COMMISSIONER OF INTERNAL REVENUE, PETITIONER V. GEORGE PRUSSIN AND SHARON PRUSSIN No. 88-2133 In the Supreme Court of the United States October Term, 1988 The Solicitor General, on behalf of the Commissioner of Internal Revenue, petitions for a writ of certiorari to review the judgment of the United States Court of Appeals for the Third Circuit in this case. Petition for a Writ of Certiorari to the United States Court of Appeals for the Third Circuit TABLE OF CONTENTS Question Presented Opinions below Jurisdiction Statutes involved Statement Reasons for granting the petition Conclusion OPINIONS BELOW The opinion of the court of appeals (App., infra, 1a-33a) is reported at 863 F.2d 263. The opinion of the court of appeals denying the Commissioner's petition for rehearing (App., infra, 34a-37a) is reported at 863 F.2d 277. The opinion of the Tax Court (App., infra, 38a-61a) is reported at 54 T.C.M. (CCH) 566. JURISDICTION The judgment of the court of appeals (App., infra, 62a-63a) was entered on November 25, 1988. A petition for rehearing was denied on January 30, 1989. App., infra, 34a-37a. On April 20, 1989, Justice Brennan extended the time within which to petition for a writ of certiorari to and including June 29, 1989. The jurisdiction of this Court is invoked under 28 U.S.C. 1254(1). STATUTES INVOLVED The Internal Revenue Code of 1954 (26 U.S.C. (1976)), as in effect for the years 1978 and 1979, provided in pertinent part: Section 163. Interest (a) General rule. There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness. Section 167. Depreciation (a) General rule. There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) -- (1) of property used in the trade or business, or (2) of property held for the production of income. * * * * * (g) Basis for depreciation. The basis on which exhaustion, wear and tear, and obsolescence are to be allowed in respect of any property shall be the adjusted basis provided in section 1011 for the purpose of determining the gain on the sale or other disposition of such property. Section 1011. Adjusted basis for determining gain or loss (a) General rule. The adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis (determined under section 1012 or other applicable sections of this subchapter and subchapters C (relating to corporate distributions and adjustments), K (relating to partners and partnerships), and P (relating to capital gains and losses), adjusted as provided in section 1016. Section 1012. Basis of property -- cost The basis of property shall be the cost of such property, except as otherwise provided in this subchapter and subchapter C (relating to corporate distributions and adjustments), K (relating to partners and partnerships), and P (relating to capital gains and losses). The cost of real property shall not include any amount in respect of real property taxes which are treated under section 164(d) as imposed on the taxpayer. QUESTION PRESENTED Whether a taxpayer who acquires income-producing property, subject to a contemporaneous nonrecourse indebtedness that greatly exceeds the fair market value of the property, is entitled to take deductions for accrued interest and depreciation computed on the basis of a portion of the nonrecourse indebtedness that corresponds to the fair market value of the collateral. STATEMENT 1. This is an income tax case involving the tax liability of an investor who purchased an interest in a limited partnership that had been formed to acquire and operate a garden apartment complex. Respondent George Prussin /1/ purchased limited partnership units in Pleasant Summit Associates (PSA). App., infra, 6a. PSA is a limited partnership that purchased the buildings comprising the Summit House in West Orange, New Jersey, from Pleasant Summit Land Corporation (PSLC) in June 1978, for a stated consideration of $7,759,200. Id. at 4a-5a, 41a. That transaction was, as the Tax Court explicitly found, "motivated by little more than a desire for tax benefits." Id. at 56a. In June 1978, PSLC actually entered into three transactions involving the Summit House. First, PSLC completed the purchase of the Summit House from a group of individuals for $4,200,000 (of which $250,000 was paid in cash). Second, PSLC sold the buildings and personal property, but not the underlying land, to a wholly owned subsidiary for $5,200,000 (of which $500,000 was to be paid in cash, and $4,700,000 was a nonrecourse wraparound mortgage). Third, PSLC then sold all of the stock of the subsidiary to the partnership (PSA) for a nonrecourse note for $2,559,200, secured by the stock of the subsidiary. The partnership immediately dissolved the subsidiary corporation and took direct ownership of the Summit House buildings, subject to the prior wraparound mortgage (and, of course, to the nonrecourse note given for the stock). It is not clear from the record whether the partnership also paid the dissolved corporation's $500,000 cash obligation to PSLC. The partnership took from PSLC a 90-year lease on the underlying land, calling for annual rental payments of $10,000. App., infra, 4a-5a, 40a-41a. On its partnership tax returns for the taxable years 1978 and 1979, PSA reported losses in the amount of $1,805,246 and $1,494,243, respectively. App., infra, 47a. In each of those years, the partnership claimed deductions in excess of $2,100,000, most of which were attributable to accelerated depreciation deductions on the Summit House property and to accrued but unpaid interest on the nonrecourse financing. Ibid.; C.A. App. 340a, 371a. On their joint federal income tax returns for 1978 and 1979, respondents took deductions of $417,012 and $345,170, respectively, as their distributive shares of the partnership losses. App., infra, 8a. /2/ On examination of the books and records of PSA, the Commissioner of Internal Revenue issued a notice of deficiency disallowing respondent's deductions for his share of the claimed partnership losses in their entirety. App., infra, 8a, 48a; C.A. App. 270a. The theory of the disallowance was that the Summit House was subject to nonrecourse obligations that unreasonably exceeded the fair market value of the property, and that as a result PSA had no real investment in the property and was not entitled to claim an allowance for depreciation measured by the principal amount of the nonrecourse notes, or to deduct accrued but unpaid interest on the notes. See Odend'hal v. Commissioner, 748 F.2d 908, 912 (4th Cir. 1984), cert. denied, 471 U.S. 1143 (1985); Estate of Franklin v. Commissioner, 544 F.2d 1045, 1048-1049 (9th Cir. 1976). See generally Crane v. Commissioner, 331 U.S. 1, 9-10 (1947). 2. Respondent petitioned the Tax Court for a redetermination of the deficiency asserted by the Commissioner. Melvin Isaacson, another limited partner in PSA, also filed a petition to the Tax Court. The Tax Court consolidated the cases of those two petitioners, as well as a petition filed by PSLC challenging the treatment of the gain realized on its sale of the Summit House. The Tax Court sustained the Commissioner's determination that PSA was not entitled to deductions for depreciation and interest computed on the ostensible purchase price, including the nonrecourse notes, because the face amount of the notes unreasonably exceeded the fair market value of the property. App., infra, 52a-60a. The court found that the transaction in which PSA purchased the Summit House from PSLC was not a bona fide sale between parties with adverse economic interests, but was motivated by little more than a desire to generate tax benefits for the investors in PSA. Although that transaction ostensibly involved a consideration of $7,759,200, that consideration consisted mostly of nonrecourse notes, and the transaction took place immediately after PSLC had purchased both the land and buildings in an arm's-length transaction for $4,200,000. The court noted that the amount of fire insurance carried on the buildings ($2,745,000) was consistent with a value of $4,200,000 for the land and buildings, but not with a value of $7,759,200 for the buildings alone. The court observed that PSA had no incentive to obtain the Summit House buildings for the lowest possible price, because its promoters were offering to sell its limited partnership units to investors as a vehicle for obtaining the largest possible tax deductions, rather than as a means of participating in a potentially profitable real estate transaction. Accordingly, the promoters sought to maximize the tax benefits to investors by having the partnership agree to "pay" an inflated price for the property in the form of nonrecourse notes. App., infra, 55a-58a. The Tax Court found that the fair market value of the entire Summit House property could not have been more than $4,200,000 at the time of its acquisition by PSA. It therefore concluded that the purported consideration of $7,759,200 for the buildings alone, of which PSA agreed to pay $7,259,200 in the form of nonrecourse notes, unreasonably exceeded the value of the property. App., infra, 58a. Applying the rule set forth in Estate of Franklin v. Commissioner, 544 F.2d at 1048-1049, the court held that respondent was not entitled to any interest or depreciation deductions attributable to the nonrecourse notes, because the partnership had no economic incentive to pay off the notes in order to preserve the property from foreclosure, and hence respondent had no investment in the property to depreciate and no genuine indebtedness on which to base a deduction for accrued but