Shared Appreciation Agreements
Certain farmers who had Farm Service Agency (FSA) loans were eligible for a write-down
of the loan if they met certain criteria. As a condition of the write-down, the
FSA is allowed to require the farmer to enter into a shared-appreciation agreement.
This agreement obligates the farmer to repay part or all of the debt if the land
appreciates in value from the time the debt is restructured until a trigger event
occurs. This material discusses the tax consequences of the write-down and the
ISSUE 4: SHARED APPRECIATION AGREEMENTS
Farmers who have loans from the Farm Service Agency are eligible for a write-down
of the loan if they meet certain criteria. As a condition for the write-down,
the FSA is allowed to require the farmer to enter into a Shared Appreciation Agreement
that obligates the farmer to repay part or all of the debt write-down if the land
appreciates in value from the time of the restructuring to the occurrence of a
recapture event. The recapture events are set out in 7 U.S.C. §2001(e)(4)
(4) Time of recapture
Recapture shall take place at the end of the term of the agreement, or sooner-
(A) on the conveyance of the property;
(B) on the repayment of the loans; or
(C) if the borrower ceases farming operations.
A Shared Appreciation Agreement raises the income tax question of whether there
is discharge of indebtedness income at the time the debt is restructured.
Example 1. In 1996, Sarah Songbird owed the FSA $270,000 and was delinquent
on her payments. The FSA offered to let her buy out the debt for the $92,000 net
recovery value of her farm if she agreed to a Shared Appreciation Agreement. Under
the Shared Appreciation Agreement, the FSA can recapture 75% of the appreciation
in value of Sarah's farm if a recapture event occurs within four years of the
date of the write-down or 50% of the appreciation in value if the recapture event
occurs more than four years after the date of the write-down. Sarah accepted the
offer and borrowed $92,000 from a local bank to pay the FSA. The FSA wrote off
the remaining $178,000 of debt.
The income tax question is whether the Shared Appreciation Agreement delays
the discharge of indebtedness until the recapture event. If so, then Sarah has
no discharge of indebtedness income in1996. If not, $178,000 debt write-down is
discharge of indebtedness in 1996.
In a letter to Chet Bailey, Farmer Program Division, Farm Service Agency, dated
May 22, 1989, Peter K. Scott, Acting Chief Counsel of the Internal Revenue Service,
states that farmers must treat the debt write-down as discharge of indebtedness
in the year of the write-down. That conclusion was based on the reasoning that
the Shared Appreciation Agreement is so contingent that it is impossible to estimate
whether and when any amount will be paid under the Shared Appreciation Agreement.
Example 2. Under the IRS interpretation, Sarah in Example 1 realized
$178,000 of discharge of indebtedness income in 1996.
Tax Court Position
In Jelle v. Commissioner, 116 T.C. 63 (2001), the Tax Court reached the same
conclusion. However, that conclusion was based on a different interpretation of
the Shared Appreciation Agreement. In Jelle, the Shared Appreciation Agreement
had only one recapture event-the sale of any part or all of the real estate within
10 years of the agreement. If taxpayers chose not to dispose of their property,
then no further payments would be due. Based on that agreement, the Tax Court
concluded that "whether and when the [taxpayers] would ever be required to
make any further payments to FmHA (the predecessor to the FSA) rested totally
within their own control." Consequently, the court found that the taxpayer's
obligation was "highly contingent" and followed prior case law in holding
that the debt write-down was discharge of indebtedness income in the year of the
Taxpayers could argue that the Shared Appreciation Agreement results in no
discharge of indebtedness income in the year of the agreement since the agreement
may require part or all of the write-down to be repaid to the FSA. The discharge,
if any, occurs when there is no longer a potential recapture of the write-down.
Example 3. Under this argument, Sarah in Example 1 has no discharge
of indebtedness income in1996. She will have discharge of indebtedness only if
the Shared Appreciation Agreement expires without triggering an obligation to
repay all of the write-down. There could be several different scenarios resulting
in part, with all or none of the write-down becoming discharge of indebtedness
Scenario 1. Sarah does not trigger a recapture event before the end of the
10-year agreement. At the end of the 10 years, her land has appreciated by $400,000.
Sarah is required to recapture $178,000, which is the lesser of:
- The $178,000 debt write-down, or
- 50% of the$400,000 appreciation, which is $200,000
Since Sarah is required to repay all of the write-down, she has no discharge
of indebtedness income in 2006 or in any other year.
