Agriculture Law: 10-07

8/14/2019 Agriculture Law: 10-07

1/8OCTOBER 2007 AGRICULTURAL LAW UPDATE 1

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VOLUME 24, NUMBER 10, WHOLE NUMBER 287 OCTOBER 2007

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Solicitation of articles: All AALAmembers are invited to submit ar-ticles to the Update. Please includecopies of decisions and legislationwith the article. To avoid duplica-tion of effort, please notify the Editorof your proposed article.

Federal Registersummary

Mortgage foreclosuretax issues

State roundup

IN FUTURE ISSUES:

Synthetic materialsand organic foods

Cont. on page 2

Recent District Court decision signals growingconcensus on RapanosThe United States District for the District of Minnesota recently decided a case thatnecessitated an application of the muddled opinions in Rapanos v. United States, 126 S.Ct2208 (2006). The courts well-reasoned and detailed opinion inUnited States v. Bailey, 2007WL 2791173 (Sept. 25, 2007, D.Minn.) provides perhaps the best guidance to date, alongwith United States v. Johnson, 467 F.3d 56, 66 (1st Cir. 2006) on how to analyze wetlandscases under Section 404 of the Clean Water Act. This article summarizes the facts of thecase and the analysis of the district court.

FactsBailey owns a 13-acre parcel of land located along the shore of Lake of the Woods in

northern Minnesota. The site consists mostly of wetlands. Bailey planned to develop thesite as a residential development. In 1998, he hired a contractor to construct an access roadthrough the site. In May and June of that year, a road sixty-six feet wide and about aquarter of a mile long was built along the portion of the lot furthest from the lake.

Bailey dug a ditch on each side of the road and used excavated material to build the roaditself. Culverts were installed beneath the north and south ends of the road. On Decembe22, 1998, Lake of the Woods County accepted a plat of the property, including a dedicationof the road to the county.

Bailey had previously attempted to develop the site in 1993 and the United States ArmyCorps of Engineers (the Corps) informed him that he would need a permit beforeplacing any dredged or fill material on the site. The Corps received a copy of Baileys June1998 Local-State-Federal Project Notification Form with the County proposing to con-struct an access road for logging the site and treated the form as an after-the-facapplication for a permit under Section 404 of the Clean Water Act (CWA). On June 121998, the Corps denied the application. On October 22, 1998, after a period of public notice

and comment, the Corps ordered Bailey to restore the property, specifically orderingBailey to: (1) remove the dredged and fill material used to construct the road; (2) fill in theditches; (3) seed the restored area with a specified seed mixture; and (4) control certainweed species for three years following the restoration.

Bailey refused to comply with the order and the United States filed suit in the UnitedStates District Court for the District of Minnesota to enforce it. Bailey brought in theCounty (now arguably the lawful owner of the road) as a third party defendant andclaimed that the Corps lacked jurisdiction. Bailey, the County, and the Corps all filedmotions for summary judgment. The District Court granted summary judgment to theCounty, stating that Bailey had identified no cognizable legal theory under which he hasa right of indemnity or contribution against the County. Bailey at 19.

AnalysisThe CWA defines navigable waters as the waters of the United States, including the

territorial seas. 33 U.S.C. 1362(7). Under the Corpss regulations, navigable watersis not restricted to waters that are navigable. Indeed, it is not even restricted to watersRather, navigable waters is defined to include navigable-in-fact or traditionallynavigable waters and the wetlands that are adjacent to such waters. 33 C.F.R. 328.3(a)(7). The district court turned to Rapanos v. United States, 126 S.Ct. 2208 (2006) todetermine whether the Corps held jurisdiction over Baileys actions.

Rapanos analysisThe district court reviewed and analyzed the Rapanos decision. The United States

Supreme Court clearly rejected the Corps argument that it could regulate all wetlandsthat were anywhere near navigable-in-fact waters. Bailey at 4. However, beyond thatthe scope of the Corps wetlands jurisdiction remains unclear, in part since no majoritydecision emerged from Rapanos.

Writing for the plurality in Rapanos, Justice Scalia held that the Corps could exercisejurisdiction over wetlands when, [f]irst, the adjacent channel contains a wate[r] of the


2/82 AGRICULTURAL LAW UPDATE OCTOBER 2007

VOL. 24, NO. 10 WHOLE NO. 287 OCTOBER 2007AALA Editor..........................Linda Grim McCormick

2816 C.R. 163, Alvin, TX 77511Phone: (281) 388-0155

E-mail: [email protected]

Contributing Editors: Roger McEowen, Iowa State

University; Jesse J. Richardson, Jr., Virginia Tech; Robert P.Achenbach, Eugene, OR.

For AALA membership information, contact RobertAchenbach, Executive Director, AALA, P.O. Box 2025,Eugene, OR 97405. Phone 541-485-1090. [email protected].

Agricultural Law Update is published by the AmericanAgricultural Law Association, Publication office: CountyLine Printing, Inc. 6292 NE 14th Street, Des Moines, IA50313. All rights reserved. First class postage paid at DesMoines, IA 50313.

This publication is designed to provide accurate andauthoritative information in regard to the subject mattercovered. It is sold with the understanding that the publisheris not engaged in rendering legal, accounting, or otherprofessional service. If legal advice or other expertassistance is required, the services of a competentprofessional should be sought.

Views expressed herein are those of the individualauthors and should not be interpreted as statements ofpolicy by the American Agricultural Law Association.

Letters and editorial contributions are welcome andshould be directed to Linda Grim McCormick, Editor, 2816C.R. 163, Alvin, TX 77511, 281-388-0155.

Copyright 2007 by American Agricultural LawAssociation. No part of this newsletter may be reproducedor transmitted in any form or by any means, electronic ormechanical, including photocopying, recording, or by anyinformation storage or retrieval system, without permissionin writing from the publisher.

