*1052 Petitioner, with coowners, leased realty for a term of 20 years, 7 months, with options in the lessee to renew for second, third, and fourth terms of 21 years for each renewal term, without any increase in rent based upon any added value to the property due to the erection of a building. The original term ran from October 1, 1923, to April 30, 1944. In April 1925 a sublessee completed constructions of a building on the leased premises at a cost of $485,455 and this building then became the property of the lessors. The building had an estimated life of 30 years to April 1955. For the taxable years 1931 and 1932, respondent determined that petitioner realized income in the amount of his proportionate interest in the depreciated value of the building at the end of the original term of the lease, 20 years, 7 months, spread over 20 years pursuant to article 63(b) of Regulations 74. Petitioner alleges error and asserts that he realized no income. Held:
(1) It is a question of fact whether a lessor realizes income from improvements made by a lessee.
(2) Whether the lessor realizes income can not be determined for purposes of taxation until the lessee has elected to either*1053 renew a lease or not to renew, where the creation of one renewal term will put the date of termination of the lease beyond the depreciated life of the building constructed by the lessee.
(3) In determining the depreciated value of the building at the termination of the lease pursuant to article 63(b), respondent erred in not considering the lessee's right to renew because in this proceeding the creation of one renewal term of the lease under the option to renew would put the date of termination of the lease beyond the depreciated life of the building.
*360 The Commissioner has determined deficiencies in No. 75030 for the year 1931 in the amount of $93.17 and in No. 78877 for the year 1932 in the amount of $219.85. Petitioner alleges as error respondent's action in adding to taxable income in 1931 and 1932, pursuant to article 63(b) of Regulations 74, the amount of $1,250 representing "income" realized by petitioner from improvements made by a lessee on property leased by petitioner and others.
FINDINGS*1054 OF FACT.
The petitioner is an individual residing in New York City, and at all of the times hereinafter mentioned, owned a one-fourth interest in property located at the southwest corner of 42nd Street and Sixth Avenue, New York City, known by the street numbers 104-106-108 West 42nd Street and 1091-1097 Sixth Avenue.
*361 The petitioner and the other owners of the above described property leased this property on October 1, 1923, to D. A. Schulte, Inc., a corporation organized and existing under the laws of the State of New York, for an original term of 20 years and 7 months, to expire on April 30, 1944, with an option on the part of the lessee to renew the lease for a successive period of 21 years upon notice given by the lessee at least 12 months prior to the expiration of the original term. The renewal lease was to contain an option of renewal for a third term of 21 years, on the condition that the lessee should have erected or caused to be erected a building upon the premises in compliance with the express terms of the lease prior to the time of the expiration period of the first renewal. If the lessee should be entitled to have an option of renewal for a third term, *1055 then the lessee should also have an option of renewal for a fourth term of 21 years, but not beyond a fourth term.
The rental for the original term from October 1923 to April 1944 was fixed in increasing amounts ranging from the rate of $70,000 per year to $105,000 for the last five years ending April 1944.
It was provided that if the parties have not agreed upon the rental for the renewal term before the first day of August preceding the expiration of the original term, the rental for the renewal term shall be equal to 5 percent per annum upon the value of the land, excluding the value of the building then thereon, at the time of expiration of the lease, and in no event to be less than $105,000; the value of the land to be determined by appraisers as provided for in detail in the lease, who shall ascertain the fair value of the property considered as vacant land. The rental for the third and fourth renewal terms, the right to which was contingent upon the construction of a building, is to be fixed in the same manner as for the first renewal term.
The lease provided that all improvements, alterations, and structures which might be built upon the demised premises during the*1056 term of the lease, or the period of any renewal thereof, should immediately thereupon become the property of the lessors.