unpaid interest. App., infra, 58a. 3. Both respondent and the estate of Melvin Isaacson (who had died during the pendency of the Tax Court proceeding) appealed from the decision of the Tax Court. Venue for the appeal in Estate of Isaacson lay to the Second Circuit because the taxpayers in that case resided in Connecticut when they filed their petition to the Tax Court. Venue for the appeal in this case lay to the Third Circuit because respondent resided in New Jersey when he filed his petition to the Tax Court. See I.R.C. 7482(b)(1)(A). /3/ The Second Circuit affirmed the decision of the Tax Court in the companion case. Estate of Isaacson v. Commissioner, 860 F.2d 55 (1988). In this case, however, the Third Circuit reversed in part. App., infra, 1a-33a, 62a-63a. The Third Circuit sustained the Tax Court's factual finding that the amount of nonrecourse indebtedness to which the buildings acquired by PSA were subject unreasonably exceeded the fair market value of the Summit House. App., infra, 20a-23a. The court held, however, that that finding did not justify disallowing all interest and depreciation deductions attributable to the nonrecourse debt. Rather, the court concluded that the partnership should be allowed interest deductions attributable to the part of the nonrecourse indebtedness that did not exceed the fair market value of the collateral, and depreciation deductions computed by including that same portion of the nonrecourse debt in its basis for the property. Id. at 31a. The court recognized that the partners may have had no economic incentive to pay off any portion of the nonrecourse debt in order to preserve the property from foreclosure -- a fact that would suggest that there was no genuine indebtedness in any amount, and therefore no justification for any deduction. The court reasoned, however, that the holders of the nonrecourse notes would have had no economic incentive to reject an offer by the partnership to pay the fair market value of the property in return for cancellation of the notes. Thus, although it acknowledged that its holding in this regard was in conflict with the Second Circuit's decision in Estate of Isaacson, the court of appeals concluded that it was appropriate to treat the nonrecourse indebtedness as genuine indebtedness up to the fair market value of the collateral. App., infra, 3a n.2, 31a. Accordingly, the court of appeals remanded the case to the Tax Court for a determination of the fair market value of the Summit House at the time of its purchase, and for a finding as to the actual cash investment, if any, made by PSA in connection with the purchase of the property. App., infra, 33a. The court of appeals sustained the Tax Court's finding that the fair market value of the property did not exceed $4,200,000. The court therefore directed that on remand respondent should be limited to proving that the property had a fair market value no greater than $4,200,000. Id. at 31a & n.18. 4. The Commissioner filed a petition for rehearing in which he argued that the panel's holding allowing a partial deduction for the nonrecourse indebtedness was in conflict not only with the decision of the Second Circuit in Estate of Isaacson v. Commissioner, supra, but also with those of the Fourth Circuit in Odend'hal v. Commissioner, supra, and the Ninth Circuit in Estate of Franklin v. Commissioner, supra. In all of those cases, interest and depreciation deductions were disallowed in their entirety when the nonrecourse indebtedness substantially exceeded a reasonable estimate of the fair market value of the collateral. The Commissioner also pointed out that the reasoning of the Third Circuit in this case might allow a taxpayer to adjust its basis each year by the amount of the unrealized appreciation in the value of the collateral up to the limit of the nonrecourse debt. That court's logic could have led to that result because, in a rising market, the borrower on a nonrecourse note would have an economic incentive to offer a larger amount each year in order to induce the holders of the nonrecourse debt to enter into the hypothetical compromise on which the court based its analysis. The Commissioner argued that changing the depreciable basis of property each year to reflect such changes in the value on which the taxpayer could base its depreciation and interest deductions would produce unmanageable administrative problems for both taxpayers and the government in calculating the deductions allowable each year and in making the corresponding basis adjustments attributable to the depreciation claimed on property purchased with nonrecourse financing. The court of appeals denied the Commissioner's petition for rehearing in a published opinion that clarified its earlier opinion. App., infra, 