*1343 In 1928 the petitioner transferred to its principal creditor certain real estate in consideration of the cancellation of its indebtedness, which indebtedness was in excess of the petitioner's net equity in the property. Held, the transfer of the real estate constituted a sale upon which the petitioner realized taxable profit in an amount equal to the difference between the depreciated cost of said real estate and the total amount of the canceled indebtedness.
*651 These proceedings, consolidated for hearing, are for the redetermination of deficiencies in petitioner's income tax as follows:
| Docket No. | Year | Deficiency |
| 51536 | 1928 | $4,146.86 |
| 60182 | 1929 | 771.65 |
The petitions set forth the following allegations of error:
With respect to the 1928 deficiency -
The Commissioner failed to eliminate from the petitioner's gross income an item of $91,794.79 erroneously returned as profit on a forgiveness of indebtedness, and added to the petitioner's gross income a further*1344 sum of $1,572.56 as additional profit on said forgiveness.
With respect to the 1929 deficiency -
(a) The Commissioner erroneously disallowed the deduction from gross income of an item amounting to $443.00 paid by the petitioner in 1929 as club dues.
*652 (b) The Commissioner failed to allow the deduction of the amount of a statutory net loss sustained by the petitioner in 1927.
FINDINGS OF FACT.
The petitioner is a Texas corporation with its principal place of business at Dallas; at all times material hereto, the petitioner was engaged in the transfer and storage business. In 1924, the Terminal Building Corporation of Dallas, hereinafter referred to as the Terminal Corporation, completed a unit of a warehouse building, which the petitioner leased for a term of 20 years from July 15, 1924. Under the terms of the lease all additions, fixtures, and improvements added to or made upon the leased premises by the lessee became the property of the lessor.
On October 15, 1925, the petitioner owed the Terminal Corporation $47,592.57 for unpaid "rental and other bills," for which the petitioner gave the Terminal Corporation its note dated October 15, 1925, in the amount*1345 stated, secured by a deed of trust conveying the petitioner's equity in certain real estate known as the Alamo Street property. The parties agreed to a reduction of the rental charge and other matters not material to our determination. The Alamo Street property had been acquired by the petitioner since March 1, 1913, at a total cost of $42,703.64, and in October, 1925, was subject to a mortgage lien for $25,000 placed thereon by the petitioner.
The petitioner continued to fall behind in its payments to the Terminal Corporation under the lease, and at the dates indicated owed the Terminal Corporation the following amounts:
| December 21, 1925 | $45,217.57 |
| December 21, 1926 | 64,270.61 |
| December 21, 1927 | 92,941.16 |
| August 14, 1928 | 110,101.90 |
The petitioner's balance sheet as of December 31, 1927, as adjusted by the Commissioner, is as follows:
| Assets | $152,470.16 | |
| Liabilities: | ||
| Creditors Accounts | $178,941.01 | |
| Capital stock | 200,000.00 | |
| Deficit | (226,470.85) | |
| $152,470.16 |
Included in the petitioner's assets account was an item of $11,958.65 representing leasehold improvements which belonged to the Terminal Corporation.
In August, *1346 1928, the petitioner owed the Terminal Corporation $110,101.90; it was in no position to pay the indebtedness and was insolvent. The petitioner and the Terminal Corporation started *653 negotiations that resulted in an agreement on or about October 30, 1928, which, after reviewing the past agreements between the parties, provided, inter alia, as follows:
(F) The Warehouse Company, that it may be in a better position to carry on and enlarge its business, is desirous of liquidating its said indebtedness to the Building Corporation and of securing a reduction of its rent under the lease referred to in Subdivision (A), and the Building Corporation is willing to assist to that end and to the extent indicated by the provisions of this agreement;
NOW THEREFORE, KNOW ALL MEN BY THESE PRESENTS: That the Dallas Transfer & Terminal Warehouse Company and the Terminal Building Corporation of Dallas, in consideration of the obligations of the parties hereto respectively assumed, agree and bond themselves each to the other as follows, to-wit:
(1) The Warehouse Company binds itself to arrange for an extension of that certain note executed by it while its corporate name was the Dallas*1347 Transfer Company, and in such name (but which said note is the obligation of the Dallas Transfer & Terminal Warehouse Company) payable to the order of the Texas Employer's Insurance Association of date September 12, 1923, secured by first lien on the land covered by the deed of trust in Subdivision (C) hereof referred to, which indebtedness matures in full on the 12th day of September, 1928, so that the same shall be payable on or before one year after date with interest from September 12, 1928, at the rate of six per cent per annum; payable semi-annually; and said Warehouse Company further binds itself to pay off and discharge all other indebtedness of every character whatsoever outstanding against or that may constitute a lien upon the real estate covered by said deed of trust referred to in Subdivision (C) hereof, for taxes or public assessments of any character whatsoever, or interest on the said first mortgage of Twenty-five Thousand Dollars ($25,000.00) up to and including the 12th day of September, 1928, or any other account, save and except such principal indebtedness in the sum of Twenty-five Thousand Dollars ($25,000.00).
