Nonresource debt affects mark-to-market calculation

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Tax Hot TopicsThe IRS concluded in an internal legal memorandum (ILM 201507019) released Feb. 13 that a taxpayer’s nonrecourse liability affected its mark-to-market computation under Section 475(a).

Under the facts of the ILM, two commonly controlled partnerships were engaged in originating and purchasing mortgage loans and issuing notes to third-party investors as mortgage-backed securities (Notes) in exchange for cash. The partnerships treated the proceeds from the Notes as nontaxable loan proceeds, and the Notes were nonrecourse liabilities of the respective partnerships.

The partnerships treated themselves as dealers in securities, subject to mark-to-market accounting under Section 475. In addition, the partnerships treated the mortgages as securities subject to Section 475(a), though they did not include the Notes in determining the fair market value of the mortgages.

Section 475(a) requires dealers in securities to mark-to-market securities with certain exceptions provided under Section 475(b). For Section 475(a) purposes, the term “mark to market” means that a dealer must treat a security that is held on the last day of its taxable year as if it had been sold on the last business day of the taxable year for an amount equal to its fair market value, and the appropriate gain or loss must be recognized for such a taxable year. Debt is considered a security under Section 475(c)(2)(C).

Furthermore, Section 7701(g) provides that for determining the amount of gain or loss (or deemed gain or loss) with related to property, the fair market value of that property is treated as being not less than the amount of any nonrecourse indebtedness to which that property is subject.

The IRS concluded in ILM 201507019 that Section 7701(g) applied to Section 475(a) and that the partnerships must treat the fair market value of the mortgages as being not less than the amount of the Notes to which the mortgages were subject.

To illustrate, assume a partnership acquired a mortgage for $100 and later issued Notes in exchange for the $100 that was secured by the mortgage. If the value of the mortgage decreased to $90, the partnership would ordinarily incur a $10 loss at the end of the year under Section 475(a). However, because Section 7701(g) applied in determining the loss under Section 475(a) at the end of the partnership’s year, the fair market value of the mortgage would be treated as not less than the Note of $100, and the partnership would not have a loss under Section 475(a).

The IRS also concluded that even if Section 7701(g) did not apply in determining gain or loss under Section 475, the principles established in case law (Crane v. Commissioner (331 U.S. 1 (1947) and Commissioner v. Tufts (461 U.S. 300 (1983)) would apply, for a similar result.

Andy Cordonnier
T +1 202 521 1502

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