5.  Inaja Land revisited, or, Watch your basis!

In Inaja Land, the Tax Court held that the taxpayer's receipt of $49,000 in exchange for the easement granted to the city was a nontaxable recovery of the taxpayer’s capital -- in other words, a nontaxable recovery of the taxpayer's basis, or cost.  The taxpayer’s basis before the easement incident was its original cost of $61,000, and since the $49,000 received was less than that basis, the result was no immediate taxable gain.

After this transaction, what is the taxpayer's new basis in the land?  The answer is $12,000.  To determine the new basis, we take the original cost basis of $61,000 and reduce it by the nontaxable cash receipt of $49,000 for the easement.  The difference is the new basis, also known as the adjusted basis.

How can we be confident that $12,000 is correct?  For one thing, consider why we need to compute the new basis — it determines the taxpayer's gain or loss on the property in any future sale or exchange transaction.  Thus, we can check our basis result here by imagining a future transaction, and reasoning back.  Imagine that a year after the easement incident, the taxpayer in Inaja Land sells the land (still burdened by the easement) for $151,000.  The taxpayer has now received a total of $200,000 — $49,000 for the easement and $151,000 for the burdened fee interest in the property.  Since the taxpayer originally paid $61,000 for the parcel and ultimately got $200,000 for it, the total gain should be $139,000.

Our $12,000 new basis achieves this result.  The amount realized on the second transaction is $151,000, and to properly reflect the total gain of $139,000, we need to subtract a basis of $12,000 from the $151,000 realized on the sale of the fee interest:

Amount realized on sale of burdened parcel: 

 $ 151,000

Less adjusted basis:

 ̶    12,000

Gain on sale of burdened parcel:

$ 139,000

 

Voilà!  Our $12,000 new basis answer was right – it got us the correct result in the end.

Another approach the Inaja Land court could have taken was to tax the landowner on some gain in the year the first $49,000 was received.  For example, under Treas. Regs. § 1.61-6(a), the taxpayer could have been forced to apportion its $61,000 basis between the property rights attributable to the easement and the rest of the property rights pertaining to the parcel.  One way to apportion the basis would be to compare the easement’s fair market value to the land’s unburdened fair market value and allow the same fraction of the basis to be recovered on the sale of the easement.  To illustrate, for simplicity’s sake assume that the easement’s value was $50,000 (that is what the city will pay for it) and the land’s value prior to the pollution was $200,000.  We could allow the taxpayer to offset only 50,000/200,000, or one-fourth, of its basis against the $50,000 paid for the easement.  The result would be gain of $34,750, computed as follows:  

Amount realized on sale of easement:

$ 50,000

Less adjusted basis:

̶   15,250  (61,000 / 4)

Gain on sale of easement: 

$  34,750

The logic would be that, since the taxpayer sold only one-fourth of its “bundle of rights,” it should be entitled to use only one-fourth of its basis.

The next question, once again, is what would the taxpayer’s new basis for the land be if (as just supposed) we taxed the $34,750 gain when the $49,000 is received?  The answer is $45,750.  We would take the $61,000 original cost basis and reduce it by the $15,250 of basis "used up" in the easement transaction.  Just as we reduced the basis in our first example by the nontaxable receipt ($49,000), we would reduce the original cost basis in this alternative analysis by the portion of the money received tax-free — on the revised hypothetical, $15,250.

Can we be confident that $45,750 is the correct new basis?  Let's assume that a year later, the taxpayer sells the land for $150,000.  Again, the taxpayer has received a total of $200,000, and since the taxpayer's original cost was $61,000, the total gain should be $139,000.

Unlike the landowner in Inaja Land, however, the taxpayer in our alternative analysis has already had gain of $34,750 on the sale of the easement.  Therefore, on the second transaction, the sale of the burdened land, the gain should be only $104,250 ($139,000 overall gain minus $34,750 previously taxed).  Our $45,750 basis ensures this result.  Here is the computation of the gain on the second transaction:  

Amount realized on sale of burdened parcel: 

 $ 150,000

Less adjusted basis:

 ̶    45,750

Gain on sale of burdened parcel:

$ 104,250

From these two lines of analysis, we see one of the key features of basis:  It starts with the taxpayer's original cost ($61,000) and is reduced by nontaxable receipts of money attributable to the asset ($49,000 under the Inaja Land holding, $15,250 in the second example above).

