1 The Honorable J. Thomas Marten, United States Dis trict Judge for the

District of Kansas, sitting by designation. 

## F I L E D United States Court of Appeals Tenth Circuit 

### FEB 16 1999 

### PATRICK FISHER Clerk PUBLISH
UNITED STATES COURT OF APPEALS

TENTH CIRCUIT

LAYNE E. PRESLAR and SUE F. PRESLAR, Petitioners-Appellees,

v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellant. No. 97-9016

APPEAL FROM THE UNITED STATES TAX COURT

(T.C. No. 0090-1:14051-94)

John A. Dudeck, Jr. (Richard Farber with him on the brief), Tax Division, Department of Justice, Washington, D.C., for the ap pellant. Ron Lewis, Ruidoso, New Mexico, for the appellees.

Before EBEL and BRISCOE , Circuit Judges, and MARTEN , District Judge. 1

BRISCOE , Circuit Judge.-2-

The Commissioner of Internal Revenue appeals the Un ited States Tax Court’s decision to redetermine the tax deficiency assessed against Layne and Sue Preslar for underpayment of 1989 federal income tax es. The Tax Court held the Preslars’ settlement of a loan obligation for less than the face amount of the loan did not create taxable income because the contested liability/disputed debt exception to the general discharge-of-indebtedness income rule rendered the write-off nontaxable. We exercise jurisdiction pur suant to 26 U.S.C. § 7482(a)(1), and reverse and remand.
I. Layne Preslar, a real estate agent of twenty-five y ears, commenced negotiations in 1983 to purchase a 2500-acre ranch near Cloudcroft, New Mexico. High Nogal Ranch, Inc., owned the ranch and was a d ebtor-in-possession in a Chapter 11 bankruptcy proceeding. Citizens State B ank of Carrizozo, Security Bank and Trust of Alamogordo, and Moncor Bank held mortgages in the ranch. Moncor Bank, which had been experiencing serious fi nancial difficulties and whose interest was subordinate to the other banks, took the lead in assisting in negotiations between High Nogal and Preslar. Monco r Bank’s actions were designed to avoid foreclosure and recoup as much of its loan as possible. On July 12, 1983, after six months of talks, Layne and Sue Preslar agreed to purchase the ranch for $1 million, with the sale to be financed by Moncor-3-

Bank. The agreement expressly referred to the factthat Moncor Bank was financing the purchase, but only the Preslars and the president of High Nogal signed the contract on September 1, 1983. The Pres lars executed a $1 million promissory note in favor of Moncor Bank, secured bya mortgage on the ranch. The Preslars were to pay fourteen annual installments of $66,667, with interest at twelve percent per annum, with final payment due Se ptember 1, 1998. Moncor Bank used $760,000 of the loan proceeds to satisfy the mortgages of Citizens State Bank and Security Bank and Trust. The Preslars thus received title to the ranch free and clear of all of High Nogal’s prior m ortgages. The Preslars intended to develop the ranch as a spo rtsman’s resort by subdividing 160 acres and selling one- to two-acre lots for cabins or vacation homes, and permitting lot owners to hunt and engage in other outdoor recreational activities on the remaining 2,340 acres. The goal was to sell each cabin lot for approximately $16,500, with total gross revenues ex ceeding $1.5 million. The Preslars’ 1989 joint tax return indicates several l ots sold for substantially higher

amounts. Moncor Bank permitted the Preslars to repay their l oan by assigning the installment sales contracts of purchasers of cabin lots to Moncor Bank at a discount. There is no reference to this unique rep ayment arrangement in the loan documents. The first written description of this r epayment method appears in a-4-

May 3, 1984, letter from Joseph Ferlo, a representative of Moncor Bank, to Layne Preslar. The arrangement is also discussed in an u nsigned 1985 “Dealer Agreement” between Moncor Bank and the Preslars. When each cabin lot was sold, the Preslars assigned and physically transferred the written sales contract to Moncor Bank. In return, Moncor Bank credited the P reslars’ debt obligation in an amount equal to 95 percent of the stated principal contract price, regardless of actual payments received from the purchaser. Monco r Bank received a security interest in each lot sold to protect its interests in the event a purchaser defaulted. Between September 1983 and August 1985, the Preslar s sold nineteen cabin lots and had assigned most of the contracts to Moncor Bank prior to its declared insolvency. Moncor Bank had credited the Preslars’ principal loan balance with approximately $200,000. Funds applied to interest are not included in this amount; thus, the aggregate amount of discounted in stallment contracts assigned to Moncor Bank exceeded $200,000. In August 1985, Moncor Bank was declared insolvent and the Federal Deposit Insurance Corporation (FDIC) was appointed as receiver. The FDIC notified the Preslars of the insolvency and advisedthem to make all future payments on their loan to the FDIC. The FDIC refus ed to accept further assignments of sale contracts as repayment and orde red the Preslars to suspend sales of cabin lots. The Preslars complied with th e suspension directive, but made-5-

no further payments on the loan. The Preslars filed an action against the FDIC for b reach of contract in September 1985, seeking an order requiring the FDIC to accept assignment of sales contracts as loan repayment. The parties settled the action in December 1988 after the FDIC agreed to accept $350,000 in fu ll satisfaction of the Preslars’ indebtedness. The Preslars borrowed the $350,000 f rom another bank and, after the funds were remitted to the FDIC, the original $ 1 million promissory note was marked “paid.” At the time of the settlement, the unpaid balance o n the Preslars’ loan was $799,463. The Preslars paid a total of $550,537 onthe loan ($350,000 settlement plus $200,537 credited for assignment of sales contracts). Therefore, as a result of the settlement, the Preslars’ outstanding debt o bligation was reduced by $449,463 ($1 million less $550,537). The Preslars did not include the $449,463 debt writ e-off as discharge-ofindebtedness income on their 1989 joint tax return. Rather, they opted to reduce their basis in the ranch by $430,000 pursuant to Internal Revenue Code § 108(e)(5), 26 U.S.C. § 108(e)(5). The Preslars’ 19 89 tax return was audited and they were assessed a deficiency because (1) they ha d realized $449,463 in discharge-of-indebtedness income, and (2) they were not eligible to treat such income as a purchase price adjustment under § 108(e )(5). A penalty was also-6-

assessed under Internal Revenue Code § 6651(a)(1), 26 U.S.C. § 6651(a)(1), for failure to file a timely return. The Preslars sought a redetermination of the defici ency in United States Tax Court, insisting they were free to treat their settlement with the FDIC as a purchase price adjustment pursuant to § 108(e)(5) and/or common law. They supported this theory in part by claiming the FDIC’ s refusal to honor their repayment agreement with Moncor Bank amounted to aninfirmity relating back to the original sale, thereby negating the general pro hibition against treating debt reductions as purchase price adjustments. They further argued the complicated nature of their return was good cause for not timel y filing. At no time, however, did the Preslars dispute their underlying liabilityon the $1 million note. The Commissioner responded that the Preslars could not invoke § 108(e)(5) because that provision applies only to situations where the seller of property agrees to reduce the amount of the purchaser’s debtflowing from the property sale. In this case, the Commissioner argued, the p roperty seller was High Nogal. The party responsible for reducing the Preslars’ de bt was not the seller but was the FDIC (as receiver for Moncor Bank), thereby ren dering § 108(e)(5) inapplicable. The Commissioner also argued the com mon law purchase price adjustment rule did not survive the adoption of § 1 08(e)(5). Finally, the Commissioner maintained the Preslars had not demons trated good cause for the-7-

