Liabilities like Cash: Crane vs. Maimonides

May 1, 2010 by Noam Waltuch

I. The U.S. Tax System’s Treatment of Liabilities like Cash 

The United States Tax system allows for deductions called ACRS (Accelerated Cost Recovery System), or otherwise known as depreciation deductions.[1]  These deductions are intended to be an allowance for the decline in the value of a building in trade or business due to wear and tear.[2]  Normally, there needs to be a realization event – either a sale or exchange – in order for a tax or deduction to be administered.[3]  Depreciation deductions are an exception to this rule. These deductions are taken by the taxpayer while he is holding the property, without a sale or exchange.[4]  The theory behind allowing depreciation deductions without a realization event is that “there should be an offset against revenues for the cost of ‘wasting’ assets that are used for the production of those revenues but have a life extended beyond the current tax year.”[5]  To clarify this idea, consider the following example: a person buys a widget machine for $50,000 and it will last for five years.  The full cost of the machine should not be deducted as a cost of producing income for the year that it was purchased in because the machine will continue to produce income for the next four years.  Allowing a full deduction in the first year will result in underestimating the taxpayer’s income, as there is still value to the machine.  On the other hand, allowing a deduction only when the machine is sold will overestimate the taxpayer’s income until that point.  Therefore, the depreciation deductions allow the taxpayer to spread the deductions over the course of the machine’s lifetime by estimating how much value the machine has lost in a given year and applying a deduction for that amount.[6]  

The question that needs to be dealt with is as follows: if a taxpayer borrows money to buy depreciable property, how much depreciation deductions will the taxpayer be allowed to take?  The tax code says that a taxpayer takes depreciation deductions from the basis of the property.[7]  We must then consider whether we apply the liabilities that the buyer owes to the basis of the property or not.  To illustrate this question, consider the example of a taxpayer (“T”) who buys a building for the production of his income for $1,000,000.  He pays $200,000 down and borrows the rest of the purchase price from the bank, giving the bank an $800,000 mortgage on the property. If T’s basis on the property includes the liabilities, then his basis will be $1,000,000 and he will be able to take yearly depreciation deductions from $1,000,000. If, however, T’s basis did not include the liabilities, he would only be able to take depreciation deductions from $200,000, the amount he paid.[8]  

The court in Crane v. Commissioner stands for the proposition that we treat liabilities like cash.[9]  Therefore, since the liabilities that a taxpayer has taken upon himself to buy a building are treated like cash, the liabilities will be part of the basis and the taxpayer would therefore get depreciation deductions from the liabilities as well.  This is very advantageous for taxpayers.[10] 

The Crane decision applied the rule that liabilities are treated like cash to all cases, whether the loan is recourse or nonrecourse.  In a recourse loan, the borrower is responsible for the entire debt even if the property loses its value, and can therefore be viewed as having paid the debt.  It is therefore reasonable to take the depreciation on the full value of the property, as it is fair to say that the borrower did lose the value of the property that the depreciation deductions accounted for.  However, when the loan is nonrecourse the borrower is not responsible for paying back the entire debt, as the loan is limited by the value of the property.  It therefore does not make sense to treat the borrower as though he owns the entire property and allow him to take depreciation deductions on its full value.  This is because it is not reasonable to say that the borrower lost the value of the property that the depreciation deductions accounted for because he is not responsible to pay back the entire loan.[11]  Therefore, the rule of treating liabilities like cash should be limited to situations in which it is reasonable for it to apply. 

II.       Jewish Law’s Treatment of Liabilities Like Cash

 

Jewish law also has a concept of treating liabilities like cash.  Unlike U.S. tax law, however, the treatment of liabilities like cash is limited to certain circumstances where it is reasonable to apply the rule.  The following section is a discussion of the Talmudic analysis of treating liabilities like cash. 