CLEAN WATER ACT/ CONTINUED FROM PAGE 1

Cont. on page 3

United States, ( i.e., a relatively permanentbody of water connected to traditional in-terstate navigable waters); and second, ...the wetland has a continuous surface con-nection with that water, making it difficultto determine where the water ends andthe wetland begins. Rapanos at 2227.Applying this test to the Bailey parcel, thedistrict court found that the Rapanosplural-ity would not find that the Corps has juris-

diction. Justice Kennedys separate opinion inRapanos would find jurisdiction where thereis a significant nexus between the wet-lands in question and navigable-in-factwaters. Rapanos, 126 S.Ct. at 2248. The testfor whether wetlands possess a significantnexus to navigable-in-fact waters iswhether the wetlands, either alone or incombination with similarly situated landsin the region, significantly affect the chemi-cal, physical, and biological integrity ofother covered waters more readily under-stood as navigable. Id. The district courtinterpreted Justice Kennedys test as giv-

ing jurisdiction over the site as long as thesite has a significant [e]ffect on the chemi-

as the most cogent defense of the latterapproach (Bailey,page 6). The First Circuitopinion inJohnson describes the shortcomings of usingMarks to determine the controlling opinion in a case like Rapanos:

Marks is workableone opinion can bemeaningfully regarded as narrower thananotheronly when one opinion is a logical subset of other, broader opinions.

This understanding of narrowesgrounds as used in Marks does not trans-late easily to [Rapanos]. The cases in which

Justice Kennedy would limit federal jurisdiction are not a subset of the cases inwhich the plurality would limit jurisdic-tion.

Johnson, 467 F.3d at 63-64 (quoting King vPalmer, 950 F.2d 771, 781 (D.C. Cir. 1991) (en

banc)).Noting that the Supreme Court has moved

away from the Marks formula, the FirsCircuit held that, rather than following aliteral reading ofMarks, the better approach

is to examine Rapanos for a legal standardthat, when applied, will produce resultswith which a majority of the Court wouldagree. Id. at 64-66.

In Rapanos, at least eight Justices wouldfind wetlands jurisdiction under the CWAwhen the pluralitys test is met, and that aleast five justices would find wetlands ju-risdiction under the CWA when JusticeKennedys test is met. See Rapanos, 126 S.Ctat 2265 (Stevens, J., dissenting) (stating tha[g]iven that all four Justices who have

joined this opinion would uphold the Corpsjurisdiction in both of these casesand in allother cases in which either the pluralitys or

Justice Kennedys test is satisfiedon re

mand each of the judgments should bereinstated if either of those tests is met.)The district court therefore followed thelead ofJohnson and adopted the approachsuggested by Justice Stevens: The UnitedStates may establish jurisdiction under either Justice Kennedys test or the pluralitytest.

Applying Justice Kennedys test toBaileys parcel

The District Court began by noting thatJustice Kennedys opinion made clear thawhen a wetland is adjacent to the navi-gable-in-fact waters, a significant nexus

exists as a matter of law (Bailey , page 6citing Rapanos at 2248). All parties in thecase agreed that Lake of the Woods is anavigable-in-fact water. The question became whether the road built on the wet-lands was adjacent to Lake of the Woodsfor purpose of CWA jurisdiction. Bailey at 7

The District Court found that the Roadwas built on wetlands adjacent to Lake othe Woods for two reasons. First, the Corppresented evidence that the wetlands extended to the edge of the Lake. Thus, thewetland borders or is contiguous to the

cal, physical, and biological integrity ofLake of the Woods.

TheRapanos dissenters would have foundthat CWA jurisdiction existed over the wet-lands at issue in the Rapanos case itself.Writing for the dissenters, Justice Stevensstated that the dissenters would find juris-diction when either the pluralitys or Jus-tice Kennedys test is met. Id. at 2265. Inother words, if the plurality would find

CWA jurisdiction over a particular wet-land, so would the four dissenters, mean-ing that at least eight justices would deem

jurisdiction to exist. And if Justice Kennedywould find CWA jurisdiction over a par-ticular wetland, so, too, would the fourdissenters, meaning that at least five jus-tices would deem jurisdiction to exist. Thedistrict court found, therefore, that if eitherthe plurality or Justice Kennedy would findthat the Corps has jurisdiction over Baileysproperty, then the Corps holds jurisdiction.

Marks v. United StatesBailey argued that under the approach

sanctioned by the United States SupremeCourt inMarks v. United States, 430 U.S. 188(1977), the Corps holds jurisdiction onlywhere the criteria set out by the Rapanosplurality are met (Bailey, page 5). InMarks,the Supreme Court said that [w]hen afragmented Court decides a case and nosingle rationale explaining the result en-

joys the assent of five Justices, the holdingof the Court may be viewed as that positiontaken by those Members who concurred inthe judgments on the narrowest grounds[.] Marks, 430 U.S. at 193 (quoting Gregg v.Georgia, 428 U.S. 153, 169 n. 15 (1976) (opin-ion of Stewart, Powell, and Stevens, JJ.)).According to Bailey, the Rapanospluralitys

test is the narrowest ground because thescope of wetlands jurisdiction that it recog-nized was narrower than the scope of wet-lands jurisdiction recognized by JusticeKennedy.

The district court noted that every courtto address the question since Rapanos, how-ever, has either (1) held that JusticeKennedys opinion is controlling under

Marks or (2) found that theMarks approachis unworkable as applied to Rapanos andheld instead that the Corps has jurisdictionif either the pluralitys test or JusticeKennedys test is met. Bailey, page 5 (citingUnited States v. Johnson, 467 F.3d 56, 66 (1st

Cir.2006); United States v. GerkeExcavating,Inc., 464 F.3d 723, 724 (7th Cir.2006) (percuriam), petition for cert. filed, No. 06-1331,75 U.S.L.W. 3556 (Apr. 2, 2007); N. Cal. RiverWatch v. City of Healdsburg , No. 04-15442,2007 WL 2230186, at *6 (9th Cir. Aug. 6,2007); United States v. Cundiff, 480 F.Supp.2d940, 944 (W.D.Ky.2007);Simsbury-Avon Pres-ervation Soc., LLC v. Metacon Gun Club, Inc.,472 F.Supp.2d 219, 226-27 (D.Conn.2007);United States v. Chevron Pipe Line Co. , 437F.Supp.2d 605, 613 (N.D.Tex.2006)).

The District Court favorably citedJohnson



.

Lake. Id. The court openly expressed itsdisdain for Bailey, finding that he failed tosupport his position that the site does notconsist primarily of wetlands with any-thing like competent evidence. Bailey at 1.Second, assuming that the wetland is notadjacent to the Lake, the Corps presentedsufficient evidence that the wetland is nev-ertheless adjacent since any strip of dryupland separating the wetland and the Lakeis akin to the man-made dikes or barriers,

natural river berms, beach dune and thelike that do not destroy adjacency under33 C.F.R. 328.3(c).

