Effron v. Commissioner , 25 B.T.A. 853 ( 1932 )

ABRAHAM I. EFFRON, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Effron v. Commissioner

Docket No. 42505.

United States Board of Tax Appeals

25 B.T.A. 853; 1932 BTA LEXIS 1461;

March 14, 1932, Promulgated

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In determining whether or not the profit on an installment sale of a 99-year lease, renewable forever, with privilege of purchasing the leased premises, which option need never be exercised, is taxable in the year of sale or may be spread over the life of the installment sale contract for taxation purposes, the amount payable on the exercise of the option to purchase may not be included either in the cost to the seller or in the amount received or to be received by him from the purchaser.

Alfred Mack, Esq., for the petitioner.

J. A. Johnston, Esq., for the respondent.

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VAN FOSSAN

This proceeding was brought for the redetermination of a deficiency in income tax for the year 1923 amounting to $6,006.52.

The issue is whether or not the petitioner is entitled to return the profit arising from the sale of a leasehold on the installment basis over a period of 10 years, the sale having been made in 1923. This issue arises from determination by respondent, alleged to be error by petitioner, that a certain sum of $60,000 did not constitute a part either of the cost or of the sale price of the leasehold sold by the petitioner on March 31, 1923.

FINDINGS OF FACT.

The petitioner is engaged in business in Cincinnati, State of Ohio.

On May 24, 1920, The F. H. Lawson Company, an Ohio corporation, entered into an agreement, as lessor, with the Seton Realty Company, an Ohio corporation, as lessee, whereby the lessor, in consideration of the sum of $1 and other valuable consideration and of the rents therein reserved, and of the covenants and agreements therein contained and to be performed by the said lessee, its successors in interest and assigns, granted, leased and demised to the lessee, its successors in interest and assigns, certain real estate in the city of Cincinnati situated on the easterly side of Fifth Street and having a frontage of 30 feet and a depth of approximately 100 feet.

The habendum clause in the agreement is as follows:

To have and to hold the same together with the privileges and appurtenances thereunto appertaining and belonging, unto the said lessee, its successors in interest and assigns, for and during the full term of ninety-nine (99) years next ensuing from the thirty-first (31st) day of December, 1920, fully to be completed and ended, and renewable forever.

The lessee, on behalf of itself and of its successors in interest and assigns, agreed to pay annually during the term of the lease the sum of $3,600 in equal quarterly installments of $900 each and also agreed to pay all taxes, rates, charges and assessments of every kind that might at any time during the demise become a lien upon or be levied, rated, charged or assessed on the demised premises or any part thereof excepting taxes for the year 1920 and any assessments which were liens on the property at the date of the agreement and excepting also any income, estate or inheritance taxes chargeable to the lessor's interest in remainder in the premises described in the agreement. The lessee also agreed to keep the premises insured in a stated amount and not to commit or suffer any waste.

The lease agreement also contained the following paragraph:

And the said lessor, for itself and for its successors in interest and assigns, covenants and agrees to and with the said lessee, its successors in interest and assigns that, paying the rents and performing the covenants aforesaid, they shall and may peaceably and quietly have and enjoy the aforesaid premises, with the appurtenances, for and during the term aforesaid, free from any let or hindrance by any person or persons whatsoever, subject to said rights and easements above set forth, and further, that (all rents, taxes and assessments being paid, and all covenants being performed by said lessee, as herein stipulated) said lessor, its successors in interest and assigns will at the expiration of any and each period of five (5) years from and after December 31, 1920, convey the said premises to the said lessee, its successors in interest and assigns by a good and sufficient deed of general warranty, with release of dower, and subject to the exceptions herein contained, upon the payment during the continuance of this lease to it or them by said lessee, its successors in interest or assigns, of the sum of Sixty Thousand ($60,000) Dollars; lessee to have the right to pay on account of said privilege of purchase at the expiration of any five year period above named, the sum of Ten Thousand ($10,000) Dollars, or any multiple thereof, the ground rents thereafter to be proportionately reduced. Provided, however, that in all cases above mentioned, the lessee, its successors in interest or assigns, shall first have given lessor, its successors in interest or assigns, at least sixty (60) days' notice in writing of its intention to exercise said privilege or purchase, or make said payments on account thereof.

The agreement further contained a provision to the effect that the demise should determine and be void in the event that the lessee failed to pay the rent reserved upon demand 10 days after it had become due or failed to pay taxes, rents, charges and assessments when due and payable or failed to keep and perform any other covenant contained in the agreement.

