*1031 1. Where a 99-year lease upon which a building had been erected by the lessee was forfeited and the property repossessed by the lessor in the taxable year, held, the added value to the property at the time of forfeiture of improvements erected thereon at the cost of the lessee, is income to the lessor. Helvering v. Bruun,309 U.S. 461">309 U.S. 461; held, further, that under the facts the building so erected did not increase the value of the property.
2. Attorney fees and expenditures occasioned by the forfeiture of a lease, held, deductible.
3. Personal state income taxes and state, county, and city property taxes, which had become a lien on the property repossessed, together with interest thereon, are deductible from gross income when paid in the taxable year.
*246 The respondent determined a deficiency in income tax against petitioner Mary E. Evans, Docket No. 95527, in the amount of $13,274.06 for the calendar year 1936, and against petitioner Helen Evans Wheeler, Docket No. 95528, in the*1032 amount of $14,091.37 for the calendar year 1936. The two dockets are consolidated for hearing and decision.
Petitioners allege that the respondent erred: (a) In determining they were each taxable on $36,914 representing gain from the cancellation of a 99-year lease; (b) in failing to allow as a deduction certain attorney fees and expenses incident to the cancellation of the lease, one-half of which was paid by each petitioner; (c) in treating the purported profit from the cancellation of the lease as ordinary gain instead of capital gain; (d) in failing to allow to petitioners a deduction for income taxes paid to the State of California in 1936 in the respective amounts of $643.60 and $1,015.89; and (e) in failing to allow as a deduction from income real estate taxes paid by each petitioner in 1936 in the amount of $4,451. Petitioners pray that the Board find they are each entitled to a refund in the respective amounts of $276.75 (Docket No. 95527) and $447.47 (Docket No. 95528).
The case is submitted on the pleadings, a stipulation of facts, oral testimony, depositions, and exhibits, from which the following facts are found.
*247 FINDINGS OF FACT.
Petitioners*1033 are individuals, residents of Pasadena, California. During the calendar year 1936 each owned in fee an undivided one-half interest, as tenants in common, in certain land located in Kansas City, Missouri, fronting 157 feet on the east side of Baltimore Avenue and 107.25 feet on the south side of Fourteenth Street, which was purchased February 21, 1924, and cost them $150,000.
On February 1, 1925, this land was leased to J. J. Taxman, and others, for a term of 99 years. This lease was subsequently assigned with the consent of the petitioners to the Balfour Realty Co., a Missouri corporation. This corporation was the lessee of the property on August 1, 1932, and continued as such until May 12, 1936.
Under the terms of the lease the lessees agreed to erect on the land, at their own cost and expense, a building to be completed within five years at a cost of not less than $100,000. The lessees agreed to pay rent for the premises at the rate of $12,000 per annum during the first five years of the lease, $14,000 per annum for the second five years, $17,000 per annum during the third five-year period, and $20,000 per annum thereafter during the term of the lease. The lessees further*1034 agreed that they would pay in addition and as rental all taxes and assessments made against the premises of every kind whatever as they became due and payable.
The lease further provided that, in case of forfeiture of the lease on account of any default of the lessees, and at the end of the term, the building and improvements then on said premises "shall, without compensation to the lessees, pass to and become the absolute property of the lessors."
During the year 1929 the lessee erected on the leased property a building costing not less than $100,000, as provided in the lease. The building is a staggered-floor type parking garage and service station. It is of reinforced concrete construction, finished on the outside with terra cotta blocks. It has 7 floor levels, connected by a ramp in the center of the building and running up to the roof, which also is used for parking automobiles. Each level has a capacity of approximately 40 cars and the roof 60 cars - a total parking capacity of approximately 340 automobiles. The building has a total floor area of 58,796 square feet, designed to carry a dead weight load of from 75 to 100 pounds to the square foot. The ceilings are 7*1035 1/2 to 8 feet high and the building is lighted from outside windows and the ramp opening at the roof. The building has a steam heating plant. The building has a filling and service station on the Baltimore Street side.
