deductions claimed by Beulah, it would appear that she utilized the unencumbered date-of-death fair market value of the Brooklyn Apartment Building as the original basis.

(53) See supra note 12.

(54) See Transcript of Record at 7, Crane v. Commissioner, 331 U.S. 1 (1947) (No. 68).

(55) Id.

(56) Id.

(57) Id.

(58) Id.

(59) Id. This would be the sum of the Crane Estate's $3,113 of tax beneficial depreciation deductions plus Beulah's $194 of tax beneficial depreciation deductions.

(60) See Crane v. Commissioner, 331 U.S. 1, 4 (1947). Neither the Record nor the Supreme Court decision provided any explanation as to why Beulah failed to claim all of the allowable depreciation deductions.

(61) See Transcript of Record at 7-8, Crane v. Commissioner, 331 U.S. 1 (1947) (No. 68).

(62) Id at 26-32.

(63) On the eve of the sale, the principal balance of the nonrecourse mortgage was $255,000 and the interest arrears had increased from $7,000 to approximately $16,000. Id. at 16.

(64) See supra note 11.

(65) The Supreme Court's decision assumed the fair market value and purchase price of the Brooklyn Apartment Building was $257,500. Although not relevant to the ultimate holding in the case, the fair market value of the Brooklyn Apartment Building was more realistically $273,500. The particulars of the sale of the Brooklyn Apartment Building to Avenue C Realty tend to support the higher amount. According to the Contract of Sale, Avenue C Really purchased the Brooklyn Property
  [s]ubject to a first mortgage now a lien on said premises, held by
  Bowery Savings Bank, upon which there is due the principal sum
  of Two Hundred Fifty Five Thousand Dollars ($255,000) and arrears
  of interest in the sum of Fifteen Thousand Eight Hundred Fifty-seven
  71/100 Dollars ($15,857.71) and interest to accrue after this date.


See Transcript of Record at 29, Crane v. Commissioner, 331 U.S. 1 (1947) (No. 68).

Based on the foregoing provision of the Contract of Sale, in addition to net monetary consideration of $2,500, Avenue C Realty purchased the Brooklyn Apartment Building subject to the principal balance of the nonrecourse mortgage ($255,000) plus interest arrears of approximately $16,000. Simple math indicates the purchase price and likely fair market value of the Brooklyn Apartment Building was the sum of the principal balance of the nonrecourse mortgage, the interest arrears, and the act monetary consideration, or $273,500. In the final analysis, however, whether the fair market value of the Brooklyn Apartment Building was $257,500 or $273,500 would have made no difference in the Supreme Court's decision. Although the amount realized on the disposition of property subject to nonrecourse liability includes principal and interest arrears, see Allan v. Commissioner, 856 F.2d 1169,1172 (8th Cir. 1988); Catalano v. Commissioner, T.C. Memo 2000-82, *3 (T.C. 2000), rev'd on other grounds 279 F.3d 682 (9th Cir. 2002), the transferor of the property is deemed to have sold the property for "cash equivalent to the amount of the debt and had applied the cash to the payment of the debt." Unique Art Mfg. Co. v. Commissioner, 8 T.C. 1341, 1342 (T.C. 1947) (citing Peninsula Prop. Co. Ltd. v. Commissioner, 47 B.T.A. 84 (1942)). So the potential inclusion of an additional $16,000 of interest arrears in the amount realized that would have increased Beulah's taxable gain would have been offset by an equivalent interest deduction she would have been entitled to take. In fact, in footnote 6, the Supreme Court noted its agreement with the Government's determination not to include the $16,000 of interest arrears in the amount realized because of the offsetting interest deduction. See Crane, 331 U.S. at n. 6.

(66) For purposes of the illustrations below, it is assumed that the taxable rental income generated each year by the Brooklyn Apartment Building was either zero or a negative number.

(67) See Transcript of Record at 6-7, Crane v. Commissioner, 331 U.S. 1 (1947) (No. 68).

(68) See Crane, 331 U.S. at 11-12.