(2) The obligations of Subdivision (1) hereof being*1348 fully complied with, said Warehouse Company shall convey to the Building Corporation or to any Trustee that it may designate, the tracts and parcels of land described in the deed of trust referred to in Subdivision (C) hereof, by general warranty deed; subject, however, to the superior lien to secure the said Twenty-five Thousand Dollar ($25,000.00) indebtedness referred to in Subdivision (1), which said indebtedness of Twenty-five Thousand Dollars ($25,000.00) and the interest from and after September 13, 1928, is to be assumed by the Building Corporation; all taxes on said property for the year 1928 to be prorated between the Warehouse Company and the Building Corporation as of date September 12, 1928.
(3) The Warehouse Company having complied promptly with its obligations under Subdivision (1) and (2) hereof, the Building Corporation will cancel the indebtedness of the Warehouse Company to it as set forth in Subdivision (E) hereof, and discharge said Warehouse Company on account thereof, it being the intention hereof that as of said August 14, 1928, the monied indebtedness of the Warehouse Company as stated in Subdivision (E) shall be fully discharged.
The cancellation*1349 and discharge in this subdivision covers only the indebtedness described in Subdivision (E), and it does not in any way release or affect any other obligations of the parties one to the other respectively under *654 the lease contract or otherwise, nor any indebtedness that one may be under to the other heretofore accruing unless such indebtedness has been taken into account in fixing the indebtedness covered by Subdivision (E).
(4) The Warehouse Company having complied promptly with its obligations under Subdivision (1) and (2) hereof, and thereafter complying with its other obligations under this instrument and under the lease described in Subdivision (A) hereof, the Building Corporation agrees that the monthly rental, * * * shall be ($5,000 per month until February 14, 1929, and $5,500 per month from then until August 14, 1929, and thereafter $6,000 per month for the remaining term of the lease, or until April 15, 1945).
The amount of the indebtedness referred to in paragraph (E) of the contract was $110,101.90, although the petitioner refers to this indebtedness as $107,880.77, which is the amount used by the revenue agent.
None of the petitioner's capital stock*1350 was owned by the Terminal Corporation.
The Alamo Street property was transferred to the Terminal Corporation and it assumed the $25,000 mortgage thereon. The Terminal Corporation had the Dallas Real Estate Board, Inc., make an appraisal of the Alamo Street property on November 26, 1928, wherein the land was valued at $41,307.20 and the buildings at $1,200, or a total appraised value of $42,507.20. The buildings on this property consisted of a few shacks and houses that were rented as dwellings, and the property had not been used for industrial purposes except as a storage place for some of petitioner's equipment. The Terminal Corporation credited the appraised value of the property upon the petitioner's indebtedness and charged the balance of the indebtedness off its books as a bad debt; the amount so charged off was allowed as a loss to the Terminal Corporation in computing its tax. The fair market value of the Alamo Street property at the time the petitioner transferred it to the Terminal Corporation was $42,507.20.