untimely filing of their 1989 return. The Tax Court ruled in favor of the Preslars without addressing the purchase price adjustment issue. Instead, the court sua sponte invoked the contested liability doctrine and held the Preslars’ unusual payment arrangement with Moncor Bank caused their liability for the ful l $1 million loan to be brought into question. The court determined the true amoun t of the Preslars’ indebtedness was not firmly established until they settled with the FDIC; thus, no discharge-ofindebtedness income could have accrued to the Presl ars as a result of the settlement. Although the court held the Preslars’ untimely filing was not justified, it reasoned the absence of a tax deficie ncy negated the penalty assessment. The Preslars do not appeal the determi nation that their untimely filing was not justified.
II. Decisions of the United States Tax Court are review ed “in the same manner and to the same extent as decisions of the districtcourts in civil actions tried without a jury.” 26 U.S.C. § 7482(a)(1). We revie w the Tax Court’s factual findings for clear error and its legal conclusions de novo. See Schelble v. Commissioner , 130 F.3d 1388, 1391 (10th Cir. 1997). The Preslars have the burden of proving the Commissioner’s determinations are incorrect on factual issues. See id. (citing Tax Ct. R. Prac. & Proc. 142(a); Welch v. Helvering , 2902 The Internal Revenue Service Restructuring and Re form Act of 1998,

Pub. L. No. 105-206, § 3001, 112 Stat. 685, 726-27 (1998) (codified at 26 U.S.C. § 7491), popularly known as the “Taxpayer Bill of R ights,” shifts the burden of proof to the Commissioner in certain cases where th e taxpayer “introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer.” However, this amendmen t did not become effective until July 22, 1998. -8- U.S. 111, 115 (1933)). 2

Discharge-of-Indebtedness Income Section 61(a) of the Internal Revenue Code broadly defines “gross income” as “all income from whatever source derived” exceptas expressly provided otherwise. 26 U.S.C. § 61(a). The phrase is inten ded to capture all “accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” Commissioner v. Glenshaw Glass Co. , 348 U.S. 426, 431 (1955). From its enactment, the “sweeping scope” of this pr ovision and its statutory predecessors has been consistently emphasized by the Supreme Court. See Commissioner v. Schleier , 515 U.S. 323, 327-28 (1995); Glenshaw Glass , 348
U.S. at 429-32 & n.11. This case centers around the Commissioner’s determi nation of the Preslars’ discharge-of-indebtedness income after they settledtheir loan obligation with the FDIC in December 1988. The concept of discharge-of -indebtedness income, first articulated in United States v. Kirby Lumber Co. , 284 U.S. 1 (1931), and later-9-

codified in 26 U.S.C. § 61(a)(12), requires taxpaye rs who have incurred a financial obligation that is later discharged in wh ole or in part, to recognize as taxable income the extent of the reduction in the o bligation. Two rationales have been identified for this rule: This rule is based on the premise that the taxpayerhas an increase in wealth due to the reduction in valid claims againstthe taxpayer’s assets. In the alternative it has been suggested that taxation is appropriate because the consideration received by ataxpayer in exchange for [his] indebtedness is not included in income when received because of the obligation to repay and the cancellation of that obligation removes the reason for the original exclusion. 2 Jacob Mertens, Jr., Mertens Law of Federal Income Taxation § 11.01 (1996). Loans ordinarily are not taxable because the borrow er has assumed an obligation to repay the debt in full at some future date. See Commissioner v. Tufts , 461 U.S. 300, 307 (1983). Discharge-of-indebtedness princip les come into play, however, if that assumption of repayment proves erroneous. Otherwise, taxpayers could secure income with no resulting tax liability. It is undisputed that the Preslars financed their p urchase of the ranch in 1983 by executing a $1 million promissory note in f avor of Moncor Bank. It is similarly uncontested that when the Preslars settle d their lawsuit with the FDIC in 1988, thereby extinguishing all obligations arising from the 1983 loan, only $550,537 had been paid on the loan principal. Neve rtheless, the Tax Court ruled the Preslars’ underlying debt was disputed and fell within the judicially-created-10-

“contested liability” exception to discharge-of-ind ebtedness income.

Contested Liability/Disputed Debt Exception The “contested liability” or, as it is occasionally known, “disputed debt” doctrine rests on the premise that if a taxpayer disputes the original amount of a debt in good faith, a subsequent settlement of thatdispute is “treated as the amount of debt cognizable for tax purposes.” Zarin v. Commissioner , 916 F.2d 110, 115 (3d Cir. 1990). In other words, the “exce ss of the original debt over the amount determined to have been due” may be disregar ded in calculating gross income. Id. The few decisions that have interpreted this doct rine have generated considerable controversy. The origins of the contested liability doctrine can be traced to N. Sobel, Inc. v. Commissioner , 40 B.T.A. 1263 (1939), a case arising during the Great Depression. In that case, a New York corporation p urchased 100 shares of a bank’s stock and signed a $21,700 note as payment. When the note matured, the stock was worthless. The corporation sued the bankfor rescission, insisting the loan contravened state law and the bank had failed to fulfill its promise to guarantee the corporation against loss. Shortly th ereafter, the state superintendent of banks closed the bank because of insolvency and initiated a countersuit against the corporation for the amount of the note. The pa rties ultimately settled the-11-

consolidated proceedings with the corporation payin g the superintendent $10,850 in return for discharge of the debt. The corporati on then took a $10,850 deduction in the year of settlement. The Commissio ner disallowed the deduction and assessed a $10,850 deficiency, representing the amount of the original loan over the settlement figure. The Board of Tax Appea ls reversed the ruling and upheld the deduction, concluding the corporation’s ownership of the shares and the degree of liability on the note were highly unclear. See id. at 1265 (“There is question whether the taxpayer bought property in 19 29 and question as to its liability and the amount thereof .”) (emphasis added). The Board found the corporation’s financial obligations could not be as sessed definitively prior to resolution of its dispute with the superintendent and, since settlement compromised the parties’ claims and precluded recog nition of their legal rights, the existence and amount of the corporation liabili ty were not fixed until the date of settlement. Thus, release of the note did not a mount to a gain for the corporation. In Zarin , the court embraced the reasoning of N. Sobel while reversing the Commissioner’s recognition of discharge-of-indebtedness income . The state gaming commission identified Zarin as a compulsive gambler and ordered an Atlantic City casino to refrain from issuing him ad ditional credit, but the casino ignored the commission. When Zarin’s debt surpasse d $3.4 million, the casino-12-

