Opinion
Docket No. 29859.
1952-05-28
MCCULLEY ASHLOCK, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Carl T. Smith, Esq., and Ivan M. West, C.P.A., for the petitioner. Frank M. Cavanaugh, Esq., for the respondent.
1. By contract of sale on April 18, 1945, petitioner purchased real property for $40,000 and the seller retained possession and rents until August 15, 1947. Held, since the seller retained legal ownership as well as control, benefits, and unfettered command of the rents, petitioner is not taxed on the rental income which was paid to the sellers by the tenant in 1945 and up to February 7, 1946.
2. On February 7, 1946, the parties executed a ‘Receipt and Release‘ agreement upon the execution of which petitioner paid the sellers $23,527.64. It was stated in this agreement, among other things, that ‘the purchaser of said property has requested the privilege of paying the balance of the purchase consideration in cash at this time and assuming the immediate possession of the premises and the right to receive all rentals to accrue hereafter * * * . ‘ Held, that petitioner is not entitled to deduct the $23,527.64 as amortization of the cost of a lease over the remaining term of the lease, but that the $23,527.64 is to be added as additional cost to petitioner of the property and is to be recovered only through depreciation or by the disposition of the property as the Commissioner has determined. Carl T. Smith, Esq., and Ivan M. West, C.P.A., for the petitioner. Frank M. Cavanaugh, Esq., for the respondent.
Respondent determined deficiencies in petitioner's income tax for the calendar years and in the amounts as follows:
+--------------------+ ¦Year ¦Deficiency ¦ +------+-------------¦ ¦1945 ¦$2,441.61 ¦ +------+-------------¦ ¦1946 ¦5,980.54 ¦ +------+-------------¦ ¦1947 ¦2,947.41 ¦ +------+-------------¦ ¦Total ¦$11,369.56 ¦ +--------------------+
This controversy arises out of petitioner's purchase of real property, while the vendor was to retain rental income for a period of time. The primary question is whether those rents were taxable income to petitioner. Subsidiary questions dependent on the primary issue involve the proper depreciation basis and whether the subsequent purchase price of the assignment of the lease and surrender of possession can be amortized separately.
In the deficiency notice the Commissioner explained the contested adjustments as follows:
Taxable Year Ended December 31, 1945
Your income is increased $7,172.36 to include rental income on the property located at 650 East Gilbert, Wichita, Kansas. It is held that, inasmuch as you were the owner of the property, payments made to the vendors by the lessee and applied against the purchase price, represent rental income taxable to you. * * *
Taxable Year Ended December 31, 1946
Rental income from the property located at 650 East Gilbert, Wichita, Kansas is increased $3,000.00 to include the payments made to the vendors by the lessee and applied by them against the purchase price of the property.
The deduction claimed on your return as ‘Amortization of Basis of Acquiring Lease‘ in the amount of $13,444.36 is disallowed. Inasmuch as you were the owner of this property, the amount paid to the vendors in settlement of the unpaid balance on the purchase price may not be amortized. If it should be held that the rights to receive the rents represented an interest separate and apart from your purchase of the fee title to the property, then it is held that the payments, upon which the amortization deduction is based, represents additional cost of the property to be recovered only through depreciation or by the disposition of the property. Depreciation claimed in your return, for 10 months, on the property at 650 East Gilbert, Wichita, Kansas, in the amount of $875.00 is increased $1,075.00 to allow 3% of $65,000.00. It is considered that the cost basis of the depreciable improvements on the property is $65,000 and inasmuch as the property was acquired in 1945 depreciation is allowed for 12 months in 1946.
A similar explanation for the disallowance of $10,083.28 amortization claimed by petitioner as was made for 1946 is here made for 1947. A similar explanation of a $900 increase in allowance for depreciation as was made for 1946 is here made for 1947.
FINDINGS OF FACT.
The petitioner McCulley Ashlock resides in Newton, Kansas. His tax returns involved here were filed with the collector for the district of Kansas and were prepared on the cash basis.