On its 1928 return the petitioner reported a profit of $91,794.79 upon the transaction whereby rent and interest due the Terminal Corporation was canceled; *1351 the Commissioner increased the petitioner's income from this transaction to $93,367.35, and, after other adjustments not in controversy, determined the contested deficiency. The Commissioner adopted the report of the revenue agent, which, in so far as material to our determination, is as follows:
(b) Profit in forgiveness of indebtedness, $93,367.35, now shown as income. Return for 1928 shows such profit as $91,794.79. Such profit per 1928 return was charged up to account on books termed, "Contract Account", and was not charged up to Surplus Account, or P. & L. Account. Profit as corrected, $93,367.35, is now shown as addition to income due to the method used by corporation in setting up such profit on its books. (See Exh. "J", 1928).
Sept. 30, 1928, the books of the above named corporation show a liability of $107,880.77 for unpaid rent, and interest due Terminal Building Corporation, *655 Dallas, Tex. This liability covers rent and interest for 1925, 1926, 1927, and 1928 to September 30th. The Terminal Building Corporation demanded payment in 1928, and was unable to collect, and in the 1928 return filed by the Terminal Building Corporation, stated that if suit*1352 had been brought it would have resulted in putting the above-named taxpayer out of business, and a vacant 9-story building left on the owner's hands. The Terminal Building Corporation took over all of the above-named taxpayer's real estate at an appraisal made by the Dallas Real Estate Board. The balance was charged off the books of the Terminal Building Corporation as a bad debt, and such was allowed as a loss per IT 1547 to the Terminal Building Corporation.
* * *
The profit in the sale and forgiveness of the debt is shown as follows:
| Kind | Yr. Acq. | Cost | Depreciation to 12-31-25 |
* * *
| Total | 12/31/1927 | $42,703.64 |
| $3,190.22 |
* * *
| Rent and interest due Terminal Building Corp | $107,880.77 | |
| Mortgage assumed by Terminal Building Corp | 25,000.00 | |
| Total amount of debt and mortgage | $132,880.77 | |
| Plus depreciation on buildings to Dec. 31, 1925, per above | 3,190.22 | |
| $136,070.99 | ||
| Less cost of property as per above | 42,703.64 | |
| Profit in forgiveness of debt, as corrected | $93,367.35 | |
| Profit in forgiveness of debt as per return, and also found charged on books to "Contract A/C" | 91,794.79 | |
| Increase to be found under Exh. "J", 1928 | $1,572.56 | |
| Depreciation to December 31, 1925, per above | $3,190.22 | |
| Cost per above | $42,703.64 | |
| Cost per return and books | 41,085.98 | |
| Cost increased | 1,617.66 | |
| Net increase in profit as per above | $1,572.56 |
*1353 The petitioner kept its books upon the accrual basis, and during the taxable year 1928 accrued on its books as rent payable to the Terminal Corporation the sum of $14,939.61 in excess of the amount paid as such rentals, and excluding, however, from such payments the real estate transferred by the petitioner to the Terminal Corporation in the latter part of 1928.
The parties have stipulated that the petitioner is entitled to deductions in 1929 for expenditures made in that year as follows:
| Industrial Dallas, Inc | $180 |
| Rotary Club | 50 |
| Traffic Club | 10 |
| Kiwanis Club | 15 |
| 255 |
*656 The petitioner's tax return showed net losses of $26,396.25 and $24,331.48 in 1926 and 1927, respectively, which the Commissioner allowed as deductions in computing the taxable net income of $34,557.19 for 1928.
OPINION.
TRAMMELL: The principal issue in this case is whether or not petitioner realized taxable income in 1928 from the transactions with its landlord, the Terminal Corporation, whereby the petitioner transferred the Alamo Street property to the Terminal Corporation and the latter canceled the balance of the petitioner's indebtedness.
In 1928 the petitioner*1354 owed the Terminal Corporation $107,880.77 for unpaid rent and interest thereon. It was then insolvent and unable to pay this indebtedness. An agreement was reached by which the petitioner was enabled to continue its business and the Terminal Corporation to rent its warehouse, but at a reduced rental.
The petitioner's indebtedness was discharged by its transferring to the Terminal Corporation the Alamo Street property, which had a depreciated cost to petitioner of $39,513.42, and was subject to a mortgage of $25,000, which the creditor corporation assumed. At the time of the transfer, the petitioner's equity in the property was $14,513.42. The Terminal Corporation canceled the balance of the indebtedness in the amount of $93,367.35, which amount the respondent contends constitutes taxable income to the petitioner.
