Sutliff v. Commissioner

WALTER H. SUTLIFF, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Sutliff v. Commissioner Docket No. 103669. United States Board of Tax Appeals 46 B.T.A. 446; 1942 BTA LEXIS 869; February 25, 1942, Promulgated *869 The petitioner's son, the fee owner of certain real estate, gave the petitioner a lease thereon. Thereafter in connection with the sale of the property and during the term of the lease the petitioner executed to the purchaser a quitclaim deed to the property, reciting his intent to convey thereby all of his rights and interest in the property and more particularly to convey all his rights under the lease. No other instrument of conveyance was executed by the petitioner, nor was any instrument of cancellation executed between him and the son, nor was any endorsement of cancellation made on the lease instrument. Held: (1) The petitioner did not cancel his lease but sold it. (2) In computing his gain on the transaction, the petitioner is entitled to the use of a basis. (3) The lease was a capital asset in the hands of petitioner and the gain therefrom was capital gain. David A. Gaskill, Esq., for the petitioner. Thomas F. Callaham, Esq., for the respondent. TURNER *446 The Commissioner determined a deficiency of $3,355.87 in the petitioner's income tax for 1937. The only issues presented are whether the gain realized by the petitioner*870 in 1937 on the disposition of a lease owned by him was capital gain and if so whether the petitioner was entitled to use a basis in computing the amount of his gain. FINDINGS OF FACT. The petitioner is a resident of Cleveland Heights, Ohio, and filed his income tax return for 1937 with the collector of internal revenue for the eighteenth district of Ohio. The petitioner was born January 23, 1878, and is the widower of Bassie T. Sutliff, who died August 3, 1909. Taylor H. Sutliff, only son of petitioner and Bessie T. Sutliff, was born July 31, 1909. *447 Bessie T. Sutliff died seized of a certain parcel of land situated in Jackson, Michigan. The property was known as No. 167 West Michigan Avenue and a three-story business building was located thereon. Bessie Sutliff left a will executed in November 1906 in which, except for a specific bequest of $500, she devised and bequeathed to the petitioner her residuary estate, which included the property in Jackson, Michigan. The will was offered for probate but was never admitted, the petitioner being advised that it had been revoked by the birth of the petitioner's son. The petitioner was told by the probate judge of*871 Jackson County, Michigan, that he had a life estate in the property and that the fee was vested in his son, Taylor H. Sutliff. From 1909 to 1929, during the infancy and minority of his son, the petitioner managed and controlled the property in the belief that he was the life tenant. In 1929, however, and in connection with the negotiation of a long term lease on the property to the Lourim-Yocum Co. of Jackson, Michigan, he learned that under the law of descent and distribution in the State of Michigan he had no interest in the property and that title thereto was vested in his son. The petitioner then qualified as special guardian of his son in the Probate Court of Jackson County, Michigan. As such guardian he leased the property to the Lourim-Yocum Co. for a term commencing August 1, 1929, and expiring May 31, 1956, at a rental of $7,200 a year from August 1, 1929, to January 31, 1936; $7,750 a year from February 1, 1936, to January 31, 1946; and $8,750 a year from February 1, 1946, to May 31, 1956. The lease was duly recorded in the Register's Office of Jackson County, Michigan. The petitioner, at or about the time of the negotiation of the lease to the Lourim-Yocum Co. *872 , discussed the situation with his son, who, though still a minor, had been in business about two to two and one-half years. The petitioner stated that he was disturbed over the situation because it would cast doubt on all that had been done in the past 20 years as well as what would be done in the future. The son told him not to worry as he would be of age the next year and then they would enter into some kind of an agreement. During the following year they discussed the kind of agreement they would make. The son thought the petitioner was entitled, morally if not legally, to an interest in the property. During the year they arrived at an agreement which the son, who had been in the insurance business and was familiar with life expectancies, thought was fair. The son became of age on July 31, 1930, at which time the petitioner was approximately 53 years of age. The petitioner and his son again discussed the matter and on August 5, 1930, the son leased the property to the petitioner for a nominal consideration of $25 a year, the lease *448 to terminate upon the death of the petitioner or on May 31, 1956, whichever first occurred. Under the lease the petitioner acquired*873 and assumed all the rights and liabilities arising from the lease which he, as special guardian, had entered into with Lourim-Yocum Co. In addition to the nominal rental, petitioner was to pay all real estate taxes and water rents assessed against the property during the