1944 U.S. Tax Ct. LEXIS 184">*184 Decision will be entered under Rule 50.
Petitioner's redemption at less than par of bonds issued by it for property of a value less than the face amount of the bonds, petitioner at all times being insolvent, held, not to result in taxable gain. Dallas Transfer & Terminal Warehouse Co. v. Commissioner (C. C. A., 5th Cir.), 70 Fed. (2d) 95, followed.
3 T.C. 342">*342 By this proceeding petitioner contests a portion of deficiencies in income tax for fiscal years ended April 30, 1939, and April 30, 1940, in the amounts of $ 2,885.18 and $ 3,340.41, respectively.
The question presented is whether petitioner realized taxable income as a result of purchases of its own bonds for amounts less than their face values. Disallowance of a deduction for depreciation is not challenged by the petitioner.
FINDINGS OF FACT.
In 1915 and 1916, respectively, two adjoining parcels of land located at the northeastern corner of Broadway and 94th Street, New York City, were improved by the erection on each of a twelve-story1944 U.S. Tax Ct. LEXIS 184">*185 brick building. The two buildings were joined and furnished for use as a hotel known as Hotel Monterey. One of the two parcels was held in fee and the other under a leasehold running for 200 years from November 1, 1915. The ground rent for the leasehold was $ 10,500 per annum, with certain provisions for an increase.
In 1926 this property, hereinafter referred to as Hotel Monterey, was owned by the Broadway-94th Street Realty Co. On March 16 of that year that company issued its bonds in the face amount of 3 T.C. 342">*343 $ 850,000. The bonds were known as the Monterey first mortgage fee and leasehold 6% serial gold bonds of Broadway-94th Street Realty Co. (hereinafter referred to as the "old bonds") and were secured by a deed of trust on the hotel property. Subsequent to the issuance of the old bonds but prior to 1932 certain of the bonds had been retired, leaving $ 726,000 in face amount outstanding in 1932. In 1932 default was made in the payment of principal ($ 49,000.02) and interest ($ 21,780) then due. There was also a default in the payment of taxes aggregating $ 42,090. It was stated in the application for a receiver that the gross annual income of the property had been1944 U.S. Tax Ct. LEXIS 184">*186 $ 233,867.12 -- an amount insufficient to pay operating expenses, taxes, and interest on the mortgage. On September 13, 1932, a foreclosure proceeding was instituted in the Supreme Court of New York for New York County by the successor trustee, the Continental Bank and Trust Co. of New York, hereinafter referred to as the "old trustee." The defendants in this action were Broadway-94th Street Realty Co., Bantri Realty Corporation, and others, the property having changed hands since the mortgage had been given.
The foreclosure was converted into a proceeding pursuant to sections 119 to 123, inclusive, of the New York Real Property Law. These sections were known as the Burchill Act, and were enacted during the depression (May 3, 1933) authorizing state court reorganizations involving holders of bonds secured by mortgages on real property held by trustees.
On October 4, 1934, a referee appointed by the court computed the amount due on the old bonds, together with trustee's fees, on that date to be:
| Principal | $ 726,000.00 |
| Interest | 118,052.34 |
| Trustee's Fees | 10,016.21 |
On October 22, 1934, a judgment of foreclosure and sale directed the referee to sell the property at public 1944 U.S. Tax Ct. LEXIS 184">*187 auction. By an order of May 29, 1935, a referee was appointed and directed to hear and report on plans of reorganization.