Scenario 2. Sarah sells the land for its $292,000 fair market value in 2001.
That triggering event requires her to recapture $100,000, which is the lesser
- The $178,000 debt write-down, or
- 50% of the $200,000 appreciation ($292,000 $92,000), which is $100,000
Since Sarah will never have to repay $78,000 ($178,000 $100,000) of the write-down,
she has $78,000 of discharge of indebtedness income in 2001. She has no discharge
of indebtedness income in any other year.
Scenario 3. Sarah quits farming in 1998, when her land is still valued at $92,000.
That triggering event requires her to recapture nothing since there is no appreciation.
Her recapture amount is the lesser of:
- The $178,000 write-down, or
- 75% of the zero appreciation ($92,000 $92,000), which is zero
Since Sarah will never have to repay any of the debt write-down, she has $178,000
of discharge of indebtedness income in 1998.
Which Position Is Best for the Taxpayer?
On its face, the alternative position discussed above appears to be the best
for the taxpayer because it postpones the recognition of discharge of indebtedness
income and may result in never recognizing discharge of indebtedness income. That
will be true in some cases.
Example 4. Assume the same facts as in Example 3, Scenario 3, and in
addition, assume that Sarah did not qualify for any of the I.R.C. §108 exceptions
to recognizing discharge of indebtedness income in1996 or in 1998.
Under the IRS position, Sarah is required to report $178,000 of discharge of
indebtedness income in 1996. Under the alternative position, she is required to
report $178,000 of discharge of indebtedness income in 1998.
However, some taxpayers may be better off under the IRS interpretation because
they may qualify for an exception to recognizing the discharge of indebtedness
income in the year of the agreement and not qualify for an exception in the year
Example 5. Assume the same facts as Example 3, Scenario 2, and in addition,
assume that Sarah was $200,000 insolvent when she entered into the agreement in
1996, but was solvent when she triggered the $100,000 recapture in 2001. Also
assume that the FSA debt was her only debt and that her only tax attribute was
$100,000 of basis.
The IRS position would allow Sarah to realize the $178,000 of discharge of
indebtedness in 1996 when she is insolvent and not have to recognize any of it
as income. She does have to reduce tax attributes as a consequence of not recognizing
the income. That requires her to reduce her basis by $8,000 down to the $92,000
of debt that remains after the discharge. After that reduction, there is no further
reduction of tax attributes as a consequence of not recognizing the $178,000 of
discharge of indebtedness income.
The alternative position would require Sarah to recognize the $78,000 discharge
of indebtedness income in 2001.
|Practitioner Note. In some cases, the IRS position will allow taxpayers
to restore tax attributes that are reduced as a result of the discharge of indebtedness
income when the taxpayer is required to repay the FSA. See the discussion of recapture
Which Position Is Likely to Prevail?
Based on current case law, it is difficult to predict which position will prevail.
Although the Tax Court ruled in favor of the IRS in Jelle, supra, the facts in
that case can be distinguished from most Shared Appreciation Agreements. The only
recapture event in Jelle was sale of the property within 10 years of the agreement.
As the Jelle court noted, the taxpayer had considerable control over that recapture
event. By contrast, most Shared Appreciation Agreements will include three more
recapture events over which the taxpayer has less control. The taxpayer has some
control over two of them-cessation of farming and default on the loan. The taxpayer
has no control at all over the third recapture event-expiration of the 10-year
period. Consequently, Jelle is not a strong precedent for the IRS with respect
to Shared Appreciation Agreements that include expiration of the 10-year period
as a recapture event.
Whether the recapture is triggered by the expiration of the 10-year period
is itself the subject of litigation. In Israel v. USDA, 135 F. Supp. 2d 945 (W.D.
Wis.), the farmers who had entered into a Shared Appreciation Agreement argued
they did not owe the recapture amount at the end of the 10-year period because
the Shared Appreciation Agreement was ambiguous and they had relied on oral statements
from FSA employees that they would not owe any recapture amount at the end of
the agreement. The trial court held that the expiration of the 10-year period
was a recapture event and required the farmers to pay the recapture amount. Israel
has been appealed to the 7th Circuit Court of Appeals and other cases on this
issue are pending in other courts. Therefore, the ultimate interpretation of the
Shared Appreciation Agreements could go either way.