filed a state action to collect the funds. Zarin i nitially denied liability on the grounds the casino’s claim was unenforceable under New Jersey law. The parties later settled the dispute for $500,000. After Zari n failed to account for the debt write-off on his tax return, the Commissioner asses sed a deficiency for approximately $2.9 million, the amount by which Zar in’s underlying debt exceeded his settlement with the casino. The Tax C ourt affirmed. However, a divided Third Circuit held Zarin had no discharge-o f-indebtedness income because, inter alia , his transaction with the casino arose from a cont ested liability. 916 F.2d at 115-16. Citing no authority, the majority reasoned that “[w]hen a debt is unenforceable, it follows that th e amount of the debt, and not just the liability thereon, is in dispute.” Id. at 116. Therefore, the $500,000 settlement “fixed the amount of loss and the amountof debt cognizable for tax purposes.” Id. The problem with the Third Circuit’s holding is it treats liquidated and unliquidated debts alike. The whole theory behind requiring that the amount of a debt be disputed before the contested liability exc eption can be triggered is that only in the context of disputed debts is the Intern al Revenue Service (IRS) unaware of the exact consideration initially exchanged in a transaction. See Daniel Shaviro, The Man Who Lost Too Much: Zarin v. Commissioner a nd the Measurement of Taxable Consumption , 45 Tax L. Rev. 215, 256 (1990). The3 Although Professors Bittker and McMahon correctlystate in their treatise

that the contested liability rule requires a valid dispute by a debtor of the amount owed to a creditor, they misapply the doctrine in their hypothetical. See Boris I. Bittker and Martin J. McMahon, Jr., Federal Income Taxation of Individuals ¶ 4.5[3][c] (2d ed. 1995). In their example, an indi vidual buys business equipment for $1,000 on credit but then refuses to pay becaus e of an alleged misrepresentation or breach of warranty. The parti es later settle for $750. The professors assert the $250 debt reduction is not taxable. We agree. The basis for the exclusion, however, is not the contested liabil ity doctrine. There is no dispute over the $1,000 purchase price figure upon which th e parties originally agreed. Taxable income avoidance flows from the purchase pr ice adjustment rule or “infirmity exception.” See discussion at pages 20-25. -13- mere fact that a taxpayer challenges the enforceabi lity of a debt in good faith does not necessarily mean he or she is shielded from dis charge-of-indebtedness income upon resolution of the dispute. To implicate the contested liability doctrine, th e original amount of the debt must be unliquidated. A total denial of liability is not a dispute touching upon the amount of the underlying debt. 3 One commentator has observed: Enforceability of the debt . . . should not affect the tax treatment of the transaction. If the parties initially treated the transaction as a loan when the loan proceeds were received, thereby not declaring the receipt as income, then the transaction should be t reated consistently when the loan is discharged and income should be de clared in the amount of the discharge. Gregory M. Giangiordano, Taxation-Discharge of Indebtedness Income-Zarin v. Commissioner , 64 Temp. L. Rev. 1189, 1202 n.88 (1991). A holdi ng to the contrary would strain IRS treatment of unenforceabl e debts and, in large part, disavow the Supreme Court’s mandate that the phrase “gross income” be-14-

interpreted as broadly as the Constitution permits. See Glenshaw Glass , 348 U.S.
at 432 & n.11. This conclusion is underscored by the Supreme Court’s holding in Tufts that a nonrecourse mortgage (i.e., taxpayer has no personal liability upon default) must be treated as an enforceable loan both when itis made and when it is discharged. 461 U.S. at 311-13. The Court reasone d that because the indebtedness is treated as a true debt when it is i ncurred, it must be treated as a true debt when it is discharged, with all the attendant tax consequences. Id. at 309-10. It seems evident from this ruling that if the distinction between the recourse and nonrecourse nature of a loan has no be aring on calculation of gross income, the enforceability of a debt should be of equally minimal importance. Of course, if the debt is unenforceable as a result of an infirmity at the time of its creation (e.g., fraud or misrepresentation), tax li ability may be avoided through a purchase price reduction under 26 U.S.C. § 108(e)(5 ) or an “infirmity exception.” The Tax Court in this case and the court in Zarin cited United States v. Hall , 307 F.2d 238 (10th Cir. 1962), in support of thei r contested liability holdings. In Hall , the taxpayer incurred gambling losses at a Las Ve gas club in an estimated range of $145,000 to $478,000. One of the owners of the club agreed to forgive the debt in return for a one-half interest in the taxpayer’s cattle. Just prior to transfer of the interest in the cattl e, which had a base value of-15-

$148,110, the parties mutually agreed to assess the taxpayer’s losses at $150,000. The Commissioner sought to assess the taxpayer with$1,890 as discharge-ofindebtedness income. Without raising the contestedliability doctrine, we rejected the Commissioner’s position and held “a gambling de bt, being unenforceable in every state, has but slight potential and does not meet the requirements of debt necessary to justify the mechanical operation of ge neral rules of tax law relating to cancellation of debt.” Id. at 241. Whether Hall has continued viability is questionable in light of the Supreme Court’s hol ding in Tufts . The emphasis on a taxpayer’s lack of legal obligation to pay a gambling debt in Hall is difficult to reconcile with Tuft ’s disregard of the nonrecourse nature of a loan in calculatin g gross income. Even if parts of Hall remain viable, however, the opinion would offer li ttle refuge to the Preslars. The debt in Hall was unliquidated. The taxpayer’s underlying obligation, therefore, could not be assessed prior to settlement with the club owner. Such a scenario is not present here. In this case, the Tax Court observed that “the unus ual payment arrangement between [the Preslars] and Moncor Bank relating to the Bank loan casts significant doubt on [the Preslars’] liability for the total $1 million stated principal amount of the Bank loan.” Tax Ct. Op. at8. Accepting the Preslars’ contention that their $1 million purchase price hadbeen inflated and did not4 The terms of this regulation have not changed sin ce it was first adopted

in 1960. See 25 Fed. Reg. 11402, 11496 (1960). Although the re gulation’s specific focus is on discharge-of-indebtedness of r ailroad corporations and does not explicitly apply to the term “indebtedness” und er Internal Revenue Code § 61(a)(12), the regulatory language is equally applicable to § 61(a)(12). See Boris I. Bittker and Barton H. Thompson, Jr., Income from the Discharge of Indebtedness: The Progeny of United States v. Kirby Lumber Co. , 66 Cal. L. Rev. 1159, 1169 (1978). -16- reflect the fair market value of the ranch, the TaxCourt suggested the Preslars had agreed to the terms of the financing arrangemen t only after Moncor Bank assented to a favorable repayment scheme involving assignment of installment sales contracts. The court held when the FDIC refu sed to honor this payment arrangement, “a legitimate dispute arose regarding the nature and amount of [the Preslars’] liability on the Bank loan.” Id. Only after the Preslars and the FDIC settled their subsequent lawsuit, the court reasone d, was the amount of liability on the loan finally established. It is conceivable that two parties could negotiate a loan transaction in which the underlying amount of a debt is tied to th e existence or nonexistence of some post-execution event. Indeed, the IRS has def ined “indebtedness” as “an obligation, absolute and not contingent, to pay on demand or within a given time, in cash or another medium, a fixed amount.” Treas. Reg. § 1.108(b)-1(c), 26 C.F.R. § 1.108(b)-1(c) (1998). 4 Contrary to the Tax Court’s representations, however, there is no evidence of such an agreement here.-17-