Pursuant to the provisions of a bondholders' deposit agreement of September 14, 1932, 72 percent of the outstanding old bonds had been deposited with the Monterey Hotel Bondholders' Committee, which was to act in behalf of the depositors. Under date of October 25, 1935, 1 this committee promulgated a "bondholders' plan" of reorganization, and notice of approval and adoption and filing of the plan of reorganization, etc., was given to the holders of certificates of deposits of the bonds. This plan, among other things, provided for the completion of the foreclosure action, the bidding in of the property 3 T.C. 342">*344 by the trustee, the organization of a new company, the transfer of the property to the new company, the issuance of its capital stock not in excess of 7,260 shares and of its income bonds not in excess of $ 726,000, and the distribution thereof to the holders of the mortgage bonds. Holders of the old bonds were to receive, in exchange for their old bonds, income bonds of the new company in the same face amount as their old bonds and in addition full 1944 U.S. Tax Ct. LEXIS 184">*188 paid nonassessable common stock in the new company at the rate of one share for each $ 100 in principal amount of their bonds.
The income bonds were to mature in fifteen years from their date, and provision was made for a sinking fund for their amortization, which was to be used from time to time to purchase the bonds at market prices. The net income of the new company was to be available for interest payments at varying rates and payments into the sinking fund.
Under date of November 14, 1936, Max J. Kramer Sons Corporation made an offer to purchase the property. Among other things this offer provided that the property should be conveyed to a new company which would issue new bonds in the principal amount of $ 726,000, secured by a mortgage, all stock in the new company being held by the offeror, which would also pay $ 50,000 in cash and apply a further amount of $ 35,000 to the improvement of the property after the taking of title. The referee held hearings on this proposal, 1944 U.S. Tax Ct. LEXIS 184">*189 as well as on proposals of two other prospective purchasers, both of whom had offered to issue new bonds and mortgage in the principal amount of $ 726,000, together with some additional cash and security.
The referee recommended approval of the Max J. Kramer Sons Corporation offer, and by a court order of January 15, 1937, a plan of reorganization embodying this offer was approved by the court. At a public sale held on March 19, 1937, the old trustee successfully bid in the property for $ 50,000 cash.
Petitioner, the new company referred to in the Kramer Sons offer, was organized as a Burchill Act corporation empowered only to hold real estate or investments legal for trusts in New York. The referee approved the certificate of incorporation of petitioner and the trust indenture securing the new bonds it proposed to issue. The Continental Bank and Trust Co. was named as trustee in the new indenture.
In accordance with the plan, petitioner issued new bonds in the face amount of $ 726,000 and delivered them to the new trustee. Holders of the old bonds delivered them to the old trustee, who in turn traded them to the new trustee for the new bonds in equal face amount. The old trustee1944 U.S. Tax Ct. LEXIS 184">*190 assigned its bid for the purchase of the property to petitioner, which upon payment of $ 50,000 to the referee was given a deed to the fee portion of the property and an assignment of the 3 T.C. 342">*345 leasehold on the other parcel. The personal property connected with and in the buildings passed with the real property. In further pursuance of the agreement petitioner expended some $ 35,000 in rehabilitating the hotel.
The bonds, known as the fifteen-year first mortgage and leasehold bonds, dated May 1, 1937, were to bear 3 1/4 percent annual interest the first five years, 3 1/2 percent the second five years, and 4 percent the last five years. The bonds provided:
As more fully provided in the Indenture, the Company shall establish a Sinking Fund, and the amount so set aside as a Sinking Fund shall be applied by the Trustee either to the purchase, at public or private sale, of Bonds at current market prices, or, in its discretion, at the lowest prices at which Bonds at such time may be offered for sale to the Trustee, or, if not so purchasable, to the redemption of Bonds by lot; but in none of such events at a price in excess of the principal amount of the Bonds plus accrued interest1944 U.S. Tax Ct. LEXIS 184">*191 thereon.
The indenture provided:
This Indenture Further Witnesseth: That it is hereby covenanted and agreed by the respective parties hereto, for the prorata benefit and security of the respective holders of Bonds, from time to time, as follows:
* * * *
Article III.
Sinking Fund.
Section 1. The Company covenants and agress to establish and maintain a sinking fund (herein called the "Sinking Fund") for the purchase, redemption and retirement of Bonds and for that purpose convenants and agrees to pay to the Trustee in trust, at or before the expiration of one year from the date hereof and at or before the expiration of every year thereafter, the sum of Ten Thousand Dollars ($ 10,000). The Company may, at its option, pay to the Trustee in trust, additional sums from time to time to be applied by the Trustee in accordance with the provision of this Article III.
