Crane v. Commissioner: Understanding How Debt Affects Property Basis and Gain

Case Summary

Crane v. Commissioner is a foundational tax case that explains how debt affects your tax basis in property. This case is essential for understanding real estate transactions, depreciation deductions, and calculating gain or loss when you sell property. The principle established here affects millions of property owners and real estate investors.

The Facts of the Case

Beulah Crane inherited an apartment building from her late husband in 1932. The property was worth approximately $262,000 but was subject to a mortgage of $262,000—meaning she inherited property with no equity.

Key Facts:

• Property value: $262,000
• Mortgage debt: $262,000
• Net equity: $0
• Mrs. Crane was not personally liable for the mortgage (non-recourse debt)

From 1932-1938, Mrs. Crane:

• Collected rents from the property
• Claimed depreciation deductions on her tax returns
• Reported the full property value ($262,000) as her basis for depreciation

In 1938, she sold the property for $3,000 cash plus the buyer's assumption of the $262,000 mortgage.

The Tax Dispute

Mrs. Crane's Position:

• Her basis was $0 (no equity inherited)
• Therefore, she couldn't claim depreciation
• Amount realized on sale: $3,000 (only the cash received)
• Gain on sale: Minimal

The IRS's Position:

• Her basis included the $262,000 mortgage
• She properly claimed depreciation, reducing her basis
• Amount realized includes the $262,000 debt relief
• Gain on sale: Substantial

The Supreme Court's Landmark Decision

The Ruling: Debt Is Included in Basis

The Supreme Court ruled in favor of the IRS, establishing several crucial principles:

1. Debt-Financed Property Has Full Basis

When you acquire property subject to debt, your basis includes:

• Cash or property you pay
• PLUS the amount of debt (even if non-recourse)

Example:

• Buy property for $500,000
• Pay $100,000 cash down
• Finance $400,000 with mortgage
• Your basis: $500,000 (not just $100,000)

2. Amount Realized Includes Debt Relief

When you sell or dispose of property, your "amount realized" includes:

• Cash or property received
• PLUS debt you're relieved of

Example:

• Sell property for $50,000 cash
• Buyer assumes your $400,000 mortgage
• Amount realized: $450,000 (not just $50,000)

3. Consistency Principle

The Court reasoned: If you include debt in basis (allowing larger depreciation deductions), you must also include debt relief in amount realized when you dispose of the property. You can't have it both ways.

Understanding Tax Basis With Debt

Why Basis Matters

Basis determines:

1. Depreciation Deductions: Higher basis = larger annual deductions
2. Gain or Loss on Sale: Gain = Amount Realized minus Adjusted Basis
3. Tax Consequences: Lower basis = higher gain = more tax

The Crane Formula

Real-World Applications

Example 1: The Rental Property

Year 1 (Purchase):

• Buy rental house for $300,000
• Down payment: $60,000
• Mortgage: $240,000
• Your basis: $300,000
• Building value (depreciable): $240,000
• Land value (not depreciable): $60,000

Years 1-10:

• Annual depreciation: $8,727 ($240,000 ÷ 27.5 years)
• Total depreciation over 10 years: $87,270
• Mortgage paid down to: $200,000

Year 10 (Sale):

• Sell property for $350,000
• Buyer pays $150,000 cash
• Buyer assumes $200,000 mortgage

Tax Calculation:

• Amount realized: $350,000 ($150,000 cash + $200,000 debt relief)
• Adjusted basis: $212,730 ($300,000 - $87,270 depreciation)
• Total gain: $137,270
• Depreciation recapture (25% rate): $87,270
• Capital gain (15% or 20% rate): $50,000

Example 2: The Underwater Property

The Situation:

• Original purchase: $400,000 (with $320,000 mortgage)
• Current value: $300,000 (declined in value)
• Current mortgage: $300,000 (you've paid down $20,000)
• Adjusted basis: $350,000 (after $50,000 depreciation)

Option 1: Foreclosure

• Amount realized: $300,000 (debt relief)
• Adjusted basis: $350,000
• Loss: $50,000 (but may not be deductible if personal residence)
• Note: May also have cancellation of debt income if mortgage exceeds FMV

Option 2: Short Sale

• Sell for $300,000
• Bank forgives remaining $0 (assuming full debt relief)
• Amount realized: $300,000
• Adjusted basis: $350,000
• Loss: $50,000

The Crane Principle and 1031 Exchanges

Debt Balancing in Like-Kind Exchanges

When doing a 1031 exchange, Crane principles affect whether you have fully tax-deferred gain:

Rule: Debt on new property must be equal to or greater than debt on old property (or you must add cash).

