Hamilton & Main, Inc. v. Commissioner

Hamilton & Main, Incorporated, Petitioner, v. Commissioner of Internal Revenue, Respondent Hamilton & Main, Inc. v. Commissioner Docket No. 49469 United States Tax Court 25 T.C. 878; 1956 U.S. Tax Ct. LEXIS 283; January 30, 1956, Filed *283 Decision will be entered under Rule 50. Petitioner as lessor received in May 1946 the sum of $ 10,000 from United Aircraft Corporation as lessee in consideration of the cancellation and termination of a 2-year lease beginning May 1, 1944, and the mutual release of each party from all obligations thereunder. The property covered by the lease, consisting of land and buildings, together with certain personal property and the right under the lease to require the tenant to repair and restore the buildings, had been acquired by petitioner in a lump-sum purchase on April 25, 1946. Held, the $ 10,000 paid to petitioner is to be treated as a return of capital and applied in reduction of petitioner's cost basis in the several properties purchased. Held, further, petitioner failed to prove that it is entitled to a deduction for depreciation on the buildings purchased by it in April 1946 in excess of that allowed by respondent. Accordingly, respondent's determination is sustained. Benjamin Nadel, C. P. A., for the petitioner. Ellyne E. Strickland, Esq., and Emil Sebetic, Esq., for the respondent. Bruce, Judge. BRUCE *878 Respondent has determined a deficiency in petitioner's income tax for the fiscal period beginning April 3, 1946, and ending March 31, 1947, in the amount of $ 4,621.73. The issues presented are: (1) Whether the sum of $ 10,000 received by petitioner as lessor from United Aircraft Corporation as lessee upon the cancellation and termination of a lease dated May 1, 1944, is taxable to petitioner as ordinary income within the meaning of section 22 (a), Internal Revenue Code of 1939. (2) Whether respondent properly determined the allowable depreciation on the buildings purchased by petitioner in 1946. FINDINGS OF FACT. Some of the facts were stipulated and are incorporated herein by this reference. The petitioner is a corporation which was organized on April 3, 1946, under the laws of the State of Connecticut. *285 It keeps its books and files its tax returns on an accrual basis. Petitioner's Federal income tax return for the fiscal period beginning April 3, 1946, and ending March 31, 1947, was filed with the collector of internal revenue for the district of Connecticut. Under date of March 29, 1946, Harry Fleisher agreed to purchase for $ 175,000 certain real estate (hereinafter sometimes referred to *879 as the Timemaster Premises) located at Hamilton and Main Streets in Waterbury, Connecticut, from the Self Winding Clock Company, formerly known as the E. J. Manville Machine Co. and the Timemaster Corporation. The real estate was improved with several buildings of a mill type construction and the purchase included certain personal property therein all as set forth in a written agreement hereinafter referred to as the agreement of sale. The agreement of sale specifically provided that the premises would be conveyed to Fleisher subject to a 2-year lease beginning May 1, 1944, and ending April 30, 1946, between the Clock Company as lessor and the United Aircraft Corporation (hereinafter sometimes referred to as United) as lessee. The agreement of sale further provided that the Clock *286 Company had made no agreement with the lessee other than that set forth in the lease dated May 1, 1944. The lease agreement provided in part as follows: Eighth: The Lessee shall at its own cost and expense make all inside and outside repairs and replacements to the buildings and garage comprising the demised premises * * * so that the same shall be in the same or similar condition as they were at the time the Lessee took possession of the same and all such repairs shall be made in good and workmanlike manner; provided that the Lessee shall not be obligated to repair any damage resulting from * * * ordinary wear, tear and deterioration or other changes or modifications made with the Lessor's prior written consent and any other conditions beyond the Lessee's control. Should the Lessee fail to make any such repair or repairs after thirty (30) days written notice from the Lessor the Lessor may cause the same to be made at the Lessee's cost and expense and charge the Lessee for the cost thereof and the Lessee shall pay all such charges as additional rent within thirty (30) days after submission to the Lessee of an invoice showing the expenditure or the incurring of any such expediture*287 by the Lessor. * * * * Fourteenth: The covenants, conditions and agreements herein contained shall be binding upon, and shall inure to the benefit of the parties hereto, and their successors and assigns. The Timemaster Premises were personally examined and inspected by Harry Fleisher in late 1943 or early 1944. At that time the property was in good repair and was offered to Fleisher for purchase at the sum of $ 225,000. In early 1946 Fleisher again inspected the property and found that considerable damage had been done to the buildings by the tenant, United Aircraft Corporation. Based upon his extensive experience over a period of 20 years in moving manufacturing plants, reconditioning buildings, and supervising the erection of new buildings, it was Fleisher's opinion at that time that the cost of repairing the damages and restoring the buildings would be around $ 15,000. United