Section 2. The Trustee shall apply the moneys so paid to it pursuant to the provisions of Section 1 of this Article III, as rapidly as may be practicable, either to the purchase, at public or private sale, of Bonds at current market prices, or, in its discretion, at the lowest prices at which Bonds at such time may be offered 1944 U.S. Tax Ct. LEXIS 184">*192 for sale to the Trustee, but not exceeding the current market price (if any) or, if not so purchasable, to the redemption of Bonds by lot; but in none of such events at a price in excess of the principal amount of the Bonds, plus accrued interest thereon. The Company may, in its discretion at any time, subject to the provisions of this Section 2, when the Trustee has in its possession sinking fund moneys request the Trustee to solicit tenders from the bondholders for the sale of bonds, under the provision of this Article III.
Pursuant to the above sinking fund agreement petitioner paid the trustee $ 10,000 on May 3, 1938, and the trustee expended $ 9,992.50 of this amount to retire $ 29,500 face amount of the bonds during May 1938. On May 21, 1939, another $ 10,000 was paid by petitioner to the trustee and within a month thereafter, and prior to June 29, 1939, the effective date of Revenue Act of 1939, this amount was expended 3 T.C. 342">*346 for the purchase of $ 31,400 face amount of the bonds. Pursuant to the trust indenture the repurchased bonds were canceled by the trustee and certificates of cancellation presented to petitioner.
The average price paid by the trustee in the repurchase1944 U.S. Tax Ct. LEXIS 184">*193 operation of 1938 was $ 33.87 per $ 100 face amount of bonds. In 1939 the average price paid was $ 31.95 per $ 100 face amount of bonds. The prices paid were the market prices as of the date of purchase.
The market prices of the old bonds which were exchanged for the new bonds were as follows:
| Bid per $ 100 | Ask per $ 100 | |||
| Date | face amount | Bonds bid for | face amount | Bonds offered |
| March 1, 1937 | 42 | 3 | 44 | 3 |
| 41 1/2 | 5 | 43 1/2 | 5 | |
| 46 | 5 1/2 | |||
| March 5, 1937 | 43 | 2 | 45 1/2 | 3 |
| 43 | 3 | |||
| March 12, 1937 | 44 | 3 | 47 | 3 |
| March 19, 1937 | 41 | 4 | ||
| March 24, 1937 | 41 | 3 | ||
| March 30, 1937 | 40 | 3 | ||
| April no quotations. | ||||
| May 7, 1937 | 33 1/2 | |||
| May 8, 1937 | 34 | |||
| 33 | ||||
| May 10, 1937 | 34 1/2 | 3 | ||
| 34 | ||||
| 33 | ||||
| May 15, 1937 | 34 1/2 | 3 | ||
| 34 | ||||
| May 17, 1937 | 34 1/2 | 5 | ||
| May 28, 1937 | 35 1/2 | 4 |
The S. W. Straus Co. placed a mortgage on the Hotel Monterey property for $ 850,000 in 1926. Real estate values in New York City dropped sharply during the subsequent depression beginning in 1930. If the $ 850,000 represented a fair value of the property in 1926 it would not necessarily have had that value in 1935 or later. The value of the1944 U.S. Tax Ct. LEXIS 184">*194 property in 1935 was about the same as its value in 1937, 1938, and 1939, except for physical depreciation. Sales of property in the neighborhood of the hotel were very infrequent.
The hotel had 380 rooms of which 351 were available for rent. There were 300 bathrooms -- nearly all the bathtubs were on legs and out of date. The buildings were fireproof, built of brick and steel, with concrete floors. Because of the terms of the lease the building on the leasehold was required to be built as a separate building, notwithstanding that it was used with the improvement on the fee as one building. This requirement of the lease made necessary separate heating plants, separate elevators, additional staircases, and wider corridors than would otherwise have been necessary. These factors led to increased costs of operation.