In Jewish law, transferring money in order to buy real property is enough of an event to acquire its title.  Transferring money to acquire title of personal property, however, is not enough of an event to acquire its title.  The buyer has to perform an act of acquisition, i.e. physically take the merchandise, to acquire title of personal property.[12]  However, transferring money does create a moral obligation for both the buyer and the seller to not retract the deal.  If one of the parties retracts from the deal, he is subjected to a severe curse given by Bais Din – a Jewish court – known as a Mi Shepara.[13]  The question that the commentaries consequentially deal with is where a creditor uses a debt owed to him to acquire personal property, is that enough to create a moral obligation to not retract from the sale?  Maimonides explains that if a creditor agrees to buy a barrel of wine from the debtor with the discharge of the debt as payment, this is enough to create a moral obligation to not retract from the sale.[14]  Maimonides also says that if a creditor buys real property by using the discharging of a debt as payment, this is enough for the creditor to acquire the title of the property.[15]  The reasoning behind Maimonides’ opinion is that Maimonides treats liabilities like cash.[16]  Therefore, if one uses a debt that is owed to him to buy personal property, there will be a moral obligation not to retract from the sale.  If one uses a debt that is owed to him to buy real property, this is considered a complete sale, and title of the property is transferred to the buyer.[17] 

Although Maimonides, like American law, is of the opinion that liabilities are to be treated like cash, he does not issue this opinion as a blanket rule without any limitations.  The following discussion encompasses those nuances and limitations that differentiate Torah law from American law in the realm of debt, liability, and property acquisition. 

The Torah forbids one to lend or borrow money with interest.  The Torah views this prohibition as a severe one, as it discusses this prohibition in five different places.[18]  Because of the severity that the Torah treats this prohibition with, the Rabbis extended this prohibition to transactions that contain any hint of a loan with interest.  One of these examples is forward contracts.[19]  A forward contract is an agreement where a buyer pays for merchandise and the seller agrees to deliver the merchandise at a later date for the fixed amount of money that was already transferred to him.  The buyer agrees to this transaction even if he will only receive the merchandise later because he has locked in a price, which protects him from any price increase.  The seller agrees to this transaction because he has use of the money without being required to deliver the merchandise until a later date.  Even though this transaction is a sale, the time period between the payment and the delivery is essentially a loan because the seller has borrowed the money and will pay the debt with the merchandise at a later point.  If, during this point in time, the merchandise increases in value, the seller is paying back more than what he received.  This can be perceived as the seller paying an extra amount of money for the use of money, which is the definition of an interest payment.  As a result of the possible price increase, the Rabbis forbade future contracts.[20]  

            There are two possible circumstances in which a forward contract is allowed.[21]  The first is if the seller has the merchandise in stock at the time that the payment is made.[22]  Since the seller has the merchandise, it can be perceived as if the buyer has acquired the merchandise at the time of the payment even though it has not been given to him yet.  Therefore, if the merchandise increases in value in between the time of the payment and the delivery, it can be viewed as having increased in value under the ownership of the buyer and is not considered as interest payments by the seller.[23]  The second situation in which a forward contract is permitted is when there is a prevailing price in the market for the merchandise that is being purchased.[24]  This exception applies even when the seller does not have the merchandise.  However, since the merchandise is available in the market at a set market price and the seller can easily use the money that he received from the buyer to acquire the merchandise, from a legal standpoint, it is as if the seller has the merchandise.[25]  Once it can be viewed as though the seller has the merchandise, a forward contract is permitted.[26]

