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Volume 7 - Opinions of Counsel SBEA No. 13

Opinions of Counsel index

Aged exemption (income requirement) (capital gains and losses - repayment of loan principal) - Real Property Tax Law, § 467:

For purposes of the income requirement of section 467 of the Real Property Tax Law, repayment of the principal of a bona fide loan does not constitute income to a lender-applicant.

Our opinion has been sought concerning the income requirement of the aged exemption authorized by section 467 of the Real Property Tax Law. An applicant claims to have income only from Social Security and to have filed no income tax return. When inquiry was made as to how the applicant was able to afford his house, the response was that the applicant received no salary from the electronics company of which he is president, but that he did receive $25,000 in repayment for a loan to that company. The issue is whether this repayment must be included as income for purposes of the income limitation on eligibility for this exemption.

Subdivision 3(a) of section 467 reads in part:

Such income [used in determining eligibility] shall include social security and retirement benefits, interest, dividends, total gain from the sale or exchange of a capital asset which may be offset by a loss from the sale or exchange of a capital asset in the same income tax year, net rental income salary or earnings, and net income from self-employment, but shall not include a return of capital, gifts or inheritances.

The terms “capital asset” and “return of capital” were added in 1975, so that the section would embody the holdings of Engle v. Talarico, 33 N.Y.2d 237, 306 N.E.2d 796, 351 N.Y.S.2d 677 (1973). (See, sponsor’s memorandum to 1975 Senate Bill No. 8, now L. 1975, c.535, amending section 467(3)(a).) While recognizing that the descriptive definition in section 467(3)(a) is not the same as that in the Internal Revenue Code (26 U.S.C. § 61), the Court of Appeals did apply the same analysis as the Federal Courts had applied to the Federal Income Tax: “Both in economics and in law the terms capital and income are generally mutually exclusive. . . . Capital represents an accumulation of assets from which income may be derived” (33 N.Y.2d at 241).

One result of this distinction between capital and income is the return of capital rule, now part of section 467(3)(a). No income is realized where income generated by a disposition of capital assets represents the return of the original investment. Doyle v. Mitchell Brothers Co., 274 U.S. 179, 38 S.Ct. 467, 62 L.Ed. 1054 (1919). As a corollary of this rule, no income is realized to the lender upon the repayment of a loan. Fairchild v. Commissioner, 462 F.2d 462 (3d Cir., 1972). Again, the repayment merely represents the return of an original outlay for which no deduction was taken.

Since the explicit inclusion of the return of capital rule in section 467(3)(a) was based upon a desire to codify the holding of Engle v. Talarico, it would not be unreasonable to apply the reasoning of that case where applicable. Thus, the return of capital rule includes its corollary, the repayment of principal rule.

The mere fact that no income is realized upon the repayment of loan principal to a lender should not result in a tax official accepting every claim of loan repayment as legitimate. This rule is open to abuse, and criminal prosecutions for sham loans are not uncommon. See, e.g., U.S. v. Durant, 208 F.Supp. 890 (N.D. Ill., 1962), aff’d, 324 F.2d 859 (7th Cir., 1963).

One particular type of abuse involves an officer or shareholder who “lends” money to a closely held corporation. What would normally be income as salary or dividends is then characterized as repaid principal.

Cases involving this abuse are known as debt-equity cases. Perhaps the most thorough of these is Estate of Mixon v. United States, 464 F.2d 394 (5th Cir., 1972), where, in discussing the proper method of exposing sham loans, the court analyzed and applied various means such as the certificate evidencing the debt, the source and use of the funds, the adequacy of the corporation’s capitalization, etc. No one of these may be determinative in any particular case.

In the instant situation, since the repayment of principal rule is so easy to abuse, the assessor should carefully scrutinize any applicant who invokes it. The best course of action would be to request as much information as is available concerning the underlying loan. If the assessor believes the loan is a sham, the application should be denied and the applicant left to the normal channels of administrative and judicial review.

April 9, 1980