The rooms in the hotel rented for approximately $ 40 per month and the property contained five stores rented, respectively, by a bank, a druggist, a restaurant, and two smaller shops.
3 T.C. 342">*347 Attached to the prospectus accompanying the plan for reorganization was an appraisal of the property made by Mark Rafalsky & Co. The value placed on the whole property, including1944 U.S. Tax Ct. LEXIS 184">*195 the buildings by this appraisal, was $ 400,000 (leasehold property $ 150,000; fee $ 250,000). Furniture and equipment were not included in this figure. They were worth approximately $ 27,000 during the period 1937 to 1940. An income statement appearing in this prospectus stated that gross income for the year ended August 31, 1935, was $ 207,607.75. Expenses for that year before deduction of receivers' fees and expenses, interest on mortgage, and depreciation on buildings were stated to be $ 178,956.70, leaving a net income before the excluded expenses of $ 28,651.05. Net income before deductions for interest on the mortgage or real estate management fees was roughly $ 5,000.
For the fiscal years ended April 30, 1938, 1939, and 1940, respectively, gross income for income tax purposes was reported by petitioner to be $ 62,251.80, $ 71,013.70, and $ 70,985.77. For the fiscal year ended in 1939 petitioner reported in its income tax return a net loss of $ 1,713.83 and for the fiscal year ended in 1940 a net loss of $ 846.66. The net income for each of the last two years -- the ones here in question -- was computed without including any gain on the bond purchases previously described.
1944 U.S. Tax Ct. LEXIS 184">*196 The assessed value of the real estate (including the portion held on leasehold) was $ 805,000 in 1935, $ 795,000 in 1937, $ 775,000 in 1938, and $ 765,000 in 1939. In New York City a leasehold is not assessed as such, but the fee is assessed. The value of the fee underlying the leasehold, which petitioner did not own, arrived at by capitalizing the annual rent at 6 percent, was approximately $ 175,000.
The value of the hotel property, including the furnishings, for the years in question was not more than $ 625,000.
In setting up its books petitioner included on the liability side of its balance sheet the face amount of the bonds, together with other indebtedness incurred in acquiring the property. Petitioner then made the asset side of its balance sheet equal its liabilities by allocating the amount appearing on the liability side among the various assets. In making this allocation tax assessments and insurance carried at the time the books were opened were taken into consideration. As a result, the buildings were carried as assets at $ 410,000, the land $ 210,325, leasehold $ 66,000, furniture and equipment $ 89,903.39, additions to building $ 26,640.37, and additions to furniture1944 U.S. Tax Ct. LEXIS 184">*197 and equipment $ 12,260.65.
Petitioner reflected on its books the May 1938 sinking fund operations, which reduced the face amount of outstanding bonds by $ 29,500 through the expenditure of $ 9,992.50 by reducing its liabilities by the difference between the $ 9,992.50 and the $ 29,500. The corresponding 3 T.C. 342">*348 change on the asset side was called an adjustment of the original purchase price. The 1939 sinking fund operations were similarly reflected by an adjustment to original purchase price.
On April 30, 1938, the balance sheet of petitioner appearing in its income tax return for the fiscal year ended on that date showed the following liabilities other than capital stock:
| Accounts payable | $ 33 |
| Bonds (original maturity date of 1 year or more) | 726,000 |
| Loans payable | 81,000 |
| Security deposits | 250 |
| Total | 807,283 |
On April 30, 1939, a similar balance sheet showed the liabilities below:
| Accounts payable | $ 32.97 |
| Bonds, notes, etc. | |
| (a) Original maturity less than 1 year | 3,094.78 |
| (b) Original maturity more than 1 year | 696,500.00 |
| Loans payable | 52,250.00 |
| Total | 751,877.75 |
And on April 30, 1940, an analogous balance sheet showed the following liabilities: 1944 U.S. Tax Ct. LEXIS 184">*198
| Accounts payable | $ 67.70 |
| Bonds, notes and mortgages payable | |
| (a) Original maturity less than 1 year | 2,305.46 |
| (b) Original maturity more than 1 year | 665,200.00 |
| Loans payable | 26,000.00 |
| Security deposits | 260.00 |
| Total | 693,833.16 |
Exclusive of the hotel property, its assets did not at any time exceed $ 20,000.
