*1552 1. Held, upon the evidence, that an amount paid in cash by petitioner at the time of the execution of a 99-year lease was part of the consideration paid for the lease instead of a payment for the improvements upon the land, and that such amount is deductible pro rata each year over the term of the lease, rather than over the useful life of the improvements.
2. Under the circumstances in this proceeding certain claimed bad debts were not charged off in the year in question within the meaning of the Revenue Act of 1926.
*1022 These are proceedings, duly consolidated for hearing, for the redetermination of asserted deficiencies in income taxes as follows:
| Docket No. | Year | Deficiency |
| 45135 | 1924 | $648.63 |
| 45135 | 1925 | 414.58 |
| 45135 | 1926 | 456.95 |
| 45135 | 1927 | 1,422.21 |
| 50328 | 1928 | 352.10 |
It is alleged that the respondent erred in computing the petitioner's tax liability for each of the years in controversy, in disallowing depreciation claimed by petitioner representing the annual estimated exhaustible life of an office*1553 building and improvements acquired under a 99-year lease, and representing an immediate capital investment of $150,000. It is also alleged that the respondent erred in computing the petitioner's tax liability for the year 1927 in disallowing an amount deducted as bad debts for the year 1927 which petitioner determined to be worthless and charged off during that year.
FINDING OF FACT.
The stipulation of facts is, verbatim, as follows:
I. Petitioner, Coronado Realty Company, with its principal office in the Denver National Bldg., Denver, Colo., was organized October 25, 1920, with a capital stock of 1,500 shares of a par value of $100 each all of which was fully subscribed and paid for in cash at par. There is attached as Exhibit A to the petition filed herein, a true copy of the 60-day letter issued by the Commissioner, dated May 17, 1929; and as Exhibit B a true copy of Petitioner's charter of incorporation, both of which may be treated as a part hereof.II. Petitioner was organized primarily for the purpose of taking over and operating an office building known as the "Coronado Building," which was *1023 owned by the International Realty Co., a Wyoming corporation. *1554 Said building is located at the corner of 15th & Stout Sts., Denver, Col., and faces 250 feet on Stout St. and 125 feet on 15th St. in what is now and was in 1920 approximately the center of the business district of Denver. This building is a two story brick structure with composition roof. The ground floor is leased to mercantile establishments and the second floor is leased to mercantile establishments and as offices. It was erected in 1901 and its useful life is expected to expire in 1953. The books of the International Realty Company show the cost of the building to have been $147,159.04 and although regularly charged prior thereto, since November 1, 1920, said company has charged no depreciation on account of said property, upon its books.
III. On November 1, 1920, Petitioner and the International Realty Company entered into a written contract, a true copy of which is appended to the petition filed herein as Exhibit C, and asked to be treated as part hereof. At the time said lease was executed, to wit, Nov. 1, 1920, the useful life of the Coronado Building was expected to expire in 33 years. The ground rental which petitioner contracted to pay under said agreement is*1555 a fair and reasonable rental therefor.
IV. Petitioner, in November, 1920, entered upon its books and treated said payment of $150,000.00 as a capital expenditure recoverable over the life of the building and improvements and has depreciated said cost as follows: Three per cent on the building; 7% on equipment; 10% on new roof recently placed on the building. V. The Commissioner by his sixty day letter ruled the payment of $150,000.00 should be depreciated over the life of the lease instead of the life of the building and improvements, and for each of the years 1924, 1925, 1926 and 1927 has increased Petitioner's net taxable income in the amounts of $3,189.05; $3,189.05; $3,384.85 and $3,384.85 respectively, which, except for 1927, represents the difference between the depreciation claimed and that allowed by him and now proposes to assess a deficiency in tax thereon for each of said years as follows:1924 - $648.63; 1925 - $414.58; 1926 - $456.95; 1927 - $1,422.21
VI. For years prior to 1927 it was the consistent practice of Petitioner to claim as a deduction only those debts actually determined to be worthless and charged off during the year. In 1927 Petitioner created*1556 a reserve account for bad debts (without prior approval of the Commissioner) in the amount of $7,150.00, and in its return for 1927 claimed said reserve as a deduction. In proposing the deficiency for 1927 the Commissioner disallowed the entire $7,150.00 because of the reasons stated in the notice of deficiency from which this appeal is taken. It is agreed and stipulated that if H. C. VanSchaack was present before the Board, after being duly sworn, he would testify as per the affidavit appended hereto.
The following statements were made in the affidavit of H. C. VanSchaack:
That he is President of the Coronado Realty Company and has held said office since November, 1920.
