Richard D. Frazier and Yvonne Frazier v. Commissioner , 111 T.C. No. 11 ( 1998 )

111 T.C. No. 11
UNITED STATES TAX COURT
RICHARD D. FRAZIER AND YVONNE FRAZIER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 3343-96. Filed September 22, 1998.
Ps owned investment real property subject to a
recourse mortgage. Upon default, the property was
acquired by the lender at a foreclosure sale. At the
foreclosure sale, the lender bid in an amount for the
property which was in excess of the property's fair
market value. R determined that the "amount realized"
by Ps at the foreclosure sale was the amount bid in by
the lender, regardless of fair market value.
Held: P's "amount realized" at the foreclosure
sale is the property's fair market value.
Held, further: Bifurcated analysis used to
determine income tax consequences of "amount realized"
and income from cancellation of indebtedness.
Held, further: Ps are not liable for accuracy-
related penalty determined by R.
Michael L. Cook and William R. Leighton, for petitioners.
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Steven B. Bass, for respondent.
PARR, Judge: Respondent determined deficiencies in
petitioners' Federal income tax for taxable years 1988 and 1989
in the amounts of $387 and $40,482, respectively. In the answer,
respondent asserted that petitioner is liable for an addition to
tax pursuant to section 6662(a).1
After concessions, the issues for decision are: (1) Whether
for 1989 petitioners realized $571,179 on the foreclosure sale of
certain real property or a lower amount which represents the
property's fair market value. We hold petitioners realized a
lower amount which represents the property's fair market value.
(2) Whether for 1989 petitioners are liable for the accuracy-
related penalty pursuant to section 6662(a). We hold they are
not.
Some of the facts have been stipulated and are so found.
The stipulated facts and the accompanying exhibits are
incorporated herein by this reference. At the time the petition
in this case was filed, petitioners resided in Austin, Texas.
FINDINGS OF FACT
Petitioners owned real property located at 3501 Dime Circle
in Austin, Texas (the Dime Circle property). The Dime Circle
1
All section references are to the Internal Revenue Code
in effect for the taxable years in issue, and all Rule references
are to the Tax Court Rules of Practice and Procedure, unless
otherwise indicated. References to petitioner are to Richard D.
Frazier. All dollar amounts are rounded to the nearest dollar.
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property was not used in any trade or business of petitioner.
The mortgage on the Dime Circle property, which secured a
recourse obligation against petitioner, was foreclosed by the
lender on August 1, 1989, at which time petitioners were
insolvent. The lender bid in the Dime Circle property at the
foreclosure sale for $571,179. The record is silent as to how
the bid-in price was determined. Apparently, the only bid was
that of the lender.
At the time of the foreclosure sale, the outstanding
principal balance of the debt was $585,943. The lender did not
attempt to collect the difference between the outstanding balance
of the debt and the bid-in amount. On August 1, 1989,
petitioners' adjusted basis in the Dime Circle property was
$495,544 (cost basis of $682,682 minus accumulated depreciation
of $187,138). After the transaction, petitioners were still
insolvent.
At the time of the sale, real estate prices had dropped
dramatically throughout Texas, causing many foreclosures and bank
failures throughout the State. The Dime Circle property was not
resold until about 2 and a half years later for approximately
$382,000.
The fair market value of the Dime Circle property at the
time of the foreclosure sale was $375,000.
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OPINION
Issue 1. Amount Realized on Foreclosure Sale
Respondent determined that petitioners realized $571,179 on
the foreclosure sale of the Dime Circle property, which
represents the amount bid in by the lender. Petitioners assert
that the amount realized on the foreclosure sale is determined by
the fair market value of the property, which is different from
the amount bid in by the lender. We agree with petitioners.
In general, the transfer of property in consideration of the
discharge or reduction of indebtedness is equivalent to the sale
of property upon which gain or loss is realized. E.g., Gehl v.
Commissioner, 102 T.C. 784, 785 (1994), affd. without published
opinion 50 F.3d 12 (8th Cir. 1995); Danenberg v. Commissioner, 73
T.C. 370, 380-381 (1979); Estate of Delman v. Commissioner, 73
T.C. 15, 28 (1979); Bialock v. Commissioner, 35 T.C. 649, 660
(1961); Marcaccio v. Commissioner, T.C. Memo. 1995-174. The
amount of gain realized is the excess of the amount realized over
the taxpayer's adjusted basis in the property, and the amount of
loss realized is the excess of the adjusted basis over the amount
realized. Sec. 1001(a).
For purposes of computing gain or loss, the "amount
realized" is defined by section 1001(b) as the sum of any money
received plus the fair market value of the property received.
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However, the amount realized from the transfer of property in
consideration of the discharge or reduction of indebtedness
depends on whether the debt is recourse or nonrecourse in nature.
In the case of nonrecourse debt, the amount realized includes the
full amount of the remaining debt. See, e.g., Commissioner v.
Tufts, 461 U.S. 300 (1983); Gershkowitz v. Commissioner, 88 T.C.