was using the buildings for storage of very heavy equipment and in moving this equipment in and out several walls had been broken down, floors had collapsed in some areas, windows had been broken, fire doors had been broken off and used *880 as flooring, and supporting beams had been damaged. Other*288 damages came to light after the tenant relinquished the premises on April 30, 1946. At the time of this second inspection Fleisher offered to buy the property in question for $ 150,000. The owner asked $ 175,000. In the oral negotiations leading to the agreement of sale and particularly to agreement on the purchase price there was discussion of the damages to the buildings and the right under the lease to require the tenant to repair and restore. Fleisher declined to pay $ 175,000 for the property (including the personalty) unless he also acquired the benefit of the restoration provisions of the lease, to which condition the seller agreed. There were no negotiations between the parties, however, assigning any specific value to the right against the tenant and the entire transaction was treated as a lump-sum purchase. On April 8, 1946, United addressed a letter to Fleisher's real estate agent admitting its responsibility under the lease to repair and restore the buildings and indicating that such work could not be done satisfactorily until the buildings were vacated. With this letter United included an estimate of the work to be done in the amount of $ 1,102 and stated its willingness*289 to make a cash settlement thereof. On April 12 Fleisher's agent replied to United by mail stating that the purchaser of the property had decided to wait until the lessee vacated the premises, at which time both parties would be in a better position to ascertain what work should be done and for which the lessee was responsible. On April 25, 1946, Fleisher, who had become an officer and stockholder of petitioner upon its incorporation, assigned the agreement of sale to petitioner by written instrument and on the same date the property covered thereby (including all rights under the above-mentioned lease save the right to rental payments) was conveyed to petitioner upon its payment of the purchase price. Between April 30, 1946, and May 13, 1946, a representative of the General Building Company of Waterbury, Connecticut, visited the Timemaster Premises and furnished an estimate of the cost of the repair and restoration of the buildings in the amount of $ 12,385. On April 30, 1946, an agreement was entered into between petitioner as lessor and United as lessee for the cancellation and termination of the lease indenture dated May 1, 1944, and the mutual release of each party from all obligations*290 thereunder. Material parts of that agreement read as follows: 1. United agrees to pay to the said Hamilton & Main, Inc., the sum of Ten Thousand Dollars ($ 10,000) receipt whereof is hereby acknowledged by the said Hamilton & Main, Inc. *881 2. Said lease is hereby terminated and cancelled and shall be of no further effect whatsoever effective as of the date of this agreement. 3. Each party to this agreement hereby releases the other from any and all obligations, agreements, covenants and promises made under or by virtue of said lease. 4. Each party to this agreement hereby releases the other of and from any claims or demands which it had, now has, or may hereafter have, under or by virtue of said lease. On May 21, 1946, United drew a check for $ 10,000 pursuant to the above agreement which check was delivered to petitioner on May 26, 1946. The real estate and the buildings thereon were in substantially the same condition on March 29, 1946, and on April 30, 1946. During the taxable period beginning April 3, 1946, and ending March 31, 1947, petitioner made no repair of the damages done by United Aircraft Corporation as lessee and incurred no expense for the restoration of the*291 property which had been covered by the aforementioned lease. OPINION. The first question with which we are presented is whether the sum of $ 10,000 received by petitioner as lessor from United Aircraft Corporation as lessee upon the cancellation and termination of the lease dated May 1, 1944, is taxable as ordinary income within the meaning of section 22 (a), Internal Revenue Code of 1939. Pursuant to an agreement dated April 30, 1946, the petitioner as lessor received in May 1946 the sum of $ 10,000 from United Aircraft Corporation as lessee in consideration of the cancellation and termination of a 2-year lease beginning May 1, 1944, and the mutual release of each party from all obligations under the lease. It seems to us quite clear that this payment of $ 10,000 to petitioner was solely in settlement of United's obligation to repair and restore as provided by paragraph eighth of the lease and no part of it was either rent or consideration for the termination of the lease. Respondent contends that the $ 10,000 paid petitioner is ordinary income within the meaning of section 22 (a). Whether or not this sum is ordinary income to petitioner must be considered in the light of the claim*292 or transaction from which it was realized. Farmers' & Merchants' Bank of Catlettsburg, Ky. v. Commissioner, 59 F. 2d 912; Swastika Oil & Gas Co. v. Commissioner, 123 F. 2d 382; Durkee v. Commissioner, 162 F. 2d 184. The facts here are that by purchase petitioner acquired buildings in a damaged condition, land, and certain personal property. As another part of the same purchase petitioner acquired the right under the above-mentioned lease to require the tenant to repair and restore *882 the buildings. 