Peter Reilly, a friend and frequent tax commenter, has this offering on his Forbes blog: IRS Veteran Insists That IRS Is Missing Billions In Real Estate Gains (Forbes 8/11/20), here. Basically, Peter deals with tools that the IRS has in its system that his informant asserts can locate large amounts of income that goes unreported through the phantom income that arises from real estate losses funded by nonrecourse debt. I am not familiar with the IRS systems that could police the reporting of the income, but I do note (as does Peter) that there is a new IRS initiative for the partnership to report partner level basis. See Notice 2020-43, here; see also Peter’s discussion on another blog Who Is IRS Aiming At In Recent Partnership Notice? (Your Tax Matters Partner 6/21/20), here.
Those who are partnership tax gurus will like Peter’s offerings and maybe even understand them. As an aside, my practice over the recent years have not focused on partnership tax, so I am a bit long in the tooth on that. (Except that I do cover the procedural aspects of the TEFRA and CPAR (often called BBA) regimes, and earlier in my private practice while substantially involved with real estate partnerships (and teaching Real Estate Taxation at UH Law School), I did have particular interest in partnership taxation originating from my handling of the appeal Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 1974), here, a leading case in partnership taxation. (The Diamond opinion was quite controversial, but in my mind just involved elemental tax principles correctly applied; but the real estate industry was quite powerful and managed to whittle away the results and essentially reverse through IRS administrative largesse, hence the carried interest notion, but I won't go off further on that rant here.)
Peter’s Forbes offering did cover some significant tax history related to Crane v. Commissioner, 331 U.S. 1, 14 n.37 (1947), here, and its tax infamous footnote 37. All tax students and practitioners should have at least a passing acquaintance with that footnote, said to be the most famous footnote in tax history. Footnote 37 should also mitigate against the expression of apparent disdain for footnotes that Justice Scalia once made in oral argument (I cover Scalia’s statement in both editions of my book). Footnote 37 said:
Obviously, if the value of the property is less than the amount of the mortgage, a mortgagor who is not personally liable cannot realize a benefit equal to the mortgage. Consequently, a different problem might be encountered where a mortgagor abandoned the property or transferred it subject to the mortgage without receiving boot. That is not this case.
That footnote spawned a myriad of offerings exploiting nonrecourse debt to generate deductions with the notion (or hope) that the taxpayer would not have to balance the books with so-called phantom taxable income at the end. Those shelters proliferated particularly in the 1970s involving both real estate where lenders might make economic nonrecourse loans in the real world and in other contexts where the nonrecourse loan was basically phony (or magic). The Supreme Court put an end to (or at least curbed somewhat) that magical thinking in Commissioner v. Tufts, 461 U.S. 300 (1983), here, requiring the taxpayer to include the amount of the nonrecourse debt in the amount realized part of the gain calculation upon foreclosure or deed in lieu of foreclosure, thus at least leaving the taxpayer with deferral and conversion shelter from playing the nonrecourse debt game.
As an aside, prior to the Supreme Court decision in Tufts, I had argued that the balancing of the books should come through treating the excess of the nonrecourse debt over fair market value on foreclosure or deed in lieu of foreclosure as cancellation of indebtedness ordinary income. John A. Townsend, Footnote 37 of Crane: What Is the Nature of the Income?, 4 Rev. of Tax. of Indiv. 128 (1980). As with many of the positions I had taken over the years, my position was an outlier in the practitioner community and, as best I could tell, among the scholarly community at that time. In her concurring opinion in Tufts, Justice O’Connor essentially adopted the position I took in the article, so that the taxpayer would recapture the excess of the nonrecourse debt over fair market value as ordinary income (rather than including that amount in the gain calculation). She did that by treating the real estate transaction gain to be the fair market value over basis (thus accounting for the economic real estate gain or loss) and treating the nonrecourse loan separate as a cancellation of indebtedness to extent the loan exceeded basis. Justice O’Connor attributed the position to Professor Wayne G. Barnett of Stanford University, here, who filed an amicus brief in Tufts. (As a further aside, after the Tufts decision, Professor Barnett wrote me a letter, long lost, saying that he regretted that he had not pressed the position more forcefully in his amicus brief, for he continued to think it was the right one and thanked me for contributing to his understanding.)
Oh, well! You win some, you lose some (even many).
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