The Preslars advanced no competent evidence to supp ort their theory that their loan obligation was linked to the repayment s cheme. They maintain that, although they did not state it in writing, their ac quiescence in the $1 million purchase price hinged on their being able to satisf y the debt through assignment of installment contracts. Thus, when the FDIC refu sed to honor the assignments, a concomitant reduction in their liability was nece ssary. In other words, the “FDIC could not enforce the ranch loan without abid ing by the [unsigned] Dealer Agreement. The loan and the Dealer Agreement were two sides of an integrated transaction.” Appellees’ Br. at 4-5. Neither the May 1984 letter from Moncor Bank to Layne Preslar nor the unsigned 1985 Dealer Agreement, however, contains any statement evincing an intent to link t he underlying liability with the repayment scheme. Further, if the parties desired the loan obligation to be inextricably intertwined with the repayment arrange ment, that condition should have been memorialized in the loan document and notmerely set out in a letter eight months after the loan was formalized. The di ssent’s protestations notwithstanding, Layne Preslar’s own self-serving t estimony regarding the intentions of the parties to the original loan agre ement is not sufficient to support the Preslars’ integrated transaction theory. See Philhall Corp. v. United States , 546 F.2d 210, 215 (6th Cir. 1976) (“[T]he testimonyof [a] taxpayer as to intent, standing alone and unsupported by objective facts, [is] insufficient as a matter of-18-

law.”); Nasser v. United States , 257 F. Supp. 443, 447 (N.D. Cal. 1966) (same). In addition, the Preslars’ characterization of thei r dispute with the FDIC as the culmination of their dispute over the ranch loa n is not faithful to the evidence. The dispute with the FDIC focused only on the terms of repayment; it did not touch upon the amount or validity of the Preslars’ debt. See Stipulation of Facts

at ¶36. This conclusion is highlighted by the relief sought from the FDIC. As an alternative to accepting assignment of contracts, t he Preslars requested that the FDIC “substantially discount the remaining amount due on their loan.” Id. Such a position evidences the Preslars’ recognition thatthey had a fixed and certain liability at the time the FDIC took control of thei r loan from Moncor Bank. In fact, Layne Preslar conceded he understood he was p ersonally liable for the full amount of the $1 million note in the event he could not sell a sufficient number of lots. In sum, the Preslars’ underlying indebtednes s remained liquidated at all times. Although ultimately irrelevant, the Preslars offere d no evidence, other than Layne Preslar’s self-serving testimony, that the fa ir market value of the ranch differed from their $1 million purchase price. The y introduced no expert appraisals at trial to support their inflation of v alue theory. The only references in the record to appraisals are those allegedly con ducted immediately prior to the settlement with the FDIC. However, the alleged app raisals were not admitted at-19-

trial. The Preslars suggest an August 31, 1983, tr anscript of judgment in the amount of $495,957 unencumbering Moncor Bank’s lienon the ranch reflects the true value of the property. This document, however , is merely one of a series of judgment transcripts filed releasing liens on the r anch. Indeed, two other banks held outstanding prior mortgages on the ranch total ing approximately $760,000. The court cannot extrapolate the value of property from a single creditor’s twoyear-old judgment. Moreover, even if the Preslars could demonstrate the property was worth less than the purchase price, they still could not invoke the contested liability doctrine in the absence of proof the loan they executed was tainted by fraud or material misrepresentations, because the u nderlying amount of their debt obligation remained liquidated. Cf. Commissioner v. Sherman , 135 F.2d 68, 70 (6th Cir. 1943) (settlement following taxpayer’s co ntest of duty to repay full amount of mortgage based on misrepresentations at t ime of contracting did not leave taxpayer with discharge-of-indebtedness incom e). There are no allegations of fraud or misrepresentation in this case. Finally, the Preslars contend their transaction with Moncor Bank made little economic sense and was done only to accommodate Mon cor Bank in its attempts to pacify bank regulators. This argument has littl e merit. It is highly doubtful that an experienced real estate agent like Layne Pr eslar would spend six months negotiating the price of the ranch only to then agr ee to a grossly overstated figure.-20-

Even more incredible is the notion that the Preslar s would have exposed themselves to $1 million of personal liability out of pure benevolence for the bank. As the Commissioner points out, if the Presl ars had sold all ninety-six lots for $16,500 as they claimed they could during loan negotiations with Moncor Bank, they would have netted a gross profit of more than $300,000. Moncor Bank fully expected the Preslars to be successful i n their sales of lots and anticipated profits. The deal that the Preslars br okered with Moncor Bank made total economic sense. The Tax Court’s invocation o f the contested liability doctrine in the face of the record presented was un warranted.

Purchase Price Adjustment Another method by which taxpayers can avoid dischar ge-of-indebtedness income is to classify their debt reductions as purc hase price adjustments. This rule permits taxpayers to reflect their debt reduct ion by adjusting the basis of their property rather than recognizing an immediate gain as cancellation of indebtedness. Although this principle had been part of the common law for decades, Congress codified the rule as part of the Bankruptcy Tax Act of 1980, Pub. L. No. 96-589, § 2(a), 94 Stat. 3389, 3389-90 (1980) (codified at 26 U.S.C. § 108(e)(5)). The statute now provides: If-- (A) the debt of a purchaser of property to the sell er of-21- such property which arose out of the purchase of su ch property is reduced, (B) such reduction does not occur -- (i) in a title 11 case, or (ii) when the purchaser is insolvent, and (C) but for this paragraph, such reduction would be treated as income to the purchaser from the dischar ge of indebtedness, then such reduction shall be treated as a purchase price adjustment. 26 U.S.C. § 108(e)(5) (1988). The Preslars cannot treat their settlement with the FDIC as a purchase price reduction. Section 108(e)(5) applies only to direc t agreements between a purchaser and seller. S. Rep. No. 96-1035 at 16 (1980), reprinted in 1980 U.S.C.C.A.N. 7017, 7031. “If the debt has been transferred by the seller to a third party (whether or not related to the seller), or if the property has been transferred by the buyer to a third party (whether or not related to the buyer),” the purchase price reduction exception is not available and normal discharge-ofindebtedness rules control. Id. ; see 2 Mertens Law of Federal Income Taxation §§ 11.20, 11.25. The seller in this case was High Nogal. Although Moncor Bank helped negotiate the terms of the sale, it did so o nly in its capacity as a mortgage holder. The Preslars make much of the fact that on e of the signatories to the “Sellers Statement” memorializing the sale was a Mo ncor Bank representative. However, the vice-president of Moncor Bank testifie d the bank signed the document at the insistence of the title companies. As neither Moncor Bank nor its5 Contrary to the dissent’s argument, the minimal p articipation of High