Petitioner was insolvent at all times during each of the taxable years in issue.
In the notice of deficiency respondent determined the difference between the face amount of bonds retired in 1938 and 1939 and the amount expended in retiring them to be taxable income to petitioner in the year such bonds were retired.
OPINION.
This proceeding falls into the vexed category of controverted gain through the reduction of liabilities. See . The distinctions from the situation presented in that case, however, are obvious. . But were it not for three other circumstances, 3 T.C. 342">*349 the present case would fall squarely within .1944 U.S. Tax Ct. LEXIS 184">*199 This petitioner issued its bonds for property, while in the Kirby case they were issued for cash. Subsequent developments indicate at least a limitation upon that ground of distinction. ; cf. the same case below (C. C. A., 2d Cir.), , and .
The discrepancy between the value of the property as we have found it and the face value of the bonds raises the question whether the latter were issued at par within the meaning of respondent's regulations. See ; cf. . But, if not, the Kirby case offers no guidance. Its reliance on the regulations, e. g., Regulations 62, art. 545, see Regulations 101, art. 22 (a) (18), demonstrates the area in which its operation was intended to be confined, and indicates that the difference between purchase price and 1944 U.S. Tax Ct. LEXIS 184">*200 face value is significant only where there is no discount upon issuance. See . We have consistently taken this view and emphasized the issue price rather than par value in computing gain from the discharge of obligations. ; ; ; certiorari denied, ; ; ; but see ; . The question was apparently left out of consideration in , and perhaps remains open.
The ultimate and conclusive1944 U.S. Tax Ct. LEXIS 184">*201 distinction from the Kirby case, however, is that the value of the property when acquired, which, under the evidence, showed only depreciation thereafter, left petitioner insolvent not only upon issuance of the obligations but both before and after the discounted purchases. That circumstance eliminates the realization of taxable gain on the "freeing of assets" theory of the Kirby case. ; ; ; . "The petitioner's purchase and retirement of its own bonds during the taxable years simply reduced its outstanding liabilities. A reduction in outstanding liabilities which does not make a taxpayer solvent does not result in taxable gain," ; cf., however, We accordingly find it unnecessary to examine the applicability1944 U.S. Tax Ct. LEXIS 184">*202 of the "adjustment of purchase price" theory represented 3 T.C. 342">*350 by ; ; affd. (C. C. A., 8th Cir.), ; and ; but see ; certiorari denied, .
That the property was worth substantially less than the face amount of petitioner's obligations seems to us an inescapable conclusion. On any theory of valuation, whether derived from the opinions of qualified witnesses, from the assessed valuation, from a capitalization of the prospective and actual earnings of the property, from a consideration of the condition of the general real estate market, or by reference to the market value of the bonds secured by the property, the result is similar. Neither the excessive valuation for bookkeeping purposes, ,,1944 U.S. Tax Ct. LEXIS 184">*203 nor the discrepancy between the value we have found and the face amount of the obligations issued requires a disregard of these uncontroverted factors. ;; cf. . In fact, the figure we have included in our findings is approximately 50 percent greater than could soundly be substantiated by the record. It represents a maximum rather than an attempt to fix a value definite for all purposes. But the possibility of error is thus adequately discounted, and, since the figure adopted is yet so low as still to demonstrate petitioner's insolvency, it satisfies us that no contrary conclusion would be tenable. We accordingly view respondent's determination as erroneous.
Decision will be entered under Rule 50.
Footnotes
1. Erroneously stipulated as "1937."↩