Thorpe v. Commissioner

SPENCER THORPE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Thorpe v. Commissioner Docket No. 97266. United States Board of Tax Appeals 42 B.T.A. 654; 1940 BTA LEXIS 972; August 29, 1940, Promulgated *972 In 1935 the petitioner received $35,000 from his lessee for breach of covenant of a lease entered into in 1924. Held, that the amount received was not from the sale or exchange of a capital asset and that the petitioner is taxable upon the entire amount as ordinary income. A. Calder Mackay, Esq., for petitioner. Byron M. Coon, Esq., and R. T. Miller, Esq., for the respondent. SMITH *654 This proceeding involves a deficiency of $2,229.93 in petitioner's income tax for the year 1935. The questions in issue are whether an *655 amount of $35,000 which the petitioner received in 1935 from his lessee in settlement of the lessee's liability under certain covenants of the lease is taxable to the petitioner as ordinary income as the respondent has determined, or as a capital gain as the petitioner contends; and whether in any event the gain from such payment is taxable to the petitioner in its entirety or whether it is taxable to him and his wife as community income in equal shares. FINDINGS OF FACT. The petitioner is a resident of Los Angeles, California, where he has lived since 1889. He was married in 1904 and has been living*973 with his wife in the State of California continuously since that time. In February 1922 the petitioner acquired a lease on a parcel of real estate in downtown Los Angeles for a period of 99 years. Pursuant to the terms of the lease agreement he erected a building on the property, which was completed in March 1924 at a cost of $24,256.14. The building was paid for prior to March 31, 1924, with funds earned by the petitioner in the practice of law after his marriage and while he was a resident of the State of California. On October 1, 1924, the petitioner subleased the property with the improvements thereon to Barker Bros., Inc., for a period of 90 years at a rental of $1,600 a month for the first five years and $2,500 a month for the remaining 85 years. Petitioner paid a commission of $7,395 in securing the sublease. Before execution of the lease agreement with Barker Bros., Inc., the petitioner's wife transferred all of her community interest in the leasehold to the petitioner, who, after execution of the sublease to Barker Bros., Inc., transferred such community interest back to the wife, by a written agreement dated March 24, 1925. The reason for the wife's transfer*974 of her community interest in the leasehold to the petitioner prior to the execution of the lease was to avoid the necessity of the wife signing the lease. The leasehold agreement of October 1, 1924, provided that the sublessee, Barker Bros., Inc., would erect on the premises at its own expense a new building costing not less than $300,000, which was to be commenced not later than November 1, 1933, and completed not later than November 1, 1934. The lease agreement further provided that Barker Bros., Inc., would furnish the petitioner a surety bond in the amount of $100,000 in guaranty of the lessee's performance of all of the terms of the lease, including the covenant to erect the building. This bond was executed by the Pacific Indemnity Co., as surety, and Barker Bros., Inc., as principal, under date of December 8, 1926. Barker Bros., Inc., failed to construct the building in accordance with the terms of the lease agreement. Upon expiration of the time *656 within which the building was to have been completed the petitioner called upon the lessee to comply with the terms of the lease agreement and gave written notice of the lessee's default to the surety. After negotiations*975 concerning the breach of the lease agreement petitioner entered into a further written agreement with Barker Bros., Inc., under date of January 7, 1935, whereby Barker Bros., Inc., agreed to pay the petitioner $35,000 cash in consideration of petitioner's surrender to it of the bond of the Pacific Indemnity Co. and the acceptance of an amendment to the lease releasing Barker Bros., Inc., from any obligation to erect a new building on the premises. This agreement of January 7, 1935, was styled "AGREEMENT AMENDING LEASE." It did not change any of the material provisions of the original leasehold agreement of October 1, 1924, except those pertaining to the erection of the new building by the lessee. In his income tax return for 1935 the petitioner reported the $35,000 which he received from Barker Bros., Inc., in that year as an amount received in the sale or exchange of a capital asset. Thirty percent thereof, or $10,500, was reported as a capital gain. In his determination of the deficiency herein the respondent has treated the entire amount of $35,000 as an ordinary gain. The $35,000 which the petitioner received from Barker Bros., Inc., in 1935 was not an amount received*976 from the sale or exchange of any interest which the petitioner held in the leasehold agreement with Barker Bros., Inc., or in the surety bond given in connection therewith. OPINION. SMITH: In this proceeding the petitioner admits that he realized a gain on the above transaction in the amount of $35,000, less the amount of $7,395 which he paid as a commission in securing the sublease, but he contends that the transaction giving rise to this gain was in substance and effect a sale or exchange of a capital asset, or capital assets, comprising his property rights in the leasehold agreement of October 1, 1924, and the surety bond given in connection therewith, and that the amount of his gain on the transaction is taxable at the capital gain rates as provided for in section 117 of the Revenue Act of 1934. Section 117 of the Revenue Act of 1934 reads in part as follows: SEC. 117. CAPITAL GAINS AND LOSSES. (a) GENERAL RULE. - In the case of a taxpayer, other than a corporation, only the following percentages of the gain or loss recognized upon the sale or exchange of a capital asset shall be taken into account in computing net income: * * * (b) DEFINITION OF CAPITAL ASSETS. *977 - For the purposes of this title, "capital assets" means property held by the taxpayer (whether or not connected with his trade or business), but does not include stock in trade of the taxpayer or other *657 property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. Granting that the petitioner's interest in the leasehold agreement and in the surety bond given