term of his lease and at his own expense comply with the laws, rules, orders and regulations of the Federal, state, and city governments applicable to the property. All improvements, additions, alterations, or repairs made to the property were to be at the expense of petitioner. At the termination of the lease all alterations, additions, and erections on the property were to become a part of the demised premises. The petitioner could not assign the lease without the written consent of his son. The lease also contained a provision for its termination in event of nonpayment of rent for a period of 60 days after it should become due or in event the petitioner should be adjudicated a bankrupt. The lease was recorded on September 4, 1930, in the deed records of the Register's Office of Jackson County, Michigan, liber 324 of deeds, pages 491, 492, and 493. The lease to petitioner remained in full force and effect*874 until the consummation of a certain transaction with Floyd D. Avis, hereinafter described. At all times subsequent to the execution of the lease and prior to the Avis transaction, the petitioner managed said property, collecting rentals from tenants occupying it, and saw that the charges required by the terms of the lease were paid. The Lourim-Yocum Co. defaulted in the payment of rentals required under its lease and by reason thereof the lease to it was terminated on or about December 21, 1932. The property remained vacant until June 1, 1933, when The Great Atlanctic & Pacific Tea Co., sometimes referred to as A & P, took possession under a lease from the petitioner for a term of two years, with a renewal term of two years. A & P continued in possession of the property as lessee and occupied it as a tenant at the time of its sale to Avis as hereinafter described. In December 1936 an offer to purchase the property was received from Floyd D. Avis of Jackson, Michigan. After discussing the offer the petitioner and his son decided that it would be advantageous to them to sell the property. Counsel was consulted and prior to the preparation of the purchase and sale agreement*875 the son, as "owner" of the property, and the petitioner, as "lessee", entered into a written agreement which was prepared for them by their counsel. Pertinent portions of the agreement are as follows: WHEREAS, Owner owns the fee simple title to the said property: WHEREAS, Lessee holds and is tenant under a lease of said premises dated August 1, 1930, and expiring May 31, 1956, unless sooner terminated by Lessee's death; and WHEREAS parties hereto have received from one Floyd D. Avis, of Jackson, Michigan, an offer to purchase the fee simple title to said premises for the *449 gross purchase price of Sixty-two Thousand Five Hundred Dollars ($62,500.00) less adjustments and the unpaid balance due upon a first mortgage to the New York Life Insurance Company and certain taxes and assessments; and WHEREAS, the parties desire to accept said offer and complete said sale and divide the net proceeds; Now, THEREFORE, Owner and Lessee, in consideration of the promises and covenants hereinafter set forth, agree as follows: That both Owner and Lessee will accept the purchase agreement and evidence such acceptance by signing duplicate originals thereof. Lessee agrees to cause*876 his lease to be cancelled and released of released of record as a part of the closing of the transaction. Owner agrees to execute the necessary deeds and other documents necessary to consummate and complete the sale and transfer in accordance with the terms and provisions of said purchase agreement. Out of the proceeds of the purchase price, there shall be paid all sums necessary to make adjustments of taxes and assessments, pro-ration of rents, and any and all other charges and expenses, including real estate commissions and attorneys' fees, and Owner hereby appoints Lessee to act in his behalf in closing the transaction and making or authorizing such deductions and payments. After all such charges, deductions and payments have been made, the net proceeds arising from such sale shall be divided between Owner and Lessee so that each shall receive one-half thereof. The equal division of net proceeds provided for in the foregoing agreement represented the son's suggestion and was thought by petitioner and the son roughly to approximate their repective interests in the property under the mortality tables. The son never said anything to the petitioner about paying the petitioner*877 a sum of money to cancel the lease or otherwise in connection with the transaction. The agreement was primarily for the purpose of providing for a division of the proceeds to be received from the property. The insertion therein by counsel of the provision that "Lessee agrees to cause his lease to be cancelled and released of record as a part of the closing of the transaction" was purely procedural and to provide for the petitioner's disposition of his interest in the property on account of his lease. In inserting the provision counsel did not mean that the parties were intending to follow the particular method which cancellation would imply. Subsequent to the execution of the written agreement between the petitioner and the son