Summary
In L&C Springs Assocs., the U.S. Court of Appeals for the Seventh Circuit did not opine on the nature of the income, which is the focus of the dispute here; rather, at issue in L&C Springs Assocs. was at what time the taxpayer abandoned certain property, thereby triggering gain from cancellation of indebtedness for purposes of section 1001.
Summary of this case from Jacobowitz v. Comm'r of Internal RevenueOpinion
No. 98-2970
ARGUED MARCH 30, 1999
DECIDED AUGUST 18, 1999
Appeal from the United States Tax Court No. 11969-94 — Stephen J. Swift, Judge.
Randall G. Dick (argued), Jeffer, Mangels, Butler Marmaro, San Francisco, CA, for Petitioners-Appellants.
Curtis C. Pert (argued), Department of Justice, Tax Division, Appellate Section, Washington, DC, for Respondent-Appellee.
Before RIPPLE, DIANE P. WOOD and EVANS, Circuit Judges.
The Internal Revenue Service determined adjustments to LC Springs Associates' income tax returns; LC Springs sought review in the United States Tax Court. The court ruled in the Commissioner's favor, and LC Springs appealed that judgment to this court. For the reasons set forth in the following opinion, we affirm the judgment of the Tax Court.
I BACKGROUND A. Tax Background
When a taxpayer sells property, the difference between the property's amount realized (generally the amount paid for the property upon sale) and the property's basis (generally the amount the seller originally paid) is included in the taxpayer's income. See I.R.C. § 1001. However, it does not take a sale to recognize income: Any "disposition" is sufficient. See id. For example, if a taxpayer abandons property, then the taxpayer is required by I.R.C. § 1001 to recognize any gain on the property. See Middleton v. Commissioner, 77 T.C. 310, 320-21 (1981), aff'd per curiam, 693 F.2d 124 (11th Cir. 1982).
The specific gain triggered in this case is the cancellation of nonrecourse debt. It is well established that nonrecourse debt that finances land ownership is included in the taxpayer's basis in the land. See Commissioner v. Tufts, 461 U.S. 300, 305-06 (1983). In any disposition of land, a related cancellation of the taxpayer's indebtedness is included in the taxpayer's amount realized. See id.; 26 C.F.R. § 1.1001-2. Therefore, cancellation of indebtedness in an abandonment of property can generate income under I.R.C. § 1001. The issue in this case is at what time LC Springs abandoned certain property, thereby triggering gain from debt cancellation for purposes of I.R.C. § 1001.
B. Factual Background
Beginning in early 1980, Tanglewood Properties, Inc. ("Tanglewood") owned land in Florida ("LC Properties"). Tanglewood's ownership was subject to a lien securing a debt that came to be owed to California Federal Savings and Loan Association ("California Federal").
LC Springs purchased the land from Tanglewood in 1981. Part of the purchase agreement allowed LC Springs to sell the property back to Tanglewood and to retain a 15-year leasehold interest in the land. LC Springs exercised that option, which reduced the original purchase price to $2.45 million. In effect, then, Tanglewood had legal title to the land, and LC Springs had a leasehold. LC Springs financed the $2.45 million price with a seller-financed nonrecourse promissory note. The Tax Court found that the same parties controlled both Tanglewood and LC Properties and that the transactions between the two entities were not carried on in an arm's length manner.
In a footnote in its reply brief, LC Springs argues that there were other owners of interests in LC Springs besides those that controlled Tanglewood. However, LC Springs never specifically disputes that, despite these nonoverlapping interests, the same parties had effective control over both LC Springs and Tanglewood.
Due to an economic downturn and a long-term inability to make a profit on the land, LC Springs failed to make a $2.25 million balloon payment due on January 31, 1987, and never made any further payment on the note or payment of property taxes. Tanglewood, however, did not take any foreclosure action.