            The hypothetical situation then arises in the Talmud where, instead of paying cash for merchandise in a forward contract, one uses previously owed money as advanced payment.[27]  There are two conflicting Baraisas in the Talmud that address this scenario.[28]  The first Baraisa, quoted by Rabba,[29] deals with a case of a debtor and creditor where the creditor wants his money back so he can purchase wheat.  The debtor tells the creditor that he has wheat, and offers the creditor the opportunity to use the previously owed money as an advanced payment for the wheat, which he will deliver at a later date.[30]  The Baraisa says that this transaction is forbidden even if there is a prevailing price in the market or the seller has the wheat in his possession.[31]  A possible explanation for this ruling is that this Baraisa does not hold that liabilities can be viewed as cash, and therefore the transfer, or discharge, of a debt is not looked upon as if there has been a transfer of money.  Since no money has been transferred, the two aforementioned exceptions do not apply; the merchandise cannot be viewed as having increased in value while being in the buyer’s ownership, since he has not given a payment or removed the merchandise into his domain to acquire the merchandise.[32]  The second Baraisa is that of Rav Oshiya quoted by Rabba.[33]  This Baraisa has the same circumstances as the first Baraisa, but says that if the seller has the merchandise in his possession, then using previously owed money as advanced payment for the forward contract will not violate the Rabbinic prohibition of charging interest on a loan.[34]  One explanation for Rav Oshiya’s Baraisa is that Rav Oshiya is of the opinion that we do view liabilities like cash.  Therefore, when the seller uses the debt that he owes the buyer as payment for the merchandise, it is viewed as if the seller has received cash.  It follows that if the seller has the merchandise in his possession, then the forward contract would be permitted because it is viewed as if the buyer acquired ownership of the merchandise with the symbolic transfer of money.  Any price increase would be viewed as having occurred in the buyer’s possession and not in the seller’s possession, thereby avoiding any interest problems.[35]  

The following question arises regarding Rav Oshiya’s Baraisa: if it is viewed as though money has been transferred when a seller pays with a debt, then why is this transaction only permitted when the seller has the merchandise and not when there is a prevailing price in the market?  The answer to this question is that Rav Oshiya’s opinion that liabilities are viewed as cash is limited to certain circumstances when it makes sense on a practical level to view them as such.  If viewing liabilities as cash does not fit with a practical reality, it will not be viewed as cash.  The entire reasoning behind a forward contract being permitted when there is a prevailing price in the market is based on the idea that, since the merchandise is available in the market at a set price, the seller can easily use the money that he received from the buyer to acquire the merchandise.[36]  Therefore, from a legal point of view, it is as if the seller has the merchandise.[37]  This exception requires that the seller actually receive money so that it can be viewed as though he has purchased the merchandise.  If the seller doesn’t receive money but agrees to accept the discharge of the debt as payment, he does not have the money in hand to go and buy the merchandise at the prevailing price in the market.  This stands in contrast with the first exception to the prohibition of forward contracts, where the seller has the merchandise, because in this situation the seller does not need the actual money.  Rather, it is only necessary to view the buyer as having acquired the merchandise.  For this, the symbolic treatment of liability like cash would apply because it does not contradict any reality.[38] 

III.                                             Conclusion

The United States legal system’s blanket usage of the rule that treats liabilities like cash creates skewed results in the U.S. tax system, specifically by depreciation deduction with a nonrecourse loan.  The U.S. tax system seems to treat liabilities like cash as a reality, even when it clashes with reality itself, as it does by a nonrecourse loan.  The Jewish legal system approaches the use of liabilities as cash as a symbolic phenomenon and not as a reality.  By doing so, when the treatment of liabilities clashes with reality, the symbolic treatment of liabilities like cash will not apply.  The U.S. tax system would stand to gain by adopting the symbolic approach of the treatment of liabilities as cash, thus reaching more logical conclusions in the U.S. tax system.   


* Articles Editor, Cardozo Journal of International and Comparative Law.  J.D. Candidate, Benjamin N. Cardozo School of Law, 2011; B.S., Finance, Yeshiva University Sy Syms School of Business magna cum laude, 2006.

[1] William Klein, Federal Income Taxation 178 (2009).

[2] Id.

[3] Reg. § 1.1001-1.

[4] Klein, supra note 1.

[5] Id.

[6] See I.R.C. §168(b) for the different depreciation methods.

[7] I.R.C. §167(c).

[8] In this case every time the taxpayer pays more money for the building he will be able to take depreciation deductions from that extra amount as well.

[9] Crane v. Commissioner, 331 U.S. 1 (1947).