Nogal officials in the negotiations culminating in the Preslars’ purchase of the ranch is of little or no relevance in assessing own ership interests in the ranch. There is not a scintilla of evidence in the record that title passed from High Nogal to Moncor Bank at any time prior to the Preslars’ p urchase. -22- receiver, the FDIC, was the seller of the property, the loan settlement the Preslars negotiated with the FDIC does not permit them to in voke the debt reduction as a purchase price adjustment under § 108(e)(5). 5 The Preslars seek to avoid the requirements of § 10 8(e)(5) by arguing the transaction is embraced by: (1) a “seller financing ” exception; (2) the common law purchase price reduction doctrine; or (3) a thi rd-party transfer exception in cases of infirmities relating back to the original transaction. We address each theory in turn. Seller Financing Exception -- Citing Danenberg v. Commissioner , 73 T.C. 370 (1979), the Preslars contend a party financing the sale of property may be treated as the seller for purposes of § 108(e)(5). The Preslars misconstrue Danenberg . Danenberg involved two insolvent taxpayers attempting to sel l property previously pledged as collateral on a bankloan. All negotiations were subject to approval by the bank. The taxpayers agr eed on a purchase price with several of their creditors and obtained the bank’s approval. The Commissioner assessed a deficiency based on failure to account f or long-term gains from the sale. The issue before the Tax Court centered not on discharge-of-indebtedness6 This section was later repealed and its relevant provisions were inserted

in 26 U.S.C. § 1001 pursuant to the Tax Reform Act of 1976, Pub. L. No. 94-455, § 1901(b)(28)(B)(i), 90 Stat. 1520, 1799 (1976). -23- income but on whether the taxpayers were required t o recognize gain from the sale of property pursuant to 26 U.S.C. § 1002. 6 The Tax Court determined a gain had to be recognized because the taxpayers were the sellers of the property. Only after the sale had been consummated did a “second t ransaction” occur in which the proceeds were paid to the bank and used to redu ce taxpayers’ indebtedness. The instant action involves neither insolvent taxpayers nor treatment of gain or loss on disposition of property. If anything, Danenberg supports the Commissioner’s contention that High Nogal and not M oncor Bank was the seller. Common Law Purchase Price Reduction Doctrine -- The Preslars insist the common law purchase price reduction doctrine may be invoked in cases where 26 U.S.C. § 108(e)(5) is inapplicable. The Commission er responds that § 108(e)(5) has displaced the common law on this issue and, in any event, a debt reduction by a third-party lender was not considered a purchase price adjustment under common law. See Fifth Ave.-Fourteenth Ct. Corp. v. Commissioner , 147 F.2d 453, 456-57 (2d Cir. 1944) (doctrine does not applywhere reduction results from arms-length transaction relating solely to debt its elf). It is clear the case law developed prior to enactme nt of § 108(e)(5) did not extend the purchase price reduction exception to de bt settlements outside the-24-

purchase money mortgage context. 2 Mertens Law of Federal Income Taxation § 11.25. The case law was not consistent, however, w ith respect to purchase money mortgages involving third parties. Compare Fifth Ave. , 147 F.2d at 456-57 (doctrine does not apply to third-party transactions), with Hirsch v. Commissioner , 115 F.2d 656, 657-59 (7th Cir. 1940) (doctrine do es apply to third-party transactions). The Hirsch case relied on Bowers v. Kerbaugh-Empire Co. , 271 U.S. 170 (1926), a decision implicitly repudiated in subsequent years. See Glenshaw Glass , 348 U.S. at 429-32 & n.11; Kirby Lumber , 284 U.S. at 2. Further, § 108(e)(5) was intended, at least in part, to create uniformity in this jurisprudence.
See S. Rep. No. 96-1035 at 16-17 (1980), reprinted in 1980 U.S.C.C.A.N. 7017, 7031-32 (“This provision is intended to eliminate d isagreements between the Internal Revenue Service and the debtor as to wheth er, in a particular case to which the provision applies, the debt reduction sho uld be treated as discharge income or a true price adjustment.”). If, as the P reslars argue, the common law rule remains viable and permits taxpayers involved in third-party transactions to treat their debt reductions as purchase price adjus tments rather than additions to their gross income, § 108(e)(5) would be rendered m eaningless. We agree with the Commissioner’s rationale for imposing the direc t seller-purchaser negotiation requirement, as articulated in a 1992 revenue rulin g:-25-

An agreement to reduce a debt between a purchaser and a third-party lender is not a true adjustment of the purchase pri ce paid for the property because the seller has received the entire purchase price from the purchaser and is not a party to the debt r eduction agreement. The debt reduction relates solely to the debt and r esults in discharge of indebtedness income to the debtor. Rev. Rul. 92-99, 1992-2 C.B. 35. Accordingly, the Preslars may not treat their settlement with the FDIC as a common law purchase p rice reduction. Infirmity Exception -- The Preslars argue they qualify for the limited “infirmity exception” to the general prohibition ag ainst treating debt reductions as purchase price adjustments in other than direct sel ler-purchaser transactions. Under this narrow exception, taxpayers may treat de bt reductions negotiated with third parties as purchase price adjustments “to the extent that the debt reduction by the third-party lender is based on an infirmity that clearly relates back to the original sale (e.g., the seller’s inducement of a h igher purchase price by misrepresentation of material fact or by fraud).” Rev. Rul. 92-99. As noted, the Preslars have made no allegations of misrepresentat ion or fraud. The “infirmity” upon which they predicate their theory is the FDIC’ s refusal to abide by terms of the repayment plan negotiated with Moncor Bank. Ho wever, that dispute did not relate back to the original sale; thus, the “infirm ity exception” is inapplicable.
III. We REVERSE the Tax Court’s vacatur of the Commissio ner’s determination of tax deficiency and imposition of u ntimely filing penalties and-26-

REMAND the case with instructions to enter judgmentin favor of the Commissioner.97-9016, Preslar v. Commissioner

EBEL, Circuit Judge, dissenting

I respectfully dissent on two independent grounds. First, the record supports—particularly under the clearly erroneous s tandard—the Tax Court’s factual finding that, “[w]hen the FDIC refused to h onor [the] payment arrangement with regard to the Bank loan, a legitim ate dispute arose regarding the nature and amount of [the Preslars’] liability on the Bank loan.” Tax Ct. Op. at 8. This factual finding properly triggers the conteste d liability doctrine. Second, the Preslars have a potential argument that they are en titled to a purchase-money debt reduction under Internal Revenue Code (“I.R.C.”) § 108(e)(5), 26 U.S.C. § 108(e)(5), as Moncor Bank could be viewed, for all substantive purposes, as the seller of the Ranch. On the first ground, I would affirm. Alternatively, if we do not affirm on the first ground, I would, at the lea st, remand on the second ground for a finding of fact as to whether Moncor Bank cou ld be considered the seller of the Ranch.