If the Shared Appreciation Agreements are ultimately held to not require recapture
at the end of the 10-year period, then the IRS position is more likely to prevail
on the tax issue. If the Shared Appreciation Agreement is ultimately held to require
recapture at the end of the 10-year period (as the FSA argues) then the IRS could
still prevail on the tax issue, but it is less likely to prevail.
In order to prevail on the tax issue, the IRS must convince the court that
the recapture provision in the Shared Appreciation Agreement is "highly contingent."
The application of the test was described as follows in Zappo v. Commissioner,
81 T.C. 77 (1983), at page 90:
When an obligation is highly contingent and has no presently ascertainable
value, it cannot refinance or substitute for the discharge of a true debt. The
very uncertainty of the highly contingent replacement obligation prevents it from
reencumbering assets freed by discharge of the true debt until some indeterminable
date when the contingencies are removed. In a word, there is no real continuation
of indebtedness when a highly contingent obligation is substituted for a true
debt. Consequently, the rule in Kirby Lumber applies, and gain is realized to
the extent the taxpayer is discharged from the initial indebtedness.
Taxpayers can argue that the date the contingency is removed is determinable
in a Shared Appreciation Agreement for which expiration is a recapture event since
it can be no later than the expiration date. They can also argue that the asset
was never free of the encumbrance and the true debt continues until a recapture
event occurs. Given that the value of land is very likely to increase in a 10-year
period, in almost all cases, the taxpayer must repay part of the write-down and
in many cases they will repay all of the write-down.
|Practitioner Note. Shared Appreciation Agreements entered into after
August 18, 2000 have a five year period. The end of the five-year period is a
To illustrate the income tax consequences of the recapture payment under the
Shared Appreciation Agreement, we begin with an example of the income tax consequences
of the debt reduction.
Example 6. On May 1, 1991, Matthew Horton owed FmHA $150,000 of principal
plus $15,000 accrued interest. At that time, he entered into a buy-out agreement
with FmHA under which he paid $125,000 (the fair market value of the farm at the
time of the workout) and the FmHA terminated his obligation to pay $15,000 of
accrued interest and $150,000 of principal on his farm loan. Under the terms of
the loan, payments are first applied to accrued interest and then to principal.
Therefore, the workout agreement resulted in a discharge of $15,000 of interest
and $25,000 of principal.
The workout included a Shared Appreciation Agreement that requires Matthew
to pay the FSA 50% of the appreciation in value of the collateral on the earlier
- The end of the agreement, which is May 1, 2001
- The date the borrower transfers the property, defaults on the debt, or ceases
The total amount recoverable under the Shared Appreciation Agreement is limited
to the $40,000 of debt written down.
Before the workout, Matthew's total debt was $338,000, his assets were worth
$300,000, and his adjusted basis in assets was $302,000. After the workout, his
debt was $298,000 and his assets were still worth $300,000. The debt was not qualified
farm indebtedness because Matthew did not meet the requirement that 50% or more
of his gross receipts were from farming for the three preceding tax years [I.R.C.
On his 1991 income tax return, Matthew followed the IRS position and reported
the following on Form 982:
1. The $15,000 of interest was not reported as income. It is excluded from
income under I.R.C. §108(e)(2) because Matthew could have claimed a deduction
if he had paid that interest.
2. After the $15,000 of interest was discharged, Matthew had $323,000 of debts
and $300,000 FMV of assets. Therefore, the first $23,000 of the $25,000 discharged
principal was excluded from income under the insolvency exception [I.R.C. §108(a)(1)(B)].
Matthew reduced tax attributes as follows.
3. The remaining $2,000 of discharged debt was recognized as income (since Matthew
was solvent to the extent of $2,000 after the discharge).
a. NOLs were reduced by $16,000. That paid the price for $16,000 of the $23,000
that was excluded under the insolvency exception leaving, $7,000 to be accounted
b. Bases of assets were reduced by $4,000. Bases were not reduced any further
because the $4,000 reduction brought Matthew's aggregate bases in assets down
to an amount that is equal to his remaining debt after the discharge ($298,000).
That paid the price for another $4,000 of the $23,000 that was excluded under
the insolvency exception, leaving $3,000 to be accounted for.
c. No attributes were reduced for the remaining $3,000 of discharged debt that
was not recognized under the insolvency rules because Matthew exhausted all available
See the 1999 Farm Income Tax School Book, Chapter 16, pages 557-563 for a detailed
discussion of reduction of tax attributes as a result of discharge of indebtedness.