In our opinion, the legal effect of the transaction, whereby the petitioner transferred real estate to the principal creditor in full satisfaction of its indebtedness, was to constitute such transfer a sale of the real estate, on which sale the petitioner realized taxable profit in an amount equal to the difference between the depreciated cost of the real estate*1355 and the aggregate amount of indebtedness canceled. See Abe Ackerman,27 B.T.A. 413">27 B.T.A. 413; also Twin Ports Bridge, Co.,27 B.T.A. 346">27 B.T.A. 346.
Petitioner contends that the gain is the difference between the depreciated cost of the property and the fair market value when transferred in cancellation of the debt. But as we view the transaction the property was transferred in cancellation of the debt, not applied to the extent of its fair market value and the balance of the debt forgiven. Our view is in accordance with written instruments of the parties. It is not shown that these instruments did not fairly set out what was done. The contract does not refer to a forgiveness of a debt, but to a cancellation thereof in consideration of the transfer. In a sale of property the taxable gain is the difference between the selling price and depreciated cost, when acquired after March 1, 1913, not the difference between the cost less depreciation and the *657 value of the property. What the acquiring company laid out for the acquisition of the property would be the basis in its hands on a subsequent sale.
This case does not involve a cash payment of a part*1356 of a debt and the forgiveness of the balance, a general composition of creditors, nor bankruptcy, nor a situation where the debtor was still insolvent or left without assets after the debt cancellation or forgiveness, but a transfer of property in cancellation of the entire debt, leaving the taxpayer solvent. The bookkeeping entries of the creditor, in which it set up the appraised value of the property on its books as being a pro tanto satisfaction of the debts, are contrary to the agreement of the parties that the entire debt was to be canceled by the property transfer. In any event it is the debtor before us, not the creditor. The petitioner, being the debtor, treated the excess over cost of property less depreciation as being taxable income.
We see no valid distinction between this case and our decision in the case of Twin Ports Bridge Co., supra, in which we held that where a corporation pays its debts with stock, the difference between the cost of the stock and the amount of debts satisfied constitutes income. It is true that in this case the taxpayer was insolvent prior to the transaction, but solvent afterwards. In that case the taxpayer was solvent*1357 both before and after the transaction. However a corporation while insolvent may still have income. The fact that a taxpayer may in prior years have operated at a loss and its debts exceed its assets does not prevent it in the taxable year from making a taxable gain by disposing of property for more than its cost.
But even treating the case for the sake of argument on the principle upon which the taxpayer relies, that is, a partial forgiveness of debt, in our opinion the taxpayer can not prevail. Assets were left cleared of debts to the extent of the amount forgiven and the taxpayer was enriched to that extent. If a taxpayer had real estate worth $10,000, with a mortgage thereon of $5,000, it would seem that by canceling the mortgage, leaving the property free, it would be equivalent to the receipt of cash to the extent of the mortgage, whether the taxpayer then be solvent or insolvent. The case of United States v. Kirby Lumber Co.,284 U.S. 1">284 U.S. 1, and the case of Bowers v. Kerbaugh-Empire Co.,271 U.S. 170">271 U.S. 170, as explained in the Kirby Lumber Co. case, support this view. The use of the capital asset, to wit its property which it used*1358 in having its indebtedness canceled or reduced, involves the use of capital in securing its enrichment to the same extent, in our opinion, as the use of money by the Kirby Lumber Company in buying back its bonds issued at par for less, thus giving rise to taxable gain.
*658 See also the recent decision of the United States Circuit Court of Appeals for the First Circuit in Commissioner v. Coastwise Transportation Corp., 62 Fed.(2d): 332, rendered after the Kirby Lumber Co. case, supra, and which reversed the decision of the Board at 22 B.T.A. 373">22 B.T.A. 373, that the taxpayer derived no income from the purchase of two of its serial notes at less than face value.
In the view we take that the canceled indebtedness in excess of the depreciated cost of the real estate constituted income to the petitioner for the year 1928, it becomes unnecessary to consider the petitioner's allegations in respect of the application of its net losses for 1926 and 1927, based upon the theory that the cancellation of the indebtedness did not constitute income, since the respondent applied said net losses against 1928 net income before computing the deficiencies.