I. Contested Liability Under the contested liability doctrine or disputed debt exception, when “there is a legitimate dispute between a creditor and a debtor concerning the existence of a liability , and a compromise between the parties is reached, no-2-

discharge of indebtedness income will arise as to the contested and unpaid portion of the original liability.” 2 Mertens, Law of Federal Income Taxation , § 11.19 at 42 (1996) (citing Zarin v. Commissioner , 916 F.2d 110 (3d Cir. 1990); N. Sobel,
Inc. , 40 B.T.A. 1263 (1939)) (emphasis added). Thus, c ontrary to the majority’s view, the contested liability doctrine is not limit ed to instances where the taxpayer specifically disputes only the amount of the debt and the original amount was unliquidated

. Indeed, the facts of N. Sobel , the seminal contested liability case, belie the majority’s position. There, the taxpayer corporati on issued a $21,700 note to pay for 100 shares of a bank’s stock. See N. Sobel , 40 B.T.A. at 1264. When the note became due, the corporation refused to pay, di sputing not the amount of the note but rather the validity of the note itself “on the ground that the bank made the loan in violation of law and failed to carry ou t promises to guarantee the [corporation] against loss.” Id. The corporation and the bank settled the dispute for $10,850. The Board of Tax Appeals found no dis charge of indebtedness income, even though the corporation did not dispute the a mount of the debt and even though the original amount was liquidated (at $21,700). Id. at 1265. The Board held that the amount of the corporation’s liability was “not actual and present” until the corporation’s subsequent comprom ise agreement with the bank. Id. at 1265.-3-

Given N. Sobel , I believe that the majority’s view that the conte sted liability doctrine applies only when the original a mount of a debt is disputed and unliquidated is mistakenly narrow. This view ignor es the fact that the original amount of a debt is necessarily disputed and may be unliquidated under a good faith dispute over liability “that can be traced to the circumstances in existence at the time of the debt’s creation.” William R. Culp, Jr., and Richard E. Marsh, Jr., Avoiding Cancellation of Debt Income Where the Liability is Disputed , 74 J. Tax’n 288, 292 (1991); see Zarin , 916 F.2d at 116 (“When a debt is unenforceable, it follows that the amount of the de bt, and not just the liability thereon, is in dispute.”); cf. N. Sobel , 40 B.T.A. at 1265 (finding corporation’s liability was not “definitely fixed” until settleme nt of its bona fide dispute regarding validity of note). Only upon resolution of the dispute over the existence of liability traceable to the origin of t he debt does the “question as to [the taxpayer’s] liability and the amount thereof” become “actual and present by any practical purpose,” including taxation. N. Sobel , 40 B.T.A. at 1265. Thus, settlement of a dispute over the enforceability of a debt traceable to its origin, such as the settlements in N. Sobel and Zarin , does not result in a windfall. Such settlements merely establish the original amount of liability, as opposed to discharging any amount of the original liability. In this case, the Tax Court made a finding of fact that the Preslars disputed-4-

with the FDIC both the nature and amount of their l iability on the loan from Moncor Bank. As the majority acknowledges, the TaxCourt accepted the Preslars’ contention that the $1 million purchase p rice for the Ranch had been inflated and that the Preslars and Moncor Bank had agreed to a correspondingly inflated method of repayment involving the assignme nt of installment sales
contracts. See Tax Ct. Op. at 4, 7-8. According to the Tax Court , “[w]hen the FDIC refused to honor this payment arrangement withregard to the Bank loan, a legitimate dispute arose regarding the nature and a mount of [the Preslars’] liability on the Bank loan.” Id. at 8. Thus, given the proper scope of the contested liability doctrine, I believe that the Pr eslars’ settlement with the FDIC would not result in discharge of indebtedness incom e if the Tax Court’s finding is

correct. The majority rejects the Tax Court’s finding, stati ng that “[t]he Preslars advanced no competent evidence to support their the ory that their loan obligation was linked to the repayment scheme,” such that the FDIC’s refusal to abide by the scheme of inflated repayment would give rise to a d ispute regarding the inflated principal of the loan. Ante at 17. However, in arriving at this conclusion, t he majority overlooks significant evidence in the reco rd as well as the high standard of clear error for overturning the Tax Court’s factual finding. See 26 U.S.C. § 7482(a)(1) (circuit courts review Tax Court decisio ns “in the same manner and to1 The majority asserts that the Preslars “offered no evidence the fair market

value of the ranch differed from their $1 million p urchase price,” and “no expert appraisals at trial to support their inflation of value theory.” Ante at 18. I do not believe this is correct. Preslar was “an experienc ed real estate agent” of twentyfive years, as the majority acknowledges, ante at 2, 19, and Preslar testified that during negotiations with Moncor Bank for the purcha se of the Ranch “it [was] conclude[d]” that the fair market value of the Ranc h was “considerably less” than $1 million, and that in his own estimate it was “extremely low,” (Tr. at 79). -5- the same extent as decisions of the district courts in civil actions tried without a jury”); Exxon Corp. v. Gann , 21 F.3d 1002, 1005 (10th Cir. 1994) (viewing the evidence “in the light most favorable to the distri ct court’s ruling,” we “must accept the district court’s findings of fact unless clearly erroneous,” that is, unless “on the entire evidence [we are] left with the defi nite and firm conviction that a mistake has been committed.”) (citations and quotat ions omitted). Under the clear error standard, I believe we must a ffirm the Tax Court’s finding. The record contains ample evidence upon w hich the Tax Court could have concluded that the Preslars disputed the initi al nature and amount of their liability on the Bank loan. Specifically, the record contains evidence that: ( 1) during negotiations for the Ranch, Layne Preslar (“ Preslar”), an experienced real estate broker, and the Bank had concluded that the fair market value of the Ranch was considerably less than $1 million, (Tr. at 79) 1 ; (2) the Bank nevertheless reassured Preslar that the deal for the Ranch wouldwork if Preslar could make the sales of the cabin lots, (Tr. at 79-80); (3) th e terms of the deal for the Ranch-6-

included the Bank purchasing the installment sales contracts of the cabin lots at 95 percent face value under the Dealer Agreement, ( Tr. at 80); (4) the standard percentage for the purchase of such contracts was 3 5 percent, (Tr. at 110); (5) the Preslars purchased the Ranch in 1983 at the $1 mill ion price based upon the Bank’s agreement to accept the assignment of instal lment sales contracts as payment, (Tr. at 82); (6) from the first sale of ca bin lots in 1984 until Moncor Bank’s bankruptcy in 1985, Preslar sold 19 cabin lo ts and assigned all the installment sales contracts received from purchaser s to the Bank, (Tr. at 85, 93); (7) when the FDIC became the receiver of the Bank, it refused to accept further assignments of these installment sales contracts as payment, (Stip. # 34); (8) that, in the alternative to accepting the assignments as payment, the Preslars wanted the FDIC to discount substantially the remaining amountdue on the Bank Loan, (Stip. # 35); (9) during settlement agreements with the FD IC, the value of the Ranch was appraised at $550,000 by a bank financing the P reslars’ settlement, (Tr. at 98); (10) Preslar settled his loan with the FDIC fo r a $350,000 payment, (Stip. # 39); and (11) the total amount the Preslars ended up paying for the Ranch was $550,537 (the $350,000 settlement payment plus $200 ,537 in installment payments previously received by the Bank) (Stip. # 40). From the above evidence, taken from Preslar’s testi mony at trial and the2 The majority discounts Preslar’s testimony as “self -serving” statements regarding the intentions of the parties. Ante at 18. However, as the cited evidence demonstrates, Preslar’s testimony mostly c ontains undisputed facts regarding the circumstances of the loan transactionfrom which inferences of intent can be drawn, rather than “self-serving” statements of intent such as that disapproved of in Philhall Corp. v. United States , 546 F.2d 210, 215 (6th Cir. 1976) (where issue was taxpayer’s intent in acquiri ng certain property, discounting taxpayer’s testimony that “I thought itwas a good investment” as self-serving statement of intent “not supported by objective facts”).