On May 31, 1922, the premises described in the perpetual lease were assessed for local taxation at a valuation of $60,000 for the land and $11,230 for the building, a total sum of $71,230

On April 14, 1922, the petitioner made an offer in writing addressed to the Seton Realty Company to purchase "your lease-hold estate as per your lease from The F. H. Lawson Company." This offer contained the following paragraphs, among others:

I agree to assume and abide by all the terms of the lease under which the Seton Realty Company hold said premises, being given by the F. H. Lawson Company, providing for a rental of thirty six hundred ($3,600.00) dollars per annum, payable quarterly; and providing for privilege of purchase at the end of any five year period after December 1st, 1920, at sixty thousand ($60,000.00) Dollars.

I agree to pay for the said lease-hold interest the sum of forty-two thousand five hundred ($42,500.00) dollars; payable one thousand ($1,000.00) dollars cash herewith; nineteen thousand ($19,000.00) dollars cash within forty-five (45) days from date; the balance of twenty-two thousand five hundred ($22,500.00) shall be evidenced by three promissory notes, payable in one, two and three years from date, bearing interest at six (6) per cent per annum, payable quarterly, and all secured by proper mortgage on premises. Said mortgage to have the usual insurance provisions, etc. I shall have the privilege of paying off any of the said notes prior to maturity.

After the date of the foregoing offer, namely, on May 31, 1922, the Seton Realty Company by an instrument in writing, under seal, granted, bargained, sold and conveyed to the petitioner, his heirs and assigns forever the "perpetual lease-hold estate with privilege of purchase" hereinbefore described. The consideration expressed in the instrument of sale was $1 and other good and valuable considerations, and by this instrument the petitioner assumed all of the obligations of the grantor, to Seton Realty Company, provided by the perpetual lease with privilege of purchase made by The F. H. Lawson Company to the Seton Realty Company.

On the 31st day of March, 1923, the petitioner, as lessor, entered into an agreement with Julius Payton of Cincinnati as lessee whereby the lessor, in consideration of the sum of $25,000, paid to the lessor by the lessee and for and in consideration of the rents reserved in the agreement and the covenants and agreements therein contained and to be performed by the lessee, his heirs, executors, administrators and assigns, granted, leased and demised to the lessee, his heirs, executors, administrators and assigns the same premises described in the agreement between The F. H. Lawson Company and the Seton Realty Company hereinbefore referred to. The agreement between the petitioner and Payton contained the following paragraphs among others:

TO HAVE AND TO HOLD the same together with the privileges and appurtenances thereunto appertaining and belonging, unto the said lessee, his heirs, executors, administrators and assigns, for and during the full term of Ten (10) years next ensuing from the 31st day of March, 1923, and ending on the 30th day of March, 1933.

The said lessee, his heirs, executors, administrators and assigns, Yielding and Paying therefor unto the said lessor, his heirs, and assigns during this demise, the following rentals.

1st. A rental of Thirty-six Hundred ($3600.) dollars per annum, payable in equal installments of Nine Hundred ( $900) dollars each on the last days of March, June, September and December in each year during this demise, the first to be paid on the last day of June, 1923 and the last to be paid on the 30th day of March, 1933 instead of the last day of March, 1933.

The following additional rentals payable as follows: $8675.00 payable on March 31st, 1924; $8375.00 on March 31st, 1925; $8075.00 on March 31st, 1926; $7775.00 on March 31st, 1927; $7475.00 on March 31st, 1928; $7175.00 on March 31st, 1929; $6875.00 on March 31st, 1930; $6575.00 on March 31st, 1931; $11275.00 on March 31st, 1932; $11925.00 on March 30th, 1933.

The stated amounts of "additional rentals" represent the principal sum of $61,250, payable in installments, with interest on the deferred payments.

The lessor also agreed to keep and perform all the terms, covenants and conditions (except the payment of rents) to be kept and performed by the lessor as the owner of the perpetual leasehold of the premises described and contained in the "perpetual lease from The F. H. Lawson Company to the Seton Realty Company," to pay all taxes, rents, charges and assessments of every kind, to keep the buildings erected or thereafter erected on the land insured against loss by fire and tornado and not to commit any waste. This agreement also contains the following paragraph:

