Morphy v. Commissioner ( 1937 )

EMMA C. MORPHY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Morphy v. Commissioner

Docket No. 76711.

United States Board of Tax Appeals

35 B.T.A. 289; 1937 BTA LEXIS 898;

January 19, 1937, Promulgated

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Where a building is erected on leased premises by lessee under optional provision in the lease and is not subject to removal on termination of the lease, held, the aliquot part of the depreciated valud of the building, at the expiration of the lease, is taxable income to the lessor for a year prior to that expiration. Regulations 74, article 63, followed.

Prewitt Semmes, Esq., for the petitioner.

E. C. Algire, Esq., for the respondent.

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LEECH

The petitioner asks a redetermination of a deficiency in income tax for the year 1931 in the amount of $129.38. The single issue is whether petitioner realized income during the taxable year on the construction of a building on her land by a lessee in 1921. If this resulted in realized income, the parties stipulate that the deficiency determined by the respondent is correct.

FINDINGS OF FACT.

The facts have been stipulated and a lease put in evidence. The following is a summary of the material facts in the stipulation and lease.

1. The petitioner, on May 1, 1920, and subsequent thereto, including the year 1931, owned an interest of 27.54 percent in a certain piece of property in Detroit, Michigan, which was leased for thirty years and three months from February 1, 1921, with the option to the lessee to erect a building thereon.

2. The lease provides: "It is also covenanted and agreed that in the event of the termination of this lease, whether by lapse of time, by forfeiture, or otherwise, all buildings and improvements (trade fixtures excepted) shall be the property of lessor."

3. The lessee, during the year 1921, constructed a building on the property at a cost of $391,000, which was the fair market value of the building at the time of its completion.

4. The depreciation on the building during the life of the lease will amount to $293,250, leaving a remaining value at the termination of the lease of the building of $97,750. The proportionate part of this value applicable to each year during the term of the lease, on the basis of amortizing it over the life of the lease, is $3,258.33, of which the petitioner's interest is $897.34.

5. The lease provided that if the lessee exercised its option to erect any building on the premises it would deposit with the lessor as security for the construction of the said building its capital stock in an amount of $250,000, and in case of the depreciation of the said stock an additional amount so that at all times prior to the completion and full payment of all of the cost of construction the security for the same should be at least $250,000, and that upon completion and full payment of the cost of construction the said security should be returned to the lessee.

6. The lease further provides that the lessee shall at its own expense keep the premises and any buildings thereon in good condition, order, and repair, and shal in cases of destruction or partial destruction of the premises by fire (if lessee shall have previously constructed a new building on the premises) begin the reconstruction or repair of the building within 60 days after the fire, and shall continue the same with reasonable diligence to completion, and shall in like manner restore or repair any present building on the premises at an expense not beyond the proceeds of the insurance available.

OPINION.

LEECH: The broad question here is when is income realized to the lessor from the erection of a building on his land by the lessee, which is not subject to removal on termination of the lease. The Treasury regulations ^{*902 The regulations under attack are grounded upon the view, expressed if not held, in , and .}

These regulations have, in effect, been sustained. ; ; ; . Cf. .

It is true the Circuit Court of Appeals for the Second Circuit in , is contra. That opinion has had the respectful consideration of this Board. It offers what may seem to be a persuasively practical answer to a difficult problem. However, no other similar authority has come to our attention. And, the court, even in its decision of that case, was not unanimous. See dissenting opinion of Chase, Judge.

Therefore, we adhere to our position and sustain the validity of the contested regulations.

It is suggested in petitioner's brief, as an alternative reason why no income was realized in the year involved that, under the lease, title to the building did not pass to the lessor until expiration or forfeiture of the lease. This argument has no merit, since that was not the effect of the present lease. Cf.

Reviewed by the Board.

Decision will be entered for the respondent.

MURDOCK dissents.

ARUNDELL

ARUNDELL, dissenting: It seems to me that the decision of the Second Circuit in the Hewitt Realty case, 76 Fed.(2d) 880, gives a sound solution to the question here involved. The substance of the holding in that case is that the erection of a building by a lessee does not result in realization of income to the lessor; the realization of income, if any, occurs when the lessor sells. This view, as stated by Judge Learned Hand, author of the majority opinion, "answers every fiscal necessity far more directly and simply than any other formula."

The lease in the instant case was for a period of over thirty years. Under the view expressed in the Commissioner's regulations and approved in the majority opinion, it is necessary to look into the future to the time when the lease terminates and determine the value of the building after taking into account the ravages of time. In many cases of long-term leases the original term extends beyond the useful life of the improvements. Some of them involve definite provisions for renewal. There are always the possibilities of termination prior to the expiration of the agreed term, and accelerated depreciation and obsolescence resulting from causes unforseeable when the lease is executed. These are factors that complicate any attempted application of the Commissioner's regulations. But what is more serious, they show the impossibility of determining with any fair certainty the amount to be treated under the regulations as realized income. A promise to turn over possession of a building many years hence, and subject to the many contingencies necessarily involved in any transaction extending over a period of years, does not seem to be in any proper sense the present equivalent of cash. Cf. . The difficulty of determining as a matter of fact the value of improvements is recognized in both opinions filed in the Hewitt case. The majority opinion obviates the difficulty and offers a sound solution. It treats as income the full amount eventually realized when it is actually realized. Anything short of this does not meet the test of realized income with which the taxing act is concerned. For these reasons, I think we should adopt the principle of the Hewitt Realty case and decline to follow the earlier cases that hold otherwise.

STERNHAGEN and TYSON agree with this dissent.

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Footnotes

• 1. Article 63 of Regulations 74, as amended, reads in part as follows:

  "Improvements by lessees. - When buildings are erected or improvements made by a lessee in pursuance of an agreement with the lessor, and such buildings or improvements are not subject to removal by the lessee, the lessor may at his option report the income therefrom upon either of the following bases:

  "(a) The lessor may report as income at the time when such buildings or improvements are completed the fair market value of such buildings or improvements subject to the lease.

  "(b)↩ The lessor may spread over the life of the lease the estimated depreciated value of such buildings or improvements at the expiration of the lease and report as income for each year of the lease an aliquot part thereof."