Petitioner had been engaged in the grocery business prior to February 1945, at which time he sold the business and invested his money in real estate. Petitioner was interested in purchasing a large one-story brick and concrete factory or warehouse building located at 650 East Gilbert Street in Wichita, Kansas, hereinafter called the property. The property was owned by three co-trustees consisting of the Wheeler Kelly Hagny Trust Company, Walter Innes, Jr., and Betty Innes, hereinafter called the trustees. The Cessna Aircraft Company, a Government-financed aircraft manufacturer had leased the property for $1,500 per month under a 4-year noncancelable lease expiring on August 15, 1947, subject to a 1-year renewal option. There were negotiations and several offers by each side prior to reaching an agreement. Two of the rejected offers were the following: On March 27, 1945, the trustees submitted a written offer to sell the property for a consideration of $75,000. On April 17, 1945, petitioner submitted a written offer of $40,000, the seller to retain the property until August 15, 1947, the tentative expiration date of the Cessna lease. On April 18, 1945, the parties entered into a contract of sale which included the following provisions:
for and in consideration of Forty Thousand Dollars $40,000.00) to be paid as follows, to-wit:
Two Thousand Dollars ($2,000.00) cash upon the execution of this agreement, the receipt whereof is hereby acknowledged, and the balance of Thirty-eight Thousand Dollars ($38,000.00) to be paid in cash upon approval of title and delivery of deed.
It is further mutually understood and agreed by and between the parties hereto that the property and premises above described is now under written lease, the primary term of which expires the 15th day of August, 1947, and which lease carries an option in favor of lessee for an additional one (1) year term. As a further consideration for the sale and conveyance of the property above described, second party has, and by these presents does, agree that the parties of the first part shall be entitled to retain the possession of the above described premises and all rents and income accrued and to accrue under the lease above mentioned and for the period ending August 15, 1947. In event the lessee under said lease exercises the option of renewal and extends the original or primary term of said lease for the additional term of one (1) year, the rents reserved and to be paid during said extended period shall be paid to and received by second party herein. Parties of the first part agree that during the period expiring August 15, 1947, they will pay all taxes levied upon the property and premises above described to and including the taxes for the year 1946 and shall, in addition thereto, pay all premiums of insurance which shall mature and become payable under policies of insurance now in force and covering improvements upon said property and will pay all normal maintenance items and expenses for and during said period of time and will deliver possession of said premises to second party herein, subject only to the lease and option herein referred to, on the 15th day of August, 1947, in as good condition as the premises now are, the ordinary wear and tear alone excepted.
Pursuant to the contract of sale a deed dated June 6, 1945, was drawn which included the following provisions:
WITNESSETH, That the said parties of the first part, in consideration of the sum of One Dollar and other good and valuable considerations to it duly paid, the receipt of which is hereby acknowledged, have sold, and by these presents do grant and convey to the said party of the second part, his heirs and assigns, all of that tract or parcel of land situated in the County of Sedgwick and State of Kansas, described as follows, to-wit:
together with the buildings and improvements thereon and with the appurtenances, and all the estate, title and interest of said parties of the first part therein. And the said grantors hereby covenant and agree that at the delivery hereof, they are the lawful owners of the premises above granted, and seized of a good and indefeasible estate of inheritance therein, free and clear of all encumbrances, and that they will warrant and defend the same in the quiet and peaceable possession of the said party of the second part, his heirs and assigns, forever, against all persons lawfully claiming the same.
Under the contract of sale and deed the trustees continued their retention of the Cessna lease. A subsequent agreement dated June 11, 1945, which was five days after the execution of the deed, was drawn up and included the following provisions:
KNOW ALL MEN BY THESE PRESENTS, That whereas, the undersigned McCulley Ashlock, party of the first part, is now the owner of the fee to the real property hereinafter described, as evidenced by deeds of conveyance executed by the Wheeler Kelly Hagny Trust Company and W. P. Innes, Jr., co-trustees, and the Wheeler Kelly Hagny Trust Company and Betty S. Innes, co-trustees, the parties of the second part herein, and
WHEREAS, under the terms of the sale and the conveyance under deeds hereinabove mentioned and as a part of the purchase consideration for said property and premises, the second parties herein were to have and reserve the right of possession of said premises and all of the rents and income accrued and to accrue under the lease above mentioned for the period ending August 15, 1947, and
does hereby ratify and confirm unto the second parties herein the right of possession of the above described property and premises for the term ending August 15, 1947, subject only to the outstanding lease now on said property and premises to Cessna Aircraft Company and first party by these presents assigns, transfers and sets over as a part of said purchase consideration all of the rents and income accrued and to accrue under the lease herein mentioned and for the period ending August 15, 1947, and authorizes Cessna Aircraft Company to make payment of all rentals during said period of time to the second parties herein.
It is by the parties further agreed that in the event of the damage to or destruction of the improvements upon the premises above described, the proceeds of all insurance in force at the time of said loss shall, subject only to the conditions hereinafter set forth, be devoted to the repair or restoration of the improvements so damaged or destroyed but first party shall not be liable to second parties for the loss of use or income from the damaged or destroyed premises during the period of their repair or reconstruction.
