*1036 1. Prepaid interest is deductible in the return for the year of payment under section 23(b) of the Revenue Act of 1934, where the taxpayer is on the cash basis of accounting.
2. Where such taxpayer, as a consideration for a lease and a right of action against an underlying lessee for past due rent, including taxes, assumed the liability to pay the amount of such taxes which were then due and a lien against the leased property, the full amount of such delinquent taxes is not deductible for the year when such liability was assumed or paid, but their amount, less any recovery by petitioner from the underlying lessee, is proratably deductible over the life of the lease as a cost of capital assets.
3. Where, on this right of action against the underlying lessee, petitioner recovers $2,680.34, no part of that sum is then income to petitioner, but is a recovery on account of the cost of the lease and right of action against the underlying lessee, the balance of which cost is recoverable over the life of the lease.
*395 This is a proceeding to redetermine deficiencies in*1037 income tax of $5,838.26 and $1,509.97 for the calendar years 1934 and 1935, respectively. The first issue concerns petitioner's right to take a deduction in the taxable year of interest prepaid on loans. The second issue is whether petitioner, having leased property under an agreement to pay taxes assessed and to be assessed, may deduct the amount of taxes paid by him which were past due and liens against the property at the time of his entering into the lease. The third issue is whether an amount recovered by petitioner as a result of an assignment to him of the lessor's rights under a prior lease is includable in his income for 1934.
FINDINGS OF FACT.
In 1934, petitioner was indebted in the aggregate sum of $770,000. He kept his books and made his tax returns on a cash receipts and disbursements basis. During that year his total interest payments were $46,947.74 and of that amount $8,385.21 did not accrue until subsequent years, i.e., $6,000 represented a prepayment for 1935, and $2,385.21 a partial prepayment for 1936. Petitioner's motive in making this prepayment was to make the demand note which evidenced the debt a time note which could not be called during the time*1038 for which the interest was prepaid. The Commissioner disallowed $7,738.95 of this prepayment as being not yet accrued and an advance *396 payment in the nature of a capital expenditure. In 1935, petitioner made a similar prepayment of $6,690, for 1936, securing thereby a reduction in interest on an indebtedness of $223,000 from 5 percent to 3 percent. The respondent likewise disallowed the deduction in 1935 of this prepayment.
On August 22, 1933, petitioner leased certain premises in the City of Cleveland, Ohio, from Maggie A. Reimer for 99 years, the rental being at the rate of $10,000 per year for the first five years and at $12,000 during the balance of the term and any renewals thereof. The indenture of lease further provided:
ARTICLE VI
As part of the consideration for this lease, and in addition to the rental hereinbefore provided, the Lessee covenants to promptly pay, when and as the same become due, to the public officials charged with the collection thereof, all taxes, special and other assessments, all water rents and other public charges which are now assessed or are a lien against the leased premises, and the buildings and improvements thereon, or any*1039 part thereof, together with penalties and interest, if any, and all such taxes, special and other assessments, water rents and other public charges which may hereafter and at any time during the term of this lease, or any renewal hereof, be levied, assessed or imposed upon this lease, the leased premises, and the buildings and improvements thereon, or any part thereof, whether under any present or future law, and will at all times exonerate and save harmless the Lessor and the said demised premises and all buildings and improvements now or hereafter thereon, from all such taxes, special and other assessments, water rents, and other public charges, including any such charges upon any use or occupation thereof or upon any business or vocation transacted thereon, and from all public requirements as to the reconstruction or repair of sidewalks, ways or alleys, and from any and all claims for damages arising from causes occurring subsequent to the execution hereof and during the term of this lease, or any renewed or extended term hereof, payable or chargeable for or in respect to said premises, the buildings and improvements thereon, or the use and occupation thereof.
At the time petitioner*1040 entered into this lease, the premises were under a lease entered into in 1916, from Maggie A. Reimer to Thomas G. Sloan, the latter's interest having subsequently been transferred to Sloan-Prospect Corporation. Under the terms of this latter lease, the lessee was likewise obligated to pay taxes.
