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Prussin v. Commissioner of Internal Revenue

filed: January 30, 1989.


On Petition for Rehearing, Tax Court No. 28283-85

Author: Greenberg


GREENBERG, Circuit Judge

The Commissioner filed a petition urging this panel of the court to reconsider our opinion filed on November 25, 1988. Although we will deny the petition we will address several of the Commissioner's arguments.

As framed by the Commissioner the issue meriting rehearing is:

Whether a taxpayer who has acquired property subject to nonrecourse indebtedness that is far larger than the fair market value of the property at the time of acquisition is entitled to deductions for interest and depreciation attributable to the nonrecourse indebtedness to the extent of the fair market value of the collateral.

Our opinion answered this question in the affirmative.

The Commissioner petitions for reconsideration on two bases. First, he objects to our reading of several precedents upon which we rely as persuasive authority. Second, the Commissioner argues that our opinion will create valuation problems which will produce intolerable administrative burdens.

The Commissioner's first argument refers to our reliance on Odend'hal v. Commissioner, 748 F.2d 908 (4th Cir. 1984), cert. denied, 471 U.S. 1143, 105 S. Ct. 3552 (1985) and Estate of Franklin v. Commissioner, 544 F.2d 1045 (9th Cir. 1976). He argues that the courts in these cases disallowed any depreciation or interest deductions rather than disallowing only deductions attributable to the excess nonrecourse debt. Accordingly, he contends that we should disregard the language in each of the opinions suggesting the contrary result.

We observe, however, that in both Odend'hal and Estate of Franklin, as the Commissioner seems to acknowledge, the issue of whether the taxpayers were entitled to a partial deduction was apparently not raised either before the Tax Court, see Odened'hal v. Commissioner, 80 T.C. 588, 590, 602-05, 617-18 (1983); Estate of Franklin v. Commissioner, 64 T.C. 752, 760-62, 770-71 (1975), or on appeal, see Odend'hal, 748 F.2d at 909, 912, 913; Estate of Franklin, 544 F.2d at 1046, 1048-49. In this case the issue was squarely presented to the court, and thus we were required to rule on it. We found the opinions and reasoning in Odend'hal and Estate of Franklin persuasive while we found their holdings, which did not directly address this issue, not in opposition. Indeed, the Commissioner acknowledges in his petition for rehearing that "[t]o be sure, there is language in the opinions in both Odend'hal and Estate of Franklin, which, taken out of context, could be read as consistent with the panel opinion here."

The Commissioner's second argument is based on a misreading of our opinion. The Commissioner correctly notes that we call "for the taxpayers to use the fair market value of the property on the date of purchase in determining how much of the nonrecourse debt to allow in calculating their basis in the property." However, the Commissioner suggests that we would allow annual recalculations of the portion constituting genuine indebtedness "because [the taxpayers] have an incentive to repay a greater amount of the nonrecourse debt each year." Accordingly, the Commissioner observes that these recalculations would impose administrative burdens and produce "computational anarchy". We cannot perceive how the Commissioner arrived at this understanding as we said that "it is appropriate to disregard only the portion of nonrecourse debt in excess of the fair market value of the property when it was acquired for purposes of the depreciation and interest deductions and to regard the nonrecourse debt as genuine indebtedness to the extent it is not disregarded." (Slip op. at 32; emphasis added.) We never suggested that there would be annual reevaluations. Thus, the administrative burdens which the Commissioner contemplates do not exist. However, to clear up any possible misunderstanding, we now expressly state that our opinion of November 25, 1988, is not to be read to require periodic recalculations of the sum of nonrecourse debt constituting genuine indebtedness.

The Commissioner argues in support of his second basis for rehearing that "a borrower whose note exceeds a reasonable estimate of the fair market value of the property has no immediate incentive to pay off any part of the note, because his payments will not give him any equity in the property unless and until the value of his interest exceeds the face amount of the note." In this regard the Commissioner points out that "the investor's entitlement to the claimed tax benefits" is fixed at the time the property is acquired. But if the lender is rational the borrower does have an incentive to pay off a portion of the debt for the lender has a disincentive to foreclose if the purchaser offers to pay the debt up to the value of the property. While the Commissioner dismisses the compromise possibility as "entirely speculative" and "wholly unpredictable at the time the borrower acquires the property subject to the non-recourse note" his argument proves too much because the concept of disallowance of the deductions in excess non-recourse financing situations is based on the theoretical economic disincentive to the borrower to pay the debt rather than upon what ultimately happens. It is no more speculative to assume that the lender will act rationally in compromising than it is to assume that the borrower will not foolishly pay the entire nonrecourse debt. We said as much in our original opinion and we see no reason to change our conclusion in this regard.

The Commissioner's Petition for Rehearing ...

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