HoldingThe district court held that the Corps

holds jurisdiction of the site under the CWA.The Corps motion for summary judgmentwas granted, while Baileys motion for sum-mary judgment was denied. Further, thecourt enjoined Bailey to comply with therestoration order.

ConclusionsThe United States District Court for the

District of Minnesota provides a cogentanalysis of the application of Rapanos tofuture wetlands cases. Following the leadof the First Circuit inUnited States v. Johnson,467 F.3d 56, 66 (1st Cir.2006), the districtcourt rejects the application of Marks v.United States, 430 U.S. 188 (1977) to Rapanosand, in essence, adopts the view of theRapanos dissenters with respect to futureapplication of the case. Although JusticeKennedys significant nexus test remainsamorphous, the Bailey decision appears tosignal a growing consensus on the applica-tion of Rapanos.

Jesse J. Richardson, Jr., Virginia Tech

CROP INSURANCE. The FCIC hasadopted as final regulations amending thefresh market sweet corn crop insuranceprovisions of the common crop policy toallow for the expansion of fresh marketsweet corn coverage into more areas wherethe crop is produced, when provided in theactuarial documents and when it is mar-

keted through direct marketing. This changewill be applicable for the 2008 and succeed-ing crop years for all counties with a con-tract change date on or after the effectivedate of this rule and for the 2009 and suc-ceeding crop years for counties with a con-tract change date prior to the effective dateof this rule. 72 Fed. Reg. 54519 (Sept 26,2007).

FARM CREDIT SYSTEM. The FCA hasadopted as final regulations which providethat, when the assets of a Farm Credit Sys-tem institution in liquidation are distrib-uted, the claims of holders of subordinateddebt will be paid after all general creditor

claims. 72 Fed. Reg. 54525 (Sept. 26, 2007).

Federal Register summary from September 24, 2007 to October 5, 2007FARM LEASES. The CCC and FSA have

announced that they intend to issue pro-posed regulations governing the treatmentof so-called combination or flex leasesfor purposes of programs administered bythe FSA, CCC, and the FCIC. The CCC andFSA are seeking comments prior to issuingthe new regulations. 72 Fed. Reg. 55105

(Sept. 28, 2007).FARM LOANS. The FCA has adopted as

final regulations amending the priority ofclaims regulations to provide priority ofclaims rights to Farm Credit System banksif they make payments under a reallocationagreement to holders of consolidated andsystem-wide obligations on behalf of a de-faulting system bank. The final rule alsoclarifies that payments to a class of claimswill be on a pro rata basis. 72 Fed. Reg.54527 (Sept. 26, 2007).

PEANUTS. The CCC has announced theuniform rates that CCC will pay for storage,handling, and other associated costs for

2007 crop of peanuts for warehouse opera-

tors operating under a CCC Peanut StorageAgreement. CCC will pay $8.00 per ton inelevation charges to the receiving ware-house, only in cases where CCC directsdelivery of CCC-owned peanuts from onewarehouse to another location. In caseswhere the producer did not prepay the inelevation charges, CCC will pay the CCC-

approved in-elevation charge at a rate of$8.00 per ton to the warehouse operator andcollect the amount from the producer afterloan forfeiture. Storage amounts may beearned at the rate of $.089 per ton per day

beginning on the day following the loanmaturity date, based on a monthly storagerate of $2.71 per ton. CCC will pay a loadout rate of $8.00 per ton which includes alitems associated with loading out CCCowned peanuts, such as weighing and placing peanuts aboard railcars or trucks, whenordered by CCC. 72 Fed. Reg. 54426 (Sept25, 2007).

Robert P. Achenbach, Jr., AALA

Executive Director

Clean Water Act/Cont. from page 2STATE ROUNDUP

IOWA. Adverse possession. The partiesowned neighboring rural land tracts. In onecorner of the plaintiffs land existed an in-dentation belonging to the defendantsland. The plaintiff treated the disputed landas part of the plaintiffs property and main-tained it until the previous owner of thedefendants land planted trees. At the timeof the planting, neither neighbor knew thecorrect boundary but mutually agreed to

the tree planting. The previous neighborerected a fence on the neighbors side of thedisputed strip to fence in livestock. Whenthe defendant purchased the neighborsland, the fence was removed and the dis-puted property included in developmentplans. The plaintiff argued that the bound-ary line was established by the planting ofthe trees or the fence by acquiescence orpractical location. The court held that thedoctrine of practical location did not apply

because, at the time the trees were plantedor the fence erected, the neighboring landowners were not intending to settle a dis-pute of a boundary which could not beotherwise determined. The court also heldthat the doctrine of acquiescence did notapply because the plaintiff failed to provethat any particular boundary had beenagreed upon for at least 10 years. Jager v.Bracker West Farm Corp. , 2007 Iowa App.LEXIS 995 (Iowa Ct. App. 2007).

Robert P. Achenbach, Jr., AALAExecutive Director

NORTH CAROLINA.Boundary. The landowned by the parties was originally owned

by one family which had split the landbetween family members. A road ran be-

tween the properties and the deeds splitting the property granted a six foot ease-ment to each side of the road to the neigh

boring landowner. Thus, the boundary lineran down the center of the road. Lateowners, the defendants, of one parcel pavedthe road, and the other owners, the plaintiffs, alleged that the paved road did nofollow the original property line. The plaintiffs commissioned a survey of the property

and constructed a fence on what theyclaimed was the true property line. Thefence blocked the road in several places andthe defendants counter-sued for trespassThe defendants claimed a prescriptive ease-ment for the road but the court held that theclaim was properly denied because the de-fendants could not show 20 years of ad-verse use. The court held that the trial courimproperly granted judgment notwithstanding the jury verdict as to the boundaryline, because the plaintiffs had presentedsufficient evidence to place the issue inquestion so as to allow the jury to find the

boundary line to be other than that deter-mined by the survey. In addition, the courheld that the trial court improperly granted

judgment notwithstanding the jury verdictas to the trespass claims in favor of theplaintiffs in that the defendant had pre-sented sufficient evidence that the fencewas placed on the easement road in violation of the defendants easement rights

Jones v. Popper, 2007 N.C. App. LEXIS 1887(N.C. Ct. App. 2007).