Effective as of August 1, 1932, the petitioners and the Balfour Realty Co., as lessee, entered into an agreement whereby the rentals *248 payable to petitioners under the lease for the period beginning August 1, 1932, and ending May 1, 1935, were reduced in the amount of $2,000 per year and deferred in the further sum of $3,000 per year to be paid in quarterly installments of $750, beginning August 1, 1935. This reduced the rent currently payable during the period from August 1, 1932, to August 1, 1935, to $9,000 per year. This agreement was entered into on condition that the lessees pay to petitioners all rents up to August 1, 1932, and were not in default in any of the terms, conditions, or provisions of the lease on that date.
On March 9, 1936, the lessee having theretofore breached the covenants of the lease and being in default, the petitioners caused to be served upon the lessee notice of intention to declare forfeiture of the lease. This notice*1036 recited, among other things, that there were rents due and unpaid in the sum of $27,750 and general state, county, and city taxes, and penalties, "now in default" in the amount of $6,105.41, and special improvement taxes and assessments in the amount of $1,402.79.
On May 11, 1936, a declaration of the forfeiture and demand for the possession of the premises was served on the lessee.
On May 12, 1936, petitioners, by and through their agent and attorney, took peaceable possession and control of the premises, together with all the buildings and improvements thereon, and canceled the lease. At all times during the period from May 12 to December 31, 1936, inclusive, each of the petitioners was the owner in fee simple of an undivided one-half interest in the land and all buildings and improvements thereon as tenants in common.
Before the building was constructed the lot was rented as a parking lot for $1,000 a month. With the building removed the property would have rented as a parking lot on May 12, 1936, at approximately $800 per month. The price for "live storage" for cars was substantially less in 1936 than it had been in the years up to 1929 and 1930. In the year 1936 about*1037 the maximum that a tenant could pay for the property in question with the building on it was $800 per month with the theatre adjoining it closed. In the latter part of December 1936, the owner obtained a five-year lease at $1,200 per month but had to reduce it to $800 a month shortly thereafter. With the Main Street Theatre open it probably would have rented for $1,000 per month. The Main Street Theatre has been opened and closed intermittently for many years. The taxes on the property were approximately $4,000 per year, with about one-half allocated to improvements.
The property here in question is located about three blocks from the center of the retail district and is uphill from that district. In 1936 there were a number of parking lots and garages located between the main shopping district and the location of the property in question. *249 There were four parking lots, besides petitioners' property, in the same block; two parking lots and a garage in the block immediately north; four parking lots in the block northeast of the block in which petitioners' property was located; three parking lots and a garage in the block northwest; a filling station, two parking*1038 lots, and a garage in the block on the west; and three parking lots in the block on the east. Numerous other parking lots and some garages were located within two or three blocks from the central business section of the city. These parking lots and garages divided up the business, and the property here under consideration could not get sufficient business to enable it to pay high rents. The Main Street Theatre, when open, provided a profitable source for patrons, but it has been open only part of the time in several years. It was open only part of the time in 1936.
In 1936 the city purchased a lot on the southwest corner of Fourteenth and Baltimore Streets, directly across the street from the petitioners' property, 30 1/2 feet on Baltimore Avenue by 80 feet on Fourteenth Street at a price in excess of a thousand dollars a front foot. The value per foot of this property was substantially the same as petitioners' property, which extended 157 feet on Baltimore Avenue by 107 feet on Fourteenth Street. There has been substantially no change in the market value of the land since 1932.
A committee of the local real estate board made an appraisal of petitioners' property, here*1039 in question, in May 1937. One-half of the property was appraised, land $62,500, and buildings $37,500.
In 1936 the bondholders' committee made an investigation to determine whether there was any practical use for the building other than a garage. The investigator came to the conclusion there was not on account of the staggered floor and ramp construction and the low ceilings. With alterations the building probably could have been used for such business as a furniture company, manufacturing dress shop, or a printing plant. When taken over by petitioners in 1936, the building was not adaptable to any use other than a garage. It would cost approximately $5,000 in excess of its salvage value to remove it.
The President Hotel, immediately across the street from the property here in question, sold in 1937 for approximately one-third of its cost. The Main Street Theatre reduced its ground rental about that time from $50,000 a year to $3o,000 a year and subsequently relinquished both its lease and the improvements on the property. The theatre building originally cost in excess of $1,000,000, and land and building are now offered for sale at $250,000.