It is further agreed that in event of the total destruction of the improvements upon said premises prior to the 15th day of August, 1947, first party shall have the option of rebuilding or restoring said premises or of retaining the proceeds of the policies of insurance covering such loss and destruction and applying the proceeds as follows: by distribution to second parties of an amount equal to the rentals that shall remain unpaid from the date of loss until the expiration of the Cessna Aircraft Company lease on August 15, 1947, and distribution of the remaining portion to the first party herein.
On its books and tax returns the trustees treated the rents collected under the lease as payments on an unpaid balance of a $75,000 sale price. Petitioner on his books and tax returns assumed that the property was purchased for $40,000, the trustees retaining a term of years in the property.
On February 7, 1946, the parties entered into an agreement which was termed ‘Receipt and Release.‘ This written instrument included the following terms:
WHEREAS, the said purchaser paid to sellers the initial consideration of Forty Thousand Dollars ($40,000.00) as provided under said contract; and
WHEREAS, subsequent to the date of said agreement, the sellers have received and credited upon the sales consideration the monthly installments of rents reserved and payable under the lease outstanding upon the premises above described; and
WHEREAS, under the terms of said agreement of April 18, 1945, the sellers reserved and are entitled to the continued possession of the above described premises and all rents and income accrued and to accrue under the lease outstanding upon said premises and for the period ending August 15, 1947, but are obligated to pay all taxes upon said property and premises to and including the taxes for the year 1946; and
WHEREAS, the purchaser of said property has requested the privilege of paying the balance of the purchase consideration in cash at this time and assuming the immediate possession of the premises and the right to receive all rentals to accrue hereafter under the lease upon said premises, which request the sellers have, under the conditions hereinafter stated, agreed to.
1. Party of the Second Part shall concurrently with the execution of this Receipt and Release pay to First Parties the sum of Twenty-three Thousand Five Hundred Twenty-seven Dollars and Sixty-four Cents ($23,527.64).
2. The First Parties agree and do hereby surrender the possession of the premises above described to Second Party and assign to Second Party all rentals reserved and hereafter payable under the terms of the lease now outstanding upon the demised premises.
On the execution of this agreement the First Parties acknowledge and agree that the full purchase consideration as provided under said agreement of April 18, 1945, shall have been fully paid and the title to the property described therein to be fully vested in the Party of the Second Part, including the full right of possession thereof, and to all rents hereafter to accrue under the outstanding lease on said property.
Subsequent to February 7, 1946, the lessee paid the rent to the petitioner and he was thereafter vested with the right of possession to the premises. As consideration for the execution of this ‘Receipt and Release,‘ petitioner McCulley Ashlock, who was designated as party of the second part, paid to the trustees, who were designated as parties of the first part, the sum of $23,527.64.
Petitioner's income tax returns for the years 1945 and 1946 contained an explanatory statement which recited that petitioner had purchased the title to the property in question and that the rents received by the co-trustees under the Cessna lease prior to February 7, 1946, were not his income. Petitioner's income tax returns for 1946 and 1947 returned as income the rents which he received from the Cessna Aircraft lease subsequent to the execution of the ‘Receipt and Release‘ agreement by the parties on February 7, 1946. Also, in his income tax return for the year 1946 petitioner claimed a deduction from income in the amount of $13,444.36 as ‘Amortization of Basis of Acquiring Lease.‘ In his return for the year 1947 petitioner claimed a similar deduction in the amount of $10,083.28.
In his determination of the deficiencies, the respondent added to petitioner's gross income for each of the years 1945 and 1946, the rent paid to the co-trustees by the Cessna Aircraft Company. Also, for the years 1946 and 1947, the respondent disallowed as a deduction from gross income the amounts claimed as ‘Amortization of Basis of Acquiring Lease‘ and determined that such amounts represented additional cost of the property to be recovered only through depreciation or by the disposition of the property. In each of the years 1945, 1946, and 1947, respondent in his determination of the deficiencies has allowed petitioner a deduction for depreciation based on a cost of $65,000 for the improvements on the property which is here involved.
OPINION.
BLACK, Judge:
This proceeding raises two issues arising out of petitioner's purchase of property from trustees who continued to receive rental income until February 7, 1946. These two issues may be stated as follows:
1. Were the amounts of rentals paid to the sellers of the property by the lessee, Cessna Aircraft Company, during 1945 and up to February 7, 1946, taxable to petitioner because they were applied in part payment of the purchase price which petitioner had agreed to pay for the property?