Petitioner's lease was made specifically subject to the underlying lease and all rights of the lessor under the underlying lease were assigned to petitioner by article IV of the lease to petitioner, which reads as follows:
Subject to the conditions, terms and provisions of this lease, the Lessor hereby assigns, transfers, bargains, sells and grants to the Lessee all of the Lessor's right, title and interest in and to said lease from Maggie A. Reimer, lessor, to Thomas G. Sloan, lessee, recorded in Volume 72, Pages 64 to 71, inclusive, as heretofore modified, so that the Lessee herein while not in default hereunder may receive and enjoy all of the benefits of said lease and may collect all rentals and other income derived or to be derived therefrom and may assert and *397 enforce any and all claims, causes of action, rights of re-entry, termination and forfeiture, and all other*1041 rights, whether remedial or substantive, which the Lessor might now or at any time during the existence of this lease assert, exercise or enforce against any lessee under said indenture of lease, or any person holding by, through or under such lessee, to the same extent and as fully and effectually as the Lessor could do.
An assignment to petitioner of the 1916 underlying lease was also endorsed on the back of that instrument.
On the same day, the owner of the property wrote petitioner that in consideration of his taking a lease on the property and assuming the payment of taxes and assessments for years prior to 1933, he would not be considered by her to be in default under the lease on account of his failure to pay those taxes prior to February 15, 1934.
In a separate letter also written the same day, the owner authorized petitioner, pending the furnishing of a statement of title and the completion of an escrow with a bank in connection with the lease. to act as her counsel in the assertion of claims for rent and payment of taxes against Sloan-Prospect Corporation and to bring suit in her name, provided that the owner should not be liable for attorneys' fees, that petitioner*1042 would indemnify her for any court costs or other expenses connected with the enforcement of the claims, and that any moneys thereby collected should be used by petitioner to pay current or delinquent taxes assessed against the premises. Petitioner wrote at the foot of the letter that he agreed to abide by its terms, and signed his name.
At the time petitioner entered into the lease, Sloan-Prospect Corporation had failed to pay parts of the 1931, 1932, and 1933 taxes assessed against the premises. For the last half of 1931, $2,360.01 was due and $5,574.65 for the last half of 1932. The 1933 taxes, conceded by respondent to be deductible by petitioner in 1934, are not here in controversy. An Ohio law known as the Whittemore Act (Special Laws of Ohio, Amended Senate Bill No. 42, effective April 5, 1933, as amended by Senate Bill No. 23, effective April 12, 1934), permitted the payment of delinquent taxes in installments of 10 percent. Under this law, petitioner paid $793.46 in 1934 and the same amount in 1935 against the delinquent 1931 and 1932 taxes. Respondent refused to allow petitioner to deduct in 1934 the amounts of the taxes which Sloan-Prospect Corporation had failed*1043 to pay for the years 1931 and 1932, holding them to be a part of the cost of the lease and hence deductible only pro rata over the term of the lease.
Petitioner brought action in 1933 against the Sloan-Prospect Corporation for unpaid rent and nonperformance of the covenant respecting taxes. He recovered $2,680.34 in 1934, and respondent included that amount in his income for that year.
*398 OPINION.
LEECH: The first issue is whether the amounts paid during the two taxable years as prepaid interest were deductible under section 23(b) of the Revenue Act of 1934. 1 That section allows the deduction of "All interest paid or accrued within the taxable year on indebtedness". Section 41 of the same revenue act 2 provides that taxable income shall be computed on the basis by which the taxpayer's books are kept, unless this basis does not clearly reflect income.
*1044 Respondent contests the deduction of the item here, only because it was prepaid.
Since the contrary does not appear in the statute, the term "interest" must be construed according to its ordinary meaning. .