(69) Id. at 3. Obviously, Beulah had a change of heart as she had previously claimed depreciation deductions on the date-of-death unencumbered fair market value ($262,000) basis of the Brooklyn Apartment Building.

(70) In response to the Government's challenge to her exclusion of the nonrecourse liability in the amount realized, Beulah stated, "Nothing could be clearer than that [Beulah] was not obliged to pay interest on the mortgage. The sale of her interest in the real estate did not relieve her of any obligation arising under the mortgage or the mortgage bond because she was never under any such obligation." Brief for the Petitioner at 24, Crane v. Commissioner, 331 U.S. 1 (1947) (No. 68).

(71) See Transcript of Record at 29, Crane v. Commissioner, 331 U.S. 1 (1947) (No. 68) (emphasis added).

(72) Crane, 331 U.S. at 3-4.

(73) See id. at 4.

(74) See Brief for the Petitioner at 50, Crane v. Commissioner, 331 U.S. 1 (1947) (No. 68).

(75) Petition for Writ of Certiorari and Brief in Support Thereof at 8, Crane, 331 U.S. 1 (No. 68), available at http://taft.law.uc.edu/taxstories/chap07/crane04.pdf; Brief in Behalf of Petitioner at 26-28, Crane, 331 U.S. 1 (1947) (No. 68); Brief for the Petitioner at 50-52, Crane, 331 U.S. 1 (No. 68); Petitioner's Reply Brief at 4, Crane, 331 U.S. 1 (1947) (No. 68).

(76) See Brief for the Petitioner, supra note 70.

(77) See supra note 75.

(78) However, in her Supreme Court brief, Beulah apparently raised the possibility of challenging the propriety of the transformation of useless depreciation deductions into taxable gain. In Paragraph (5) of the Assignment of Errors in her brief, Beulah indicated she intended to urge the Supreme Court to consider as an alternate argument, "whether depreciation on the building should be included in the 'amount realized' upon the sale in 1938 and if so, whether the amount to be included was depreciation 'allowed or allowable', or only the depreciation which resulted in tax benefit for [Beulah]." Brief for the Petitioner, supra note 70, at 6. There is nothing in the Record to indicate whether Beulah took any further steps to advance this argument. The Supreme Court never considered it.

(79) This includes the $3,200 depreciation deduction Beulah claimed in the year of the sale. See Tax Court Petition VI at 11, Crane, 3 T.C. 585 (1944) (No. 110361) available at http://taft.law.uc.edu/taxstories/chap07/crane01.pdf. The fact that Beulah claimed a depreciation deduction in the tax year of the sale makes her reporting position seem more disingenuous. Having determined she was selling a nondepreciable equity interest in the Brooklyn Apartment Building, Beulah should have claimed no depreciation in that year.

(80) See Crane v. Commissioner, 153 F.2d 504, 505 (2d Cir. 1945) ("In the years 1932-1936, inclusive, she had filed income tax returns as executrix of the devisor, in each of which she had claimed and had been allowed deductions for depreciation upon the building; and in the years 1937 and 1938 she had claimed and been allowed similar deductions in her individual income tax return."); Brief for the Respondent at 6, Crane, 331 U.S. 1 (1947) (No. 68) ("She claimed and was allowed depreciation on the basis of the full value of the apartment building with any reduction on account of the mortgage.").

(81) Apparently, 1938, the tax year of the sale, was the only tax year open for examination by the Government. Interestingly, the Tax Court agreed with Beulah's contention that the equity interest in the Brooklyn Apartment Building was nondepreciable. For that reason, the Tax Court disallowed the $3,200 depreciation deduction Beulah claimed in 1938. See Crane, 3 T.C. at 591. As to the prior tax years' depreciation deductions, the Tax Court declined to address the question since those tax years were not before it. Id.

(82) See Brief for the Petitioner at 42, Crane, 331 U.S. 1 (1947) (No. 68).