34a-37a. The court stated that, under its holding, a purchaser would be entitled to treat as genuine indebtedness only the amount of the nonrecourse debt that did not exceed the fair market value of the collateral on the date of purchase. Such a purchaser would not be permitted to adjust its basis in the property to reflect subsequent changes in its value. Id. at 36a-37a. The court distinguished Odend'hal and Estate of Franklin on the ground that it did not appear from the opinions in those cases that the taxpayers had asserted a right to a partial deduction based on the fair market value of the collateral, whereas respondent in the present case had made such a claim. Id. at 35a-36a. REASONS FOR GRANTING THE PETITION The court of appeals has decided an important question of federal tax law incorrectly. Its decision conflicts with the decision of the Second Circuit in Estate of Isaacson v. Commissioner, supra, which affirmed in its entirety the very same Tax Court ruling that the court of appeals here partially reversed. The decision below also conflicts with the previously uniform decisions of other circuits holding that, under Crane v. Commissioner, 331 U.S. 1, 9-10 (1947), nonrecourse indebtedness may be treated as genuine indebtedness if, but only if, the fair market value of the property securing the debt is at least equal, at the time of acquisition, to the principal amount of the debt. See Odend'hal v. Commissioner, 748 F.2d 908, 912 (4th Cir. 1984), cert. denied, 471 U.S. 1143 (1985); Estate of Franklin v. Commissioner, 544 F.2d 1045, 1048-1049 (9th Cir. 1976); see also Brannen v. Commissioner, 722 F.2d 695 (11th Cir. 1984). /4/ 1. Section 167(a) of the Code provides that "(t)here shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear * * * of property used in the (taxpayer's) trade or business, or * * * held for the production of income." Section 167(g) of the Code provides that the taxpayer's basis for calculating depreciation shall be the same as the adjusted basis of the property for purposes of determining the gain on a sale or other disposition of the property, as defined in Section 1011 of the Code. That section, in turn, requires the taxpayer to use the cost of the property as his basis, subject to certain exceptions and adjustments that are not involved in this case. The "cost" of property is defined in Treas. Reg. Section 1.1012-1(a) as "the amount paid for such property in cash or other property." Both the consistent administrative practice of the Internal Revenue Service and the decisions of the courts, including this Court, have allowed a taxpayer to include in his cost basis the principal amount of a mortgage if the taxpayer is personally liable for the mortgage or if it encumbers the property and does not exceed a reasonable estimate of the fair market value of the collateral. Crane v. Commissioner, 331 U.S. at 9-10; Odend'hal v. Commissioner, 748 F.2d at 912; Estate of Franklin v. Commissioner, 544 F.2d at 1049; Rev. Rul. 55-675, 1955-2 C.B. 567; see also Commissioner v. Tufts, 461 U.S. 300 (1983); Rev. Rul. 81-278, 1981-2 C.B. 159; Rev. Rul. 77-110, 1977-1 C.B. 58. The deductibility of respondent's share of the amount accrued by PSA as interest on the nonrecourse notes collateralized by the Summit House is controlled by Section 163 of the Internal Revenue Code, which allows as a deduction "all interest paid or accrued within the taxable year on indebtedness." In order for any amount to be deductible there must be a valid and enforceable obligation requiring the payment of both principal and interest. Knetsch v. United States, 364 U.S. 361, 365-366 (1960); Autenreith v. Commissioner, 115 F.2d 856 (3d Cir. 1940). Here, there is no recourse against the partnership for failure to make payments on the debt; the partnership merely holds property that is encumbered by the obligation. In that situation, the established rule for the deductibility of interest has been that such a nonrecourse obligation gives rise to a genuine indebtedness if, but only if, the value of the property is at least equal to the amount of the debt. As the Ninth Circuit explained in Estate of Franklin v. Commissioner, 544 F.2d at 1049: To justify the deduction the debt must exist; potential existence will not do. For debt to exist, the purchaser, in the absence of personal liability, must confront a situation in which it is presently reasonable from an economic point of view for him to make a capital investment in the amount of the unpaid purchase price. In the absence of proof that the value of the collateral reasonably approximates the principal amount of the nonrecourse debt, the nonrecourse borrower has no economic incentive to pay off the nonrecourse obligation in order to preserve the property