*717 Pursuant to the terms of a 30-year lease entered into in 1910, the lessee, as additional rent for the premises, erected a new building on the leased property. In 1925 the parties terminated the instrument and executed a new lease for a term of 99 years. In 1932 the lessor terminated the lease because of default of the lessee and acquired repossession of the premises, including the building erected under the terms of the first lease. Held, that repossession of the property did not result in a realization of taxable income to the lessor in 1932 of the value of improvements erected by the lessee.
*423 This proceeding involves the redetermination of a deficiency of $12,306.25 in income tax for 1932. The issues raised by the pleadings are: (1) the deductibility of the sum of $500 for legal fees; and (2) whether the fair market value of improvements erected by a lessee constituted taxable income to the petitioner in the year in which the lease was terminated because of default of the lessee. At*718 the hearing the respondent conceded that the item of $500 was an allowable deduction.
FINDINGS OF FACT.
On March 26, 1910, Delia Durkheimer and Leo Friede held fee simple title to certain improved real property situated in Portland, Oregon, and leased it to Harrison G. Platt, Robert T. Platt, and the Fidelity Trust Co. for a term of 30 years commencing July 1, 1911, subject to an existing lease expiring July 1, 1914. The lessees agreed to pay as rent during the term of the lease, the sum of $448,500, of which $1,200, $1,300, $1,400, and $1,500, respectively, was payable monthly during five-year periods commencing July 1, 1921. As additional rental for the premises, the lessees agreed to erect on the premises, on or before January 1, 1912, unless delayed by inability to acquire possession from the tenant, a new building at a cost to the lessees of not less than $50,000.
The lease required the lessee to insure all buildings then upon, or thereafter erected upon the premises, against loss by fire in a sum equal to two-thirds of their value, the policies of insurance to be payable to the lessors. If the new building was damaged by fire, the lessees were required, at their own*719 expense, to repair the damage or erect a new building of the same class and of equal or greater *424 value, and if they complied with the requirements, they were entitled to receive the insurance money collected by the lessors on account of the loss. In the event fire loss occurred after June 30, 1931, the lessees had the option of terminating the lease, subject to a release of claims to the proceeds of incurance. The lessees agreed to pay all taxes assessed against the property and to "quit and deliver up the said leased premises and all erections to or upon the same to the lessors, peaceably, quietly, and in as good condition and order as the same now are or may be put in (reasonable use and wearing thereof excepted)." The lessors were given the right to "repossess themselves" of the premises in the event of default of the lessees.
On about July 13, 1911, the lessors conveyed the property, subject to the existing lease, and two other parcels of ground to the petitioner, an Oregon corporation, in exchange for all of the grantee's capital stock. At all times important since then the petitioner has been the owner of the property and the lease thereon.
In 1913 after March*720 1 the lessees, in accordance with the terms of the lease, erected a new building on the premises at a cost of $94,084.56, plus the architect's fee of 5 or 6 percent.
On May 7, 1925, the lease was terminated by an agreement, the pertinent parts of which read as follows:
WHEREAS the parties hereto have agreed to enter upon a new lease of said premises, to take effect July 1st, 1925, and to run for a period of ninety-nine (99) years thereafter, terminating at midnight of June 30, 2024,
Now, THEREFORE, IT IS HEREBY AGREED by and between the parties hereto that, upon the execution, delivery and taking effect of said new lease, siad lease of March 26th, 1910 shall terminate at midnight of June 30th, 1925, and thereafter the parties shall hold under said new lease.
On the same day the petitioner entered into a contract of leasehold with the lessees for a term of 99 years, commencing July 1, 1925, at a rental of $1,200 per month for the first year, and $1,300 per month for the next five years. Thereafter, the rent was to be increased $100 per month at the end of each five-year period until July 1, 1961, when the rental was to be $2,000 per month for the remainder of the term of*721 the lease. Installments of rental not paid when due were to bear interest at the rate of 6 percent per annum if delinquent more than five days. The lessees agreed to pay water rents and taxes and assessments assessed against the property during the term of the lease, and to insure the building at their own expense against fire in a sum equal to two-thirds of its value. The proceeds of insurance collected for losses were to be paid to a trustee designated by the lessors (1) as security for the performance by the lessees of their obligations under the lease; (2) for the purpose of repairing or reconstructing the building; and (3) for the payment of any balance to the lessees. In the event of loss by fire, the lessees agreed to make *425 necessary repairs or construct a new building of the same class and of equal or greater value, except that if the damage occurred after June 30, 2014, they had the right to terminate the lease subject to a waiver of their claims to insurance money. The lessees were authorized, subject to certain conditions, to erect a new building on the premises at their own expense. The lessors had the right to enter upon and take repossession of the premises*722 in the event of default of the lessees for a period of 60 days. Upon the termination of the lease, the lessees were to "quit and deliver up the said leased premises and all erections to or upon the same to the lessor, peaceably, quietly and in as good condition and order as the same now are, or may be put in (reasonable use and wearing thereof excepted)."
The petitioner received the sum of $75,000 from the lessees as consideration for the termination of the lease entered into in 1910 and for the execution of the lease of May 7, 1925. The petitioner included the amount in its taxable income for 1925.
On June 1, 1925, the lessees, pursuant to permission granted by the lease, executed a mortgage under the leasehold to secure the payment of bonds in the amount of $175,000.
