The IRS’s Hollow Victory in Crane v. Commissioner, 331 U.S. 1 (1947)

[Editors’ note: This is the fourth in our series, What Is the Most Important U.S. Supreme Court Case in Your Area of the Law? The first three installments are here, here, and here.]

There are many important Supreme Court tax cases.  However, few are identifiable just by reference to a footnote number.  Tax scholars and academics will easily recognize the Supreme Court’s decision in Crane v. Commissioner simply by reference to footnote 37.  In my opinion, Crane is the most important case in tax history, and footnote 37 is the most famous footnote.

The issues presented in Crane arose when the taxpayer inherited an apartment building from her husband.  The taxpayer took the apartment building subject to a mortgage.  There was no equity in the apartment building because the outstanding balance of the mortgage debt and interest in arrearage equaled its appraised value.  During her seven years of ownership, the taxpayer claimed depreciation deductions.  Eventually, the taxpayer sold the apartment building to a third party for $3000 with the taxpayer paying $500 for expenses on the sale and the third party taking the apartment building subject to the mortgage.  The taxpayer claimed that her adjusted basis in the apartment building was zero and her amount realized on the sale was $2500 resulting in a $2500 gain.  As noted by the Court, this argument was inconsistent with the taxpayer claiming depreciation deductions on the apartment building.

The IRS assessed a deficiency against the taxpayer claiming that the taxpayer’s adjusted basis in the property at the time she inherited it was the fair market value of the physical property rather than her equity.  Under the tax code, the adjusted basis of property acquired from a decedent was its fair market value at the time of the decedent’s death.  The IRS also claimed that the taxpayer’s amount realized upon her disposition of the apartment building included the outstanding balance of the mortgage debt.  The Tax Court decided the issue in favor of the taxpayer, but the Court of Appeals for the Second Circuit reversed.

In a 6-3 decision, the Supreme Court held in favor of the IRS. The majority first concluded that the property that the taxpayer acquired for purposes of determining her adjusted basis was the physical property rather than its equity.  The majority then held that the taxpayer had to include the debt relief in her amount realized even though she was not personally liable on the debt.  It was already established as a principle of tax law that had the taxpayer been personally liable on the mortgage debt, the debt relief would have been included in her amount realized.  The Court’s rationale was based on an economic benefit theory that the taxpayer would pay the debt simply to protect the equity in the property.  Hence, assuming that the fair market value of property was $100,000 and it was encumbered with a $20,000 nonrecourse mortgage debt, the taxpayer would pay the debt in order to protect the $80,000 of equity.  In the famous footnote 37, the Court indicated that there might be a different result where the fair market value was less than the outstanding balance of the mortgage debt because there would be no economic incentive to pay it; rather, it would make more economic sense for the taxpayer to abandon the property rather than to pay the mortgage debt.  Thirty five years later in Commissioner v. Tufts, 461 U.S. 300 (1983), the Supreme Court addressed footnote 37 and determined that because a nonrecourse debt was true debt, a taxpayer being relieved of that debt must include the debt relief in the amount realized.  As true debt, it was not included in gross income at the time the obligation was incurred because of the obligation to repay.  If the debt relief was not included in gross income, the taxpayer would have received an untaxed accession to wealth.

On the surface, it does not appear that Crane can realistically be categorized as one of the most important tax cases in history.  However, the significance of the case be explained by reference to two words—tax shelter.  The Crane decision established the foundation for the onslaught of tax shelters by allowing a taxpayer to claim depreciation deductions exceeding the amount of the taxpayer’s true investment in the venture.  These tax shelters made unprofitable ventures viable because of the tremendous potential for tax savings.  The taxpayer in Crane, for example, claimed about $25,000 in depreciation deductions even though she had not repaid any of the mortgage debt.

The enormous impact of the Crane case materialized upon Congress’s enactment of the accelerated depreciation rules (ACRS) under the Economic Recovery Tax Act of 1981, allowing for depreciation over a much more compressed timeframe than in the past.  For example, under ACRS, a taxpayer could acquire certain types of equipment for $10,000 cash and a $90,000 nonrecourse note and claim $20,000 in depreciation deductions for the taxable year.  The taxpayer’s tax savings would have already exceeded the $10,000 investment.

The vehicle of choice for holding depreciable assets during the tax shelter craze was a limited partnership because the limited partners enjoyed limited liability but could claim their distributable share of depreciation deductions and losses on their individual tax returns.  The limited partners became less concerned with whether the asset generated income because the primary goal of acquiring the asset was the sheltering of income earned from other sources, such as wages.  A typical limited partner might have invested in a limited partnership that was formed to develop office buildings.  These buildings were being constructed even though unoccupied office buildings were in the vicinity.  The problem worsened during the early 1980s as taxpayers invested in unprofitable ventures and took advantage of the accelerated depreciation deductions created under ACRS.

The ability to invest in these types of tax shelters spiraled out of control until Congress enacted the Tax Reform Act (TRA) of 1986.  Prior to the enactment of the TRA of 1986, the government lost billions of dollars in revenue resulting from tax shelter abuse.  The TRA of 1986 essentially prevented taxpayers from reaping the benefits of many of these tax shelters.  Under IRC § 465, a taxpayer could only claim a loss or deduction up to the amount that the taxpayer had at risk—generally cash or personal liability loans.   The TRA of 1986 expanded the scope of these rules to include real estate activities but allowed for the inclusion of nonrecourse indebtedness in the amount that a taxpayer had at risk if certain requirements were met. While the at-risk rules limited the benefits of investing in tax shelters, Congress’s enactment of the section 469 passive active limitation (PAL) rules under the TRA of 1986 essentially closed the door on these types of tax shelters. Under the PAL rules, a taxpayer was prohibited from using losses from passive sources, such as limited partnerships and rental activities, to offset income from active sources, including wages, interest and dividends.  If the majority in Crane had concluded that the taxpayer was prohibited from claiming depreciation deductions based on the facts in the case, these reforms would have been unnecessary.

Significantly, the 1986 tax reforms were partially responsible for the savings and loan crisis in the late 1980s.  The real estate market became depressed in several states after the TRA of 1986 resulting from the number of unoccupied real estate.  After the enactment of the PAL and at-risk rules, investors began abandoning these properties.  They no longer had a tax incentive to own unprofitable depreciable property.  Because the investors lacked personal liability, the banks were unable to recover deficient judgments against them.  The federal government insured the deposits under the Federal Deposit Insurance Corporation, and the government (and therefore taxpayers) had to bail out the savings and loan associations.  Although there were many additional causes for the savings and loan crisis, the inability of investors to continue claiming the tax benefits created by Crane was a critical factor.  It is unlikely that many of these investors would have invested in unprofitable real estate holdings without the tax benefits.

Consequently, Crane is the most important case in tax history.  It created the foundation for tax shelters, and the resulting tax reforms were partially responsible for the savings and loan crisis in the 1980s.  The government technically prevailed in the Crane case, but as history showed, it was a very hollow victory.

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