from foreclosure. He has no equity in the property (because his indebtedness exceeds the value of the property), and he has nothing to fear from nonpayment of the debt except loss of the property. He therefore may not include any part of the nonrecourse financing in his basis, nor may he deduct any part of the interest on the supposed debt. These basic principles had, until this case, produced a uniform line of decisions requiring that an artificially inflated nonrecourse loan be entirely disregarded in computing depreciation and interest deductions. See, e.g., Estate of Isaacson v. Commissioner, 860 F.2d at 56; Estate of Franklin v. Commissioner, 544 F.2d at 1048; Narver v. Commissioner, 75 T.C. 53, 98 (1980); Rev. Rul. 77-110, supra. /5/ By allowing a partial deduction for both depreciation and accrued but unpaid interest attributable to nonrecourse financing, even though the principal amount of the debt unreasonably exceeded the fair market value of the collateral, the court of appeals has overturned the established rule disallowing such deductions in their entirety. The decision below squarely conflicts with the decision of the Second Circuit in Estate of Isaacson, an appeal from the same Tax Court ruling involving another partner in the same tax shelter as the present case. In Estate of Isaacson, 860 F.2d at 56, the Second Circuit recited with approval the holding of the Tax Court (App., infra, 52a) that, because the nonrecourse mortgages encumbering the Summit House substantially exceeded the fair market value of the property, "no 'investment in the property' occurred and no 'genuine indebtedness' exists." Although the appellant there advanced the same arguments that respondent made in this case, /6/ the Second Circuit affirmed the decision of the Tax Court for the reasons set forth in the Tax Court opinion. The Tax Court opinion, as adopted by the Second Circuit, rejects the alternative claim made by the limited partners in both cases that, even if they were not entitled to deduct interest and depreciation computed upon the entire principal amount of the nonrecourse financing, they should be permitted to show that the nonrecourse notes had a value equal to the fair market value of the collateral, and should be allowed to claim interest and depreciation deductions attributable to the nonrecourse debt as thus limited. As the Tax Court noted, no case had ever adopted such a test. Id. at 58a-59a. The Third Circuit has now adopted the position rejected by the Tax Court and by the Second Circuit in Estate of Isaacson. The decision here also cannot be reconciled with either the results or the analysis of the decisions in Odend'hal and Estate of Franklin. In each of those cases, the nonrecourse notes that substantially exceeded the fair market value of the property in question were disregarded in their entirety. In Estate of Franklin, 544 F.2d at 1048, the Ninth Circuit observed that, if a purchaser buys property subject to a nonrecourse obligation that is approximately equal to the fair market value of the property, his payments on the nonrecourse note "would rather quickly yield an equity in the property which the purchaser could not prudently abandon." This, the court held, was "the stuff of substance" that would cause the form of the transaction to mesh with the realities of the marketplace. The court further pointed out that "(n)o such meshing occurs when the purchase price exceeds a demonstrably reasonable estimate of the fair market value." Ibid. In that circumstance, the purchaser would obtain no equity in the property by making payments on the nonrecourse note. The most he could lose by abandoning the transaction would be a mere chance to acquire an equity if the value of the property increased beyond the principal amount of the nonrecourse obligation. The Ninth Circuit held that such a mere chance was insufficient to justify treating the transaction as a sale and allowing the nonrecourse "purchaser" to claim the depreciation and interest deductions that would have been allowable if he had actually held an ownership interest in the property. Ibid. Similarly, in Odend'hal v. Commissioner, 748 F.2d at 912, the Fourth Circuit held that a taxpayer who had purchased property subject to a nonrecourse debt could include the amount of the loan in his basis so long as the fair market value of the property is at least equal to the amount of the nonrecourse debt at the time it was incurred, because the taxpayer, even though he has no personal liability at stake, has an economic incentive to pay off the debt rather than to lose the collateral. But if the stated price financed by nonrecourse debt exceeds the fair market value of the property, to the extent of the excess, the taxpayer has no equity in the property to protect and no economic incentive to pay off the debt. In the absence of an economic incentive to pay off the nonrecourse loan, Odend'hal rejected the taxpayers' claim that the nonrecourse debt should be treated as a true loan, and disallowed all deductions for depreciation and interest in excess of an amount sufficient to offset the taxpayers' income from the property. Id. at 909, 912-913. 