The petitioner has never returned any amount, exception rents, as income received by it on account of improvements made to the property by the lessees in 1913.
In May 1932 the petitioner terminated the 99-year lease on account of the failure of the lessees to pay rent for that month and taxes assessed against the property for 1929, 1930, and 1931. The petitioner acquired repossession not later than August 1, 1932.
*723 In his determination of the deficiency the respondent determined that the petitioner's termination of the lease resulted in a realization of taxable income in 1932 in the amount of $89,000, representing the fair market value of the building at the time of repossession.
OPINION.
DISNEY: The respondent included the value of the improvements at the time of repossession in gross income pursuant to provisions of article 63 of Regulations 77, as amended April 10, 1935, by T.D. 4539, reported in C.B. XIV-1, 141. The regulations, after providing, in substance, that when buildings erected by a lessee immediately become the property of the lessor, as in cases where they are not subject to removal by the lessee, the lessor has the option of reporting the fair market value thereof or an aliquot part of the value, based upon the life of the lease, in the year of completion of the buildings, reads as follows:
If the lease is terminated so that the lessor comes into possession or control of the property prior to the time originally fixed for the expiration of the lease, the lessor shall report income for the year in which the lease is so terminated to *426 the extent*724 that the value of such buildings or improvements when he becomes entitled to such possession exceeds the amount already reported as income on account of the erection of such buildings or improvements. * * *
The respondent contends that the regulations are valid and govern the question. The argument is based upon the theory that in substance there was no termination prior to 1932 of the lease under the terms of which the building was erected. The case of Emma C. Morphy,35 B.T.A. 289">35 B.T.A. 289, cited by the respondent as sustaining the validity of the regulations, involved the propriety of including in income of a lessor, for the year during which a lessee erected a building on the leased premises, an aliquot part of the value of the improvements under the optional provision of like regulations promulgated under the 1928 Act. The question was a narrow one and did not include the validity of the paragraph of the regulations in question here.
The petitioner relies upon the rule announced in Miller v. Gearin,258 Fed. 225; certiorari denied, *725 250 U.S. 667">250 U.S. 667. There, as here, the lessee, pursuant to provisions of a lease, erected a new building on the realty, and, upon the termination of the lease because of default of the lessee, the Commissioner held that the lessor received taxable income in the year of repossession in an amount equal to the value of the improvements. The court held that the income was derived in a prior year during which the improvements were made, "Assuming that the building was income derived from the use of property"; that the owner acquired nothing in the taxable year "save the possession of that which for many years had been her own," and that such possession did not result in a realization of income. The rule there announced is recognized as sound, Louise C. Slack et al., Executors,35 B.T.A. 271">35 B.T.A. 271, and Emma C. Morphy, supra, and cases cited therein on the point, and is reflected in the Commissioner's regulations. G.C.M. 9755, C.B. X-2, p. 120, and opinion of Judge Chase in Hewitt Realty Co. v. Commissioner, 76 Fed.(2d) 880.
The respondent contends that *726 Miller v. Gearin, supra, and Cryan v. Wardell,263 Fed. 248, are distinguishable on the ground that in the former, ownership of the property vested in the lessor immediately upon the erection of the improvements and that in the latter, the lessee had no right to remove the building from the realty. The alleged differences in the facts do not exist. The terms of each lease involved here required the lessee to protect the petitioner against loss of the building by fire and to deliver up the premises upon the termination of the lease in as good condition as the improvements were in at the time of execution of the lease, or might be put in, ordinary wear and tear excepted.
In Louise C. Slack et al., Executors, supra, the facts were in all material respects the same as those here, and, following the reasoning of Miller v. Gearin, supra, we concluded that the lessor did not *427 realize income upon the termination of the lease in the taxable year because of default of the lessee. We reach the same conclusion here, assuming that the two leases are, in substance, but one lease.
*727 Although the petitioner relies upon the 99-year lease entered into in 1925 merely as one of several circumstances requiring a holding that it acquired the building prior to the taxable year, the fact that the petitioner acquired repossession in 1932 under the terms of a lease separate and distinct from the one under the terms of which the building was erected is an additional ground for deciding that there was no realization of income within the taxable year.
Article 48 of Regulations 65, promulgated under the 1924 Act, like article 63 of Regulations 77, supra, required lessors coming into possession of property prior to the termination of the lease to report as income in the year or repossession the value of the improvements at the time the right to take possession occurred, less the amount already reported as income. The building in question here was erected in 1913, pursuant to provisions of the lease entered into in 1910 for a term of 30 years. This lease was terminated May 7, 1925, effective June 30, 1925, 15 years prior to the expiration of its term, by mutual consent for the purpose of entering into a new lease with the same lessee, having terms in many respects different*728 from those embodied in the first lease. The intent of the parties to rescind the original lease is as clear as it was possible to express it.
It does not appear that the lessor took actual possession of the property upon the termination of the old lease, or made physical delivery under the new lease. The circumstances did not require it. There was, however, constructive delivery, first from the lessee to the lessor under the old lease, and then from the latter to the former under the new lease. Thereafter, the position of the petitioner as regards the ownership of the property was the same as though it had erected the building at its own expense. If, therefore, the old lease was terminated prior to the expiration of its term, and there appears to be little, if any, doubt about it, pursuant to the Commissioner's regulations in effect at that time, the income was realized in 1925.
Decision will be entered for the petitioner.