The parties*1359 have stipulated that the petitioner is entitled to an additional deduction from gross income for 1929 on account of expenditures for club dues, as set out in our findings of fact. Said stipulation will be given effect in redetermining the deficiency for that year.
Reviewed by the Board.
Judgment will be entered under Rule 50.
SMITH, dessenting: I can not agree that the transaction by which the petitioner transferred the Alamo Street property to its principal creditor constituted a sale of that property upon which the petitioner realized a taxable profit of $93,367.35. The facts do not warrant that conclusion. The petitioner had operated at large losses from the date of its organization. Its capital of $200,000 had been entirely wiped out. At December 31, 1927, it had on hand assets of a value of $152,470.16 and had accounts payable of $178,941.01. In order that the petitioner might continue in business its principal creditor agreed to cancel a part of its claim. The petitioner owned property on Alamo Street, which had a depreciated cost to the petitioner of $39,513.42 and which was subject to a mortgage of $25,000. The agreed fair market value*1360 of the property in 1928 was $42,507.20. The principal creditor took over this property, assumed the mortgage thereon, and canceled the balance of its claim against the petitioner. To hold that the petitioner realized a taxable profit of $93,367.35 does violence to the principle that the income tax law shall be interpreted in accordance with truth and substance.
The petitioner admits that it realized a profit upon the transaction represented by the difference between the depreciated cost of *659 its equity in the Alamo Street property and its fair market value at the date of transfer, or a profit of $2,988.78. It contends, however, that the difference between $2,988.78 and $93,367.35 was a concellation of indebtedness from which it derived no taxable income. I think its contention is well founded. A reduction of debt liability is not necessarily a realization of taxable income. Bowers v. Kerbaugh-Empire Co.,271 U.S. 170">271 U.S. 170; Meyer Jewelry Co.,3 B.T.A. 1319">3 B.T.A. 1319; United States v. Oregon-Washington R.R. & Nav. Co.,251 Fed. 211; *1361 Commissioner v. Simmons Gin Co., 43 Fed.(2d) 327; Burnet v. John F. Campbell Co., 50 Fed.(2d) 487; Commissioner v. Rail Joint Co.,22 B.T.A. 1277">22 B.T.A. 1277; affd., 61 Fed.(2d) 751.
In each case the facts must be considered. In United States v. Kirby Lumber Co.,284 U.S. 1">284 U.S. 1, the facts are that the Lumber Company had gained $137,521.30 in cash within the taxable year by redeeming certain of its bonds for that amount less than it had received for the bonds upon the issuance earlier in the year. By the transaction the company's cash assets were increased by $137,521.30. The Supreme Court said that the amount was "an accession to income" which was "realized within the year." No facts obtain in the instant proceedings which bear a close analogy thereto. The proper interpretation of the Kirby Lumber Co. decision is in my opinion indicated by the decision of the Circuit Court of Appeals for the Second Circuit in Commissioner v. Rail Joint Co., supra, in which the decision of this *1362 Board at 22 B.T.A. 1277">22 B.T.A. 1277, was affirmed. It was held in that case both by the Board and by the Court that the reduction of the liability was not an "increment to its [petitioner's] assets."
Manifestly if a debtor turns over to his creditor all of his property, which is only a fractional part of the debt owed by him, in settlement of his debt, the debtor derives no taxable income from the transaction. Nothing is received which answers to the definition of "income" laid down by the Supreme Court in Eisner v. Macomber,252 U.S. 189">252 U.S. 189. I can not see, in the instant proceedings, that the petitioner has had any "increment to its assets" through the cancellation of a portion of its indebtedness in 1928. At most it realized only a profit measured by the difference between the depreciated cost of its equity in the Alamo Street property and the fair market value of that property at the date of sale.
In my opinion the petitioner's accounts should be restated for the years 1926, 1927, and 1928, and the net losses for the years 1926 and 1927, to the extent that they were caused by the accrual of unpaid rent which was canceled in 1928, should be restated in*1363 accordance with section 272(g) of the Revenue Act of 1928.