*766 The petitioner constructed a building and installed equipment in it at his own expense upon leased realty. The lease ran for 20 years to November 1, 1937, and gave the lessee the option to renew for another 20 years. At the end of the first term, title to the improvements vests in the lessor. In the taxable year, the petitioner had not exercised his option to renew and there was no certainty then that he would in the future. Held, under section 23(k) of the Revenue Act of 1932, the petitioner is entitled to a deduction for exhaustion based on the term of the 20-year lease. Respondent is in error in his determination basing the allowable deduction on the life of the building and improvements which extends beyond the 20-year term. Bonwit Teller & Co. v. Commissioner, 53 Fed.(2d) 381, followed.
*149 This proceeding involves a deficiency in income tax of $2,101.05 for the period of January 1 to September 20, 1932. The respondent added to the net income reported by the petitioner the total of $15,280.38 as "excessive depreciation*767 deducted", and his action in this regard is the only point in issue.
*150 FINDINGS OF FACT.
Stipulated facts filed at the hearing are adopted and incorporated herein by reference. The facts, summarized, are as follows:
The petitioner is a New York corporation, with its principal office in New York City.
On December 26, 1916, the petitioner entered into a lease agreement with the Barney Estate Co. whereby it leased unimproved property at 1620 Broadway, New York City. The term of the lease was for 20 years from the date of completion of a building which petitioner agreed to erect on the property. The building is the Rivoli Theatre. It was completed on November 1, 1917, and the lease runs from that date to November 1, 1937. Under the terms of the lease title to the building, equipment, additions, alterations, and improvements on the leased property vests in the lessor at the expiration of the term of the lease, subject, however, to the right on the part of the lessee to renew the lease for another term of 20 years from November 1, 1937.
The provision in the lease for renewal gives the lessee (our petitioner) the option to renew the lease for a second period of*768 20 years on the condition that the lessee exercise his option to renew in writing at least one year before the termination of the lease. The lessor agrees to execute a new lease for a further period of 20 years. Annual rental under the new lease shall be 5 percent of the value of the leased property at the date of expiration of the first lease, including the value of the building thereon. The parties agree to engage appraisers and accept their valuation, if they fail to agree to the valuation, to determine the annual rental.
The petitioner subleased the premises for a period of 20 years, from November 1, 1917, to the Biddle Realty Corporation which operates the theatre. The stockholders of the petitioner and of the Biddle Realty Corporation, the operating company, are the same. The sublessee was given the option to renew for a subsequent 20-year period provided the underlying lease of the petitioner should be renewed.
The cost to the petitioner of the Rivoli Theatre Building was $287,400. In 1932 the petitioner installed an organ at a cost of $31,401.08 and a cooling system at a cost of $122,168.35. In its income tax return for the taxable period in 1932, the petitioner*769 deducted a total amount of $20,045.23 for these three items. This amount is an aliquot part of the construction cost to the petitioner allocable to the taxable period for 1932, based upon the terms of the lease from November 1, 1917, to November 1, 1937.
The respondent has determined that the remaining useful life for each of the items - building, organ, and cooling system, is 24 1/6 years *151 from the beginning of the year 1932. The respondent contends that the deduction should be for depreciation spread over the remaining useful life of the improvements and on the basis of his determination computes for the current period the amount of $4,764.85, which he alleges to be the proper amount for deduction.
OPINION.
HARRON: Petitioner claims its deduction from gross income under the provisions of section 23(a) and (k) of the Revenue Act of 1932, which provides as follows:
In computing net income there shall be allowed as deductions:
(a) EXPENSES. - All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, * * *
* * *
(k) DEPRECIATION. - A reasonable allowance for the exhaustion, wear and tear of property*770 used in the trade or business, including a reasonable allowance for obsolescence.