On May 12, 1936, the property*1040 in question would yield as much or more net income without the building and improvements, considering *250 the added cost attributed to the building on account of taxes, insurance, repairs and upkeep. The building had no market value aside from the land and no realizable salvage value. It was in fact a liability to the land. The building and improvements located on the property in question had no fair market value on May 12, 1936, when taken over by petitioners, and petitioners were not enriched by the acquisition of such property on that date.
Neither of the petitioners reported or paid Federal income tax upon any amount whatever for the year 1936 as income, profit, or gain, from or on account of the cancellation of the lease here under consideration or the surrender of the leased property during the year 1936. The respondent has determined that each petitioner is taxable upon $37,500, as gain from the cancellation of the lease.
Petitioner Mary E. Evans (Docket No. 95527) paid personal income taxes for the year 1935 to the State of California during the year 1936 in the amount of $643.60. No claim for refund has been filed for any part of this amount and petitioner*1041 is not entitled to file such claim, and no part of this amount of $643.60 was claimed by her upon her Federal income tax return for 1936.
Petitioner Helen Evans Wheeler (Docket No. 95528) paid personal income taxes for 1935 to the State of California during the year 1936 in the sum of $1,015.89. No claim for refund has been filed for this amount or any part thereof and petitioner is not entitled to file such claim. Petitioner did not claim any part of this $1,015.89 as a deduction in her Federal income tax return for 1936.
After the cancellation of the lease and the repossession by petitioners of the garage property, the city, county, and state real property taxes for the calendar year 1936 became a lien upon the property in the total amount of $3,835.27. This amount was paid by petitioners in the year 1936. On June 11, 1936, petitioners paid city taxes on the property for 1935 in the sum of $1,332.85, which the former lessee had allowed to get into default. On September 29, 1936, petitioners paid county and state taxes on the garage property for the years 1934 and 1935 in the amount of $4,053.28, together with interest and costs thereon in the amount of $646.29, a total*1042 of $4,699.57, which the former lessee had allowed to get into default.
The original petitions were filed September 19, 1938.
By checks dated June 11, 1936, petitioners paid the sum of $5,410.86 principal, and $676.36 interest, on condemnation bonds that had become liens against the property at the time it was repossessed by petitioners.
On June 16, 1936, petitioners paid to Edward D. Ellison, an attorney, legal fees in the sum of $1,500 incurred in connection with the forfeiture of the lease and taking over the property. They also paid *251 Ellison the sum of $59.10 to reimburse him for payments made by him on their account in connection with the garage property.
Petitioner Mary E. Evans filed her Federal income tax return for the calendar year 1936 on March 15, 1937, reporting thereon tax payable in the amount of $2,709.49, which she paid on March 15, 1937.
Petitioner Helen Evans Wheeler filed her Federal income tax return for the calendar year 1936 on March 15, 1937, reporting thereon tax payable of $4,391.70, which she paid during the year 1937, as follows:
| March 15 | $1,097.93 |
| June 15 | 1,097.93 |
| September 14 | 1,097.92 |
| December 15 | 1,097.92 |
*1043 OPINION.
KERN: The respondent determined that each of the petitioners received taxable gain in the amount of $37,500 upon the forfeiture and cancellation of the lease May 12, 1936. This gain is attributable to the value of the improvements placed upon the property by the lessee and taken over by the lessor upon cancellation of the lease. In their second amended petitions the petitioners each claim this determination to be in error to the extent of $36,914.
The question of whether the lessor realizes taxable gain to the extent of the added value to the property upon the forfeiture of a long term lease and the repossession of the property, including building and improvements erected thereon by the lessee at its own cost, has been decided by the Supreme Court adversely to the petitioner's contention in Helvering v. Bruun,309 U.S. 461">309 U.S. 461; and the petitioners in supplemental brief admit the decisive application of this case. The petitioners still contend, however, that the building and improvements erected by the lessee and taken over by them upon forfeiture of the lease did not increase the value of the property, but, on the other hand, were really an encumbrance*1044 on the land which entailed additional expenditures by way of taxes, maintenance, insurance, and repairs, without materially increasing the net income from the property.
On first impression this contention seems untenable, since the building in question was only six years old and erected by the lessees at a cost in excess of $100,000. But after carefully considering and evaluating all of the evidence, we agree with the petitioners.