Because it was not receiving payments from LC Springs, Tanglewood defaulted on its mortgage obligations to California Federal on July 1, 1989. On May 1, 1990, California Federal obtained a final judgment of foreclosure on LC Properties. As part of the final judgment of foreclosure, all rental income from the LC Properties was ordered to be turned over directly to California Federal, and a court-ordered sale of the LC Properties was scheduled for May 24 and 29, 1990. In various foreclosure proceedings, Tanglewood represented that it owned the properties and did not disclose LC Springs' interest in the property. LC Springs did not report rental income on the property past November 1, 1990.
In May of 1990, before the foreclosure sale of LC Properties, Tanglewood filed for bankruptcy in order to delay the foreclosure sale. In an October 1990 agreement, Tanglewood agreed with California Federal that it would dismiss the bankruptcy proceedings in exchange for California Federal's delay in the foreclosure sale of LC Properties until after February 15, 1991. Under that October 1990 Agreement, management and control of LC Properties were turned over to California Federal. A foreclosure sale eventually took place in mid-1991.
C. The Tax Court's Opinion
The Tax Court found that the October 1990 Agreement effectively conveyed to California Federal LC Springs' remaining 6-year leasehold interest and relieved LC Springs of its obligation to Tanglewood on the nonrecourse note. The Tax Court held that this effective termination of LC Springs' interest in the land was a recognition event under I.R.C. § 1001, so that LC Springs recognized $2.25 million in income in 1990 from cancellation of its indebtedness to Tanglewood. The court rejected LC Springs' argument that the abandonment took place in 1991, when the foreclosure sale of LC Properties occurred.
The court's conclusion was based on a variety of factors that, in its view, indicated that California Federal had taken effective, yet not legal, title to the property. The October 1990 Agreement between Tanglewood and California Federal effectively transferred all rights and obligations of ownership to California Federal and relieved LC Springs of its debt to Tanglewood and leasehold in LC Properties. Indeed, in 1987, LC Springs already had ceased making payments to Tanglewood on the debt and to the government on the property taxes. Only formal title was withheld from California Federal until 1991. Additionally, LC Springs failed to claim rental income from the property after the October 1990 Agreement. These factors, concluded the Tax Court, indicate a complete abandonment of the property.
II DISCUSSION
We review the Tax Court's factual determinations for clear error, but its legal conclusions de novo. See Pittman v. Commissioner, 100 F.3d 1308, 1312 (7th Cir. 1996).
A.
LC Springs submits that, for there to be an abandonment of property creating a "disposition" for purposes of I.R.C. § 1001, there must be both an intent to abandon and an unmistakable and overt act of abandonment. LC Springs argues that the October 1990 Agreement, upon which the Tax Court relied, cannot be evidence of LC Springs' intent or of an overt act by LC Springs because LC Springs was not even a party to that agreement. Moreover, the Tax Court did not rely on any overt acts by LC Springs, except failure to make payments on the debt. The actual time of abandonment occurred, contends LC Springs, when the foreclosure sale occurred in 1991.
We agree with the Tax Court that the abandonment occurred in 1990. At the outset, we emphasize that it is firmly established that the determination of the existence or timing of an abandonment is inherently a factual matter that requires a practical examination of all of the circumstances. See Davis v. Commissioner, 241 F.2d 701, 703 (7th Cir. 1957). The weight given to various factors must depend on the economic realities of the situation. For instance, when a taxpayer seeks to take a beneficial deduction because of an abandonment, an affirmative act on the part of the taxpayer is entitled to great weight because it provides some objective measure of the taxpayer's intent. See, e.g., id.; Middleton v. Commissioner, 77 T.C. 310, 322 (1981), aff'd per curiam, 693 F.2d 124 (11th Cir. 1982). On the other hand, when the abandonment will result in the recognition of income, the taxpayer's unilateral activity is entitled to less weight because it might well be motivated by a desire to postpone the recognition of income. See Brountas v. Commissioner, 74 T.C. 1062, 1073-74 (1980). The proper test is whether, under the facts and circumstances, it is clear for all practical purposes that the taxpayer will not retain the property; an overt act of abandonment by the taxpayer is not necessary. See Cozzi v. Commissioner, 88 T.C. 435, 445-46 (1987).