Robert P. Achenbach, Jr., AALAExecutive Director



Roger A. McEowen is Leonard Dolezal Profes-sor in Agricultural Law, Iowa State University,

Ames, IA and Director, Iowa State UniversityCenter for Agricultural Law and Taxation.

Mortgage foreclosure tax issues

By Roger A. McEowen

Numerous factors have contributed to thecurrent problems in the mortgage and hous-ing industries. In large part, many of theproblems stem from home buyers, mort-

gage companies, and investors making baddecisions and either not understandingclearly or misusing some of the new andvaluable financial innovations that have

become available in recent years.1 Conse-quently, credit and housing markets aregoing through a period of painful adjust-ment, with the result that some homeownerswill face foreclosure.

Foreclosure can result in unexpected taxconsequences to the debtor, with the pre-cise impact depending on the type of debtinvolved, state law, and whether the fore-closure is structured as a short sale. Inaddition, mortgage foreclosure can have

tax consequences to the lender.On September 17, 2007, IRS issued a newsrelease announcing that it has added a fre-quently asked questions (FAQs) section onits website devoted to tax issues facingtaxpayers who lose their homes due to fore-closure.2 In the news release, IRS also reas-sured homeowners that while mortgageworkouts and foreclosures can have taxconsequences, special relief provisions ex-ist to reduce or eliminate the tax bite forfinancially strapped taxpayers who losetheir homes. In addition, there may beviable alternatives to foreclosure that donot carry the same negative tax conse-

quences.The current problems in the credit andhousing markets have also caught the at-tention of the Congress and the Adminis-tration. Legislation has been proposed thatwould alter the tax consequences of mort-gage foreclosure.

Tax consequences to the debtorClassification of the indebtedness

An important part of debt resolution isthe income tax consequences to the debtor.Gross income generally includes all in-come from whatever source derived.3 Thisincludes cancellation of debt income(CODI).4 When a foreclosure occurs, thereare two major categories of income tax con-sequences (1) gain or loss if the propertyis transferred to the lender in satisfaction ofindebtedness; and (2) possible CODI to theextent debt discharged exceeds the fairmarket value of property that the debtorgives up.

As a starting point, the tax impact ofmortgage foreclosure is heavily dependent

on the type of debt involved. If the debt isrecourse, the collateral serves as securityon the loan. If the collateral is insufficient,the debtor is personally liable for the obli-

gation and the debtors non-exempt assetsare reachable to satisfy any deficiency. Ifthe debt is nonrecourse, the collateral againserves as security on the loan. But, if thecollateral is worth less than the balance onthe debt, the debtor is not personally liablefor the balance. So, the creditor must looksolely to the collateral in the event of de-fault.

State law determines the type of indebt-edness involved. In many states, homemortgages are classified as recourse debt,

but California, for example, treats mort-gages that are used to purchase a residenceas nonrecourse (but, mortgages from refi-

nancing a previous mortgage are usuallyrecourse).

Nonrecourse debtWhen a nonrecourse mortgage is fore-

closed, a simple one-step process is involved.The property is treated as being sold for the

balance of the mortgage.5 Thus, the entiredifference between the income tax basis ofthe property (that is transferred to the credi-tor) and the amount of the debt dischargedis gain (or loss). There is no CODI.6

Note: In the IRS FAQ, Q and A No. 3, IRSstates, incorrectly, that CODI is not tax-

able in the case of non-recourse loans. Thecorrect statement should be that foreclo-sure of a nonrecourse loan does not result inCODI.

Recourse debtThe income tax consequence on foreclo-

sure of a recourse mortgage is treatedtaxwise as if the property is sold to thecreditor with the sale proceeds applied onthe debt. Thus, a two-step process is in-volved (1) there is no gain or loss (and noother income tax consequence) up to theincome tax basis on the property, but thedifference between fair market value andthe income tax basis is gain or loss;7 and (2)if the indebtedness exceeds the propertysfair market value, the difference is CODI.8

So, the foreclosure of a recourse mortgage(as well as a transfer as a result of an agree-ment between the parties) is treated as asale up to the point of the propertys fairmarket value.9 If the lender forgives the

balance of the mortgage, that amount isCODI.10

For recourse debt, the tax consequencesof mortgage foreclosure are heavily depen-dent on a determination of the propertysfair market value (FMV). But, determiningexactly what the FMV of the property is

may not be an easy task. If the taxpayersurrenders property to a creditor in exchange for cancellation of debt in a foreclo-sure sale, absent clear and convincing proof

to the contrary, the FMV will be presumedto be the sale price at the foreclosure sale.1

Note: Unless a taxpayer rebuts this presumption, the amount bid at the foreclosuresale will be deemed to be the propertys fairmarket value. Lenders frequently bid anamount higher than the propertys fairmarket value. A taxpayer in an appropriatecase should obtain appraisal evidence athe time of sale if the value of property isless than the amount bid at foreclosure.12

However, if the transfer is in lieu of foreclosure and the creditor sells the homeshortly thereafter, the taxpayer will have to

determine the propertys selling price.13

Nonrecognition of gainAny taxable gain triggered on foreclo

sure of the taxpayers principal residence iseligible for exclusion under I.R.C. 121 that is up to $250,000 for a taxpayer filing asa single person and $500,000 on a jointreturn.14 The taxpayer must satisfy the oc-cupancy and use requirements of the statutethe taxpayer must own the home anduse it as the taxpayers principal residencefor at least two out of the previous fiveyears.15 There are exceptions from the twoyear rule if the sale of the residence is on

account of a change in the taxpayers employment, health or unforeseen circum-stances. IRS, in its FAQ, did not say whetherit would treat foreclosure of a residence asan unforeseen circumstance.16

As is the case with foreclosure of nonrecourse debt, if the holding period requirement is met and the residence was thetaxpayers principal residence, the foreclosure amount representing gain is tax-free(up to $250,000 on a single return, $500,000on a joint return), but the cancellation ofdebt would generally be taxable as ordinary income.17

Nonrecognition of CODI18

CODI is not automatically included inincome. There are several ways in whichCODI may not trigger income.