(83) See id. at 46 ("The double deduction in [Beulah's] case, if it exists at all, was due only to the error of [Beulah] in claiming depreciation which she was not entitled to and the error of the Commissioner in tailing to disallow it. The evidence showed that the actual amount of tax loss to the Treasury was between $150 and $200.").

(84) See Crane, 331 U.S. at 12-13.

(85) See, e.g., Brief for the Petitioner, supra note 70, at 50; Petition for Writ of Certiorari and Brief in Support Thereof, supra note 75, at 8.

(86) See Crane, 331 U.S. at 13.

(87) Id. at 15 (internal citation OMITTED).

(88) See id.

(89) See Petition for Writ of Certiorari and Brief in Support Thereof, supra note 75, at 4 (noting the Tax Court made no finding with regard to Beulah's lack of lax benefit); see Brief for the Petitioner at 46, Crane, 331 U.S. 1 (1947) (No. 68).

As discussed supra note 17, it is possible the Supreme Court was paraphrasing the following statement from Ludey: "The amount of the depreciation must be deducted from the original cost of the whole in order to determine the cost of that disposed of in the final sale of properties. Any other construction would permit a double deduction from the same capital assets." Ludey, 274 U.S. at 301 (emphasis added) (footnote OMITTED). Even though the Supreme Court did not attribute its "double deduction" statement to Ludey, it is possible the Supreme Court was advancing the No Tax Benefit Decisions rationale as an alternate reason to decide the case against Beulah. If this was the Supreme Court's intention, what it "already showed" could have been a reference to the Ludey case in which it held that the depreciation deduction and corresponding basis reduction were mandatory. This would be a plausible interpretation of that language considering in the defense of her reporting position, Beulah did not directly raise the section 1016(a)(2) basis reduction the real cause of her harsh lax consequences. Even so, the Supreme Court misconstrued the minimal tax benefits the depreciation deductions actually produced for Beulah and the Crane Estate.

(90) See supra notes 51-60 and accompanying text.

(91) One explanation for the Supreme Court's failure to mention Beulah's minimal tax benefits might be due to the Tax Court making no finding of fact on this point. See supra note 89.

(92) See Crane, 331 U.S. at 12-13.

(93) Id.

(94) See id. at 12-14.

(95) See id.

(96) See id.

(97) Id. at 12-14.

(98) One scholar noted in footnote 37 it "laid the foundation stone of most tax shelters." Bittker, supra note 6, at 283.

(99) See Parker v. Delaney, 186 F.2d 455. 458 (1st Cir. 1950) (holding that the Crane decision established that the amount realized on the sale of property included the amount of the encumbering nonrecourse liability to the extent of the property's fair market value).

(100) See Millar v. Commissioner, 577 F.2d 212 (3d Cir. 1978.), cert denied, 439 U.S. 1046 (1978).

(101) See Tufts v. Commissioner, 70 T.C. 756 (1978), rev'd, 651 F.2d 1058 (5th Cir. 1981), rev'd, 461 U.S. 300 (1983).

(102) See Millar v. Commissioner. 577 F.2d 212 (3d Cir. 1978.), cert, denied, 439 U.S. 1046 (1978).

(103) Millar, 577 F.2d at 213.

(104) 577 F.2d. 212 (3d Cir. 1978).

(105) Tufts, 70 T.C. at 758-60.

(106) Millar, 577 F.2d at 214-15.

(107) Id. at 214.

(108) Id. at 215.

(109) Id.

(110) See Parker v. Delaney, 186 F.2d 455, 458 (1st Cir. 1950).

(111) The Tufts case involved a similar scenario. See Tufts, 70 T.C. 756.

(112) Millar, 577 F.2d at 215 ("A finding that the taxpayers did not realize gain as a result of this exchange, after having realized the full economic benefit of this transaction, would entitle them to the type of double deductions of which the Supreme Court so clearly disapproved in Crane."). In coming to the same conclusion, the Tax Court cited this part of the Millar decision with approval. Tufts, 70 T.C. at 765.