[10] This does not mean that the taxpayer will be paying less tax it just means that the tax will be deferred.  To illustrate using the example above, if the liabilities are treated like cash, the taxpayer will be taking depreciation deductions from the entire value of the property at $1,000,000.  After each depreciation deduction the basis of the property is lowered.  When the taxpayer sells the property he will have to include the liabilities into the amount realized as well, because we are treating liabilities as cash.  Therefore, if we treat liabilities like cash the taxpayer will be paying a larger tax when he sells the property than if we do not treat liabilities like cash.  As a result, the advantage of treating liabilities as cash is not that the taxpayer will be paying less tax, rather the taxpayer will have a tax deferral.  This decision was a significant one for the development of U.S. tax law, for it laid the foundation for most tax shelters.  For examples of tax shelters that resulted from the Crane decision See Klein, supra note 1 at 185-186.

[11] The court in Crane only dealt with the situation where the nonrecourse mortgage was less than the value of the property. Crane, 331 U.S. at 14.  The court attempted to explain that when the mortgage is less than the value of the property, the taxpayer will treat the nonrecourse loan as recourse in order to protect his equity, referred to as “economic benefit.” Id.  The Crane court in footnote 37 left the situation where there is no “economic benefit” – where the loan is more than the value of the property – unanswered. Id.  The court in Commissioner v. Tufts, 461 U.S. 300 (1983), however, extended the Crane rule to situations where  the loan is more than the value of the property, which therefore dismisses Crane’s  “economic benefit” reasoning for treating liabilities like cash by a nonrecourse loan.

[12] Even if the buyer only does this act of acquisition and does not pay for the item, the sale is complete and neither party can retract from the sale.  The buyer owns the merchandise and the seller is owed the money.

[13] The Babylonian Talmud, Bava Metzia 44a.

[14] Maimonides, Laws of Mechira 7:4, in Mishne Torah (Abraham M. Hershman trans., Yale Univ. Press 1949).

[15] Id.

[16] Stating that when the creditor discharges a debt, it is as if the creditor is giving the debtor the money at that time.  The question asked on this is that when money is lent to a borrower, it is lent to be spent, known as milveh lehotza’ah nisnah.  Therefore, the borrower is not viewed as having the money that was lent to him when the lender discharges the debt to buy the property.  The commentaries ask how Maimonides could consider the debtor to have received the money if he has already spent it? See Ra’avad, Commentary, in Maimonides, Mishne Torah, Laws of Mechira 7:4, supra note 14; Magid Mishna, Commentary, in Maimonides, Id.; Lechem Mishna, Commentary, in Maimonides, Mishne Torah, Laws of Mechira 5:4, supra note 14. Lechem Mishna, Id., explains that Maimonides is of the opinion that in the case of a loan, even if the money is not physically in the hands of the debtor, it is viewed as if it is in his hands.  Therefore, when the creditor discharges the loan as payment to the debtor, it is viewed as though the debtor has actually received the cash now, Lechem Mishna is explaining that, according to Maimonides, liabilities are treated like cash. (See also Sma, Commentary, in Shulchan Aruch, Choshen Mishpat § 204:15, explaining Maimonides to hold that liabilities are treated as cash).  Similarly, a transaction that discharges a debt for property is also viewed as a sale in American tax law, as the American tax law treats liabilities like cash.  To illustrate: A debtor owes a creditor $10,000 and the debtor owns property worth $10,000 with a basis of $2,000.  If the debtor sells the property and uses the cash proceeds to pay the creditor, he will recognize an $8,000 gain.  If the debtor instead transfers the property to the creditor in satisfaction of the debt, the American tax law treats this as a sale and the debtor will still recognize an $8,000 gain.  