2. In the present case, the court of appeals cited with approval the holdings of the Fourth Circuit and the Ninth Circuit that a taxpayer could not deduct depreciation and interest attributable to a nonrecourse note that unreasonably exceeded the fair market value of the property because he had no economic incentive to pay off the debt. App., infra, 25a-31a. Nevertheless, the court held that, even though a nonrecourse borrower would have no incentive to pay off the full amount of the debt in order to save the property from foreclosure if the property were worth less than the debt, he did have an economic incentive to offer to compromise the nonrecourse loan by paying the fair market value of the property. If he were to do so, the court added, the holder of the nonrecourse note would have no reason to refuse the offer and force a foreclosure sale. Thus, the court concluded that in this case the partnership had incurred a genuine indebtedness to the extent of the fair market value of the Summit House, so that respondent was entitled to claim depreciation and interest deductions computed on the nonrecourse indebtedness to the extent that it did not exceed the fair market value of the property. That reasoning is flawed. In the first place, it assumes that the investors in PSA, which was formed as a tax shelter partnership, would have had an incentive to purchase the Summit House property even if the tax benefits had been limited to the fair market value of the property. In the second place, the nonrecourse borrower would not even begin to build up any "equity" in the property so long as the unpaid indebtedness continued to exceed the fair market value of the property. Having no equity in the property to protect, the nonrecourse borrower would have no particular incentive to pay its full fair market value, even if foreclosure were otherwise imminent. Likewise, the lender would have no particular incentive to accept an offer from the borrower to pay the fair market value of the property in exchange for a discharge of the indebtedness encumbering it. The lender would not, by selling the property to the borrower, recover the full (inflated) amount of the nonrecourse loan but would have to compromise that putative debt for whatever he could receive from the borrower for the property. In those circumstances, a rational lender would just as soon foreclose and offer the property to the highest bidder, who might or might not turn out to be the original nonrecourse borrower. At best, both parties would be in a state of equipoise, even if they were in full agreement as to the present value of the property. At that point, they would simply deal with the property in the same manner as they might deal with any similar property that might then be on the market, without regard to their prior course of dealings with respect to such property. The hypothetical transaction on which the court of appeals based its decision is thus entirely speculative to begin with. It becomes even more unlikely when one considers the effect of the clarification that the court of appeals issued in denying rehearing. The court explicitly rejected the idea that the amount of the compromise (and therefore the amount of the genuine indebtedness to be taken into account by the purchaser) would be subject to annual revision as the value of the collateral changed. App., infra, 36a-37a. The court's rule limiting any deductions to those based on the market value of the property at the time of purchase, although easier to administer than a rule requiring annual valuations, would also virtually guarantee that the compromise contemplated in the court's analysis could never occur. An example should make the point clear. If the Summit House property were found to have been worth $4,000,000 in June 1978, under the court's analysis that would be the amount of genuine indebtedness that respondent could use in calculating the amount of interest and depreciation that he could claim each year. If the value of the property were to rise to $5,000,000 by June 1979, and the lenders then sought to foreclose, PSA certainly could not expect to be able to prevent the foreclosure by offering $4,000,000, the value of the property one year earlier. In such a situation, the lenders would have an economic incentive to reject the compromise and to force the foreclosure