(113) Millar, 577 F.2d at 215.

(114) Id.

(115) United States v. Ludey. 274 U.S. 295 (1927), Virginian Hotel Corp. v. Commissioner, 319 W.S. 523 (1943).

(116) See Beckridge Corp. v. Commissioner, 129 F.2d 318 (2d Cir. 1942); Kittredge v. Commissioner. 88 F.2d 632 (2d Cir. 1937); Hardwick Realty Co. v. Commissioner, 29 F.2d 498 (2d Cir. 1928). Beulah was a resident of New York located in the Second Circuit.

(117) 274 U.S. 295 (1927).

(118) Id- at 304.

(119) Id. at 296-97.

(120) Id. at 303.

(121) Id. at 296. Although not explained in the opinion, in spite of claiming approximately $5,000 of depreciation deductions, the taxpayer failed to decrease the basis of the equipment by even that amount.

(122) Id. at 304.

(123) 7 B.T.A. 1108 (1927).

(124) Id. at 1110.

(125) Id.

(126) Hardwick Realty Co. v. Commissioner, 29 F.2d 498, 500 (2d Cir. 1928).

(127) Id.

(128) 88 F.2d 632 (2d Cir. 1937).

(129) 129 F.2d 318 (2d Cir. 1942).

(130) Kittredge, 88 F.2d at 633.

(131) Id.

(132) Id.

(133) Id.

(134) Id.

(135) To further explain this point, the difference between the initial cost of $37,000 and the selling price of $12,000, or $25,000 reflects an economic loss for which the corresponding depreciation deductions produced no tax benefits. To the extent depreciation deductions reduced the basis of the winery below the selling price of $12,000, the resulting gain was attributable to their transformation into taxable gain.

(136) Beckridge Corp. v. Commissioner, 129 F.2d 318, 318 (2d Cir. 1942).

(137) Id.

(138) Id.

(139) See Beckridge, 129 F.2d at 319; Kittredge, 88 F.2d at 633.

(140) 319 U.S. 523 (1943).

(141) Id. at 524. Of course since the excessive depreciation deductions produced no tax benefits for the taxpayer, the Commissioner would have had nothing to gain by challenging them.

(142) Id. The depreciation deductions not challenged by the Commissioner during the applicable limitations period are considered to be "allowed."

(143) Id. at 525 (emphasis added) (quoting I.R.C. [section] 113(b)(1)(B) (1939)).

(144) Id. at 526.

(145) Id.

(146) Justice Douglas's decision was a major statutory interpretation of the predecessor of section 1016(a)(2) with a significant negative tax impact for taxpayers. Ironically, thirty-one years later, in Commissioner v. Idaho Power, 418 U.S. 1, 19 (1974) (Douglas, J., dissenting), a case in which the Supreme Court decided that the cost of equipment utilized to construct a capital asset could not be depreciated but instead was to be capitalized as part of the cost of the capital asset. Justice Douglas stated: "This Court has, to many, seemed particularly ill-equipped to resolve income tax disputes between the Commissioner and the taxpayers. ... Indeed, we are called upon mostly to resolve conflicts between the circuits which more providently should go to the standing committee of the Congress for resolution." Obviously, Justice Douglas had a change of heart hue in life regarding the propriety of the Supreme Court resolving tax issues.

(147) Beckridge Corp. v. Commissioner, 129 F.2d 318 (2d Cir. 1942).

(148) Virginian Hotel, 319 U.S. at 528 (citing Beckridge Corp. v. Commissioner, 129 F.2d 318 (2d Cir. 1942)).

(149) This assumes a constitutional challenge to the Basis Reduction Tax Trap would be unsuccessful. In addition, the tax benefit rule does not apply to depreciation deductions. Treas. Reg. [section] 1.111-1(a).

(150) See supra notes 140-48 and accompanying text.

