1946 U.S. Tax Ct. LEXIS 46">*46 Decision will be entered under Rule 50.
Petitioner, as lessor, executed a ground lease upon certain property, under the terms of which the lessee was obligated to erect a building to cost not less than $ 3,000,000, the lessor being obligated to furnish $ 1,026,227.50 of the cost of its construction. The lessee was not obligated to repay this amount, but merely to keep the building in good repair and operating condition. The term of the lease exceeded the useful life of the building. Held, the lessor had a capital investment in the building in the amount of its contribution to its cost, upon which it was entitled to depreciation over the useful life of the building.
7 T.C. 1061">*1061 Respondent has determined deficiencies in income tax of $ 51.54, $ 146.95, and $ 184.51 for the calendar years 1939, 1940, and 1941, respectively. The petitioner claims an overpayment in such taxes for each of the years involved. The issue is whether in each of the taxable years petitioner is entitled to the deduction of depreciation on that portion of the cost of a building supplied by1946 U.S. Tax Ct. LEXIS 46">*47 petitioner and erected by its tenant on land held under a ground lease from petitioner.
Most of the facts were stipulated and we so find them. Additional facts to those stipulated are found upon testimony and exhibits presented at the hearing.
FINDINGS OF FACT.
The petitioner is a Pennsylvania corporation, with principal place of business in Pittsburgh, Pennsylvania. Strasswill Corporation and Grant Building, Inc., are both Pennsylvania corporations, each having its principal office in Pittsburgh, Pennsylvania. Petitioner's returns for the taxable years were filed with the collector of internal revenue for the twenty-third district of Pennsylvania, at Pittsburgh, Pennsylvania.
On July 30, 1927, the petitioner entered into a written agreement with Strasswill Corporation, evidencing the fact that it was engaged in the acquisition of three adjoining parcels of land in Pittsburgh. Under this agreement Strasswill Corporation was given an option to lease this property, if acquired by petitioner, upon the condition that the lessee erect on the premises an office and garage building to cost not less than $ 3,000,000. By this agreement petitioner bound itself to furnish the sum of $ 1,030,877.951946 U.S. Tax Ct. LEXIS 46">*48 of the sum required to construct the building, it being provided that this total amount should 7 T.C. 1061">*1062 be expended and applied exclusively by the lessee on account of the cost of the construction and completion of the building.
On the same date that this agreement was executed, Strasswill Corporation assigned to Grant Building, Inc., all of its rights under the contract and, on August 1, 1927, Grant Building, Inc., served formal notice upon petitioner of its exercise of the option granted by the contract.
On August 5, 1927, Grant Building, Inc., entered into a contract with Thompson-Starrett Co. for the erection of an office building and garage at a cost limit of $ 4,350,000, upon the property to be leased from petitioner. On August 16, 1927, a lease agreement was entered into by petitioner with Grant Building, Inc., under the terms of which the latter was leased the three parcels of land, hereinbefore referred to, for a term of 99 years, with privilege of several successive renewals for terms of 99 years. The rental to be paid was $ 138,000 per year, with a proviso that it should be reduced by 6 per cent upon the amount of any award of compensation to the lessor in a pending1946 U.S. Tax Ct. LEXIS 46">*49 proceeding for condemnation of part of the property for street purposes. Under this proviso the rental was reduced to $ 130,000 per year.
Under the lease, the lessee obligated itself to erect the building at a cost of not less than $ 3,000,000 and in accordance with plans and specifications approved by petitioner and, during the term of the lease, to pay taxes and insurance and, in case of destruction of or damage to the building, to replace it in such manner as should make it or the substitute therefor as nearly as practicable of the same character and condition as the building so destroyed or damaged. The lease further provided:
* * * during the term of this lease the Lessee shall at all times keep in good order and repair inside and out all buildings and structures hereafter constructed on or appurtenant to said premises, including any and all equipment which may be therein contained, and shall from time to time make renewals and replacements of such equipment so that at all times said buildings, structures and equipment shall be in good order, condition and repair.
Upon the termination of the lease the lessee was obligated to return the premises to the lessor together with the1946 U.S. Tax Ct. LEXIS 46">*50 structures thereon.
Upon the execution of the lease, the lessee proceeded to erect a 35-story stone, steel, and brick office building, with a 5-story underground garage, and having a composite depreciable life of 50 years from the date of its completion on August 31, 1929.
Petitioner paid an aggregate of $ 1,273,772.50 for the three parcels of land leased to Grant Building, Inc. This cost was later reduced by a payment of $ 130,975 from the city of Pittsburgh, pursuant to condemnation proceedings, making petitioner's investment in the ground upon which the Grant Building was erected $ 1,142,772.50, after crediting 7 T.C. 1061">*1063 the lessee with $ 25 paid by it to petitioner for the purpose of making the total credit an even amount, namely, $ 131,000.
