Dr. Thomas P. Foltz and Eleanor Foltz v. United States

458 F.2d 600, 29 A.F.T.R.2d (RIA) 960, 1972 U.S. App. LEXIS 9991

• Court: Court of Appeals for the Eighth Circuit
• Decided: April 20, 1972
• Docket: 71-1314
• Status: Published

Opinions

MATTHES, Chief Judge.

This is an appeal by the government from a decision of the district court, after trial without a jury, that taxpayer Foltz¹ had sustained a deductible loss under the Internal Revenue Code of 1954 322 F.Supp. 414. The pertinent Code Section, 26 U.S.C. § 165(a), provides that “[t] here shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.” Also of some relevance are subsections (1) and (2) of Tr. Reg. 1.165-3 (b):

(1) Except as provided in subpara-graph (2) of this paragraph, the loss incurred in a . . . transaction entered into for profit and arising from a demolition of old buildings shall be allowed as a deduction under Section 165(a) if the demolition occurs as a result of a plan formed subsequent to the acquisition of the buildings demolished. . . .

(2) If a lessor or lessee of real property demolishes the buildings situated thereon pursuant to the requirements of a lease . . ., no deduction shall be allowed to the lessor under Section 165(a) on account of the demolition of the old buildings. However, the adjusted basis of the demolished buildings, increased by the net cost of demolition or decreased by the net proceeds from demolition, shall be considered as a part of the cost of the lease to be amortized over the term thereof.

Mrs. Foltz owns a parcel of land in Fort Smith, Arkansas, upon which was situated an office building. The building was valued for tax purposes in 1946 at $40,000. Its useful life, for depreciation purposes, was established at that time as 33x/3 years.

Mrs. Foltz and officers of the Fort Smith Parking Authority conducted negotiations during 1961, pursuant to which the parking authority sought to lease or purchase Mrs. Foltz’ lot for the purpose of establishing thereon a multilevel parking facility. The negotiations ultimately were abandoned. We need note only the following facts pertaining to these negotiations: (1) one of the two parking authority representatives was McLoud Sieard; (2) according to the un-controverted testimony of the second parking authority representative, Mrs. Foltz sought a monthly rental rate of $500 from the authority; and (3) according to the same testimony, Mrs. Foltz would not agree to inclusion of a demolition clause within the contemplated lease.

Mrs. Foltz subsequently entered into negotiations with the First National Bank of Fort Smith. The bank was represented throughout these negotiations by McLoud Sieard, its President, who had represented the municipal parking authority in the latter’s dealings with Mrs. Foltz.² Sieard and Mrs. Foltz reached an agreement, pursuant to which an instrument was executed and the Foltz property was leased to the bank. The lease term is 15 years, commencing February 1, 1962, and terminating January 31, 1977. The bank agreed to pay rent in the sum of $9,000 annually, which would be equivalent to a monthly rate of $750. The bank was given an option to renew the lease for two successive 15-year terms. Further, the lease contained the following provisions:

Lessee shall have the right to demolish and raze all or any part of the structure now on the lease premises at its own expense.

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Any improvement constructed by lessee shall be first approved in writing by lessor. Any improvements permanently affixed to the realty shall become the property of lessor upon termination of the lease agreement and any extensions.

It is apparent from the record that the bank leased Mrs. Foltz’ property in order to expand its own physical plant. A contractor employed by the bank after execution of the lease determined that it would not be feasible to connect by tunnel the existing bank building, which was situated upon a lot adjacent to the Foltz property, and the leased building. The bank subsequently caused the latter building to be demolished.

Demolition occurred in September, 1963, at which time Mrs. Foltz had an undepreciated cost basis in the building of $19,600. Mrs. Foltz and her husband filed a joint federal income tax return for 1963, claiming therein a deduction equal to the entire amount of the unde-preciated basis. The deduction subsequently was disallowed. Mrs. Foltz then paid the deficiency assessed against her, filed a timely request for refund, and, when that claim was denied, filed a timely action in the district court.

The district court found that demolition had not been a specific subject of bargaining between Mrs. Foltz and the bank, and that “neither party . intended or contemplated that the office building would necessarily be demolished during the term of the lease.” Relying upon Tr. Reg. 1.165-3 (b) (1-2) and the construction given this regulation in Feldman v. Wood, 335 F.2d 264 (9th Cir. 1964), the district court held that a deductible loss had been incurred.

The basic issue for our consideration is whether the district court erred, as contended by the government, in allowing the taxpayer to claim a deductible loss for the entire amount of the undepreciated basis of the building in the year of its demolition. As a prelude to consideration of the contentions in this controversy we take note of the well settled principle that the burden is upon the taxpayer to establish the statutory basis for the deductible loss. Burnet v. Houston, 283 U.S. 223, 227, 51 S.Ct. 413, 75 L.Ed. 991 (1931).