(151) Act of July 14, 1952, Ch. 741, 66 Stat. 629, which amended section 113(b) and added section 113(d) to the Internal Revenue Code of 1939. 26 U.S.C. [section] 113(b), (d) (1939). Obviously, this adjustment would be necessary for taxpayers who under the authority of the Virginian Hotel case had reduced the basis of depreciable property by allowed depreciation deductions that produced no tax benefits.

(152) 83 P.L. 591; 83 Cong. Ch. 736; 68 Stat. 730, 68A Stat. 3.

(153) I.R.C. [section] 1245(a)(3).

(154) I.R.C. [section] 1245(a).

(155) I.R.C. [section] 1245(a)(1).

(156) I.R.C. [section] 1245(a)(2).

(157) I.R.C. [section] 1001(a).

(158) I.R.C. [section] 1245(a).

(159) See Treas. Reg. [section] 1.1245-2(a)(7).

(160) Pursuant to section 1001(a), the taxpayer's taxable gain would be $1,000, the difference between the amount realized ($1,500) and the adjusted basis ($500).

(161) I.R.C. [section] 1245(a)(2).

(162) See generally I.R.C. [section] 1231.

(163) As an illustration, consider the following example: Assume a donee received a gill of property with a fair market value of $800 and a basis to the donor of $1,000. If the donor had sold the property for $800, the donor would have recognized a $200 loss. Conversely, if the donee were to sell the properly for $800, the donee would not recognize a loss because the fair market value loss basis of $800 would offset the selling price. Accordingly, the fair market value loss basis prevents the donee being able to take advantage of the donor's pre-gift built in loss.

(164) To modify the illustration in supra note 163, assume the donee were to sell the gifted property for $1,200. Since for purposes of computing gain, the donee takes the donor's basis of $1,000 in the gifted property (as compared to the $800 fair market value loss basis), the donee would recognize a gain of $200 ($1,200 minus $1,000). So unlike the loss scenario, the donee's taxable gain would be exactly the same as the donor's would have been if the donor had sold the property.

(165) The purpose of the Gain Basis is to prevent the transformation of useless depreciation deductions into taxable gain. Pursuant to sections 1001(a) and (c), the taxpayer recognizes taxable gain only if the amount realized exceeds the adjusted basis. So as long as the Gain Basis is equal or greater than the amount realized, no gain would ever be recognized. In this case, upon the sale of the Brooklyn Apartment Building, Beulah realized an economic loss of $4,500. Only $3,307 of that loss, however, was reflected in depreciation deductions that produced tax benefits for her over the course of the ownership period of the property. This was also the amount of depreciation deductions that reduced the Gain Basis from $262,000 to $258,693. Thus, the negative difference between the amount realized ($257,500) and the Gain Basis ($258,693), or $1,193 plus the $3,307 of productive depreciation deductions equals Beulah's realized economic loss of $4,500. So even though the Gain Basis is unreduced by the $1,193 of depreciation deductions that produced no tax benefits, it is of no consequence other than eliminating phantom taxable gain. As discussed in Part V.B.2. below, for purposes of computing loss, the conventional current law adjusted basis fully reduced by all allowable deductions is utilized.

(166) L.R.C. [section] 1001(a).

(167) 331 U.S. 1 (1947).

(168) As under current law, basis would also be reduced by allowed depreciation deductions that produced lax benefits for the taxpayer.

I. Jay Katz *

* Formerly Associate Professor of Law, Widener University School of Law and Adjunct Professor Temple University School of Law; LL.M. in Taxation, University of Florida, College of Law, Graduate Tax Program 1991; LL.M. in Taxation, New York University School of Law 1983; J.D., University of Tennessee College of Law 1982.

The author wishes to thank Liz Stern the author's high school English teacher at Hillel Academy of Pittsburgh who in spite of her memories of him as a student provided insightful editing comments on earlier drafts of the article.

The author dedicates this article to his ever-supportive wife Peggy who through countless hours over a ten-month period endured the author's scores of editing and re-editing of the article.
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Title Annotation:part 2
Author:Katz, I. Jay
Publication:Virginia Tax Review
Date:Jan 1, 2011
Words:15146
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