An apparent difficulty with Maimonides’ opinion would arise in a situation where a man discharges a debt that he has from a woman to acquire her in marriage, the marriage is not valid according to Maimonides. See Maimonides, supra note 14, Laws of Ishus 5:13. (In Jewish law, in order for a man to marry a woman he must do an act to acquire her, i.e. transfer money to her, just as he would to acquire a piece of property).  Maimonides is therefore of the opinion that discharging a debt is not enough of an event to acquire a woman in marriage, while it is enough of an event to acquire a piece of property.  Mishnas Yaavetz, (see Mishnas Yaavetz, Choshen Mishpat § 32), answers this apparent contradiction in Maimonides‘ opinions by explaining that in order for a person to acquire property with cash, all that is needed is that the purchaser receive the buyer’s money.  The buyer does not have to physically transfer the money to the seller.  However, in order for a man to acquire a woman in marriage, the woman must receive the man’s money and the man must personally transfer the money to her.  Therefore, Mishnas Yaavetz explains that when a creditor discharges a debt owed to him, it is as if the debtor received the creditor’s cash, which is sufficient to acquire property.  However, it is not as if the creditor actually transferred the money to the debtor, and is therefore not enough of an event to acquire a woman in marriage.

Both Ra’avad and Magid Mishna, supra, disagree with Maimonides, and say that when a creditor discharges a loan it is not as if the creditor is giving the debtor cash, as liabilities are not like cash.  Rather Magid Mishna explains that the creditor acquires the property through the enjoyment that he is transferring to the debtor by discharging the loan. See Shulchan Aruch, Choshen Mishpat § 204:10, citing both these opinions, with the second opinion being similar to Magid Mishna’s, as explained by Rama there.

[17]  This is one of the instances in Jewish law that treats liabilities like cash.  The cases in Maimonides, supra note 16, and the court in Crane, only dealt with the treatment of liabilities like cash regarding direct debtor-creditor transactions.  However, other possible instances where liabilities are treated like cash in Jewish law can arise where a creditor transfers the debt that is owed to him to either purchase property from a third party, pay off a different loan, or transfer the rights to collect the debt to another person.  Shulchan Aruch is of the opinion that this transfer would be valid in certain situations, such as: 1) where the creditor transfers the actual contract between him and the debtor and writes another contract between him and the purchaser identifying the transfer between them, see Shulchan Aruch, Chosen Mishpat § 66:1; and 2) where the creditor transfers his debt by means of an oral declaration in the presence of the creditor, debtor, and purchasee/donee, known as maamad shloshtan. Shulchan Aruch, Choshen Mishpat §126:1. (Shach, Commentary, Id. at § 126:6, says that maamad shloshtan only works when the creditor transfers the debt as a gift or to pay off another debt, but not to purchase property.  However, the opposite seems to be true from Be’er Heitiv, Commentary, Id., that explains Tosafos, Commentary, in The Babylonian Talmud, Gittin 14a, as saying that maamad shloshtan can be used to purchase property.  Be’er Heitiv explains that maamad shloshtan is a rabbinic decree which was enacted in order to facilitate business transactions in the marketplace,  allowing it to be used for purchases).

Furthermore, even though Shulchan Aruch is of the opinion that these transactions work, there is some disagreement as to why they work.  Ramban says that the debt owed to the creditor is not considered to be in his possession and this is why the transfer of a debt only works in certain circumstances.  Baal Meor, however, is of the opinion that the debt owed to the creditor is as if it is in his possession; considering it like cash. See Ketzos Hachoshen, Choshen Mishpat § 211:5, citing the opinions of Baal Meor and Ramban.  Therefore, in Jewish law, liabilities are treated like cash not only when the creditor forgives the debtor’s liability to purchase property, but also where the creditor transfers the debt owed to him to a third party.

[18] Exodus 22:24, Leviticus 25:36, Id., Deuteronomy 23:20, Id. at 23:21.

[19] The Babylonian Talmud, Bava Metzia 72b.

[20] Id.; See Nesivos Shalom, Hilchos Ribis § 175:1 (The biblical prohibition against lending money with interest is only by a complete loan, where the money was given at the onset for a loan.  In the case of a forward contract, on the other hand, the money is given for a sale at the onset and is therefore not biblically prohibited. Because of the severity of lending money on interest, the Rabbis have prohibited transactions that aren’t complete loans as well).