The land upon which the building and improvements were erected cost petitioners $150,000. Its value in the taxable year, as established by the sale to the city of the lot directly across the street, was substantially the same.
*252 The building erected on the property was a garage of concrete construction, low ceilings, and staggered floors connected by ramps and used for automobile parking. There is some evidence that it could be used for a few other purposes if remodeled, but there is no evidence that such use would produce a larger income than its use as a garage and the decision of the committee for the bondholders, who, after making an extensive survey of its adaptability to other uses, decided that its only practical use was that*1045 of a garage, is persuasive of that point in view of the fact that the bondholders were faced with the loss of their entire investment and were tremendously interested in making the building pay. The architectural construction of the building is a strong argument that its only practical use was that for which it was built.
Various valuations were placed on the property by local real estate dealers. After considering this testimony, we are of the opinion that the respondent's experts valued the property too high. The value of $195,000 by respondent's witnesses was based on a theoretical computation of the value of the building and had no foundation in practical fact. The respondent's value assumed two forms - one based on the "replacement cost" method, and the other based on the income method. The replacement cost of a building alone, as is clearly shown by the facts before us, does not determine its fair market value at a given time. The President Hotel, directly across the street from the garage property, sold in 1937 for approximately one-third of its cost. The Main Street Theatre building, which adjoins the garage property, cost in excess of $1,000,000, and now both land*1046 and building are being offered for $250,000. Nor is the market value of a building determined by a hypothetical showing of its possible income. The respondent's witnesses determined the value of the building on an income basis by assuming that its 300 car stalls would be filled all the time at a rental of $15 per month, but the respondent has failed to show that the 300 stalls were or could be filled all the time in the taxable year at a price of $15 per month. In fact there is evidence that some stalls rented for $8 per month in the taxable year, and the lessees, unable to keep up the payments of rent and taxes, forfeited their lease and surrendered property that cost them over $100,000, rather than continue to operate the property.
The record shows that for the period beginning August 1, 1932, and ending May 1, 1935, the petitioners agreed with the lossors to reduce the rent $2,000 per year and defer to August 1, 1935, the further sum of $3,000 per year. But, even with these concessions, it appears that on March 9, 1936, the lessees were in default in unpaid rent in the amount of $27,750, and taxes in excess of $7,500, or a total of $35,000 in the period of approximately three*1047 and one-half years. At the *253 end of that period the bondholders, after a thorough investigation of the possibilities of the property, including other uses, surrendered their lease and took a total loss on their investment. Obviously the lessees would, if possible, have kept up the rent and taxes to protect their investment. That they did not do so convinces us that the business was not sufficient to pay the rent and that the value of the property as computed by the respondent did not reflect its fair market value May 12, 1936. In the light of the evidence it is extremely doubtful if the garage property had sufficient business to pay one-half the rent it was obligated to pay. As a matter of fact it did not do so in the three and one-half years prior to the surrender of the lease.
The petitioners' witnesses valued the property as of May 12, 1936, at $125,000. The entire value was allocated to the land, on the theory that the building was in fact an encumbrance which could not be removed without a cost of $5,000 in excess of its salvage value, and that it did not yield enough additional income over the income from the land as a parking lot to meet the increased expenditures*1048 which it entailed, such as taxes, maintenance, and insurance.
The record discloses that the garage property was over three blocks from the main business center of the city, that it was uphill from the business section, and that there were four parking lots in the same block and approximately fifteen parking lots and two garages in the adjacent blocks, besides numerous other parking lots and garages located nearer to the business district than the garage property here in question.
Considering all the facts in the record, we find that the fair market value of the land with building and improvements was not in excess of its fair market value without such building and improvements as of May 12, 1936, when the lease was forfeited and the property taken over by the petitioners. The Commissioner erred in determining that petitioners received taxable income upon the forfeiture of the lease to the extent of $36,914 each.
In the taxable year petitioners expended, in connection with the cancellation of the lease and the recovery of the property, attorney fees in the amount of $1,500, fees for the abstract of title $25.50, and sums apparently paid in connection with the personal property*1049 in the amount of $33.60. Petitioners claim that these expenditures, totaling $1,559.10, should be allowed as a deduction in computing their net taxable income for 1936 as ordinary and necessary business expenses. The Commissioner argues that the items of $1,500 and $25.50 are capital expenses, which would serve only to reduce the net gain to the petitioners attributable to the value of the building at the time of acquisition, and that the other items do not enter into the situation.