1 The total consideration of $ 175,000 represents the cost to petitioner of one conglomerate parcel of property consisting of land, personalty, and of the damaged buildings and the right to have them restored, or as viewed differently, the buildings in a restored condition. See H. Wilensky & Sons Co., 7 B. T. A. 693. If the tenant herein had made the necessary repairs and restoration the petitioner's basis in the restored buildings would have been the same as its combined basis in the damaged buildings and in the right to have them restored. *293 The fact that petitioner voluntarily agreed to accept a money settlement in lieu of actual restoration did not alter the character of that which it had acquired, whether viewed as damaged buildings and the right to have them restored or as restored buildings, and as such the settlement constituted the sale or exchange of a capital asset. See Guy L. Waggoner, 15 T. C. 496; Washington Fireproof Building Co., 31 B. T. A. 824. When so considered it must follow that all or a part of the $ 10,000 is a return of capital. Hence respondent's contention has no merit. It is not to be overlooked, however, that capital recoveries in excess of cost do constitute taxable income. Normally this would call for a determination as to the cost of the capital *294 asset sold. Such a determination is believed unnecessary in the instant case, however, insofar as ultimate tax consequences are concerned. Burnet v. Logan, 283 U.S. 404. There is evidence that at the time of his second inspection Fleisher was of the opinion that the cost of repairing and restoring the buildings would be $ 15,000. Shortly thereafter a contractor's representative inspected the premises and estimated the cost of repair and restoration to be $ 12,385. It does not appear unreasonable, therefore, to assume that the cost of the capital asset sold was at least $ 10,000, the amount received from United. On the other hand, the record reveals that in the oral negotiations leading to the agreement of sale, and particularly to the purchase price, there was discussion of the damages to the buildings and the right under the lease for their repair and restoration. The record further reveals that the purchase price was fixed with reference to the transfer of this right. There were, however, no negotiations between the parties to the agreement of sale assigning any specific value to the right. Therefore if the assumption that the cost was at*295 least $ 10,000 is not reasonable, then an allocation as to the cost of the right to have the buildings repaired and restored is not practicable or possible herein and the rule relating *883 to property acquired for a lump sum and subsequently disposed of a portion at a time would apply. The established rule for determining profit where property is acquired for a lump sum and subsequently disposed of a portion at a time is that there must be an allocation of the cost or other basis over the several units and gain or loss computed on the disposition of each part. If, however, apportionment is wholly impracticable or impossible no gain or loss is to be realized until the cost or other basis has been recovered. Nathan Blum, 5 T. C. 702; William T. Piper, 5 T. C. 1104; Inaja Land Co., Ltd., 9 T. C. 727; United Mercantile Agencies, Inc., 23 T. C. 1105 (on appeal C. A. 6); Warren v. Commissioner, 193 F. 2d 966, reversing on other grounds 16 T. C. 563. See Orvilletta, Inc., 47 B. T. A. 10.*296 Accordingly as the sum received from United is less than the aggregate cost of the several units it cannot be determined that petitioner has in fact realized gain in any amount. Therefore, no portion of the payment in question should be considered as income but the full amount must be treated as a return of capital and applied in reduction of petitioner's aggregate cost basis. We come next to the question whether the respondent properly determined the allowable depreciation on the buildings purchased by petitioner in 1946. Respondent determined depreciation upon the buildings purchased by petitioner on the basis of a 50-year expected useful life. Petitioner assigned to the buildings a remaining useful life of 25 years commencing April 1946. On brief petitioner states: "The remaining useful life of twenty-five years was based upon the composite basis, that is, the construction and mechanical portions, such as electric lighting and power lines, plumbing, heating, etc., are grouped together." In our opinion petitioner has failed to prove that it is entitled to a deduction for depreciation in excess of that allowed by respondent. The only evidence offered as to the construction of*297 the buildings was that they were of a "mill type," brick walls, wood and concrete flooring, and wood supporting beams. No evidence was offered as to the "mechanical portion" as petitioner terms it. The only testimony with respect to the age of the buildings was by one of petitioner's officers that at the time of the purchase it was the opinion of an official of the Clock Company that the buildings were then 30 years old. Accordingly, respondent's determination with respect to this issue is sustained. Decision will be entered under Rule 50. Footnotes 1. It matters not whether the work for which the tenant herein was obligated may properly be classified as repairs rather than replacements. H. Wilensky & Sons Co., 7 B. T. A. 693↩.