TAX CONSEQUENCES OF THE RECAPTURE
The tax consequences of recapture depend on the position the taxpayer took
in the year of the agreement.
Under the IRS position, taxpayers must reverse the income tax consequences
of the debt discharge when the taxpayer is required to repay part or all of the
discharged debt. That means the taxpayer begins at the bottom of the list of tax
consequences and reverses those consequences in the year of the repayment until
the repayment amount is accounted for.
Example 7. Assume the same facts as in Example 6. When the workout agreement
terminated in 2001, Matthew's farm was worth $185,000, which was a $60,000 increase
over the value of the farm at the time of the workout. Consequently, Matthew was
required to repay $30,000 (50% $60,000) of the $40,000 debt reduction.
That repayment reverses the tax consequences that were reported on Matthew's
1990 income tax return. Therefore, Matthew starts at the bottom of the list of
tax consequences in Example 6 and reverses them until he has accounted for the
$30,000 of discharged debt that he repaid.
- Since the last $2,000 that was discharged was recognized as income in 1991,
Matthew claims a $2,000 deduction in 2001 when he repays the discharged debt.
(That accounts for $2,000 of the $30,000 repaid, leaving $28,000.)
- Since the next to last $3,000 that was discharged was not recognized as income
and did not cause tax attributes to be reduced, Matthew has no deduction nor any
attribute restoration for that $3,000 that he repaid. (That accounts for another
$3,000 of the $30,000 he repaid, leaving $25,000.)
- The next $4,000 (in reverse order) of the $40,000 discharge resulted in reduction
in the bases of assets in 1991. Therefore, Matthew adds $4,000 to the bases of
his assets in 2001. (That accounts for another $4,000 of the $30,000 repaid, leaving
- The next $16,000 (in reverse order) of the $40,000 discharge resulted in reduction
of NOLs in 1991. Therefore, Matthew increases his NOLs in 2001 by $16,000. (That
accounts for another $16,000 of the $30,000 repaid, leaving $5,000.)
- The remaining $5,000 of the $30,000 that was repaid was part of the $15,000
on interest that was discharged in 1991. Since that interest was not claimed as
a deduction in 1991, Matthew can claim an interest deduction when that discharged
interest is repaid in 2001.
Taxpayers who took the alternative position at the time of the FmHA debt reduction
do not have any tax consequences to reverse when they make a recapture payment
under the Shared Appreciation Agreement. However, they may have debt discharge
income to be reported at the termination of the Shared Appreciation Agreement
because there is no longer any obligation to repay any debt that was not repaid
at the end of the agreement.
Example 8. Assume the same facts as in Example 6 except that Matthew
Horton took the alternative position on his income tax return.
Matthew reported no attribute reduction and no discharge of indebtedness income
in 1991 because the Shared Appreciation Agreement could require him to repay all
of the debt reduction.
Example 9. Assume that Matthew followed the alternative method of reporting
the debt reduction in 1991 as in Example 6 and paid the same $30,000 recapture
amount in 2001 as in Example 7.
Matthew has no tax consequences to reverse in 2001 because he reported no discharge
of debt in 1991. However, he does have $10,000 discharge of debt to account for
in 2001 since his debt was written down by $40,000 in 1991 and he has repaid only
$30,000 in 2001. Since that $10,000 was accrued interest that could have been
deducted if it had been paid, Matthew has no income tax consequences for the discharge
of that debt in 2001.
|Practitioner Note. Some taxpayers who used the alternative method of
reporting the debt reduction at the time of the FmHA workout agreement will have
discharged debt that must be reported at the termination of the Shared Appreciation
Example 10. Assume the same facts as in Example 9 except that Matthew
Horton was required to repay $18,000 (rather than $30,000) of the debt reduction
at the end of the Shared Appreciation Agreement. Since Matthew's obligation to
repay the remaining $22,000 of the $40,000 debt reduction in 1991 is terminated
when the Shared Appreciation Agreement terminates in 2001, he must account for
that $22,000 debt discharge in 2001.
As in the previous examples, the first $15,000 of the debt discharge is accrued
interest and does not have to be reported as income because Matthew could have
claimed a deduction if he had paid that interest.
The remaining $7,000 is discharge of indebtedness income to Matthew in 2001
unless it fits within one of the other exceptions under I.R.C. §108. In this
example, Matthew does not qualify for any of the exceptions, so he must report
$7,000 of discharge of indebtedness income in 2001.
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