InsolvencyCODI is not taxable if the debtor is insol-

vent (both before and after the transfer ofproperty and transfer of indebtedness) andnot in bankruptcy.19 But, the amount oCODI that can be excluded from income islimited to the extent of the debtors insol-vencyif the amount of debt dischargedexceeds the amount of the insolvency, in-come is triggered as to the excess.



The determination of the taxpayers sol-vency is made immediately before the dis-charge of indebtedness. Insolvency isdefined as the excess of liabilities over thefair market value of the debtors assets.Both tangible and intangible assets are in-cluded in the calculation. Likewise, bothrecourse and nonrecourse liabilities are in-cluded in the calculation, but contingentliabilities are not. The separate assets of thedebtors spouse are not included in deter-mining the extent of the taxpayers insol-vency. Historically, the courts have heldthat property exempt from creditors understate law is not included in the insolvencycalculation. However, the IRS has ruled tothe contrary,20 and the Tax Court hasagreed.21

BankruptcyA debtor in bankruptcy need not report

CODI,22 but must reduce tax attributes andreduce income tax basis.23 However, it iscritical that the mortgage is foreclosed andthe property is completely out of the debtors

name before the bankruptcy discharge oc-curs.

Deductible itemsAny portion of a cancelled debt, includ-

ing interest, which would have been de-ductible if paid, is not subject to federalincome tax. Thus, the portion of cancelleddebt that is attributable to accumulateddeductible mortgage interest is not taxable.

Short-sale transactionsA short sale occurs when a homeowner

sells the home for less than the existingmortgage balance. The seller then tries to

get the lender to forgive the unpaid bal-ance.24 Typically, a debtor considers the useof a short sale in lieu of foreclosure in anattempt to protect his or her credit history.

A short sale is taxed under the same rulesas foreclosures are taxed. If the underlyingdebt is recourse, the cancelled debt is notsatisfied with the surrender of the prop-erty. Thus, any debt not satisfied with thesale proceeds is taxable as CODI.25 Thatmeans that the tax consequences would bethe same as mortgage foreclosure involv-ing a recourse debt.26 If the short sale in-volves nonrecourse debt, and the seller andthe buyer require cancellation of the debt

by the lender as a condition of the sale, thedebt cancellation is included in the saleproceeds, like for a foreclosure.27 So, a shortsale can be a viable alternative to a foreclo-sure for debtors with nonrecourse debt andwho qualify for the exclusion from incomeof the gain from the sale of a principalresidence.

Drop in value of homedeductibilityand timing of a loss

In the present real estate market, it isentirely possible that the fair market valueof a home may have dropped beneath itspurchase price if the purchase occurred

relatively recently. If foreclosure then oc-curs (or a short sale transaction is enteredinto), and the underlying debt is nonre-course, the difference between the mort-gage balance at the time of foreclosure andthe taxpayers basis in the home28 is a non-deductible personal loss if the residence isthe taxpayers principal residence.29 If thedebt is recourse and a foreclosure or shortsale occurs, CODI results on the difference

between the fair market value of the homeand the existing mortgage balance, and anon-deductible personal loss (if the home isthe taxpayers personal residence) is trig-gered as to the difference between thetaxpayers basis in the home and the homesfair market value.

Regardless of whether the debtor is anaccrual-basis or cash basis taxpayer, anyloss resulting from the foreclosure is treatedas occurring when the foreclosure (or trans-fer in lieu of foreclosure) takes place.30 If thedebtor exercises the right to redeem andrecovers possession of the property, no gainor loss is realized.31 Also, if state law pro-

vides for redemption rights, the debtor mayavoid postponement of any foreclosure gainor loss by quitclaiming the redemptionrights.32

If the fair market value of the foreclosedproperty is less than the outstanding mort-gage and the mortgagee releases the mort-gagor from his obligation to pay the defi-ciency, any CODI which the mortgagorrealizes is reported in the year the mort-gagee provides the release.

Tax consequences to the mortgageeIn general

A mortgagee may face two possible tax

impacts when property is foreclosed. First,assuming the mortgage is a bad debt, themortgagee may have a bad debt deductionin the year of foreclosure on the outstand-ing portion of the mortgage,33 and can takea partial bad debt deduction if the mort-gage is partially worthless and the mort-gagee charges off the worthless portion.34

Second, the mortgagee may recognize gainor loss on the final disposition of the prop-erty.

To the extent that amounts received froma foreclosure sale of mortgaged property toa third party exceed the mortgagees totalclaim, (including all costs associated withthe foreclosure), the excess is normally paidto the mortgagor. So, it is unusual for amortgagee to realize a gain from a foreclo-sure sale.35 However, the mortgagee couldexperience gain if the mortgagee originallypurchased the mortgage debt at a discountor had previously taken a partial bad debtdeduction which reduced the mortgagees

basis in the loan.

Nonrecourse debtIn the case of a nonrecourse mortgage

where the mortgagee purchases the mort-gaged property in a foreclosure sale, themortgagee has a taxable gain or loss to the

extent of the difference between the bidprice36 and the mortgagees basis in themortgage.37

Recourse debtIf the mortgagee purchases mortgaged

property in a foreclosure sale, and the mortgage is recourse, the mortgagee has theright to try to recover the deficiency fromthe mortgagor. Since recovery on a deficiency judgment would make the mortgagee whole, any loss which the mortgageemight have can only be taken in the foreclosure year if it can be shown in that year thathe deficiency is uncollectible.38 Otherwisethe mortgagee subtracts the foreclosure recovery from its original debt basis to determine its basis in the deficiency. The mortgagee then defers reporting gain or lossuntil the collectibility (or uncollectibility) othe deficiency is determined.39 Accrued interest may be included as part of the deduction allowable with respect to a mortgageforeclosure, but only if the interest has beenreported as income.40

Handling expenses of foreclosures andrepossessions

Court costs, legal fees, and other foreclosure costs related to property sold at fore-closure reduce the proceeds that the mortgagee receives. Any expenses and liens themortgagee pays to protect the mortgagedproperty before the foreclosure sale will beadded either to the mortgagees basis forthe loan or to its basis for the acquiredproperty, depending upon when they arepaid. Amounts paid before foreclosure areadded to the mortgagees loan basis, whileoutlays during the foreclosure proceeding

are added to the mortgagees property basis or to the deficiency judgment if themortgagee does not acquire the property.4