D. A. Schulte, Inc., on January 14, 1924, subleased these premises to a corporation organized under the laws of the State of New York, known as 42nd Street & Sixth Avenue Corporation. This last named corporation erected a building upon the premises, completing the same in April 1925, at a cost of $485,455.18. The improvements thus erected had an expected life of 30 years at the time of their erection and the respondent has agreed that exhaustion, wear, and tear on such imrpovements should be computed at the rate of 3 1/3 percent on a cost of $480,000, $320,000 for a period of 20 years, which represents a reasonable allowance for depreciation. Prior to the erection of the new building in 1925 there were situate on the demised premises improvements of a residual value in 1925 of $60,000, which improvements were demolished by the 42nd Street & Sixth Avenue Corporation.
*362 In 1931 the 42nd Street & Sixth Avenue Corporation defaulted in the payment of rent and was dispossessed in June 1931 by D. A. Schulte, Inc.
The respondent added to petitioner's*1057 taxable income in each taxable year the amount of $1,250 as income realized by petitioner from improvements made by a sublessee.
OPINION.
HARRON: The sole question is whether petitioner realized income in the years 1931 and 1932 as the result of the construction of a building by a sublessee on leased premises of which the petitioner was a part owner. The building was completed in April 1925 and has an estimated useful life of 30 years to April 1955. The original lease of the premises on which the building was constructed was for a term of 20 years, 7 months, to April 30, 1944. The lessees had options to renew the lease for three successive terms of 21 years thereafter.
The Commissioner has prescribed alternative method of reporting income where a lessor realizes income as the result of improvements on premises by lessees. The regulation is quoted in the margin, 1 as amended by T.D. 4282, C.B. VIII-2, p. 82.
*1058 The petitioner and the other lessors involved did not report income as a result of the construction of the building in 1925, pursuant to subsection (a) of article 63. The respondent has determined that he should therefore report income pursuant to subsection (b). Respondent has determined a deficiency by applying subsection (b), specifically, as follows: The Commissioner held that the building erected in 1925 by the sublessee had a fair market value of $480,000. From this figure he deducted $320,000 representing 20 years depreciation, the original term of the lease, at 3 1/3 percent. As there were old buildings torn down which had a value of $60,000 for which obsolescence was allowable, the "income" received by the lessors by reason of the erection of the building was determined to be $100,000. This amount respondent spread over 20 years, the term of the original lease, under option (b) of article 63 of Regulations 74. He thereby determined that the lessors realized a yearly "income" of $5,000, which, apportioned among the four owners resulted in "income" to the petitioner *363 of $1,250. This amount was added to petitioner's taxable income in each of*1059 the taxable years.
The petitioner, one of the lessors, in his income tax returns for the taxable years reported no income by reason of the erection of the building and the acquisition of title thereto.
Petitioner contends that he derived no income in the taxable years from the completion in 1925 of a building erected by the sublessee on the premises leased for an original term expiring April 30, 1944, with options for renewals for 3 terms, totaling 63 years, options exercisable by the lessee solely, when the probable life of the building from April 1925 was 30 years. He further argues that he could not realize income from construction of the building until he disposed of his interest in the leased premises. Petitioner relies on Hewitt Realty Co. v. Commissioner, 76 Fed.(2d) 880, which was decided by the Circuit Court of Appeals for the Second Circuit, which reversed this Board's opinion, Hewitt Realty Co.,29 B.T.A. 1205">29 B.T.A. 1205.
The respondent has determined that petitioner realized taxable income as a result of constructing a building on the premises leased by petitioner and others. This determination has been made pursuant to article 63*1060 (b) of Regulations 74. In applying the pertinent provision of the regulations, respondent has considered only the depreciated value of the improvements at the expiration of the original term of 20 years and has disregarded the option in the lessee to renew the lease for a renewal term of 21 years. This, we now believe to be in error.
In considering the question whether construction of a building on leased property enriches the lessor so that he realize taxable income, we must enquire whether the improvement has enhanced the value of the property. Whether or not there is an increase in value is a question of fact. Cf. United States v. Boston & Providence Railroad Corporation, 37 Fed.(2d) 670; Hewitt Realty Co. v. Commissioner, supra, p. 883. The facts are to be considered in relation to the terms of the lease.
