tax geek

In this week’s Tax Geek Tuesday, we hop into our way-back machine and travel to 1944, when a loaf of bread cost nine cents, boxing was a thing, and the world was enjoying an unprecedented period of peace and harmony.*

Of equal importance to tax geeks, it was at this time that the widow Beulah Crane sold an apartment building, reported the resulting gain, and was subsequently challenged by the IRS.  This set into motion a string of events that would ultimately take Crane all the way to the Supreme Court, leaving a legacy of one of the most important judicial precedents in tax law history.

Today, we’ll follow Crane from the Tax Court to the Supreme Court, and (hopefully) gain an understanding of the decision’s impact, both at the time it was settled and today.


The property

When William Crane (William) died in 1932, he left an apartment building to his wife, Beulah (Crane).

The building was subject to a first mortgage held by a local bank. The unpaid balance of the mortgage was $262,042, comprised $255,000 of principal and $7,042 of accrued interest.

When a taxpayer dies, any property owned by the taxpayer must be valued for purposes of inclusion in the taxpayer’s estate. The fair market value of the building, perhaps not coincidentally, was determined to be exactly equal to the unpaid balance of the mortgage, or $262,042.

Thus, if we were to define the property according to common conventions, the value of the building was $262,042, while the equity Crane held in the property – the value less any debt to which the property was subject – was exactly zero.

The mortgage

To appreciate the significance of Crane, one must understand a bit about the nature of mortgages. Generally, there are two types of mortgages: nonrecourse and recourse.

If a mortgage is nonrecourse, the only option the lender has in the event the borrower fails to satisfy the mortgage is to seize and sell the property securing the mortgage. If the value of the property is not sufficient to satisfy any remaining obligation on the mortgage, the lender may not pursue the borrower for any additional deficiency. In effect, with a nonrecourse mortgage, the lender bears the risk of loss.

Example: X loans $1,000,000 to A on a nonrecourse basis. A uses the money to buy property for $1,000,000. Two years later, when the loan balance is $800,000 and the property has a FMV of $600,000, A ceases paying the mortgage. X’s only option is to seize the property and sell it for its value of $600,000. X may not pursue A for the remaining deficiency of $200,000.

Obviously, if a mortgage is recourse, the opposite is true. With a recourse mortgage, not only can a lender seize and sell the subject property in the event the borrower fails to satisfy the mortgage, the lender may also pursue the borrower for any remaining deficiency. Thus, in a recourse mortgage, the borrower bears the risk of loss.

Assume the same facts as in the previous example. If the mortgage is recourse, not only may X seize the property and sell it for $600,000, X may also continue to pursue A individually for the $200,000 remaining deficiency.

Post-death use of the property