A foreclosure by a prior lien holder gen-erally eliminates a mortgagee as a securedcreditor, but any resulting loss is not deductible by the mortgagee until the juniornote (previously secured by the foreclosedproperty) is proven to be worthless.42

Alternatives to foreclosureIn any given situation, there may be some

alternatives to foreclosure that can be utilized that may, depending on the circum-stances, have a better tax consequence

Restructuring the debtIt may be mutually beneficial for the par-

ties to restructure the debt. A substitutionof a new debt instrument in satisfaction ooutstanding indebtedness is treated as satisfaction of the outstanding indebtednessfor an amount equal to the issue price of thenew debt instrument.43 That may triggerCODI for the debtor equal to the difference

between the new debt instruments issueprice and the adjusted issue price of the olddebt instrument. Alternatively, if the debis actually cancelled, the debtor may realize

Cont. on page



Cont. on page 7

ordinary income to the extent of the dis-charge.

Modifications of the indebtednessOther restructuring alternatives may in-

clude an extension of the mortgage term,waiver of current debt service payments,and addition of unpaid interest to the prin-cipal balance of the mortgage. If the modi-

fication is not material, these types of ad-justments have historically been treated asnonrecognition events.44 But, the U.S. Su-preme Court has created a rather low thresh-old in determining whether a modificationof terms of an outstanding debt obligationis material enough to be treated as a deemedexchange of old debt for new debt withresulting tax consequences.45 Likewise, theregulations specify that there is a realiza-tion event if there is a modification in thedebt instrument which is a significantmodification.46 Most temporary forbear-ances of a mortgagors failure to performare not considered significant modifications

and, therefore, do not result in a realizationevent.47

The bottom line is that the restructuringof an existing loan by entering into a loanmodification agreement may cause thelender to be treated as having disposed ofthe original mortgage, and the borrowermay have CODI if the principal amount ofthe old loan exceeds the principal amountof the new one. The modification may alsotrigger the original issue discount rules thatwould treat a portion of the new debt prin-cipal as imputed interest. If the principal ofthe old debt is greater than the imputedprincipal of the new debt, a solvent bor-

rower generally realizes CODI.

48

Installment saleInstallment sale reporting may be used to

defer recognition of a part of the gain untilthe installment payments are collected inthe future. But, the major limitation is thatany excess of the mortgage balance over theadjusted basis of the property is treated aspayment received in the year of sale.

Like-kind exchangesLike-kind exchanges may be used as an

alternative to foreclosure.49 However, it may be difficult to find property suitable forexchange. In addition, the debtors prop-erty typically has a relatively high out-standing mortgage balance, along with alow equity value. So, the debtor wouldhave to include some cash along with theproperty in the trade and trade up to ahigher-value property. That may not bepossible.

Constructive receipt issues in debtrestructurings

Constructive receipt of income may oc-cur when a mortgage or other debt is ex-tended or restructured. Constructive re-

ceipt of income occurs when the taxpayerhas an unrestricted right to receive the in-come, is able to collect it, and the failure todo so results from the exercise of thetaxpayers own choice.50 If the debtor isunable to pay a mortgage note when due,the mortgagee has not constructively re-ceived income. If, however, a note is ex-tended or restructured as an accommoda-

tion to a debtor who is otherwise able topay, constructive receipt of the entire prin-cipal due may occur on the due date of thenote.51 To avoid constructive receipt in thissituation, any extension or supersedingagreement with respect to the loan must beagreed to before the existing mortgage noteor loan becomes due.52

Proposed legislationLegislation has been proposed that would

exclude CODI from gross income that istriggered by the discharge (after December31, 2006) of qualified principal residenceindebtedness.53 The House bill, which

would permanently exclude CODI fromgross income, passed by a wide margin onOctober 4, 2007.54 Under the bill, qualifiedprincipal residence indebtedness is definedas acquisition indebtedness (as defined byI.R.C. 163(h)(3)(B), but without regard toany dollar limitation) with respect to thedebtors principal residence (as defined forpurposes of I.R.C. 121).55 The debtors ba-sis in the residence would be reduced by theamount excluded from income. Also, theexclusion would not apply to debtors in

bankruptcy, but it would apply to insolventdebtors unless the debtor elects to have theexclusion for insolvent debtors apply. But,

the exclusion would not apply to the dis-charge of a loan if the discharge is on ac-count of services performed for the lender.

The legislation would also extend theexisting deduction for private mortgageinsurance to amounts paid or accrued after2007, but only with respect to contractsentered into after 2006 and before 2015.56

To pay for the new tax break, beginningin 2008, the legislation limits the existingI.R.C. 121 exclusion for gain attributable tothe sale of a principal residence to onlythose periods during which the taxpayeractually used the residence as the taxpayersprincipal residence.57

Policy implications of the proposedlegislation

Completely eliminating the tax on CODIattributable to a debtors principal residenceis not the correct policy approach. The valueof the cancelled mortgage is a beneficialgain to the former borrower which should

be subject to taxit is an accession to wealth.Thus, complete elimination of the tax onCODI amounts to a windfall (at taxpayerexpense) for debtors who, in many respects,made poor economic decisions.58 Existingtax law already provides an incentive for

homebuyers to borrow too much for mortgage indebtedness, and making mortgagedebt tax free would only further increasethat incentive.59 Perhaps a better approachwould be to tax CODI at long-term capitagain rates rather than ordinary income ratesWhen a lender cancels a mortgage debt, thelender suffers a capital loss. It logicallyfollows that the borrower has received a

capital gain and should be taxed accord-ingly.60

From a broader perspective, requiringloan applicants to undergo an approvaprocess based on genuine ability to paymight go a long way to avoiding a similarproblem in the future.61

1 Also involved are homeowners who bor-rowed against the perceived equity in theiresidence (often via 125 percent home equityloans and adjustable rate mortgages that arecontractually beginning to adjust the interesupward) to buy consumable, non-necessarygoods in effect, attempting to monetizetheir home through borrowing (or repay unse

cured credit card obligations). Likewise, somelenders were overly eager to extend credit arelatively higher interest rates to people withnot-so-good creditworthiness (so-calledsubprime loans), and borrowers who boughproperties to fix and flip on the expectationthat the real estate market would only continueto go up

2 IRS News Release 2007-159 (Sept. 172007).

3 I.R.C. 61(a).4 I.R.C. 61(a)(12). Under I.R.C. 1001(a)

gain realized from the sale of property equalsthe excess of the amount realized over thetaxpayers adjusted income tax basis in theproperty. The amount realized from the sale oother disposition of property includes the

amount of liabilities from which the transferois discharged as a result of the sale or disposition.