Example: Partial Taxable Exchange

• Relinquished property: FMV $500,000, Mortgage $300,000
• Replacement property: FMV $500,000, Mortgage $200,000
• Result: You're relieved of $100,000 more debt than you assume
• Tax Consequence: $100,000 "boot" (taxable gain)

Solution: Add $100,000 cash to maintain equal or greater debt.

Recourse vs. Non-Recourse Debt

Non-Recourse Debt (Crane)

• Definition: Lender can only foreclose on property; can't pursue you personally
• Tax Treatment: Included in basis and amount realized
• Common For: Commercial real estate, investment property

Recourse Debt

• Definition: You're personally liable; lender can pursue your other assets
• Tax Treatment: Also included in basis and amount realized
• Common For: Personal residences, most loans

The Tufts Case Extension

In Commissioner v. Tufts (1983), the Supreme Court extended Crane, holding that debt relief is included in amount realized even if the debt exceeds the property's fair market value.

Example:

• Property FMV: $500,000
• Non-recourse debt: $600,000
• You abandon the property in foreclosure
• Amount realized: $600,000 (the full debt amount, not just $500,000)

Implications for Real Estate Investors

The Power of Leverage

Crane makes leveraged real estate investing tax-advantaged:

1. Full Basis for Depreciation: Deduct depreciation on the full value, even though you only put down 20%
2. Amplified Returns: Appreciation and depreciation apply to full value, not just your equity
3. Tax Deferral: Depreciation creates tax losses that shelter other income

Example: Leveraged Real Estate

• Buy $1,000,000 building with $200,000 down payment
• Depreciate $900,000 (building only) over 39 years = $23,077/year
• Your actual cash invested: $200,000
• Annual depreciation deduction: $23,077 (11.5% of your cash investment!)

Potential Traps and Pitfalls

Trap #1: Phantom Gain on Foreclosure

If you lose property to foreclosure, you can have taxable gain even though you lost money:

• This happens when accumulated depreciation exceeds your equity
• You still recognize gain equal to debt relief minus adjusted basis
• May also have cancellation of debt income

Trap #2: Refinancing and Basis

Common misconception: Refinancing increases basis

WRONG: Refinancing doesn't change basis. Only acquisition debt and capital improvements increase basis.

Trap #3: Debt Assumption in Sale

Sellers often forget that buyer's assumption of debt is part of amount realized:

• Receive $50,000 cash
• Think you only made $50,000
• Actually realized $450,000 (including $400,000 debt relief)
• Surprise: Large tax bill!

Special Situations

Principal Residence Exclusion

Good news: The $250,000/$500,000 home sale exclusion applies to gain calculated using Crane principles:

• Your amount realized includes mortgage debt relief
• But you can still exclude up to $250,000 (single) or $500,000 (married)
• This protects most homeowners from tax on sale

Cancellation of Debt Income

If debt exceeds property value and lender forgives the excess:

• You may have cancellation of debt (COD) income
• This is separate from gain on disposition
• Exceptions exist for insolvency, bankruptcy, qualified principal residence

Documentation and Record-Keeping

To properly apply Crane principles, maintain records of:

• Purchase Price: Settlement statement showing price and debt
• Debt Amounts: Original mortgage and subsequent changes
• Debt Paydown: Annual mortgage interest statements
• Capital Improvements: Receipts for improvements that increase basis
• Depreciation: Annual depreciation schedules
• Sale Details: Settlement statement showing debt relief

Key Takeaways from Crane v. Commissioner

1. Debt Is Part of Basis: Include mortgage debt when calculating initial basis
2. Debt Relief Is Income: Include debt relief when calculating amount realized on sale
3. Consistency Required: If you get the benefit (depreciation), you must accept the burden (gain recognition)
4. Applies to All Debt: Both recourse and non-recourse debt follow these rules
5. Track Everything: Maintain detailed records of debt and basis changes

How Tax Help Guy Can Help

At Tax Help Guy, we help property owners navigate the complexities of debt-financed property:

• Basis Calculations: Correctly calculate basis including debt
• Depreciation Planning: Maximize depreciation deductions
• Sale Planning: Calculate expected gain before you sell
• 1031 Exchange Coordination: Ensure debt balancing for tax-free exchanges
• Foreclosure/Short Sale Help: Calculate tax consequences of distressed sales
• Audit Support: Defend basis and gain calculations to IRS