respecting the division of the proceeds to be realized from the sale of the property, the petitioner and the son received a purchase and sales agreement prepared by Avis, the purchaser of the property. Certain minor changes were made in the agreement by counsel for the petitioner and the son and under date of December 23, 1936, the son as "owner" of the property and the petitioner as "lessee" of the property, both designated as "sellers", executed the*878 purchase and sale agreement with Avis, who was designated therein as the "purchaser." In this agreement the "sellers" agreed to sell and the "purchaser" agreed to buy the property for the sum of *450 $62,500, the "purchaser" agreeing to accept the property subject, among other things, to the lease of A & P. Pursuant to the provisions of the purchase and sale agreement the petitioner's son, on January 4, 1937, executed and delivered a warranty deed conveying all his interest in the property to Avis. The deed contained a recital that Avis accepted the property "subject to the occupancy of said premises in connection with the adjoining premises on the wast by The Great Altantic & Pacific Tea Company under lease, and does hereby agree to hold the vendor harmless as to the condition or terms of said lease." On the same day the petitioner executed and delivered to Avis a quitclaim deed to the property which contained, among others, the following provision: It is the intent of this conveyance to convey herein all rights and interest of said vendor in said property, and more particularly to convey all rights of said vendor under lease dated August 5, 1930, between Taylor Hurst*879 Sutliff and Walter H. Sutliff and recorded in Liber 324 of Deeds on pages 491-2-3 in the office of the register of deeds for Jackson County, Michigan, on the 4th day of September, 1930. The warranty deed from the son and the quitclaim deed from the petitioner were drawn by the purchaser of the property or by his representative and after delivery to the purchaser were recorded simultaneously. Aside from the quitclaim deed given by petitioner to Avis, the petitioner executed no other form of conveyance of his lease nor was there any instrument of cancellation of the lease executed by the son and the petitioner nor was any endorsement of cancellation made on the lease instrument. The cash proceeds from the sale of the property were paid by check of Avis drawn payable to the petitioner and the son. The check was endorsed by both the petitioner and the son and deposited in the petitioner's bank account with the Cleveland Trust Co. The petitioner then gave the son a check for the son's share. The petitioner and the son divided the net proceeds equally between them pursuant to their previous written agreement, and the amount received by the petitioner from the transaction was*880 $28,896.62. In his income tax return for 1937 the petitioner reported his share of the net proceeds from the transaction as $28,896.62. Treating the lease as a gift from the son, the petitioner computed the cost basis thereof to him to be $13,224.22 and showed a net gain of $15,672.60 from the transaction. On the ground that the property was a capital asset and had been held for more than 10 years and that therefore only 30 percent of the amount of $15,672.60 or $4,701.78 was includable in income, the petitioner entered only that portion of the gain as income in his return. In determining the deficiency the respondent determined *451 that the $28,896.62 represented ordinary income and that the entire amount thereof was taxable. OPINION. TURNER: The first question to be considered is whether the portion of the net proceeds received by petitioner from the sale of the property represented consideration received from the sale of his lease, as petitioner contends, or was payment to him for the cancellation of his lease, as respondent contends. In support of his contention the respondent points to the agreement between the petitioner and the son respecting the division*881 of the net proceeds and containing the provision that the petitioner agreed "to cause his lease to be canceled and released of record as a part of the closing of the transaction", and urges that under the decision in Hort v. Helvering,313 U.S. 28, the amount received by petitioner was essentially a substitute for the rental payments which the petitioner might receive throughout the unexpired period of his lease. From the testimony of Robert F. Bingham, the attorney who drew not only the lease for the petitioner but also the agreement containing the above quoted provision, it appears that said provision was intended to be merely procedural and for the purpose of providing for the petitioner's disposition of his interest in the property, and that it was not inserted to show that the parties were intending to follow the particular method which cancellation would imply. The sale of the property was consummated by two deeds which were prepared by the purchaser or his representative. The petitioner's conveyance of his interest in the property was by quitclaim deed which indicated the petitioner's intention to convey all his rights and interest in the property including*882 all his rights under his