2. Is petitioner entitled to have deducted from his gross income in 1946 and 1947, amortization of $13,444.36 and $10,083.28, respectively, on account of a payment of $23,527.64 which he paid to the sellers of the property upon the execution of a ‘Receipt and Release‘ agreement executed February 7, 1946?
Issue 1.
Respondent determined that the entire property was purchased on April 18, 1945, for $75,000; $40,000 was paid in cash and petitioner assigned the rents to the sellers until August 15, 1947, to be applied toward the purchase price. But petitioner contends that the total consideration for his purchase on April 18, 1945, was $40,000 and that the trustees, under written agreement, retained the income and possession of the property until August 15, 1947.
The proposed and rejected offers, testimony, and accounting-tax treatment indicate that each party intended or at least hoped that the Cessna rents would not be taxable income to him. Equally clear is the fact that the rental income is taxable to one, but only one, of the parties. In deciding who is taxable on these rental payments in 1945 and up to February 7, 1946, we are concerned with the contracts which were executed by the parties in arm's length transactions. ‘But the question of the legal effect of the contract upon income tax depends upon the contract itself, rather than upon circumstances motivating its execution.‘ See Wood Process Co., 2 T.C. 810,816.
The essential agreement that governed the original transfer of the property in question to petitioner was the contract of sale on April 18, 1945, and the deed on June 6, 1945. The deed and contract of sale are to be construed together. Livingston v. Story, 36 U.S. 351, 385-386; Coughran v. Bigelow, 164 U.S. 301, 310. The contract of sale is not ambiguous. The ‘consideration‘ was $40,000, and the trustees were ‘entitled to retain the possession of the above described premises and all rents and income accrued and to accrue under the lease above mentioned and for the period ending August 15, 1947.‘ Thus, under this language the trustees retained possession and rents until August 15, 1947, and transferred the remainder interests to petitioner. Under real property law interests may be carved up and any quantity may be transferred. The grantor can reserve rents for a term of years while transferring the fee and all other interests in Kansas. Pitts v. Blair Milling Co., 117 Kan. 626, 233 P. 114, 116; Tiffany, Real Property, 3d ed. vol 3 sec. 881, p. 532.
The subsequent agreement dated June 11, 1945, merely confirms the retention of rents by the trustees and adds some new terms. That agreement could not constitute an assignment of rental income by petitioner until August 15, 1947, since petitioner did not own those rights at that time. He had never acquired them. ‘It is the general rule that an assignment at law will not be sustained unless the subject-matter has an actual or potential existence when the assignment is made * * * .‘ Clendening v. Wyatt, 54 Kan. 523, 38 P. 792, 793.
The conclusion that the rental income was legally retained by the trustees and initially only a remainder interest was purchased by petitioner does not by itself absolve petitioner from income taxes. In Corliss v. Bowers, 281 U.S. 376, 378, Mr. Justice Holmes stated:
But taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed— the actual benefit for which the tax is paid. * * * The income that is subject to a man's unfettered command and that he is free to enjoy at his own option may be taxed to him as him income, whether he sees fit to enjoy it or not. * * *
Here, the trustees not only retained the rents legally but they also retained control and benefits of ownership. Under the contract of sale on April 18, 1945, the trustees specifically agreed to pay property taxes, insurance premiums, and ‘all normal maintenance items and expenses,‘ so that the property would be delivered to petitioner in the present condition except for normal wear and tear. Furthermore, the June 11, 1945, agreement stated that in the event that the property was damaged or destroyed, and loss of income during the period of repair or reconstruction would be the trustees' loss. It further provided that insurance proceeds would be devoted to restore and repair the property, except in the event of total destruction petitioner would have the option of rebuilding the premises or compensating the trustees for unpaid rent. Thus the trustees bore the risks of ownership of the rents and managed the property. Larger expenses or a cessation of rents were risks incurred by the trustees. Petitioner did not guarantee any fixed net profit nor have any other obligation to support the trustees' contention that rents were payments on a $75,000 consideration. The rental income was not part of a debtor-creditor relationship; it was subject to the trustees' unfettered command.
A legal owner of property is not taxed on income which he has no legal rights to claim and does not control or receive any benefits therefrom. Similar conclusions were reached in the following cases. The owner of real estate who transferred rents only while retaining a reversion was not taxed on rents. United States v. First Nat. Bank of Birmingham, 74 F.2d 360; Lum v. Commissioner, 147 F.2d 356, affirming in part and reversing in part a Memorandum Opinion of this Court, February 26, 1944; Edward G. Swartz, Inc., 25 B.T.A. 1065, affd. 69 F.2d 633; R. E. Nail, 27 B.T.A. 33. A purchaser of oil interests was not taxed on income which was retained either by a seller, Thomas v. Perkins, 301 U.S. 655, or by a mortgage of a mortgage which was not assumed, J. Gregory Driscoll, 3 T.C. 494.