5See Commr v. Tufts, 461 U.S. 300 (1983)revg, sub. nom., Tufts v. Commr, 651 F.2d1058 (5th cir. 1981); Helvering v. Hammel, 311U.S. 504 (1941).

6 One significant difference between nonrecourse and recourse mortgages is that, with anonrecourse mortgage, the amount realizedon foreclosure, or a transfer in lieu of foreclosure, is never less than the outstanding debtI.R.C. 7701(g). Thus, the debt is not treatedas canceled and the debtor does not haveCODI.

7See, e.g.,Emmons v. Commr, T.C. Memo1998-173.

8 Treas. Reg. 1.1001-2(a)(1).9 For recourse debt, the amount realizedgenerally cannot exceed the fair market valueof the property. Rev. Rul. 90-16, 1990-1 C.B12; Treas Reg. 1.1001-2(c). This limitationapplies even if the amount bid at the foreclosure sale exceeds the propertys fair markevalue. Frazier v. Commr, 111 T.C. 243 (1998)

10 Treas. Reg. 1.61-12. That amount isreported to the taxpayer on Form 1099-C, Box7.

11 See Community Bank v. Commr, 819F.2d 940 (9th Cir. 1987), affg, 79 T.C. 789(1982); Frazier v. Commr, 111 T.C. 243 (1998)

Tax issues/ cont. from p. 5



Maracaccio v. Commr, T.C. Memo. 1995-174.12See, e.g.,Frazier v. Commr, 111 T.C. 243

(1998).13 One of the IRS FAQs suggests that taxpay-

ers who do not agree with the information on aForm 1099-C should contact the creditor andhave the creditor issue a corrected form if theinformation is incorrect.

14 I.R.C. 121(b)(1)-(2).15 I.R.C. 121(a).16 While IRS has liberally interpreted unfore-

seen circumstances in recent years, a drop inmarket value of a home would likely not meetthe test, and neither would readjustment of theinterest rate of an adjustable rate mortgage.

17 I.R.C. 61(a)(12).18 The amount of CODI that is not taxable is

claimed on IRS Form 982 (Reduction of TaxAttibutes Due to Discharge of Indebtedness) bychecking the box at Line 1(b) in Part I andindicating the amount of debt forgiveness that isexempt from federal income tax on Line 2. Form982 must be attached to the taxpayers Form1040 for the year in which the debt is cancelled.

19 I.R.C. 108(a)(1)(B). But, insolvent debt-ors must reduce tax attributes and reduce theincome tax basis of property.SeeI.R.C. 108(b).

20 Priv. Ltr. Rul. 199932013 (May 4, 1999),

revoking, Priv. Ltr. Rul. 9125010 (Mar. 19, 1991);Tech. Adv. Memo. 199935002 (May 3, 1999).

21Carlson v. Commr, 116 T.C. No. 9 (2001).22See, e.g., I.R.C. 108(a)(1)(A).23 It is noted, however, that under The Bank-

ruptcy Abuse Prevention and Consumer Pro-tection Act of 2005 (BAPCPA), Pub. L. 109-8,119 Stat. 23, it is more difficult for individuals tofile bankruptcy than under pre-BAPCPA law.

24 The short sale technique refers to atechnique that has arisen out of the currentmortgage foreclosure climate and is a new useof the term it does not refer to the InternalRevenue Code definition of the term. Under theCode, a short sale involves the sale of aborrowed item to be replaced at a future date,usually a security. IRS has never applied the

term short sale to a real estate sale transac-tion.

25 Rev. Rul. 92-99, 1992-2 C.B. 35. See also,Treas. Reg. 1.1001-2(a)(2).

26 In addition, it is questionable whether thelender would consent to the transaction and, infact, forgive the debt.

272925 Briarpark Ltd. v. Commr, 163 F.3d313 (5th Cir. 1999), affg, T.C. Memo. 1997-298.

28 The fair market value of the property isdisregarded for a non-recourse mortgage.

29 The loss incurred is deductible only if themortgage indebtedness was incurred in con-nection with property either held for investmentor used in the debtors trade or business. But, ifthe foreclosure proceeds are used to pay out-

standing interest or property tax obligations,they will typically be deductible. See, e.g.,Malmstedt v. Commr, 578 F.2d 520 (4th Cir.1978).

30Lamm v. Commr, 873 F.2d 194 (8th Cir.1989). That is also the case if the debtor has aright of redemption under state law. See, e.g.,Securities Mortgage Co. v. Commr, 58 T.C.667 (1972); William C Heinemann & Co. v.Commr, 40 B.T.A. 1090 (1939). But, IRS hastaken the position that if the debtor has a statu-tory right to reaquire the property followingforeclosure (i.e., redemption), the debtors abil-ity to deduct a loss is postponed until the right ofredemption expires. Rev. Rul. 70-63, 1970-1C.B. 36. However, if the foreclosure matter is in

litigation, the year in which the litigation termi-nates is the year in which tax items are takeninto account. Great Plains Gasification Asso-ciates, et al. v. Commr, T.C. Memo. 2006-276.

31Hotz v. Commr, 42 B.T.A. 432 (1940).32 Atmore Realty Co. v. Commr, B.T.A.

Memo. 1942-248 (1948).33 I.R.C. 166(a). See, e.g., Commr v.

Spreckels, 120 F.2d 517 (9th Cir. 1941). If themortgage is a nonbusiness bad debt, subjectto I.R.C. 166(d), the loss is a short-term

capital loss.34Seegenerally I.R.C. 166(a)(2) and Treas.Reg. 1.166-3.

35 A loss may be recognized for tax pur-poses in the year of foreclosure, even thoughthe mortgagor has a right of redemption. SeeSecurities Mortgage Co. v. Commr, 58 T.C.667 (1972); William C Heinemann & Co. v.Commr, 40 B.T.A. 1090 (1939).