in connection therewith constituted property rights which might be classified as capital assets, we do not think that there was in any sense "a sale or exchange" of those property rights. In substance the petitioner merely agreed to relieve his lessee and the lessee's surety of the obligation to erect a new building on the leased premises in consideration of the lessee's payment of $35,000 in cash. The lease itself was not sold or exchanged or canceled, but was merely amended so as to eliminate the provisions pertaining to the erection of the new building. We held in *978 Walter M. Hort,39 B.T.A. 922, that the complete cancellation of a lease for a consideration paid to the lessor was not a sale or exchange of the lease and that the amount received by the lessor for such cancellation was ordinary income and not a capital gain. In Fairbanks v. United States,306 U.S. 436, the Supreme Court held that the redemption by a corporation of its outstanding bonds before their maturity date was neither a sale nor an exchange within the commonly accepted meaning of the words. In Hale v. Helvering, 85 Fed.(2d) 819, it was held that a compromise settlement of promissory notes for an amount less than their face value was not a sale or exchange of capital assets giving rise to a capital loss deduction. In its opinion the court said: * * * There was no acquisition of property by the debtor, no transfer of property to him. Neither business men nor lawyers call the compromise of a note a sale to the maker. In point of law and in legal parlance property in the notes as capital assets was extinguished, not sold. In business parlance the transaction was a settlement and the notes were turned over to*979 the maker, not sold to him. In John H. Watson, Jr. v. Commissioner of Internal Revenue,27 B.T.A. 463, overruling Henry P. Werner v. Commissioner of Internal Revenue,15 B.T.A. 482, it was held that the payment at maturity, of the face amount of bonds purchased at a premium, was not a sale or esxchange resulting in a capital loss. If the full satisfaction of an obligation does not constitute a sale or exchange, neither does partial satisfaction. * * * We do not think that the petitioner's agreement to accept a compromise payment of $35,000 in settlement of his claim against his lessee, and the lessee's surety, for breach of a covenant of the lease was in any sense a sale or exchange of a capital asset. Petitioner submits that the amount of $7,395 which he paid as a commission in subleasing the property to Barker Bros., Inc., constituted a part of the cost of the sublease, or the surety bond, or both, and should be applied against the $35,000 which he received in the transaction. This would be true if the payment of the $35,000 had been received in a sale or exchange or other disposition of the sublease *658 but, as we have found, *980 that is not what took place. The sublease was not disposed of by the petitioner, but is still held by him. Moreover, there is no basis for an allocation of any portion of the $7,395 commission to that feature of the leasehold agreement pertaining to the erection of the building of the sublessee. We find no error in the respondent's determination that the entire amount of $35,000 represented taxable gain in 1935. A further contention is made by the petitioner, that in any event the amount of $35,000 constituted community income under the laws of the State of California and is taxable to him and his wife in equal shares. Although the petitioner and his wife filed separate income tax returns for 1935, it does not appear that any portion of the amount of $35,000 was reported by the wife in her return. It is plain from the facts above set forth, we think, that the leasehold interest which gave rise to the income in dispute was community property. It does not follow, however, that such income is not taxable to the petitioner in its entirety. For the law is well settled that the income from community property in the State of California acquired prior to July 29, 1927, the effective*981 date of the amendment to the code of California conferring a vested interest in community property upon each spouse (sec. 172(a) of the California Civil Code), is taxable in its entirety to the husband. Hirsch v. United States, 62 Fed.(2d) 128; certiorari denied, 289 U.S. 735; Helen N. Winchester, Administratrix,27 B.T.A. 798; Gouverneur Morris,31 B.T.A. 178; Clara B. Parker, Executrix,31 B.T.A. 644; Estate of J. Harold Dollar,41 B.T.A. 869. Since the petitioner acquired the original leasehold interest as well as the sublease to Barker Bros., Inc., prior to July 29, 1927, all of the income therefrom is taxable to him individually. It cannot be questioned, we think, that the $35,000 payment which the petitioner received from Barker Bros., Inc., was income arising from this leasehold interest. This amount was paid to the petitioner by his sublessee in settlement of its obligations under the leasehold agreement. In this respect it was no different from the rents or other revenue received under the leasehold agreement. In *982 Sara R. Preston,35 B.T.A. 312, 322, we said: The Board has consistently held that the test of when property is acquired for the purpose of determining whether or not it is community or separate property is not the time of the vesting of the property in the husband or receipt of the income therefrom, but the time of the inception of the rights whereby income is earned. See John M. King,26 B.T.A. 1158; affd., 69 Fed.(2d) 639; Helen N. Winchester, Administratrix,27 B.T.A. 798; Gouverneur Morris,31 B.T.A. 178; Albert J. Houston,31 B.T.A. 188. The controlling principle is that as between husband and wife: * * * when a right, legal or equitable, is acquired whether before or during marriage, all things of value into which the initial right develops *659 by the performance of conditions, the running of time or the like, or into which it is converted by an assignment, or, if the initial right rests in obligation, all that which is obtained through the performance, discharge, satisfaction, enforcement or assignment of the obligation, are deemed in law to have been acquired as of*983 the date of the acquisition of the initial right, and take the character, as separate or common, of that right. [Community Property - McKay, § 517.] We sustain the respondent in his determination that the entire amount of $35,000 is taxable to the petitioner in 1935 as ordinary income. Decision will be entered for the respondent.