And the said lessor, for himself and for his heirs, executors, administrators and assigns, covenants and agrees to and with the said lessee, his heirs and assigns, that, paying the rents and performing the covenants aforesaid, they shall and may peaceably and quietly have and enjoy the aforesaid premises, with the appurtenances, for and during the term aforesaid, free from any let or hindrance by any person whatsoever; and further, that (all rents, taxes, assessments and insurance being paid, and all the covenants and agreements herein assumed by the lessee being performed by said lessee, as herein stipulated) said lessor, his heirs and assigns will convey to said lessee, his heirs or assigns the perpetual leasehold estate with privilege of purchase of lessor in and to the real estate above set forth by a good and sufficient deed of general warranty, with release of dower, excepting however, from said warranty any taxes or assessments payable thereafter, at any time after said 30th day of March, 1933 without the payment of any additional consideration for said conveyance of said leasehold with privilege of purchase.

The agreement between the petitioner and Payton also contained a covenant providing that the lease should cease, determine and be void in the event of the failure of the lessee to pay the rent reserved or on his failure to keep and perform the covenants and agreements on his part to be kept and performed.

On or about March 15, 1924, the petitioner filed his income-tax return for the calendar year 1923. In this return he stated the cost to him of the leasehold property hereinbefore described as $106,940 and stated the selling price to Payton as $146,250, showing a gross gain of $39,310. In computing the cost to him of the leasehold estate the petitioner included the sum of $42,500 as stated in his offer to the Seton Realty Company hereinbefore referred to, and the further sum of $60,000 representing the amount to be paid to The F. H. Lawson Company in the event that the lessee exercised the privilege of purchase contained in the lease made by that company to the Seton Realty Company. There was also included in the computation the cost of certain improvements and the cost of examination of title. From the sum so calculated the petitioner deducted the sum of $2,060 for depreciation. By this computation the petitioner determined a total cost to him of $106,940 as hereinbefore stated. None of the amounts used by the petitioner in this computation are disputed except the amount of $60,000.

In stating in his income-tax return that the selling price of the leasehold estate was $146,250, the petitioner computed this amount by adding together the sum of $25,000, the cash received as a down payment from Payton, the principal sum of $61,250, payable in installments as hereinbefore set forth, and the further sum of $60,000 representing the price to be paid to The F. H. Lawson Company in the event that the lessee of the perpetual leasehold exercised the privilege of purchase contained in the agreement between The F. H. Lawson Company and the Seton Realty Company. None of these amounts are disputed by the respondent except the sum of $60,000.

In his return the petitioner computed the gain as being 26.88 per centum of the total price received and computed the amount of profit taxable for the year 1923 as 26.88 per centum of the sum of $25,000 received in that year, namely, $6,720.

The respondent excluded the aforesaid sum of $60,000 both from the computation of cost of the leasehold to the petitioner and from the computation of the price receivable from Payton by the petitioner. By such exclusion he determined the cost of the leasehold to the petitioner in the sum of $46,940 and the selling price to Payton in the sum of $86,250. By this computation the respondent determined that the down payment received from Payton by the petitioner was more than 25 per cent of the total selling price.

OPINION.

VAN FOSSAN: The question in this proceeding is whether, in determining both the cost to the petitioner of the perpetual leasehold with privilege of purchase referred to in the findings of fact and the price for which he agreed to convey to Payton all his interest in that perpetual leasehold, there should be included as part of the cost and of the sale price an item of $60,000, the same being the amount to be paid if the option to purchase was exercised. The petitioner contends that, under the law of the State of Ohio, in which the property leased is situated, the agreement between The F. H. Lawson Company and the Seton Realty Company set forth in the findings of fact was in legal effect the conveyance of the fee of the property described therein, subject to a mortgage to secure the purchase price of $60,000, the amount stated in the agreement as the sum to be paid by the lessee in the event of the exercise of the privilege of purchase granted in the agreement. The petitioner also contends that when he and his purchaser assumed all the terms and conditions of the agreement between The F. H. Lawson Company and the Seton Realty Company they assumed a mortgage to secure $60,000 and consequently that amount must be included in the cost to the petitioner of the perpetual leasehold with privilege of purchase and also must be included in the amount agreed to be paid by Payton, the purchaser.

The record contains some testimony to the effect that the sums paid by the Seton Realty Company, by the petitioner, and by Payton for the perpetual leasehold with privilege of purchase, included the sum $60,000, the option price, secured by a mortgage, but these statements were more in the nature of the witness' interpretation of contract obligations than statements of fact. Such evidence must be tested in the light of a proper construction of the actual terms and conditions of the various instruments set out in the findings of fact.

