Nonrecourse debt sets floor for securities mark-to-market value

Plain-English summary

Related partnerships issued mortgage-backed securities in exchange for cash and treated the notes as nonrecourse liabilities secured by mortgage assets. When calculating year-end mark-to-market gain or loss under IRC § 475, they valued some assets below the associated debt and claimed substantial losses. Chief Counsel advised that IRC § 7701(g) applies because section 475 expressly uses fair market value to determine deemed gain or loss. The assets' fair market value therefore could not be treated as less than the nonrecourse debt to which they were subject. Chief Counsel also concluded that the symmetry principles in Crane and Tufts independently required including the debt in the amount realized, preventing tax losses disconnected from economic losses.

Ruling snapshot

• Question: May a securities dealer mark mortgage securities below the nonrecourse debt securing them when computing gain or loss under IRC § 475?
• Outcome: Advice given: no, section 7701(g) and the Crane and Tufts principles require accounting for the nonrecourse debt
• Key authorities: IRC §§ 475(a)(2) and 7701(g); Commissioner v. Tufts, 461 U.S. 300 (1983); Crane v. Commissioner, 331 U.S. 1 (1947)

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service
Memorandum
Number: 201507019
Release Date: 2/13/2015
CC:PSI:01
POSTF-140485-12

UILC:    475.00-00, 7701.29-01

 date:   June 30, 2014

   to:   Associate Area Counsel,
         (Large Business & International)


 from:   Chief, Branch 1
         (Passthroughs & Special Industries)

subject: Application of § 7701(g) to § 475

This memorandum responds to your request for assistance. This advice may not be
used or cited as precedent.

LEGEND

Partnership X = -------------------------------------------

Partnership Y = ------------------------------

Partnership Z = ----------------------------------------

Year 1 = -------

Year 2 = -------

x = ------------

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ISSUES

1. Does section 7701(g) apply to the determination of gain or loss under section
   475(a)(2), such that a dealer in securities determining year-end mark-to-market gain or
   loss on securities must treat the fair market value of the securities as being not less
   than the amount of nonrecourse indebtedness to which the securities are subject?

2. If section 7701(g) does not apply to section 475, do the principles established in
   Commissioner v. Tufts, 461 U.S. 300 (1983) and Crane v. Commissioner, 331 U.S. 1
   (1947) require a dealer in securities determining year-end mark-to-market gain or loss
   on securities to include in the amount realized the amount of nonrecourse indebtedness
   to which the securities are subject?

CONCLUSIONS

1. Yes, section 7701(g) applies to section 475(a)(2), and a dealer in securities
   determining year-end mark-to-market gain or loss on securities must treat the fair
   market value of securities as being not less than the amount of nonrecourse
   indebtedness to which the securities are subject.

2. Yes, even if section 7701(g) does not apply to section 475, the principles in the
   Crane and Tufts cases do apply, and a dealer in securities determining year-end mark-
   to-market gain or loss on securities must include in the amount realized the amount of
   nonrecourse indebtedness to which the securities are subject.

FACTS

     Partnership X, Partnership Y, and Partnership Z (collectively, the "Partnerships")

are commonly controlled entities that were treated as partnerships for federal income
tax purposes during the years at issue. Originally created in Year1, Partnership X
served as a traditional holding company for Partnership Y and held a majority interest in
Partnership Z. Historically, Partnership Y and Partnership Z engaged in the business of
originating and purchasing mortgage loans on the open market and issuing notes to
third-party investors as mortgage backed securities in exchange for cash.1 Partnership
Y and Partnership Z treat the receipt of the cash as non-taxable loan proceeds. The
transactional documents reflect that the Partnerships are not personally liable for the
payment of the notes, and the Partnerships concede that the notes are nonrecourse
liabilities to which the mortgage securities were subject. Therefore, no issue is being
raised as to the whether the notes are nonrecourse indebtedness to which the mortgage
securities were subject.

1
The Partnerships generally conducted this business through grantor trusts or other disregarded entities.
For federal tax purposes, the Partnerships treated the mortgage securities as their own assets.

POSTF-140485-12 3

   In Year 2, Partnership Y sold some of its mortgage securities subject to

nonrecourse liabilities to Partnership X. Partnership Y included the amount of the
nonrecourse liabilities in calculating its amount realized on the sale, and Partnership X
included the amount of the nonrecourse liabilities in calculating its basis in the
purchased mortgage securities.