Toward the cost of the Grant Building, petitioner furnished $ 1,026,227.50, which was expended solely in the construction of that building.
In determining the deficiencies here involved, respondent has allowed petitioner no depreciation with respect to $ 1,026,227.50, the cost of the Grant Building furnished by petitioner from its funds. Petitioner contests that action.
OPINION.
It is generally true that a lessor may not deduct depreciation1946 U.S. Tax Ct. LEXIS 46">*51 upon improvements placed on leased premises by the lessee at the expense of the lessee. In those cases, however, the lessor has no investment represented by its cost of such improvements. Consequently the lessor has nothing to depreciate.
But here we have an entirely different situation. The petitioner contributed $ 1,026,227.50 of the cost incurred in the erection of the building by the lessee. This payment was not an advance to be repaid by the lessee, but constituted a capital investment by the lessor in the building. This investment will not be returned to the lessor unless by deductions for depreciation, as the normal life of the building is less than the term of the lease, or unless by the terms of the lease the lessee is obligated to make good to the lessor, at the termination of the lease, such loss in value as the improvements have sustained through depreciation or obsolescence.
Respondent makes two contentions with respect to his refusal to allow deduction for depreciation. The first is that the payment by petitioner of a portion of the cost of the building was, in reality, an additional cost to petitioner of the land leased.
We do not agree. The stipulated facts 1946 U.S. Tax Ct. LEXIS 46">*52 are that petitioner had acquired full and complete title to the land prior to the execution of the lease. The payment in question by petitioner toward the cost of the building had no connection whatever with the acquisition of the land. The payment constituted, in our opinion, a cost to petitioner of the building erected.
The second contention of respondent is that petitioner will not sustain a loss of this investment upon the termination of the lease even if depreciation is denied. In support of this contention he cites: ; ; certiorari denied, ; (affirming ); certiorari denied, ; and .
7 T.C. 1061">*1064 The cases cited are included in a well known line of decisions holding that where the obligation1946 U.S. Tax Ct. LEXIS 46">*53 assumed by the lessee is such that it is obligated at the expiration of the lease to return the property in the same condition as when received, the lessee is bound by such covenant to restore all depreciation and obsolescence, or to compensate the lessor for any such loss. The rule there announced is that the covenant against loss to the lessor precludes its deduction of depreciation, since it will not suffer a loss due to exhaustion of its assets.
We think the cited cases have no aplication here. Under the present lease, at its termination, the lessee is not bound to restore the property with the building in the same condition as when received, or to compensate the lessor for the loss of its investment in the depreciable improvements. The lessee is obligated merely to "keep in good order and repair inside and out all buildings and structures hereafter constructed on or appurtenant to said premises, including any and all equipment which may be therein contained, and shall from time to time make renewals and replacements of such equipment so that at all times said buildings, structures and equipment shall be in good order, condition and repair."
Thus, even if the lessee fully complies1946 U.S. Tax Ct. LEXIS 46">*54 with this condition of the lease, that fact will not prevent the building or buildings on the premises from becoming depreciated or obsolete by the end of the lease. This has been generally recognized by the courts. ; ; ; .
Our most recent application of this rule occurred in . There the tenant had, at its own cost, erected upon leased premises a building with a useful life less than the term of the lease. The lease provision only obligated the tenant to maintain and keep the property in good condition and repair, such provision being similar in effect to that existing here. By devise, upon the death of the lessor, the leased property came to the owner taxpayer and, because of the fact that the property was included in the estate of the lessor, the devisee had a capital1946 U.S. Tax Ct. LEXIS 46">*55 investment in the building by reason of the incidence of the estate tax. We held that, since the lease placed no obligation upon the lessee to indemnify the taxpayer-owner against loss by obsolescence and the leased premises would, in fact, depreciate even though maintained in good repair, the taxpayer was entitled to depreciation of a capital interest in the improvements.
Respondent points to one clause in the lease which provides that if, at any time during the term of the lease or renewal thereof, the buildings then upon the leased premises are deemed by the lessee to have become obsolete, the lessee, in that event, shall have the right and privilege to remove the buildings, provided it replace them with a building 7 T.C. 1061">*1065 or buildings to cost not less than $ 2,000,000. It is argued that under this proviso it is highly improbable that the lessor will ever suffer a loss by reason of depreciation or obsolescence of improvements. This provision of the contract, however, places no obligation on the lessee. It merely gives the lessee an option to replace the building if it so desires. This is obviously no guarantee to the lessor against loss by reason of obsolescence.
The parties1946 U.S. Tax Ct. LEXIS 46">*56 have stipulated that the useful life of the Grant Building is 50 years. We hold that petitioner is entitled to the deduction of depreciation at the rate of 2 per cent upon its capital investment of $ 1,026,227.50 for each of the 3 taxable years.
Decision will be entered under Rule 50.