sale in order to capture the appreciation in the value of the property. By contrast, if the value of the property were to decline to $3,000,000, no rational borrower would offer to pay $4,000,000 for it in order to avoid foreclosure. Thus, only in the extremely unlikely circumstance that the property remained at exactly the same value from the date of sale until the date when the lenders decided to foreclose would a compromise, if one were to be made, occur at the price that represented the fair market value of the property on the date of the original sale to the nonrecourse borrower. The nonrecourse borrower in the circumstances of this case, therefore, has no genuine indebtedness to the lender. It has no more economic incentive than anyone else to make payments of principal and interest to the lender, or to pay the present or past fair market value of the property to the lender in order to compromise the unpaid indebtedness. Hence, it is wrong to allow the borrower to take tax deductions on the basis of an indebtedness that is, for all practical purposes, nonexistent. 3. The decision below, in addition to being erroneous, would, if permitted to stand, produce grave inequities in tax administration and cause a substantial disruption in the efforts of the Internal Revenue Service to achieve a prompt and fair disposition of a large number of tax shelter cases, especially cases involving real estate shelters. We have been informed by the Internal Revenue Service that there are now approximately 20 national tax shelter projects involving almost 2300 docketed Tax Court cases and more than $630,000,000 in deficiencies that could be adversely affected by the holding of the Third Circuit in this case. In addition, there are large numbers of tax shelter cases not involved in a national litigation project that could be similarly affected. The potential for disparities in tax treatment arising from the holding of the Third Circuit is well illustrated by the facts of the present case. Because of a difference in appellate venue, respondent and the estate of Melvin Isaacson have been ordered to receive different tax treatment, even though respondent and Isaacson were both limited partners in the same partnership, were the subject of a common adjudication in the Tax Court, and were represented by the same counsel and made the same arguments before their respective courts of appeals. Because tax shelter partnerships are often marketed to investors living in different judicial circuits, the existence of a different rule for the calculation of the depreciation and interest deductions allowable to investors residing within the territorial jurisdiction of the Third Circuit from that which applies elsewhere in the country would produce unseemly confusion and inconsistency. It is therefore appropriate for this Court to grant certiorari to correct the error of the court below and to establish a uniform rule to govern the recurrent fact pattern of this case. The decision below is of great importance to the public fisc and creates a substantial potential for tax shelter abuse. Under the holdings of the Second, Fourth, and Ninth Circuits in Estate of Isaacson, Odend'hal, and Estate of Franklin, an investor who has purchased property subject to a nonrecourse mortgage that unreasonably exceeded the fair market value of the collateral stands to lose all deductions for depreciation and interest attributable to the nonrecourse financing. Under the decision below, by contrast, an investor whose tax shelter deductions have been disallowed will have a substantial incentive to attempt to establish the highest possible value for the collateral on the date of purchase, by litigation if necessary, in order to salvage at least part of the benefits that he claimed on his returns. Thus, in addition to its inherent unsoundness of predicating the allowance of deductions for interest and depreciation on a hypothetical borrower-lender compromise that almost certainly will never occur, the decision below would open the way to frequent valuation litigation and to a form of tax abuse that the decisions of the Second, Fourth, and Ninth Circuits have effectively precluded. Accordingly, review by this Court is necessary to resolve the conflict in the circuits and to restore evenhanded administration of this important aspect of the tax laws. CONCLUSION The petition for a writ of certiorari should be granted. Respectfully submitted KENNETH W. STARR Solicitor General SHIRLEY D. PETERSON Assistant Attorney General LAWRENCE G. WALLACE Deputy Solicitor General ROY T. ENGLERT, JR. Assistant to the Solicitor General JONATHAN S. COHEN MICHAEL J. ROACH Attorneys JUNE 1989 /1/ Respondent Sharon Prussin joined in the petition to the Tax Court and in the