984, 1016 (1987); Estate of Delman v. Commissioner, supra at 28-
29. In the case of recourse debt, on the other hand, the amount
realized from the transfer of property is the fair market value
of the property. See, e.g., Bialock v. Commissioner, supra at
660-661; Marcaccio v. Commissioner, supra.
Furthermore, the amount realized from the sale or other
disposition of property that secures a recourse debt does not
include income from the discharge of indebtedness under section
61(a)(12). See sec. 1.1001-2(a)(2), Income Tax Regs. Such
income will arise when the discharged amount of the recourse debt
exceeds the fair market value of the property.
Generally, a taxpayer must recognize income from the
discharge of indebtedness. Sec. 61(a)(12); United States v.
Kirby Lumber Co., 284 U.S. 1 (1931). There are exceptions,
however, to the recognition of income from the discharge of
indebtedness, including cases where the discharge occurs when the
taxpayer is insolvent. See sec. 108(a).
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Absent clear and convincing proof to the contrary, the sale
price of property at a foreclosure sale is presumed to be its
fair market value. See Community Bank v. Commissioner, 79 T.C.
789, 792 (1982), affd. 819 F.2d 940 (9th Cir. 1987); Marcaccio v.
Commissioner, supra. In this case, however, petitioners have
rebutted this presumption with the required clear and convincing
proof. Petitioners introduced an appraisal opining that the fair
market value of the Dime Circle property on August 1, 1989, was
$375,000, not $571,179 as bid in by the lender. Respondent
offered no expert testimony on the fair market value and does not
challenge the accuracy of the appraisal. Respondent merely
argues that the bid-in amount must be used to determine the
amount realized, regardless of how arbitrarily that amount may
have been determined. We disagree.
In arguing that the bid-in amount must be used to determine
the amount realized, respondent, in effect, maintains that we
must respect the transaction for Federal income tax purposes. We
are not bound to blindly accept a transaction, and the law is
clear that courts may look behind a paper facade to find the
actual substance and economic realities of a transaction.
Knetsch v. United States, 364 U.S. 361, 369 (1960); Gregory v.
Helvering, 293 U.S. 465, 469 (1935); Sandvall v. Commissioner,
898 F.2d 455, 458 (5th Cir. 1990), affg. T.C. Memo. 1989-56 and
T.C. Memo. 1989-189; Merryman v. Commissioner, 873 F.2d 879, 881
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(5th Cir. 1989), affg. T.C. Memo. 1988-72; Killingsworth v.
Commissioner, 864 F.2d 1214, 1216 (5th Cir. 1989), affg. 87 T.C.
1087 (1986); Boynton v. Commissioner, 649 F.2d 1168, 1172 (5th
Cir. 1981), affg. 72 T.C. 1147 (1977); Swaim v. United States,
651 F.2d 1066, 1069-1070 (5th Cir. 1981); Kuper v. Commissioner,
533 F.2d 152, 155-156 (5th Cir. 1976), affg. in part and revg. in
part 61 T.C. 624 (1974); Horn v. Commissioner, 90 T.C. 908, 939
(1988); Price v. Commissioner, 88 T.C. 860, 884 (1987); Capek v.
Commissioner, 86 T.C. 14, 47 (1986); Forseth v. Commissioner, 85
T.C. 127, 164 (1985), affd. 845 F.2d 746 (9th Cir. 1988);
Houchins v. Commissioner, 79 T.C. 570, 589-590 (1982). In a case
such as this, where the transaction is so disparate from the
actual substance and economic realities of the situation, we are
empowered, and in fact duty-bound, to look behind the transaction
in order to apply the Internal Revenue Code accurately. Forseth
v. Commissioner, supra at 164 (citing Saviano v. Commissioner,
765 F.2d 643, 654 (7th Cir. 1985), affg. 80 T.C. 955 (1983)).
The facts of the instant case are analogous to those
provided in an example in the regulations. Section 1.1001-2(c),
Example(8), Income Tax Regs., provides as follows:
In 1980, F transfers to a creditor an asset with a fair
market value of $6,000 and the creditor discharges
$7,500 of indebtedness for which F is personally
liable. The amount realized on the disposition of the
asset is its fair market value ($6,000). In addition,
F has income from the discharge of indebtedness of
$1,500 ($7,500 - $6,000).
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Respondent relies on Aizawa v. Commissioner, 99 T.C. 197
(1992), affd. without published opinion 29 F.3d 630 (9th Cir.
1994), for the proposition that the amount realized constitutes
the amount of the proceeds of the foreclosure sale, i.e., the
bid-in amount of the lender. In Aizawa, the taxpayers owned
rental property which was subject to a recourse mortgage, and
upon default, the property was acquired by the mortgagee at a
foreclosure sale. We held that the amount of the proceeds of the
foreclosure sale constituted the amount realized under section
1001(a). Notwithstanding the similar facts and circumstances,
Aizawa is distinguishable from the instant case on one key
matter. In Aizawa, the amount that the lender paid for the
property at the foreclosure sale was equal to the fair market
value of the property. In Aizawa v. Commissioner, supra at 200-
201, the Court stated:
It cannot be gainsaid that the property was sold for
$72,700 (an amount which we have no reason to conclude
did not represent the fair market value of the
property) and that petitioners received, by way of a
reduction in the judgment of the foreclosure, that
amount and nothing more. That is the "amount realized"
under section 1001(a) which is subtracted from
petitioners' basis in order to determine the amount of
their loss. [Fn. ref. omitted; emphasis added.]