It is apparent from the memorandum opinion filed by the district court in this case that exclusive reliance was placed by that court upon Tr. Reg. 1.165-3(b), as construed in the Feldman case. In Feldman, as in the present case, the lessee demolished a building pursuant to a permissive demolition clause in the lease. The Court of Appeals for the Ninth Circuit, reversing a district court ruling in favor of the government, im-

The lease obligated the bank to bear posed a narrow construction upon the regulation. Subsection (2) of the regulation, which disallows deduction where demolition occurs pursuant to the requirements of the lease, was held not to embrace permissive demolition clauses. Subsection (1), which controls cases not affected by subsection (2), therefore was held to require allowance of the claimed deduction. At least one other Court of Appeals has refused to adopt the Feldman rationale. In Landerman v. C. I. R., 454 F.2d 338 (7th Cir. 1971), the narrow approach of the Ninth Circuit was rejected for the following reason, among others:

Initially, we observe nothing in the meaning of the word requirement itself which compels the narrow construction placed upon it by the Ninth Circuit. “Requirement”.,is deftned as “something required, wanted, needed, called for or demanded; a requisite or essential condition.” See Webster's Third New International Dictionary (Unabridged). Since the definition includes something which is wanted, needed or called for, only a restrictive interpretation of the word requirement would demand the presence of a formal mandatory undertaking.

454 F.2d at 340.³

We agree with the Landerman court that there is nothing in the language of Tr. Reg. 1.165-3(b) which mandates allowance of the deduction claimed in cases such as the present one. To hold otherwise, and thus require that deductions be allowed wherever a lessee demolishes pursuant to an optional clause, would be to subvert the underlying statutory mandate that only uncompensated losses be deductible, for a permissive demolition well might redound to the financial benefit of a lessor. Indeed, the opinion in Feldman recognizes that the construction there placed upon the regulation might allow deduction where demolition profitable to the lessor has occurred. 335 F.2d at 266. We agree with the following pronouncement from Landerman:

Even assuming arguendo that the language of the regulation is sufficiently ambiguous to support constructions which are both consistent and inconsistent with the statute, it is the consistent construction which must be preferred for a regulation not consistent with the statute would, of course, be void. Koshland v. Helvering, 298 U.S. 441, 446-447, 56 S.Ct. 767, 80 L.Ed. 1268 (1936); United States v. Korpan, 237 F.2d 676, 682 (7th Cir. 1956).

454 F.2d at 342.

Quite apart from the regulation, however, the critical question in this case is whether the taxpayer sustained an uncompensated loss within the meaning of 26 U.S.C. § 165(a) by reason of the demolition of the building in 1963. Holder v. United States, 444 F.2d 1297 (5th Cir. 1971). Upon consideration of all relevant factors, we hold she did not bring herself within the ambit of § 165.

We note first that in 1961, the year before the present lease was executed, Mrs. Foltz was willing to lease her realty to the Fort Smith Parking Authority for a monthly rental of $500. Taxpayer’s testimony indicates that a demolition clause was to have been included in the lease; one parking authority negotiator testified that Mrs. Foltz refused to include such a clause. The rent promised under the subject lease is 50 per cent greater than that which would have satisfied the lessor during the preceding year. The discrepancy in rental rates, coupled with the fact that a demolition clause was included in the lease executed, would suggest strongly that whatever objections Mrs. Foltz might have had to inclusion of a demolition clause in the proposed parking authority lease were dissolved by the additional rent promised her under the terms of the bank lease. This conclusion is supported by the fact that Mr. Sicard, who participated in the parking authority negotiations and thus was aware of,Mrs. Foltz’ posture during those negotiations on the matters of rent and demolition, also conducted negotiations for the bank prior to execution of the present lease.

It is significant also that the rental rate under the subject lease remains constant notwithstanding the fact of demolition. This indicates to us, as Mrs. Foltz in fact affirmed during her testimony, that the annual rent “covered the property, whether the building was there or not.”

costs of any demolition occurring pursuant to the lease. This, as noted in Landerman, is another indication that lessor has received something in exchange for her accession to demolition, because these costs otherwise would have fallen ultimately upon the lessor. 454 F.2d at 341.

It is also significant that the premises with any improvements erected thereon during the term of the lease will revert to the lessor. In this connection the evidence shows that a new drive-in banking facility has been constructed on the lot formerly occupied by the demolished building.

Finally, as the government concedes, the taxpayer will not lose the undepre-ciated cost basis of the building. She is entitled to amortize that cost as a capital expense over the term of the lease.

To summarize, the taxpayer did not sustain an uncompensated loss within the meaning of § 165(a) of the Internal Revenue Code of 1954. She gave up her right to retain the building by a specific provision permitting its demolition. In return she was guaranteed an annual rent of not less than $9,000, regardless of whether the building remained or was removed. The demolition stemmed from the lease which was negotiated at arm’s length, and the value of the building was thus a part of the value of acquiring the lease, so that the undepreciated value of the building must be amortized over the term of the lease and such value cannot be taken as a loss in the year in which the building was demolished. In short, the taxpayer has recovered quid pro quo for the demolished building. The taxpayer has failed to carry the burden of establishing the statutory basis for a deductible loss. Accordingly, we reverse and remand with directions to dismiss the taxpayer’s complaint.

1 . Appellee Eleanor Foltz is the owner-lessor of the real property involved in this case. Her husband, appellee Thomas P. Foltz, was joined as a plaintiff in the district court only because he and his wife filed a joint federal income tax return for 1963, the year here involved. We shall refer to appellee as Mrs. Foltz or taxpayer.

2 . The second parking authority representative also was a director of the bank, but it is apparent that Mr. Sieard alone represented the bank in its negotiations with Mrs. Foltz,

3 . The Feldman approach was rejected also, at least by implication, in Holder v. United States, 444 F.2d 1297 (5th Cir. 1971).