Rev. Rul. 78-29

Advice has been requested concerning the allowability of deductions for depreciation and interest under the circumstances described below.

A, an individual who is an inventor, owns the entire right, title, and interest to a United States patent issued on March 10, 1976. On April 14, 1976, A entered into a purchase agreement with M, a domestic corporation, under which M agreed to pay A 2,000x dollars for A's entire right, title, and interest to the patent including the exclusive right to make, use, and sell the invention disclosed and claimed in the patent for the unexpired term of the patent, together with the exclusive right to sue for past or future infringements on the patent. Pursuant to the terms of the agreement, M paid A 5x dollars and gave A a note in the face amount of 1,995x dollars. As collateral for the note, M gave A a security interest in the patent and 95 percent of the net receipts earned from the patent. The note was a nonrecourse, negotiable note bearing interest at the annual rate of 4 percent with principal and interest due and payable on April 14, 1986. Prepayment of principal and interest was required to the extent of 95 percent of the net receipts derived from the patent.

M was not personally liable for payment of the note. The sole recourse of A in the event of default was to the collateral securing the note.

The specific questions are (1) whether, for purposes of depreciation, the basis of the patent acquired by M includes the amount of the note, and (2) whether interest accrued on the note is deductible by M.

Section 167(a) of the Internal Revenue Code of 1954 allows as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property used in the trade or business or of property held for the production of income.

Section 167(g) of the Code provides that the basis on which exhaustion, wear and tear, and obsolescence are to be allowed in respect of any property shall be the adjusted basis provided in section 1011 for the purpose of determining the gain on the sale or other disposition of the property.

Section 1011(a) of the Code provides that, in general, the adjusted basis for determining gain or loss from the sale or disposition of property whenever acquired, shall be the basis determined under section 1012, adjusted as provided in section 1016.

Section 1012 of the Code provides that, in general, the basis of property shall be its cost.

Section 163(a) of the Code allows a deduction for all interest paid or accrued within the taxable year on indebtedness.

In Crane v. Commissioner, 331 U.S. 1 (1947), 1947-1 C.B. 97, the Supreme Court of the United States held that the basis of improved real property acquired from a decedent as subject to a nonrecourse mortgage is equal to the amount of the mortgage obligation plus any equity above the amount of the obligation and that the sales price of such property includes the amount of any nonrecourse obligation assumed by the purchaser. The Court based its decision upon the ordinary meaning of the term "property" that was used in the applicable basis provision of the Internal Revenue Code of 1939 and upon "the reality that an owner of property, mortgaged at a figure less than that at which the property will sell, must and will treat the conditions of the mortgage exactly as if they were his personal obligations." If the value of the property is less than the amount of the note, however, the owner will not have this economic incentive to treat the obligation as if it were a personal obligation.

In addition, an obligation, the payment of which is so speculative as to create a contingent liability, cannot be included in the basis of property. Denver & Rio Grande Western R.R. Co. v. United States, 505 F.2d 1266 (Ct. Cl. 1974); Columbus and Greenville Railway Co. v. Commissioner, 42 T.C. 834 (1964), aff'd per curiam, 358 F.2d 294 (5th Cir. 1966); and Albany Car Wheel Co. v. Commissioner, 40 T.C. 831 (1963), aff'd per curiam, 333 F.2d 653 (2d Cir. 1964).

An indebtedness, for purposes of section 163(a) of the Code, has been defined as an unconditional and legally enforceable obligation for the payment of money. Autenreith v. Commissioner, 115 F.2d 856 (3rd Cir. 1940). An obligation that is contingent is not an indebtedness with respect to which interest paid or accrued may be deducted. Burlington-Rock Island R. R. Co. v. United States, 321 F.2d 817 (5th Cir. 1963), cert. denied, 377 U.S. 943 (1964). See also, Estate of Franklin v. Commissioner, 544 F.2d 1045 (9th Cir. 1976), aff'g 64 T.C. 752 (1975), in which the court denied deductions for interest on a nonrecourse note, stating that "[f]or debt to exist, the purchaser, in the absence of personal liability, must confront a situation in which it is presently reasonable from an economic point of view for him to make a capital investment in the amount of the unpaid purchase price."

The fair market value of the property is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of relevant facts. The amount of income an asset might produce over its useful life is not in itself a fair market value of the property. In the present case, M has failed to demonstrate that the fair market value of the patent at least approximates the amount of the nonrecourse note.

Accordingly, the liability created by the nonrecourse note given by M to A may not be included in the basis of the patent for depreciation purposes and no deduction is allowable in respect of interest paid or accrued on the note.

The cash investment of 5x dollars made by M is includible in the basis of the patent and may be depreciated under section 167(a) of the Code if the patent is used in a trade or business or held for the production of income and if other requirements of section 167 and the regulations thereunder are satisfied. See Rev. Rul. 77-110, 1977-1 C.B. 58.

¹ Also released as News Release IR-1921, dated December 23, 1977.