For some purposes the courts of Ohio have construed perpetual leases with privilege of purchase of the character of the one in question in this proceeding as conveyances of a freehold. Cf. . In , the court said, of such a perpetual lease with privilege of purchase, that it is a deed of conveyance in fee subject to a condition of defeasance and is equivalent to a sale and conveyance with a mortgage to secure payment of a purchase price. To the same effect is . But the later cases decided by the Supreme Court of Ohio do not go so far as to hold explicitly that the perpetual leases with privilege of purchase are conveyances in fee simple subject to a mortgage to secure the purchase price. In , the court: "A perpetual leasehold estate is not a fee simple. * * * The fee simple remains in the lessor, his heirs and assigns."

Construing the application of an Ohio statute the court said, in ; , that: "A lessee in possession under a lease of real property for 99 years renewable forever, the property standing in his name for taxation, is so far the owner [italics ours] of such property as to authorize him to subscribe a petition for street improvements" under a section of the statutes of Ohio.

In ; , the court decided that a perpetual leasehold with privilege of purchase is subject to partition. The option clause in the lease agreement in the Rawson v. Brown case was substantially similar to the clause in the lease from The F. H. Lawson Company to the Seton Realty Company granting the privilege of purchase on payment of the sum of $60,000. In discussing the question whether or not the perpetual leasehold with privilege of purchase was subject to partition, the court said:

We think that where the owner of a fee in land leases it for 99 years, renewable forever, he is still the owner of the fee. * * * The possession of the lessee is the possession of the lessor. * * * So far as the option to purchase, which is included in the perpetual lease, is concerned we do not think that until it is exercised it would affect the right of the parties as involved in this proceeding. The parties, by the inclusion of the option to purchase, recognized that the fee still resided in the lessor, his heirs and devisees.

The case of ; , involves the question of whether or not, under the Ohio statutes, the right of dower attaches to a perpetual leasehold with privilege of purchase, and in that case it was held in substance that a permanent leasehold is real property because it is an estate of inheritance and that it is, therefore, subject to dower under the statutes of Ohio. In the Ralston Steel Car Co. case the court quoted with approval the opinion in , but also stated as follows:

The estates and interests of both grantor and grantee are inheritable and descend to the heirs, and neither is subject to the laws of distribution. The grantee has a corporeal hereditament and the grantee has the right to receive the rents forever * * *.

The court also stated that the usual and ordinary "permanent lease" in Ohio contains an option of purchase clause upon the exercise of which the grantee "becomes invested with the full fee simple title."

In none of the cases which have come to our attention is it held, or said by way of dicta, that the estate granted by the respective perpetual leases with privilege of purchase is subject to defeasance by reason of failure to exercise the option to purchase. On the contrary, it appears that the estate granted by the leasehold agreements is subject to defeasance only because of failure to pay the annual rent reserved, taxes, insurance, etc., or by reason of failure to keep and perform the covenants to be performed by the lessee such as to keep buildings in repair, not to commit waste, etc. Moreover, neither in the various instruments set out in the findings of fact nor in the cited decisions is there any indication that there is any obligation on the part of the lessee of the perpetual leasehold with privilege of purchase to exercise the option to purchase. This privilege of purchase is coterminous with the duration of the perpetual leasehold. It need never be exercised. The lease may prove improvident and purchase undesirable. If the perpetual lease with privilege of purchase be, as is contended, a conveyance of a fee subject to a mortgage to secure the purchase price, then it follows that the so-called mortgage never need be satisfied, since the purchase price need never be paid. It is apparent, too, that the lease provision creating what petitioner's counsel contends is a mortgage does not secure any obligation of the lessee. It is collateral to no debt due or to grow due, and if a mortgage exists, it is the creature of judicial construction.

The taxing statutes deal with facts and not with subtleties. It is obvious that in determining questions involving the amount of initial cost and purchase price received and to be received we may include only amounts actually or constructively paid and amounts which the seller or the purchaser are under actual obligation to pay. Since neither the seller, the petitioner in this proceeding, nor the purchaser of the perpetual leasehold ever actually paid or was under any obligation to pay the sum of $60,000 in question, this amount should not be included either in the cost of the leasehold to the petitioner or in the purchase price received and to be received by him from Payton. We, therefore, approve the respondent's exclusion of the sum of $60,000 in question from these amounts.

The above holding is dispositive of the entire proceeding. Since the payment of $25,000 was in excess of 25 per cent of the selling price, it follows that petitioner must report the entire profit in the year 1923.

decision will be entered for the respondent.