lease. Aside from the quitclaim deed, petitioner executed no other form of conveyance of his lease nor of his interest arising therefrom. Neither was there any instrument of cancellation executed by the petitioner and the son nor was any endorsement of cancellation entered on the lease instrument. In addition, the warranty deed from the son to Avis specifically provided that the latter accepted the premises subject to the occupancy thereof by A & P under a lease. This indicates an intent to preserve as between Avis and A & P the latter's rights and liabilities with respect to the property arising from its lease, which was obtained from the petitioner, who in turn held his lease from the son. From the evidence before us we are unable to find that the petitioner canceled his lease or that the amount received by him from the sale of the property was anything other than consideration received by him through the sale of his leasehold interest. We are also unable to see wherein the decision in Hort v. Helvering, supra, is applicable *452 to the instant case. In the Hort case the taxpayer was the owner of certain real estate*883 which he had acquired by devise from his father in 1928. Prior to his death the father executed a lease on a portion of the property to a trust company for a period of 15 years beginning on February 1, 1932, at an annual rental of $25,000. In 1933 the trust company found it unprofitable to continue the occupancy of the property. After some negotiations the taxpayer in December 1933 canceled the lease in consideration of the payment to him of $140,000 by the trust company. In his income tax return for 1933 the taxpayer claimed a loss deduction on the transaction of $21,494.75 on the theory that the amount he received for cancellation was $21,494.75 less than the difference between the present value of the unmatured rental payments and the fair rental value of the portion of the property covered by the lease. The respondent disallowed the loss deduction claimed and included the $140,000 in income. The Court held that the taxpayer was not entitled to deduct the claimed loss because to allow it would result in the reduction of ordinary income actually received and reported by the amount of income that the taxpayer had failed to realize, a result which was not permissible under the*884 act. It was also held that the $140,000 received was essentially a substitute for the unmatured rental payments under the lease and as such constituted ordinary income and not capital gain. Obviously the factual situation in the instant case is materially different from that in the Hort case. That case was grounded on the uncontroverted and apparently conceded fact that the taxpayer had canceled a lease on real estate which he owned in fee. Here the petitioner was not the owner of the fee nor was the amount in controversy received by him from his lessee. After the sale of his lease he no longer owned any interest in the property. To apply to the instant case the rule of the Hort decision would be the equivalent of holding that when the owner of an interest in a rental property disposes of such interest the consideration received therefor in excess of the cost basis is essentially the equivalent of anticipated rentals therefrom. We find nothing in the Hort decision to indicate that the Court intended that it should be given such a construction. Under his lease from the son the petitioner was required to pay a rental of $25 a year for the property. Concededly*885 such a rental was nominal and obviously was not intended to and did not approximate the annual rental value of the property. Under the circumstances we think the lease is to be considered as a gift from the son to the petitioner. Since the lease appears to have been of considerable value, it is our opinion that for the purpose of computing the gain to the petitioner from its disposition he is entitled to the use of a basis. Secs. 111(a) and 113(a)(2) of the Revenue Act of 1936. At the hearing the parties stipulated that in event we should hold that the petitioner *453 is entitled to a basis in computing his gain from the transaction the amount of such basis is $7,909.90. Accordingly we hold that amount to be the basis to which the petitioner is entitled. The lease was an asset in the hands of the petitioner and we think comes within the definition of capital assets as contained in section 117 of the applicable act. Therefore the gain realized by the petitioner from the sale of the lease was capital gain within the meaning of that section of the act. But compare *886 John D. Fackler,45 B.T.A. 708, arising under section 117 of the Revenue Act of 1938, which contained a different definition of capital assets from that contained in the act applicable herein. In his petition the petitioner alleged that only 30 percent of the gain realized from the sale was to be taken into account in computing net income. However, on brief he concedes that he held the lease for more than five years but less than ten years. In view of this and in accordance with the provisions of section 117, supra, 40 percent of the gain is to be taken into account in computing his net income. Decision will be entered under Rule 50.