appeal to the Third Circuit in this case solely because she filed a joint return with her husband George Prussin for each of the taxable years in suit. Accordingly, for convenience, we will sometimes refer to George Prussin as "respondent." /2/ Section 702 of the Internal Revenue Code of 1954 provides that, in calculating the tax liabilities of persons doing business in partnership form, each partner should take into account his distributive share of the income or loss of the partnership. See United States v. Basye, 410 U.S. 441 (1973). Thus, as the court of appeals recognized in this case, respondent's ability to deduct a distributive share of partnership losses depends on whether the partnership actually suffered cognizable losses. App., infra, 19a-20a. /3/ Unless otherwise noted, all statutory references are to the Internal Revenue Code of 1954 (26 U.S.C.), as in effect during 1978 and 1979, the years at issue (the Code or I.R.C.). /4/ This is not a case in which the purchaser simply made a bad bargain and gave notes for too much for the property securing the loan. The purchaser should be entitled to treat a nonrecourse loan as genuine indebtedness and to include the amount of the nonrecourse debt in the basis of the property, as long as the purchase price falls within an acceptable range of business judgment. See Estate of Franklin, 544 F.2d at 1049. In this case, however, as both courts below agreed, the amount to which the Summit House property was subjected clearly falls outside any reasonable range of business judgment. PSLC bought the land and buildings comprising the Summit House for $4,200,000 in an arm's-length transaction and immediately resold the buildings, without the land, to PSA for an ostensible consideration of $7,759,200, almost all of which consisted of nonrecourse obligations. App., infra, 4a-5a, 53a-54a. /5/ Although the question presented in this case superficially resembles the question that this Court decided in Commissioner v. Tufts, supra, Tufts is not contrary to the decisions cited in the text, and the court below properly did not rely on Tufts as support for its decision. In Tufts, the Court held that a borrower on a nonrecourse mortgage who sold the property after its fair market value had declined below the face amount of the loan was required to include the full amount of the nonrecourse obligation in the amount realized on the sale. In that case it was undisputed that the nonrecourse loan had all the indicia of genuine indebtedness at the time it was made, and that the Commissioner had treated it as a true loan for purposes of depreciation and interest deductions. See Odend'hal v. Commissioner, 748 F.2d at 912-913. By contrast, the amount of the nonrecourse loan here was egregiously inflated from the outset, and the borrower therefore never had any economic incentive to repay the loan. See Estate of Franklin v. Commissioner, 544 F.2d at 1049. The analysis of this Court in Tufts, 461 U.S. at 312, was explicitly premised on the fact that the borrower had "received the loan proceeds tax-free and (had) included them in his basis on the understanding that he had an obligation to repay the full amount." The Court held that, in those circumstances, "a taxpayer must account for the proceeds of obligations he has received tax-free and included in basis." Id. at 313. By contrast, in Odend'hal, 748 F.2d at 912, the Fourth Circuit held that the principal amount of a nonrecourse loan could not be included in the taxpayer's basis because the nonrecourse obligation unreasonably exceeded the fair market value of the property, and the taxpayer therefore had no "economic incentive to pay off the debt." Similarly, in Estate of Franklin, 544 F.2d at 1048-1049, the Ninth Circuit held that a taxpayer that had ostensibly purchased property subject to a nonrecourse loan had no real investment in the property, and therefore could not claim depreciation and interest deductions computed on the amount of the nonrecourse loan, because the amount of the loan so unreasonably exceeded the fair market value of the collateral that the purported purchaser could "lose no more than a mere chance to acquire an equity in the future" if he abandoned the transaction. Thus, the debt in Estate of Franklin and Odend'hal, like the debt here, was essentially spurious from the outset; the debt in Tufts was essentially genuine, although the value of the encumbered property later declined. /6/ Indeed, the appellants in both cases were represented by the same counsel. The appellants and the government each made virtually simultaneous filings in the Second Circuit and in the Third Circuit, and the briefs filed in the two courts were in all pertinent respects identical. Only the outcome was different. APPENDIX