   The Partnerships treated themselves as dealers subject to mark-to-market

accounting under section 475, and treated the mortgage securities as subject to section
475(a)(2).2 In calculating the section 475 mark-to-market gain or loss at the end of each
year, the Partnerships did not include the nonrecourse liabilities to which the securities
were subject in the determination of the fair market value of the mortgage securities.
Thus, to calculate the year-end section 475(a) gain or loss, the Partnerships first
compared the basis of each mortgage security to its respective fair market value
(without regard to the nonrecourse indebtedness), which in many cases resulted in a
loss amount (the "Current Loss"). The Partnerships then compared the cumulative
section 475(a) gains and losses attributable to the mortgage security with the Current
Loss and reported the difference as gain or loss on its tax return. For example, assume
one of the Partnerships acquired a mortgage security for $100 and later the same year
incurred nonrecourse indebtedness of $100 secured by the mortgage security. If the
value of the mortgage security dropped to $90 at the end of that year, the Partnership
would report a $10 mark-to-market loss during that year. In the next year, if the fair
market value of the mortgage security dropped to $85, with the nonrecourse debt
remaining at $100, the Partnership would calculate a $15 Current Loss, but only report
a $5 loss deduction (the difference between the $10 cumulative loss and $15 Current
Loss) on its tax return so as to not "double count" the loss. As a result of this treatment,
the Partnerships claimed over $x in mark-to-market loss deductions.

LAW AND ANALYSIS

Issue 1: Application of Section 7701(g) to Section 475

   Section 475(a) requires a dealer in securities to use a mark-to-market method of

accounting for any securities that it holds. In the case of inventory, section 475(a)(1)
applies and requires that the security be included in inventory at its fair market value.
Under section 475(a)(2), any security not held as inventory and which is held at the end
of the year shall be treated as if it were sold at its fair market value on the last business
day of the year, and any gain or loss shall be recognized. Proper adjustment shall then
be made in the amount of any gain or loss previously taken into account under section
475(a)(2).

2
In a CCA dated Jan. 22, 2014, we determined that Partnership X was not a dealer in securities in Year

2. Therefore, the analysis in this CCA regarding section 7701(g) and Crane/Tufts is an alternative
   argument with respect to Partnership X in Year 2.

POSTF-140485-12 4

   Section 7701(g), “Clarification of Fair Market Value in the Case of Nonrecourse

Indebtedness,” provides that for purposes of subtitle A, in determining the amount of
gain or loss (or deemed gain or loss) with respect to any property, the fair market value
of such property shall be treated as being not less than the amount of any nonrecourse
indebtedness to which such property is subject.

    Section 7701(g) was enacted in 1984 to reflect the rationale in Tufts regarding

the amount realized for property subject to nonrecourse debt. The Joint Committee on
Taxation explained that section 7701(g) was "to be limited in application to those Code
provisions which expressly refer to the fair market value of property in determining the
amount of gain or loss with respect to certain transfers of property.”3 For example, the
Joint Committee referenced section 338, which creates a deemed sale of corporate
assets that are subject to a qualified stock purchase, as a Code section that is subject
to the fair market value definition in section 7701(g).

     Section 475 was enacted in 1993, nine years after section 7701(g), and does not

contain any language precluding the application of section 7701(g). In contrast, several
Code sections enacted after section 7701(g) expressly preclude section 7701(g) from
applying to the respective definitions of "fair market value" used therein. See Sections
357(d) ("... nonrecourse liability ... reduced by the lesser of ... the fair market value of
such other assets (determined without regard to section 7701(g))") and 362(d) ("In no
event shall the basis of property be increased ... above the fair market value of such
property (determined without regard to section 7701(g)) ..."). As previously discussed,
section 475 contains a provision that dealers "shall recognize gain or loss as if such
security were sold for its fair market value on the last business day of such taxable year
....." Section 475(a)(2) (emphasis added). Unlike sections 357(d) and 362(d), section
475 does not preclude the application of section 7701(g). It is generally assumed that
"Congress is aware of existing law when it passes legislation." Miles v. Apex Marine
Corp., 498 U.S. 19, 32 (1990). Because section 475 was enacted nine years after
section 7701(g), it should be assumed that Congress intended section 7701(g) to apply
to the term "fair market value" in determining the deemed gain or loss under section
475.

    Therefore, section 7701(g) applies to section 475(a)(2), and in determining their

year-end mark-to-market gain or loss on the mortgage securities, the Partnerships must
treat the fair market value of the securities as being not less than the amount of
nonrecourse indebtedness to which the securities are subject.