It has been defined to be "the compensation allowed by law, or fixed by the parties, for the use or forbearance of money, or as damages for its detention." See . That the payments here were made in advance for bona fide purposes does not affect the fact that they were made as "the compensation * * * fixed by the parties, for the use * * * of money." See . They thus constituted interest within the meaning of the statute. Since petitioner kept his books and made his income tax returns on the cash basis, he is, therefore, entitled to the contested deduction unless its permission would work a distortion of his income under section 41. But, distortion of the petitioner's income would not result here from the deduction of this prepaid interest payment any more than it would from the payment in one of the*1045 current taxable years for interest covering an elapsed period of more than those years. See . And that does not prevent the deduction. Cf. ; Jungkind Photo Supply Co. v. Remmel (U.S. Dist. Ct., E. Dist. Ark., Feb. 5, 1926). *399 The effect of denying it here would be to place petitioner on an accrual basis as to one item on his return and leave him on a cash basis as to the remainder. Such inconsistency is not permissible. ; .
Respondent cites , and , as supporting his denial of these deductions. Those cases are distinguishable in that the disputed deductions there were held to be capital expenditures or otherwise not within the specific deductions permissible under the revenue acts. See also *1046 ; ; . Here, whatever other designation, by analogy, may be applied to the disputed items - they are "interest" payments and are thus deductible within the specific provisions of the statute. That they may not have been ordinary or necessary expenses of business of the taxpayer is not a requisite to their deduction under the statute.
The petitioner is sustained on the first issue.
The second and third issues will be discussed jointly. The second issue involves the proper treatment here of the past due taxes for 1931 and 1932 and the taxes for 1933, due in 1934. The third issue concerns petitioner's recovery in 1934 of $2,680.34 on his right of action against the Sloan -Prospect Corporation, the underlying lessee.
It is clear on the face of the lease that the payment of the current taxes was regarded by the parties as current rental. Respondent now concedes this and agrees that the 1933 taxes were deductible as rent for the year 1934 when paid by petitioner. However, the past due taxes*1047 have a different status. In 1933, by the agreement incorporating the lease, petitioner intended to and did acquire a lease for 99 years, subject to an underlying lease; and, in addition thereto, a right of action against the underlying lessee. We think the lease is clear on this point and that this effect is not impaired by the lessor's separate assignment of the original lease to petitioner, nor the other writings in evidence. At the time the petitioner entered into the lease, the unpaid 1931 and 1932 taxes, amounting to $7,934.66, had become liens against the premises pursuant to the Ohio General Code, section 5671. . Petitioner's assumption of the liability to pay those past due taxes constituted the consideration he paid for his overlying lease and the right of action against the underlying lessee. ; ;; *1048 . The assumption of that liability was the *400 equivalent here of a cash payment in that amount. Respondent concedes this. However, that consideration was not allocated nor is it allocable on this record between the lease and the right of action against the underlying lessee, Sloan-Prospect Corporation. . Cf. ; modified, .
Petitioner, by his receipt of the disputed sum of $2,680.34 in 1934 from that corporation, has thus recovered that amount of his capital so expended. It follows that this amount can not be taxed as income of petitioner for 1934, but, though it may well be that petitioner can not recover further on account of his claim against Sloan-Prospect Corporation, he still has the lease for which the entire capital outlay was also made. He is, therefore, not now entitled to the deduction of any amount by way of loss or otherwise except the pro rata annual amount necessary to recoup the balance of his unrecovered capital over the period of the lease.
Decision will be entered*1049 under Rule 50.
Footnotes
1. SEC. 23. DEDUCTIONS FROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
* * *
(b) INTEREST. - All interest paid or accrued within the taxable year on indebtedness, except on indebtedness incurred or continued to purchase or carry obligations (other than obligations of the United States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest upon which is wholly exempt from the taxes imposed by this title. ↩
2. SEC. 41. GENERAL RULE.
The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income. If the taxpayer's annual accounting period is other than a fiscal year as defined in section 48 or if the taxpayer has no annual accounting period or does not keep books, the net income shall be computed on the basis of the calendar year. (For use of inventories, see section 22(c).) ↩