The Tax Court was therefore correct in assessing the totality of the circumstances to determine when the abandonment took place. The Tax Court was not clearly erroneous in its determination that LC Springs had abandoned the property in 1990. LC Springs had failed to make a balloon payment, had failed to claim any rental income from the property as of November 1, 1990, and had not paid its property taxes. Given that the land had not produced a profit in many years, it was extremely unlikely that LC Springs would concern itself with the extinguishment of its leasehold interest. In addition, under the October 1990 Agreement between Tanglewood and California Federal, California Federal took over the management and control of the property, effectively destroying any interest that LC Springs had. The later passage of legal title by foreclosure sale was a mere formality. In these respects, this case is similar to Cozzi, in which the Tax Court held that abandonment occurred when it was clear that a venture would not turn a profit and the taxpayer made no effort toward payment of a debt; a later formal agreement extinguishing the taxpayer's interest did not establish the time of abandonment. See id. at 445-48.
We also cannot accept LC Springs' argument that the Tax Court erred in relying on the October 1990 Agreement because LC Springs was not a party to that agreement. Engaging in the pragmatic sort of assessment that is required under the governing principles, the Tax Court realistically concluded that, given the fact that the same parties controlled both Tanglewood and LC Springs, "all individuals associated with LC Springs and Tanglewood and the other entities involved in the transaction had for all intents and purposes . . . treated LC Springs as having no continuing substantive ownership interest in the LC Properties." LC Springs Assocs. v. Commissioner, 74 T.C.M. (CCH) 928, 934 (1997).
B.
LC Springs also contends that its interest in the property had not been completely abandoned because it retained a "right of redemption" under Florida law. Pursuant to that right, LC Springs could choose, after foreclosure, to purchase the property by paying a price higher than the foreclosure price. It relies upon R. Odell Sons Co. v. Commissioner, 169 F.2d 247, 249 (3d Cir. 1948), in which the Third Circuit held that the possibility of redemption delayed the recognition of gain.
In the end, we believe that this contention must be governed by the same guiding principle articulated in our earlier discussion: The duty of the Tax Court was to focus on the practical realities of the transaction rather than the formalities. At the outset, we note that the Tax Court raised a substantial doubt as to the continued existence of the right of redemption that LC Springs now asserts. The Tax Court was of the view that any such right of redemption had been waived under an agreement in 1981. LC Springs offers no adequate rebuttal to that assertion. More fundamentally perhaps, whatever right of redemption a mere lessee might retain under Florida law is a subordinate interest to that held by the lessor; extinguishment of the latter extinguishes the former. See Riley v. Grissett, 556 So.2d 473, 475 (Fla.Dist.Ct.App. 1990). Viewing the economic substance of the situation facing LC Springs, it is clear that Odell is not controlling and the Tax Court was on solid ground in concluding that there was no realistic possibility that LC Springs could exercise any right of redemption that might remain. The same individuals controlled Tanglewood and LC Springs. The Tax Court found that, through the October 1990 Agreement, those individuals had agreed to give control and management of the property to California Federal. The Tax Court also found that no additional funding was available and that the individuals concerned knew that no further funds would become available. They agreed that no right of redemption would be exercised. Moreover, because the debt was nonrecourse, LC Springs' relinquishment of the property relieved it of any debt it owed.
LC Springs submits that the waiver applied only to the right of redemption under Illinois law. However, the text of the 1981 agreement indicates that the waiver was not limited in this way.
Conclusion
In Commissioner v. Court Holding, 324 U.S. 331, 334 (1945), Justice Black reminded us that to allow the true nature of a transaction to be disguised by mere formalisms is to run the risk of impairing seriously the effective administration of tax policies established by Congress. In Diedrich v. Commissioner, 457 U.S. 191, 194-95 (1982), the Court emphasized the importance of this principle with respect to discharge of indebtedness income. Here, the Tax Court heeded well the Supreme Court's admonition in determining that LC Springs did not have any real economic interest in the property after the October 1990 Agreement.
For the foregoing reasons, the judgment of the Tax Court is affirmed.
AFFIRMED