3 The majority states that this request by the Preslars “evidences the Preslars’ recognition that they had a fixed and certain liability at the time the FDIC took control of their loan from Moncor Bank.” Ante at 19. This, however, ignores the possibility that the request also couldreflect the Preslars’ desire to discount to real dollars the inflated principal on the loan since the FDIC would (continued...) -7- Stipulation of Facts agreed to by both parties, 2 the Tax Court could permissibly conclude that “a legitimate dispute arose regarding the nature and amount” of the Preslars’ liability on the Bank loan once the FDIC refused to accept what the Preslars argued were the original terms allowing hi m to make payment by assigning installment sales contracts. The evidenc e would allow the Tax Court to infer that the purchase price of the Ranch was infl ated; that the Preslars nevertheless agreed to the Ranch deal, even though the Bank insisted on an inflated purchase price, because they wanted the de al to go through and the Bank agreed to an inflated method of repayment; that the Preslars disputed the nature and amount of their liability on the loan when theyrequested the FDIC to discount the remaining balance if it would not accept furthe r assignments of sales contracts as payment 3 ; and that this dispute is traceable to the origins of the loan.3 (...continued)

not accept the inflated medium of repayment origina lly agreed to by Moncor Bank. This latter inference is consistent with the Tax Court’s decision, and cannot be said to be clearly erroneous.

4 The majority reasons that the Preslars had a “fixedand certain liability” when the FDIC took control of the Bank loan in partbecause “Preslar conceded he understood he was personally liable for the full amount of the $1 million note in the event he could not sell a sufficient number of lots.” Ante at 19 (emphasis added). It seems to me that this reasoning is flaw ed. As the emphasized language indicates, Preslar’s concession that he was persona lly liable for the entire $1 million note was premised on his ability to make payments on the loan using the inflated medium of installment sales contracts assi gned at significantly above market value. This concession says nothing about P reslar’s understanding of his liability on the note if he was precluded from usin g the repayment scheme. Indeed, the record indicates otherwise, as the thru st of the Preslars’ dispute was that they “wanted the FDIC to substantially discount the remaining amount due on their loan” as an “alternative to [the FDIC] accept ing the purchase contracts.” (Stip. # 35.) -8- Additionally, the fact that the total amount the Pr eslars ended up paying for the Ranch ($550,537) approximated the appraised value o f the Ranch at the time of settlement negotiations with the FDIC ($550,000) gi ves further evidentiary support to the Tax Court’s conclusion that the Preslars dis puted the nature and amount of their liability: once deprived of the inflated medi um of repayment for a loan based upon an inflated purchase price, the Preslars settl ed for an uninflated repayment sum approximately equal to an uninflated purchase p rice. 4 Thus, because the evidence, viewed “in the light mo st favorable” to the Tax Court’s ruling, does not leave me “with the definit e and firm conviction that a mistake has been committed,” Exxon , 21 F.3d at 1005, I do not believe that the-9-

Tax Court’s finding that the Preslars disputed the nature and amount of their debt is clearly erroneous. Accordingly, I would affirm that finding. As a result, I would also affirm the district court’s conclusion that the contested liability doctrine precludes settlement of that dispute from generating discharge of indebtedness income. Such affirmance, however, should be subject to a caveat. Lurking beneath the Preslars’ contention that both the purchase pri ce and the medium of repayment were inflated is the possibility that the Preslars aided Moncor Bank in the commission of fraud. The Preslars explain that the “[t]he purchase price financing of Moncor bank was nothing more than an attempt to pacify bank regulators,” because the inflated price would allow Moncor bank “to perpetrate a fiction that a nonperforming loan was satisfied.” (Aplee. Br. at 3.) Because the contested liability exception is an equitable doctrine, uncle an hands on the part of the Preslars would preclude them from taking advantage of it. See Hocker v. New Hampshire Ins. Co. , 922 F.2d 1476, 1486 (10th Cir. 1991). Thus, evenwith an affirmance, I would remand for a determination of t he Preslars’ role in the deception perpetrated against bank regulators. If the Preslars were involved in fraud, I would not allow them the benefit of the co ntested liability doctrine. Two additional points in the majority’s discussion of the contested liability doctrine merit comment. First, the majority relies on Commissioner v. Tufts , 4615 The majority does recognize that, in the case of a debt that is

unenforceable “as a result of an infirmity at the t ime of its creation (e.g., fraud or misrepresentation), tax liability may be avoided th rough a purchase price reduction under 26 U.S.C. § 108(e)(5) or an ‘infirmity exception.’” Ante at 15. Unenforceability, however, may arise for reasons other than fraud or misrepresentation, see, e.g. , Zarin , 916 F.2d at 113 (illegal extension of credit); United States v. Hall , 307 F.2d 238, 241 (10th Cir. 1962) (unenforceable gambling debt); N. Sobel , 40 B.T.A. at 1264 (illegal loan and failure to ca rry out promises to guarantee borrower against loss), and m ay arise after the creation of the loan but relate back to the circumstances of it s origin, such as in this case or, in part, in N. Sobel

. -10- U.S. 300 (1983), which held that cancellation of a nonrecourse loan realizes discharge of indebtedness income. See id. at 311-13 (1983). The majority believes that this “underscore[s]” its own holding that cancellation of an unenforceable debt realizes discharge of indebtedne ss income, stating that “if the distinction between the recourse and nonrecourse nature of a loan has no bearing on calculation of gross income, the enforceability of a debt should be of equally minimal importance.” Ante at 14-15 . 5 Although unstated, the only way Tufts ’ holding “underscores” the majority’s holding is if a nonrecourse loan is treated as the functional equivalent of an unenforceable debt. To the extent the majority relies on this premise, I disagree. Nonrecourse loans and unenforceable debts are not functional eq uivalents. Nonrecourse loans are enforceable, unenforceable debts are not. A pa rty may sue to collect on a nonrecourse loan, but cannot sue to collect on an u nenforceable debt. While a taxpayer has no personal liability upon default of a nonrecourse loan, the taxpayer-11-

nonetheless is always liable for the loan. That li ability merely is capped by the value of the underlying security interest. See Michael J. Graetz & Deborah H. Schenk, Federal Income Taxation 194 (3d ed. 1995). Given an unenforceable debt, the taxpayer has no liability. This distinct ion can make all the difference for tax purposes. For example, Tuft s held that a nonrecourse mortgage, like a recourse mortgage, must be treated as a true loan for tax pu rposes, so that a disposition of secured property where the buyer assumes the nonrec ourse mortgage would result in a realization by the seller of the full unpaid b alance of the mortgage, even if the value of the secured property is less than that of the unpaid balance. See 461 U.S. at 311-13; see also Marvin A. Chirelstein, Federal Income Taxation 291-92 (1997) (discussing Tufts ). In so holding, the Supreme Court reasoned that “[t]he only difference between [a nonrecourse] mortgage and one on which the borrower is personally liable is that the morgagee’s remedy is limited to foreclosing on the securing property,” and that this “difference does not alter the nature of the obligation; its only effect is to shift from the bo rrower to the lender any potential loss caused by devaluation of the property.” Tufts , 461 U.S. at 311-12. Hence, “[w]hen the obligation is canceled, the mortgagor i s relieved of his responsibility to repay the sum he originally received and thus realizes value to that extent.” Id.
at 312.-12-