In the instant case, we have clear and convincing proof to
conclude that the bid-in price of the lender does not represent
the fair market value of the Dime Circle property.
We note that this was not an arm's-length transaction
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between a willing buyer and a willing seller, neither being under
compulsion to buy or sell and both having reasonable knowledge of
relevant facts. See United States v. Cartwright, 411 U.S. 546,
551 (1973); United States v. Simmons, 346 F.2d 213, 217 (5th Cir.
1965); Frazee v. Commissioner, 98 T.C. 554, 562 (1992); see also
sec. 1.170A-1(c)(2), Income Tax Regs. The amount bid in by a
lender at a foreclosure sale may be arbitrary. As petitioners
stated on brief, there are many possible reasons why a lender
would bid in higher than the fair market value, such as if the
lender believed it would be unable to collect a deficiency
judgment because the debtor is contemplating bankruptcy, or
simply to erase the loss from its books. See, e.g., Securities
Mortgage Co. v. Commissioner, 58 T.C. 667, 669-670 (1972).
However, we need not determine the intent of the lender in
formulating the bid-in price. We are satisfied that the bid-in
price did not represent the fair market value of the Dime Circle
property. We find that the fair market value of the Dime Circle
property on August 1, 1989, was $375,000. Accordingly,
petitioners realized $375,000 on the disposition of the Dime
Circle property.
We must now determine the Federal income tax consequences of
this transaction for petitioners. Petitioners rely on Rev. Rul.
90-16, 1990-1 C.B. 12, and argue for bifurcation of the
transaction. Respondent argues against his own revenue ruling,
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asserting that a revenue ruling has limited precedential value
for a court. While we agree that a revenue ruling is not binding
on the Court, Stubbs, Overbeck & Associates, Inc. v. United
States, 445 F.2d 1142, 1146-1147 (5th Cir. 1971), a bifurcated
analysis of the tax consequences for petitioners is appropriate
here.
As discussed above, petitioners' gain or loss on their
disposition of the Dime Circle property is computed pursuant to
section 1001 and, as a general rule, the amount realized includes
the full amount of the remaining debt. Sec. 1.1001-2(a)(1),
Income Tax Regs. However, section 1.1001-2(a)(2), Income Tax
Regs., provides an exception for recourse liabilities. The
regulation states that
The amount realized on a sale or other disposition of
property that secures a recourse liability does not
include amounts that are (or would be if realized and
recognized) income from the discharge of indebtedness
under section 61(a)(12). * * *
This regulation effectively bifurcates the instant
transaction into a taxable transfer of property and a taxable
discharge from indebtedness. Cf. Michaels v. Commissioner, 87
T.C. 1412, 1415 (1986). Thus, according to the regulation, each
should be treated as a separate transaction for tax
purposes.2 Id.
2
For a complete review of the bifurcation approach, see
Cunningham, "Payment of Debt with Property--The Two-Step Analysis
(continued...)
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Therefore, on the first step of the bifurcation analysis,
petitioners realized a capital loss of $120,5443 on the transfer
of the Dime Circle property. On the second step of the analysis,
petitioners realized $210,9434 of ordinary income from discharge
of indebtedness.
Under certain circumstances, a taxpayer may exclude from
gross income the income from discharge of indebtedness if the
discharge occurs when the taxpayer is insolvent. Sec.
108(a)(1)(B). However, the exclusion cannot exceed the amount by
which the taxpayer is insolvent. For purposes of this section,
"insolvent" is defined as "the excess of liabilities over the
fair market value of assets." Sec. 108(d)(3).
Petitioners' insolvency exceeded the income they realized
from discharge of indebtedness. Accordingly, the income
petitioners realized from discharge of indebtedness in the
instant transaction is excluded from their gross income pursuant
to section 108(a)(1)(B).
2
(...continued)
After Commissioner v. Tufts", 38 Tax Law. 575 (1985).
3
This represents the difference between the fair market
value of the property, $375,000, and petitioners' adjusted basis
in the property, $495,544.
4
This represents the difference between the fair market
value of the property, $375,000, and the outstanding balance of
the debt, $585,943. Petitioner testified that the lender did not
attempt to collect the difference between the outstanding balance
of the debt and the bid-in amount.
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Issue 2. Penalty Under Section 6662(a)
In the answer, respondent determined that for 1989
petitioners were liable for the accuracy-related penalty of
section 6662(a).
On the basis of our holding above, there was no underpayment
of tax due to petitioners' characterization of the disposition of
the Dime Circle property. Accordingly, petitioners are not
liable for the accuracy-related penalty pursuant to section 6662.
To reflect concessions,
Decision will be entered
under Rule 155.