In this proceeding the improvements were not removable from the realty and title to them vested in the lessors. The rental for the original term of the lease was fixed upon the basis of the value of the unimproved realty, i.e., ground rent. For the last five years of the original term the rental per year was $105,000. It*1061 was provided in the lease that the rental for any renewal term should be not less than $105,000 per year or a ground rental of 5 percent per annum of the value of the land, as found by appraisers, excluding the value of the newly constructed building. In other words the lessors gave the lessee the option to renew without any increase in the rent based on any added value to the property due to the erection of the building. Therefore, so long as the lease should continue into a second term of *364 21 years from the end of the first 20 1/2 years, the improvement resulting from construction of the building would enhance the value of the leased premises only if the useful life of the building were for a period longer than the life of the lease. It is agreed that the building's estimated useful life was 30 years, to 1955. The second term of 21 years from April 30, 1944, would run to April 30, 1965, which exceeds the estimated useful life of the building.
Article 63(b) of Regulations 74 provides that the depreciated value of a building at the expiration of the lease may be spread over the life of the lease. This regulation has been interpreted by the Commissioner to*1062 mean that the term "expiration" refers to the period covered by the original term of a lease without consideration for whether there may be any renewal. In Hewitt Realty Co.,29 B.T.A. 1205">29 B.T.A. 1205, we approved this interpretation by stating that the lease may not be considered as extending over possible renewal terms, referring to Bonwit Teller & Co. v. Commissioner, 53 Fed.(2d) 381. The Circuit Court of Appeals has held that the Board was in error in its opinion. The opinion of the court is not unanimous on the point of whether the regulation applicable is valid. We believe that the regulation is valid and have so indicated. See Emma C. Morphy,35 B.T.A. 289">35 B.T.A. 289; Julia Willms Sloan,36 B.T.A. 370">36 B.T.A. 370. However, in these last cited cases the issue was not concerned with the problem of how to apply the pertinent regulation where the improvements were made upon premises subject to renewal lease at rental to be computed on the basis of ground rent, nor were there such other factors as are present in this proceeding. We believe that in determining the issue here involved we must consider whether the improvements on the leased*1063 property increased the value of the property so as to result in taxable income to the lessor and that, to properly determine whether there is income to the lessor, consideration should be given to whether the lease may be extended over possible renewal terms.
Therefore, giving recognition to the fact that the creation of one renewal term of the lease under the option to renew would put the date of expiration of the lease beyond the depreciated life of the building, and where, further, the option to renew does not involve any increase in rent based upon any added value to the property due to the erection of the building, we believe that it can not be said that the petitioner in this proceeding realized any taxable income in the taxable years. We believe that the question of when or whether taxable income is realized may not be determined until the time, under the terms of the lease, when the lessee will elect either to renew or not to renew the lease for a further term of 21 years. Therefore, the Commissioner erred in ignoring the possibility of renewal for another term in estimating the depreciated value of the building at the termination of the lease for purposes of taxation.
*1064 *365 It is held that the Commissioner erred in determining the deficiency and there is no deficiency in No. 75030.
Reviewed by the Board.
Decision will be entered for petitioner in No. 75030. Decision will be entered under Rule 50 in No. 78877.
Footnotes
1. Article 63 of Regulations 74, as amended, reads in part as follows:
"Improvements by lessees. - When buildings are erected or improvements made by a lessee in pursuance of an agreement with the lessor, and such buildings or improvements are not subject to removal by the lessee, the lessor may at his option report the income therefrom upon either of the following basis:
"(a) The lessor may report as income at the time when such buildings or improvements are completed the fair market value of such buildings or improvements subject to the lease.
"(b)↩ The lessor may spread over the life of the lease the estimated depreciated value of such buildings or improvements at the expiration of the lease and report as income for each year of the lease an aliquot part thereof."