Better to Burn Out than to Fade Away? Tax Consequences on the Disposition of a Tax Shelter
59 Pages Posted: 20 Mar 2008
Date Written: 1983
In Tufts v. Commissioner the court addressed but failed to resolve the issue of how an individual taxpayer must account for the disposition of a burned out tax shelter when that tax shelter provides significant tax benefits. This article addresses Tufts and focuses on what treatment taxpayers deserve when they dispose of depreciable property subject to a nonrecourse mortgage in excess of the property's fair market value.
This article disapproves of certain proposed approaches to this problem. It discredits the suggestion that the debt should be included in the taxpayer's amount realized because this result provides capital gains treatment to taxpayers who have in fact suffered capital losses. The article poses alternative solutions to these unjustified deductions. First, it proposes an application of the tax benefit rule, which would require the taxpayer to account for previous tax benefits to the extent they turn out to have been inappropriately granted in the first place. It would produce some ordinary income upon taxpayers' disposition of their property, but it would also produce limited capital gains, unless the property were transferred to someone other than the lender. The second proposal is the application of cancellation of indebtedness principles. This approach would produce ordinary income and a capital loss. It mirrors the real decline in both the taxpayer's obligation and the property's value; but at the same time, it may allow certain taxpayers to defer recognition of any income until some later time.
Keywords: Federal income tax, burned out tax shelter, nonrecourse mortgage, tax benefit rule, discharge of indebtedness rule, Tufts v. Commissioner
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