We hold that petitioner is not taxable on the $7,172.36 rents which the Commissioner added to the income reported on his return for the year 1945. We also hold that he is not taxable on the $3,000 rentals which the Commissioner added to the income reported by petitioner on his return for 1946 and which $3,000 represented rentals collected by the sellers prior to the execution of the written instrument of February 7, 1946, designated as ‘Receipt and Release.‘
Issue 2.
Petitioner returned as income on his 1946 and 1947 returns the amounts of the rentals which he received from Cessna subsequent to the execution of the ‘Receipt and Release‘ agreement of February 7, 1946. He, however, claims that these amounts represented income to him under a lease which he acquired from the sellers by assignment and that inasmuch as the lease with Cessna was to expire August 15, 1947, the $23,527.64 which he paid to the sellers upon the execution of the ‘Receipt and Release‘ instrument is amortizable over the remaining term of the lease. In pursuance of this claim, petitioner has deducted from the gross income reported on his 1946 return the sum of $13,444.36 as ‘Amortization of Basis of Acquiring Lease.‘ He has deducted from gross income reported on his 1947 return $10,083.28 as amortization with the same explanation as that given for 1946. The Commissioner has disallowed the foregoing amortization deductions. In disallowing the deductions, the Commissioner stated in his deficiency notice:
The deduction claimed on your return as ‘Amortization of Basis of Acquiring Lease‘ in the amount of $13,444.36 is disallowed. Inasmuch as you were the owner of this property, the amount paid to the vendors in settlement of the unpaid balance on the purchase price may not be amortized. If it should be held that the rights to receive the rents represented an interest separate and apart from your purchase of the fee title to the property, then it is held that the payments, upon which the amortization deduction is based, represents additional cost of the property to be recovered only through depreciation or by the disposition of the property.
As has already been explained under Issue 1, we have held that the rents prior to February 7, 1946, had been reserved by the sellers and did represent an interest separate and apart from petitioner's purchase of the land and were not taxable to petitioner. However, we do not think that the same may be said of the rents which Cessna paid to petitioner after the execution of the ‘Receipt and Release‘ agreement. That agreement contains, among others, the following provisions:
WHEREAS, the purchaser of said property has requested the privilege of paying the balance of the purchase consideration in cash at this time and assuming the immediate possession of the premises and the right to receive all rentals to accrue hereafter under the lease upon said premises, which request the sellers have, under the conditions hereinafter stated, agreed to.
On the execution of this agreement the First Parties acknowledge and agree that the full purchase consideration as provided under said agreement of April 18, 1945, shall have been fully paid and the title to the property described therein to be fully vested in the Party of the Second Part, including the full right of possession thereof, and to all rents hereafter to accrue under the outstanding lease on said property.
Under the foregoing provisions of the ‘Receipt and Release‘ agreement, we think it should be held that the $23,527.64 payment which petitioner made on February 7, 1946, was made as respondent has determined, as ‘additional cost of the property‘ and is to be recovered through depreciation in so far as the improvements are concerned and not by way of amortization deductions over the remaining life of the Cessna lease, as petitioner claims in this proceeding.
For tax purposes of depreciation, we see no difference between this situation and one in which real property, including the right to collect rent, was purchased subject to an outstanding lease. Petitioner here has done substantially the same thing, but in two steps. Subsequent to petitioner's purchase under the ‘Receipt and Release‘ agreement of February 7, 1946, petitioner owned the fee simple of real property with all rights of possession except as to the Cessna lease. Respondent has allowed petitioner in each of the years 1946 and 1947 depreciation deductions of 3 per cent based upon a cost basis of $65,000 for the improvements on the property which petitioner purchased from the sellers. The pleadings do not raise any issue as to this rate of 3 per cent or the cost basis of $65,000 for the improvements situated on the property. Therefore, the allowances for depreciation which respondent has allowed in his determination of the deficiencies for the years 1946 and 1947 will remain undisturbed in a recomputation under Rule 50.
The Commissioner is sustained in his disallowance of amortization of $13,444.36 for the year 1946 and in his disallowance of amortization of $10,083.28 for the year 1947.
Decision will be entered under Rule 50.