36 The bid price usually is presumed to thethe fair market value of the property. See, e.g.,Community Bank v. Commr, 62 T.C. 503(1974), acq., 1975-2 C.B. (presumption up-held even where IRS claimed that bid priceless than fair market value). See also Treas.Reg. 1.166-6(b)(2). But, the presumptiondoes not apply when the mortgagee is the

seller and is also the party foreclosing on theproperty. I.R.C. 1038 provides that when theseller/mortgagee reposseses property in sat-isfaction of the indebtedness, no loss is recog-nized and, under certain circumstances, gainmay be recognized.

37 The result is the same with a recoursemortgage if the bid price equals or exceedsthe outstanding debt. The mortgagees basisis determined by subtracting principal paidfrom the loans face amount. I.R.C. 166(b);Treas. Reg. 1.166-1(d).

38 Treas. Reg. 1.166-6(a); 1.165-5(e).See also Estate of Jewett v. Commr, T.C.Memo. 1949-163 (1949); Havemeyer v.Commr, 45 B.T.A. 329 (1941), acq1942-1 CB8.

39See Treas. Reg. 1.166-6(a)(1).40 Treas. Reg. 1.166-6(a)(2);Federal HomeLoan Mortgage Corporation v. Commr, 121T.C. 279 (2003) (in computing gain or lossfrom a mortgage foreclosure, taxpayer cannotincrease adjusted cost basis in the mortgageby interest that accrued while taxpayer wastax-exempt).

41But seeHeger v. Commr, T.C. Memo.1993-408, affd, 35 F.3d 561 (5th Cir. 1994),where payments made to avoid foreclosurewere notallowed to be added to basis.

42Berenson v. Commr, 39 B.T.A. 77 (1939),affd113 F.2d 113 (2d Cir. 1940).

43 I.R.C. 108(e)(10).44 Rev. Rul. 73-160, 1973-1 C.B. 365 (ex-

tension of maturity date of notes not a taxable

transaction); Soter v. Commr, T.C. Memo.1968-43; Rev. Rul. 68-419, 1968-2 C.B. 196(modification of purchasers note to defer prin-cipal payment dates and increase interest ratenot disposition or satisfaction of an installmentobligation); Rev. Rul. 55-429, 1955-2 C.B.252.

45Cottage Savings Assoc. v. Commr, 499U.S. 554 (1991), revg and remg, 890 F.2d848 (6th Cir. 1989).

46 Treas. Reg. 1.1001-3. For this purpose,a modification is any alteration, including anydeletion or addition, in whole or in part, of alegal right or obligation of the issuer or a holderof a debt instrument, whether the alteration isevidenced by an express agreement (oral or

written), conduct of the parties, or otherwise.Treas. Reg. 1.1001-3(c)(1).

47See Treas. Reg. 1.1001-3(c)(4)(ii), providing that a forbearance of under two years(and sometimes longer) is temporary for thesepurposes.

48 I.R.C. 108(e)(11).49 I.R.C. 1031.50 Treas. Reg. 1.451-2(a);Saint Claire Corp

v. Commr, T.C. Memo. 1997-171.51 This type of situation is likely to occur when

real property is sold to related parties, to controlled entities, or to parties who are well-known to the seller.

52 Martin v. Commr, 96 T.C. 814 (1991)Oates v. Commr, 18 T.C. 570 (1952), affd,207F.2d 711 (7th Cir 1953); Saint Claire Corp. vCommr, T.C. Memo. 1997-171 (constructivereceipt of entire remaining principal occurredwhen mortgage note was extended on the dateit became due and obligor was otherwise ableto pay).

53See S. 1394, The Mortgage CancellationRelief Act of 2007, introduced May 15, 2007and H.R. 3648, The Mortgage ForgivenessDebt Relief Act of 2007, introduced on Sep-tember 25, 2007, and passed by the House onOctober 4, 2007.

54 H.R. 3648 passed by a vote of 386-27. Ithe legislation is being enacted to address thecurrent situation in the mortgage and housingindustries, a question is raised as to why theHouse deemed it necessary to craft permanenrelief.

55 Thus, loans for purchasing and improvinga residence would qualify, but equity loanswould not.

56 This relief would apply (at least partially) totaxpayers with adjusted gross income of lessthan $55,000 (single return) or $110,000 (joinreturn).

57 Thus, the I.R.C. 121 exclusion of gainattributable to the sale of a rental or vacationproperty would be reduced beginning in 2008So, even if the legislation passes, the reduction

in the exclusion would only be for nonqualifieduse after 2007. That would give taxpayers theremainder of 2007 to move into a vacationhome or rental property, live there for theminimum two-year period, and qualify for thefull exclusion.

58 On October 3, 2007, the Administrationwhile expressing support for H.R. 3648, alsourged lawmakers to narrow the scope of thebill. Such narrowing, the Administration notedshould be in the form of temporary relief andshould not put in place tax policy that wouldinfluence future borrowing behavior.

59 A related economic effect of increaseddebt financing would be an increase in themarket price of new and existing homes.

60 It is noted that the alternative minimum tax

(AMT) may be imposed on the portion of capitagains that is excluded from income. Thusreclassifying CODI as capital gain income whichis then excluded under I.R.C. 108 couldcreate an AMT preference item. The Congress, from a policy perspective, would have toconsider whether an amendment to the AMTstatute would be in order.

61 Clearly, there is a need for additional emphasis on education concerning financial matters. To this end, the Bush administrationannounced on August 31, 2007, that it wouldcreate a Presidential Council on Financial Literacy to help raise awareness of the financiaissues surrounding home buying and financing.



2007 Conference Handbook on CD-ROM

By the time this issue reaches most members, the 28th Annual Agricultural Law Symposium will becompleted. If you could not attend the conference in San Diego but still want a copy of the papers, youcan get the entire written handbook plus the 1998-2007 past issues of theAgricultural Law Update onCD. The files are in searchable PDF with a table of contents that is linked to the beginning of each paper.Order for $45.00 postpaid from AALA, P.O. Box 2025, Eugene, OR 97402 or e-mail RobertA@aglaw-

assn.org. Copies of the printed version are also available for $90.00.

Both items can also be ordered using PayPal or credit card using the 2007 conference registration formon the AALA web site. Just select enter the quantity in the Extra Conference handbooks section ofthe form.

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Agriculture Law: 10-07