On the other side of all this lies a concept we looked at in Drescher: the increase of basis for prior taxable gain without receipt of money.  As you may recall, Drescher was taxed in 1939 and 1940 on the fair market values of two annuity contracts bought for him by his employer.  Assume for the moment that each was worth $4,800 for a total taxable income in 1939 and 1940 of $9,600.  When Drescher turns 65 and begins drawing a total of $100 a month on the contracts, is he taxed again? Aside from an earnings, or interest, component in each payment, our answer was no – certainly not until he has collected a total of $9,600 in “principal” from his monthly payments.  In other words, Drescher gets a basis in the contracts of $9,600.  But wait!  What was Drescher's cost? Nothing!  His employer paid for the annuity contracts!  How does he get basis without cost?

The answer is that for Drescher, although actual cost was zero, there was an increase in basis for the taxable income.  He was taxed on $9,600 of income and got no cash to invest or spend; as a result, assignment of a $9,600 basis to the policy is appropriate.  Drescher receives $9,600 of payments tax-free.  His basis of $9,600 — his “tax cost” — ensures this result.

But why doesn't the taxpayer in our second Inaja Land analysis (the hypothetical one, in which gain would be recognized immediately on the sale of the easement) get an increase in basis for the $34,750 gain on the sale of the easement?  Instinctively, we know that such an increase leads to an inappropriate result.  We saw above that the new basis of $45,750 offset the $150,000 realized on the second transaction, the sale of the burdened parcel, for a gain of $104,250 on the land sale and a total gain of $139,000 overall.  We knew this was the right result since the taxpayer paid $61,000 for the land and ultimately got $200,000 for it.  If the new basis of $45,750 is increased by the $34,750 gain on the first part of the transaction, the sale of the burdened land generates only $69,500 of gain ($150,000  ̶  $80,500) for a total gain of $104,250 —  too little overall gain.  Thus, instinctively, we know the upward adjustment would be wrong.

The key fact is that in 1939 and 1940, Drescher got no money to spend or invest as a result of the taxable transaction.  He got only a promise of future receipts.  In contrast, the taxpayer in our Inaja Land example has, immediately after the city pays for the easement, $50,000 to spend or invest.  The taxpayer can spend the $50,000 for consumption, invest in other property (thus acquiring a basis in those other investments), or do any number of other things with it.  Drescher's gain, on the other hand, is tied up in the annuity contract and can’t be spent, invested or otherwise disposed of until much later.

Thus, Drescher should have a right to refer back to the prior gain when he begins to receive the annuity payments.  But when the taxpayer in our second Inaja Land example gets more money in the second transaction, the sale of the burdened parcel, the case for referring back is too weak.  The first $50,000 payment has been “realized” for tax purposes, just as Drescher's $9,600, but by the time of the sale of the burdened parcel, the landowner's $50,000 cash receipt may well have been spent on personal consumption or invested in other assets.  Drescher, on the other hand, has no money with which to create basis in other assets — nor does he have anything spendable on consumption — until he reaches 65.  Hence, Drescher's upward adjustment of basis is legitimate; one for the taxpayer in our alternative Inaja Land analysis is not, even though we would tax some gain on the sale of the easement.

Over the years, I’ve come with this working hypothesis for these questions: If a taxpayer receives cash and is taxed on that amount, the basis of his or her assets should stay the same.  If the taxpayer receives cash and doesn’t pay tax on it (what happened in Inaja Land), the basis of some property should decrease.  On the other hand, if the taxpayer doesn’t receive cash but is taxed on income (what happened in Drescher), that should create basis in what the taxpayer received.  (Note that this rule doesn’t apply to money received by borrowing – more on that shortly.)
 
 
 

Created by:  bojack@lclark.edu
Update:  26 Aug 16
Expires:  31 Aug 17