3
Joint Comm. on Tax'n, 98th Cong., 2d Sess., General Explanation of the Revenue Provisions of the fax
Reform Act of 1984, at 239 (1985).

POSTF-140485-12 5

Issue 2: Application of Tufts and Crane to Section 475

   In Crane v. Commissioner, the Supreme Court dealt with the proper calculation

of adjusted basis and amount realized for the disposition of property subject to
nonrecourse debt. The Court first determined that the basis of such property included
the amount of nonrecourse mortgage used to purchase the property. In determining the
amount realized upon sale of the property, the Court, likewise, included in the amount
realized the remaining nonrecourse debt assumed by the purchaser. The Court
recognized that to do otherwise would have permitted the taxpayer "to recognize a tax
loss unconnected with any actual economic loss." Tufts, 461 U.S. at 307 (explaining the
rationale of Crane). In dicta, the Court in Crane observed:

  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.

Crane, 331 US 1, at 14, n. 37.

    In Tufts, the Supreme Court addressed the situation discussed in the Crane

dicta: nonrecourse indebtedness exceeding the sale price. In Tufts, real estate
developers who financed an apartment complex with nonrecourse debt included such
debt in their basis for calculating depreciation deductions. As the real estate market
declined, the developers sold the property for less than the adjusted basis of the
property and less than the amount of outstanding debt. The developers claimed a loss
on the sale based on the difference between the adjusted basis and the sale price. The
Supreme Court rejected the taxpayers' position and held that the buyer's assumption of
the nonrecourse debt should have been treated as part of the selling price in
determining the amount realized by the selling taxpayers:

  Crane teaches that the Commissioner may ignore the nonrecourse nature
  of the obligation in determining the amount realized upon disposition of the
  encumbered property. He thus may include in the amount realized the
  amount of the nonrecourse mortgage assumed by the purchaser. The
  rationale for this treatment is that the original inclusion of the amount of
  the mortgage in basis rested on the assumption that the mortgagor
  incurred an obligation to repay. Moreover, this treatment balances the fact
  that the mortgagor originally received the proceeds of the nonrecourse
  loan tax-free on the same assumption. Unless the outstanding amount of
  the mortgage is deemed to be realized, the mortgagor effectively will have
  received untaxed income at the time the loan was extended and will have
  received an unwarranted increase in the basis of his property. The
  Commissioner's interpretation of § 1001(b) in this fashion cannot be said
  to be unreasonable ... .

POSTF-140485-12 6

Tufts, 461 U.S. at 309-310.

   The Court's rationale was thus essentially one of symmetry. That is, if a tax

benefit is claimed and allowed from debts incurred under nonrecourse obligations, the
taxpayer must treat the transfer of these obligations as part of the consideration for a
sale of the property. See Herrick v. Commissioner, 85 T.C. 237, 262 (1985). Odend'hal
v. Commissioner, 748 F.2d 908 (4th Cir. 1984), affg 80 T.C. 588 (1983).

   Here, Partnership X received the tax benefit of including the amount of the

nonrecourse liabilities in calculating its basis in the mortgage securities it purchased
from Partnership Y. Partnership Y and Partnership Z received the tax benefit of treating
cash received in exchange for issuance of the mortgage backed securities as non-
taxable loan proceeds. Therefore, even if section 7701(g) did not apply to section 475,
the Partnerships’ omission of the nonrecourse indebtedness in determining the amount
realized under section 475(a)(2), fails to follow the symmetrical approach endorsed by
the Supreme Court in Crane and Tufts. This asymmetrical treatment resulted in the
Partnerships inappropriately claiming to recognize a tax loss unconnected with any
actual economic loss.

CASE DEVELOPMENT, HAZARDS, AND OTHER CONSIDERATIONS

POSTF-140485-12 7

POSTF-140485-12 8

    This writing may contain privileged information. Any unauthorized disclosure of

this writing may undermine the ability of the Internal Revenue Service to protect the
privileged information. If disclosure is determined to be necessary, please contact this
office for our views.

POSTF-140485-12 9

 Please call Benjamin Weaver at (202-317-    or Marsha Sabin at (202) 317-
if you have any further questions.



                                Sincerely,




                                ________________________________
                                David R. Haglund
                                Chief, Branch 1
                                Office of the Associate Chief Counsel
                                (Passthroughs & Special Industries)