That during 1927 the Coronado Realty Company employed C. H. Fulton, a certified public accountant, to examine its books with a view to determining what, if any, reserve should be set up for bad accounts. That said accountant reported to the officers of the company bad accounts aggregating $7,170.89, as a result of which the company set up as a reserve for bad debts the sum of $7,150.00 which amount was claimed as a deduction in its income tax return for the *1024 calendar year 1927. Included in said*1557 items reported were the following accounts, aggregating $5,052.13, which the officers of the company, including affiant, deemed to be worthless in 1927 but which were not actually charged against the reserve until 1928. The bases upon which said accounts were determined to be worthless in 1927 were as follows:
Jefferay Hat & Furnishing Company, $4,700.00. This represents an accumulation of rental. The corporation had no assets attachable to the time it forfeited its lease in 1927. Neither was there any showing of personal liability on the part of its officers and stockholders.
Henrich Realty Company, $23.38. This represents balance on a check given petitioner upon which it has been unable to collect.
James A. Fleming, $105.00. This represents an accumulation of rent by tenant who is now serving time in the Colorado Penitentiary.
Henry Carlson, $90.00. This represents an accumulation of rent for which petitioner received a worthless check and has since been unable to collect on.
Continental Advertising Company, $133.75. Represents an accumulation of rent of tenant who went out of business.
All of said items were reported as income in prior taxable years.
*1558 Under the contract of lease between the petitioner and the International Realty Company, referred to in the stipulation as Exhibit C, the International Realty Company, "for and in consideration of the sum of $150,000 cash in hand paid," and in consideration of the rents, covenants and agreements contained therein, leased and demised to petitioner the premises upon which the Corponado Building was situate for a period of 99 years, beginning the first day of November, 1920. It was also agreed therein that in addition to the payment of $150,000 in cash and other covenants, petitioner would pay the following sums as rental: (a) For the first ten years of the term of the lease, $22,500 per annum, payable monthly; (b) for the remaining 89 years, $25,000 per annum, payable monthly. Petitioner further agreed therein:
To pay all lawful taxes, charges and assessments, both general and special accruing after Oct. 31, 1920;
To speedily restore, repair or reconstruct any improvements or fixtures on the premises lost, destroyed or injured during the term of the lease, and in case of reconstruction to erect a building of equivalent grade and at least equal as that lost or destroyed at its*1559 own expense;
To bear all expense of every kind, incident to the maintenance, operation or reconstruction of the building or improvements, including cost of repairs, furnishing water, heat, light and other services;
To keep the premises insured against loss in an amount agreed upon but for not less than $100,000.00, any moneys payable thereunder to be applied to the erection of a new building;
To accept possession of the premises subject to the existing leases and demises;
That lessor shall have a first lien upon any buildings, improvements or fixtures now or hereinafter put upon the demised premises, as security for any moneys payable from petitioner;
*1025 That at the end of said term of 99 years all buildings and improvements then upon said demised premises shall remain the property of the lessor without compensation;
At all times during the lease and at its own expense to maintain all buildings and improvements in good order and first class repair;
That during the first 25 years of the lease it will not erect or permit the erection or use of any buildings for hotel purposes upon the demised premises without the consent of lessor;
At the end of the term of*1560 lease to surrender to the lessor possession of the premises together with all buildings thereon without compensation.
Petitioner was empowered under this contract of lease at its option to "remove and rebuild, at its own expense, at any time during the term" of the lease "all or any portion of the buildings or improvements now on said demised premises, provided, however, that any new buildings, improvements or structures so to be erected by the lessee shall be at least double the market value of the improvements or structures which are torn down and rebuilt."
In the deficiency letter, referred to in the stipulation as Exhibit A, appears the following statement:
Since in filing your returns for the years prior to 1927 you elected to take as a deduction the bad debts actually charged off, this method must be followed in handling bad debts in succeeding years. The amount added to bad debt reserve and claimed as a deduction for the year 1927 has, therefore, been disallowed.
OPINION.
MCMAHON: The first question presented is whether the respondent erred in holding that the amount of $150,000 should be deducted pro rata each year over the life of the lease, 99 years, instead*1561 of the useful life of the improvements, 33 years. Petitioner contends that the amount of $150,000 was paid for the improvements, since the yearly rental provided in the lease was a fair consideration for the use of the land itself, and that, since petitioner expected to derive its income from the improvements alone, it should be entitled to a ratable return of its investment over the life of the improvements before the earnings therefrom are subjected to tax.
Respondent contends that there is nothing in the lease agreement indicating or implying that the $150,000 represented the purchase price of the improvements. After a careful examination of the lease, we find ourselves in agreement with the contention of the respondent. While the stipulated facts do show that petitioner was organized primarily for the purpose of taking over and operating the "Coronado Building," which constituted the improvements upon the realty, yet the lease itself covered the premises upon which the Coronado Building is located, and provided that all the consideration, including the $150,000, was for the execution of the lease. We *1026 can not find from the evidence that the $150,000 was paid*1562 for the improvements or for the specific use of such improvements (to the exclusion of the land itself). The case of , cited by petitioner is distinguishable from the instant proceeding. In that case the improvements were purchased by the lessee of the land upon which such improvements were located. We hold that the respondent did not err in prorating the $150,000 over the life of the lease.