[21] The Babylonian Talmud, Bava Metzia 72b.

[22] Id. This exception is known as Yesh Lo (he has it). Id.

[23] Rashi, Commentary, in The Babylonian Talmud, Bava Metzia 72b.  As explained above, transferring money is not enough to acquire personal property.  The buyer has to physically remove the merchandise to acquire ownership of it.  However, transferring money does create a moral obligation from the buyer and the seller to not retract from the deal.  If one of the parties retracts from the deal, he is subjected to a sever curse given by Bais Din – the Jewish court – known as a Mi Shepara.

[24] The Babylonian Talmud, Bava Metzia 72b.  This exception is known in the Talmud as Yotza Hashaar (there is a prevailing price). Id.

[25] Rashi, Commentary, in The Babylonian Talmud, Bava Matzia 62b.

[26] Using the same rationale as the first exception (Yesh Lo).

[27] The Babylonian Talmud, Bava Metzia 62b (This question arises in trying to explain a passage in the Mishna. It is beyond the scope of this article to explain how this question explains the Mishna).

[28] A Baraisa is a teaching in Jewish oral law that is not in the Mishna.

[29] The Babylonian Talmud, Bava Metzia 62b.

[30] This is a case of using the discharge of a debt as payment for the forward contract.

[31] The Babylonian Talmud, Bava Metzia 62b.

[32] It was said above that even though transferring money is not enough to acquire personal property, it is enough to create a moral obligation to uphold the sale. Supra note 13.  According to this Baraisa, since transferring a debt or discharging a debt is not considered like transferring money, there isn’t even a moral obligation to uphold the sale and therefore it cannot be viewed as though the buyer has acquired the merchandise and the merchandise increased in his possession.  It would follow, that according to this Baraisa, using previously owed money as an advanced payment for a forward contract to purchase merchandise would constitute a Rabbinic prohibition of charging interest, even if the seller has the merchandise or there is a prevailing market price.

[33] The Babylonian Talmud, Bava Metzia 62b-63a.

[34] Id.

[35] Rashi, supra note 23, at 62a, explains Rav Oshiya with this reasoning. Ra’avad, supra note 16, says that Maimonides’ opinion that one can use a transfer of a loan to acquire property originates from this Baraisa of Rav Oshiya.  As stated above, supra note 16, Ra’avad disagrees with Maimonides’ opinion that one can use a transfer of a loan to acquire property and explains Rav Oshiya’s Baraisa differently.  Ra’avad says that the reason Rav Oshiya is of the opinion that using the discharge of debt as payment for the forward contract is permitted is not because we are treating liabilities like cash, and therefore it is as if the buyer has acquired the property already.  Rather, because a forward contract is only Rabbinically forbidden, the Rabbis were lenient and said that when the buyer discharges a debt as payment we will view it as though the buyer has bought the property.  Ra’avad says that this leniency is only applicable to the Rabbinic prohibition of charging interest and should not be extended to all laws of acquiring property as Maimonides does. Tosafos, Commentary, in The Babylonian Talmud, Bava Metzia 46b, agrees with Ra’avad that one cannot use a debt to acquire property.  However, Tosafos does hold that the enjoyment of the discharging of a debt is enough to acquire property (like Rama in the second approach, Shulchan Aruch, supra note 16, Choshen Mishpat § 204:10).  Therefore, Rav Oshiya’s reasoning in allowing the discharge of a debt as payment for a forward contract when the seller has the merchandise is that the enjoyment experienced by the discharge is enough to acquire property.  It can therefore be viewed as though the buyer has acquired the seller’s merchandise with the discharge of the debt, so any price increase occurred while he owned it.

[36] Rashi, supra note 23, at 62a.

[37] The first exception, where the seller has the merchandise (Yesh Lo), would then apply.

[38] Rashi, supra note 23, at 63a, makes this distinction.