From Tuft ’s reasoning, it is apparent that the lack of disti nction between a nonrecourse and a recourse debt for discharge of in debtedness purposes does not negate but rather reinforces the applicability of t he contested liability doctrine in this case. Because a nonrecourse debt is an enforc eable obligation to repay, the cancellation of that debt would result in discharge of indebtedness income. Although the mortgagee’s only remedy upon default i s acquisition of the secured property, that limited remedy does not affect the m ortgagor’s gain upon cancellation of the mortgage. That gain is the dif ference between the original amount of the debt which the mortgagor was obligate d to repay and the canceled balance. In contrast, the borrower realizes no economic gain in the settlement of disputed debt which is unenforceable for reasons re lating back to the origin of the debt. The settlement determines the original amount of liability. See N. Sobel , 40 B.T.A. at 1265; Zarin , 916 F.2d at 116. On the other hand, cancellation of an enforceable debt would realize income to the extent of the discharge. See United States v. Kirby Lumber Co. , 284 U.S. 1, 2 (1931). Thus, contrary to the majority’s reasoning, I belie ve an unenforceable debt is not the functional equivalent of a nonrecourse l oan either in concept or in consequence, and the enforceability of a debt is of critical importance for purposes of the contested liability doctrine. Indeed, altho ugh cancellation of a nonrecourse loan ordinarily would result in discharge of indebt edness income, cancellation of a-13-

nonrecourse loan which is unenforceable for a reaso n relating back to the origin of the loan might have no tax consequences. Cf. Culp & Marsh, supra , at 292 (both nonrecourse and recourse debts may “give rise to a good faith dispute to which” the contested liability doctrine might be applied). The majority suggests another limitation to the contested liability doctrine, stating that “even if the Preslars could demonstrat e the property was worth less than the purchase price, they still could not invok e the contested liability doctrine in the absence of proof the loan they executed was tainted by fraud or material misrepresentations.” Ante at 20. It is unclear whether the majority would r equire a showing of fraud or material misrepresentation inall invocations of the contested liability doctrine or only in cases where the value of property purchased is less than the stated purchase price. Regardless, no cas e law or commentary on the doctrine of contested liability requires proof of f raud or material misrepresentation generally or in the case at hand. Although the majority cites Commissioner v. Sherman , 135 F.2d 68 (6th Cir. 1943), nowhere in the case does the Sixth Circuit state or imply the limitation suggested by the majo rity. Indeed, in reaching its holding that the taxpayers did not realize discharg e of indebtedness income, Sherman did not discuss the contested liability doctrine, but rather relied on the purchase-price reduction doctrine. See id. at 70. Moreover, I believe the majority’s focus on the val ue of the property-14-

received is misplaced. For purposes of the contest ed liability doctrine, the value of what a taxpayer receives as consideration for entering into debt is not in itself dispositive. Instead, what is critical is what a taxpayer gives up , as that amount goes to the taxpayer’s liability. See Culp & Marsh, supra, at 290 (“The disputed liability doctrine should focus on the indebtedness created, not on the property received.”) In this case, however, it just so happ ens that the value of what the Preslars actually received (the Ranch) is probative of what the Preslars actually gave up (their indebtedness to Moncor Bank), becaus e Moncor Bank agreed from the outset to an inflated medium of repayment on it s loan to match an inflated purchase price for the Ranch.

II. Purchase-Money Debt Reduction under I.R.C. § 108(e)(5) I believe the Preslars’ have a potential argument t hat their settlement with the FDIC falls within the purchase-money debt reduc tion exception of I.R.C. § 108(e)(5), thereby rendering the settlement non-tax able. Although § 108(e)(5) only applies to reduction agreements between purcha sers and sellers, the provision might possibly apply to the settlement between the Preslars and the FDIC. Section 108(e)(5) may apply because the FDIC merely took Mo ncor Bank’s place as its receiver, and Moncor Bank could be viewed for these purposes as the seller of the Ranch. Although High Nogal had formal title to the Ranch at the time it was6 The majority questions the “continued viability” of Hall in light of Tufts ,

but Tufts does not put into doubt the “hardly . . . exceptio nal” “idea that ‘Courts need not apply mechanical standards which smother the reality of a particular transaction.’” Zarin , 916 F.2d at 116 n.11 (quoting Hall , 307 F.2d at 241). Morever, as discussed supra Part I, Tufts ’ holding on nonrecourse loans does not implicate the contested liability doctrine. -15- transferred to the Preslars, it is arguable that th e substantive attributes of title had already passed to Moncor Bank at the time of negoti ations between Moncor Bank and the Preslars. The owner of High Nogal did not participate in the six-month negotiations leading up to the sale of the Ranch, ( see Aplt. App. # 2 at 3), considered the Bank the “true seller,” (Tr. at 118- 19), and told Preslar to deal with the Bank because he had no control over any sale of the property, ( Id. at 77-78). Additionally, the Bank financed the deal and receiv ed and disposed of all the assets of the sale without High Nogal’s involvement. ( Id. at 117-18.) In fact, the owner of High Nogal did not even know the particulars of the deal, only the dollar amount. ( Id. at 118.) Thus, from my review of the record, I be lieve Moncor Bank may have had de facto title to the Ranch. See United States v. Hall , 307 F.2d 238, 241 (10th Cir. 1962) (stating, in deciding that taxpayer did not realize discharge of indebtedness income, that “[c]ourts need not apply mechanical standards which smother the reality of a particular transaction”) 6 ; cf. Danenberg v. Commissioner , 73 T.C. 370, 382 (1979) (finding taxpayer to be sel ler of collateral where bank controlled final purchase price but owner in all ot her respects “was active in-16-

arranging the disposition of such assets”); Allen v. Courts , 127 F.2d 127, 128 (5th Cir. 1942) (stock broker who financed purchase of s eat on New York Stock Exchange deemed “in effect” seller of seat). Becau se the Tax Court did not reach this issue, I would remand for a finding as to who was the actual seller of the Ranch.

In sum, I would AFFIRM the Tax Court’s holding thatthe contested liability doctrine precludes the Preslars from recognizing di scharge of indebtedness income, although I would REMAND for a finding as to whether the Preslars participated in fraud in their deal with Moncor Ban k, as unclean hands would prevent them from taking advantage of the equitable doctrine. Alternatively, because the Preslars might be entitled to a purchas e-money debt reduction under I.R.C. § 108(e)(5) if Moncor Bank was the true sell er of the Ranch, I would REMAND for a finding as to whether the seller of th e Ranch in fact was Moncor Bank. For these reasons, I respectfully dissent.