The determination of the respondent is based on article 130 of Regulations 77, promulgated under the Revenue Act of 1932, which is quoted in the margin. 1
The only question here is the*771 amount of the deduction to be allowed the petitioner for depreciation of the building erected and installations at its own expense on leased premises. The petitioner maintains the right to exhaust its cost of the building and improvements over the term of the lease of 20 years without regard to the life of the building and improvements or the privilege of renewal. The respondent contends that the depreciation deductions should be spread over the useful life of the property, which he estimates as 24 1/6 years from the beginning of 1932. The petitioner does not contest this estimate.
We have before us the year 1932. At that time the lease in question had not been renewed by the petitioner and there is no evidence in the record to show that there was any certainty then that it would be renewed. There is evidence in the record to show that the petitioner elected to renew the lease in 1936 but we feel constrained to decide the issue on the facts existing at end of the taxable period, *152 i.e., the fact that then neither the petitioner nor its sublessee, the operating company, had determined to exercise their respective options of renewal and there are no facts as of that*772 time showing any reasonably certain probabilities that there would be renewals. There is the added fact that at the end of the 20-year term, November 1, 1937, title to the building and improvements vests in the lessor. The petitioner relies on , a per curiam decision affirming judgment for the plaintiff given by a lower court on the authority of . The facts in the Varick Charlton Corporation case are very similar to the facts here. The respondent relies upon . In that case the taxable years were 1919 to 1925, inclusive. The facts showed that prior to March 1, 1913, the lessee had been given assurance that the lease would be renewed and that less than a year from March 1, 1913, the lease was renewed and occupation was continuous. Upon the facts existing in 1932 in this case, it is distinguishable from the case of Pittsburgh Union Stock Yards Co., for the petitioner had not renewed his lease in 1932.
*773 This issue has been before this Board and the courts previously and the petitioner relies upon the court decisions in ; certiorari denied, , followed by three decisions, ; Poly Holding Corporation v. Commissioner, decided by the Circuit Court of Appeals for the Second Circuit, February 27, 1935, no opinion, reversing ; and Varick Holding Corporation v. Bowers, supra, no opinion.
The facts in this proceeding are substantially the same as those in , reversed by the Circuit Court of Appeals for the Second Circuit, supra. There is the additional fact in this proceeding that the title to the building and improvements vests in the lessor on November 1, 1937. This fact was present in the facts in the case of The decisions of the Circuit Court of Appeals for the Second Circuit relied on by the petitioner are in point. The only fact in*774 the instant case which would seem to justify distinguishing it from the cases relied upon by the petitioner is that we are on notice that just prior to the hearing of this proceeding, in October 1936, the petitioner exercised its option to renew the lease. However, as stated above, we feel constrained to arrive at a decision on the situation existing at the end of 1932, with respect to possible renewal of the lease in question. Further, Regulations 77, article 130, quoted above, recognizes that improvements made by a lessee at his own expense on *153 leased property represent investment of capital and that annual deductions are in lieu of a deduction for depreciation and are allowed over the term of a lease in such way as to return to the taxpayer his investment of capital. It appears to be consistent with the Commissioner's regulation that where title to improvements vests in the lessor at the expiration of a lease, the taxpayer should be allowed annual deductions over the term of that lease rather than over the estimated useful life of the property. Upon the authority of *775 , and the subsequent court decisions, the petitioner is sustained in its assignment of error and the Commissioner's disallowance of the claimed deduction is reversed.
Since the entire deficiency is due to disallowance of the claimed deduction,
Decision will be entered for the petitioner.
Footnotes
1. The cost borne by a lessee in erecting buildings or making permanent improvements on ground of which he is a lessee is held to be a capital investment and not deductible as a business expense. In order to return to such taxpayer his investment of capital, an annual deduction may be made from gross income of an amount equal to the total cost of such improvements divided by the number of years remaining of the term of lease, and such deduction shall be in lieu of a deduction for depreciation. If the remainder of the term of lease is greater than the probable life of the buildings erected, or of the improvements made, this deduction shall take the form of an allowance for depreciation.
[The above provision has been contained in the Treasury regulations from 1921 to date: Regulations 62, art. 109; Regulations 65 and 69, art. 110; Regulations 74 and 75, art. 130; Regulations 86 and 94, art. 23(a)-10.] ↩