Petitioner has also introduced some evidence for the purpose of showing that debts of the face value of $5,052.13 were ascertained to be worthless and charged off in 1927. In that year, after an examination of petitioner's records by a certified public accountant and upon being advised by him that there were bad accounts to the extent of $7,170.89, petitioner set up a reserve for bad debts in the amount of $7,150. While the items reported by the accountant to the officers of the petitioner as being bad included the items set forth in our findings of fact, the evidence further shows that such items were not actually charged against the reserve until 1928.
Section 234(a)(5) of the Revenue Act of 1926 provides:
(a) In computing the net*1563 income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions:
* * *
(5) Debts ascertained to be worthless and charged off within the taxable year (or in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts); and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt to be charged off in part.
Article 151 of Regulations 69, relating to the Revenue Act of 1926, provides in part as follows:
Bad debts may be treated in either of two ways -
(1) By a deduction from income in respect of debts ascertained to be worthless in whole or in part, or
(2) By a deduction from income of an addition to a reserve for bad debts.
Taxpayers were given an option for 1921 to select either of the methods mentioned for treating such debts. (See article 151, Regulations 62.) The method used in the return for 1921 must be used in returns for subsequent years and for returns under the Revenue Act of 1926 unless permission is granted by the Commissioner to change to the other method. * * *
In *1564 , the taxpayer had elected in 1921 to take deductions of debts ascertained to be worthless, instead of employing the reserve method. In 1922 it took a deduction of an addition to a reserve for bad debts, although the addition to the reserve was not made on the books of account until 1923. The taxpayer had not sought or obtained the Commissioner's permission to change the election made in 1921. We held that, under section 234(a)(5) of the Revenue Acts of 1921 and 1924 and article 151 of Regulations 62 and 65, the petitioner was precluded from using *1027 the reserve method. To the same effect is . Section 234(a)(5) of the Revenue Act of 1926 is identical with the corresponding provision of the Revenue Acts of 1921 and 1924, and article 151 of Regulations 69 is similar to the same numbered article in Regulations 65.
However, as pointed out in , it does not necessarily follow that, because petitioner claimed in its return only deductions of additions to a reserve for bad debts, petitioner is not entitled to deductions for such debts as were ascertained*1565 to be worthless and charged off in the taxable year in question. We therefore turn to a consideration of whether petitioner has met the requirements of the statute with regard to ascertainment of worthlessness and charging off of the debts. As stated in :
* * * The fundamental purpose in requiring the charge-off is to evidence the worthlessness of the debt, or, in other words, to establish the loss sustained by the taxpayer, and this end is accomplished and the charge-off effected by the elimination of the bad debt from the taxpayer's assets. If the debt is in fact ascertained to be worthless, it should no longer be treated or considered as as asset. The effective elimination of the debt as an asset meets the statutory requirement as to charge-off. Cf. Thomas J. Avery, supra; ; .
In the instant proceeding we can not determine from the ambiguous and contradictory evidence that the debts in question were eliminated from the petitioner's assets in 1927. There is evidence to show that it was not until 1928 that they were charged against the reserve. *1566 It is our opinion, therefore, that, whether or not the debts were in fact worthless in 1927 (which question we do not here decide), petitioner is not entitled to deduct them in that year, for the reason that it has not shown that they were charged off in that year. See .
The petitioner cites . However, that case is distinguishable from the instant proceeding for the reason that in that case direct charges to profit and loss were made, in the year in which the bad debt deductions were claimed, of the exact amounts of the accounts involved which had been ascertained to be worthless, but, instead of placing those amounts to the credit of the various accounts, the credit was made in a private ledger in an account denominated "reserve for bad and doubtful accounts." In the instant proceeding it appears from the evidence that the specific items of bad debts in question were not charged to the reserve until 1928, the year subsequent to the year in which the deductions are sought to be taken.
Nor have we overlooked *1567 , and . Both of those cases are likewise distinguishable from the instant proceeding. In *1028 , an entry was made on the petitioner's cash book in the year in which the bad debt deductions were sought to be taken, setting forth each of the individual accounts as a reserve for bad debts. In , each bad debt sought to be deducted was taken out of the loose-leaf accounts receivable ledger and marked "reserved," in the year in which the deduction was sought to be taken, and at the end of the year the officers of the taxpayer went over those accounts and made notations of "reason for charging off." As pointed out above, in the instant proceeding the evidence discloses that the specific items which petitioner claims as deductions for bad debts were not charged to the reserve for bad debts until 1928.
Judgment will be entered for the respondent.