*254 We think the attorney fees and the title abstract fee in the total amount of $1,525.50, while occasioned on account of the cancellation of the lease and the repossession of the property, were in the nature of unavoidable expenditures incident to the forfeiture and termination of the contract of lease and are to be distinguished from Henry B. Miller,10 B.T.A. 383">10 B.T.A. 383, and related cases, cited by the respondent, where payments made by the lessor for the cancellation of the lease were held to be capital expenditures, recoverable through deductions spread over the unexpired term of the lease. Here the lease was forfeited by the fault of the lessee and the resulting expenditures*1050 by the lessor were a loss incident to such default and are deductible as such from gross income in the taxable year.
Petitioner has failed to show that it is entitled to deduct expenditures in the amount of $33.60, apparently made in connection with the personal property and a mortgage.
Neither of the petitioners claimed any deduction for income taxes paid by them to the State of California in the taxable year. Petitioner Mary E. Evans paid $643.60, and petitioner Helen Evans Wheeler paid $1,015.89. There is no question but that the amount of income taxes paid was the personal liability of the respective petitioners. We hold that they are entitled to a deduction from gross income in the respective amounts under section 23(c) of the Revenue Act of 1936.
Petitioners in 1936 paid special assessments against the property that had become due prior to the forfeiture of the lease in the amount of $5,410.86, allocable to the condemnation bonds and $676.36 interest due on such bonds. There is no evidence in the record that the improvements for which the assessment was levied were not a benefit to the property. The assessment paid in the amount of $5,410.86 is therefore not deductible*1051 in the taxable year under section 23(c)(4), Internal Revenue Code; P. J. Hiatt,35 B.T.A. 292">35 B.T.A. 292; F. M. Hubbell Son & Co.,19 B.T.A. 612">19 B.T.A. 612; affd., 51 Fed.(2d) 644; certiorari denied, 284 U.S. 644">284 U.S. 644. The interest paid, however, has a different status and is deductible as interest paid in the taxable year, one-half or $338.18, being deductible by each petitioner. Sec. 23(c)(4), Internal Revenue Code. Evens & Howard Fire Brick Co.,8 B.T.A. 867">8 B.T.A. 867; Andrew Little,21 B.T.A. 911">21 B.T.A. 911; Lee Wilson & Co.,25 B.T.A. 840">25 B.T.A. 840; Chapman & Dewey Lumber Co.,25 B.T.A. 1166">25 B.T.A. 1166.
In the taxable year the petitioners, after repossession of the property, paid state, county, and city taxes on the property in the total amount of $9,867.69. Of this amount $5,386.18 was in default for the years 1934 and 1935, and $3,835.27 became a lien on the property after it was repossessed in 1936. They also paid interest on the amount in default in the sum of $646.29. The respondent contends that the amount in default was an obligation of the lessee to be paid as rent *255 and that the petitioners merely*1052 paid the obligation of another and can not claim as deductions such payments from gross income in the taxable year. The petitioners contend that these amounts were not included as deductions from gross income in the income tax returns of petitioners for the taxable year, and are properly deductible.
Regulations 94, article 23(a)-10, interpreting the Revenue Act of 1936, which was in force in the taxable year, provides, among other things, that: "Taxes paid by a tenant to or for a landlord for business property are additional rent and constitute a deductible item to the tenant and taxable income to the landlord, the amount of the tax being deductible by the latter." The same language has been continued in subsequent regulations. Obviously the regulations regard the owner of the fee as having the obligation to pay the taxes, which, if unpaid become a lien on the property. The fact that the lessee defaults on the payment of taxes does not change the situation. The landlord on a cash basis is entitled to deduct the amount of the taxes which should have been paid by the lessee but are paid by the landlord, in the year in which he pays them. We hold, therefore, that the petitioners*1053 are entitled to a deduction from gross income of the taxes paid during the taxable year which had become a lien against the property, together with the interest paid on the taxes in arrears and such deductions will be allocated one-half to each of the petitioners.
Reviewed by the Board.
Decision will be entered under Rule 50.
MELLOTT dissents.