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Client Letter - What this idea is about  

Description / Scope  / Skill Level Pre-requisite Knowledge

This topic describes transactions between a renter and an owner of real estate.  At times the renter may be a corporation owned by or controlled by the owner of the property - those relationships are included herein.  Also included are those parties which are individuals with family relationships - however, to fully understand the tax impact of those relationships you must read the section on renting to related and family members.

At times the lessor may pay taxes, insurance and other similar costs of ownership.  This section discusses how each party must treat the transactions.

At times the lessor may pay for improvements, including building and other capital improvements.  Those events are also covered within this paper.

Topic - Objective - Purpose Why This Is Important: Usefulness General Benefits 7 Objectives: 

Text

Materials  - Equipment-Tools - Library Resources: Understanding of contracts and case law involving taxation

Who This Applies to: Lessors and Lessees

When to Perform: Before finalizing any contract and before paying for costs of ownership or making improvements of rental real property

Special Circumstances: Defending your self is expensive and risks of losing can be expensive

Engagement Status Letter 

You have not engaged Bob Parrish CPA PC, Bob Parrish CPA, pro1040, Consulting on line, any related parties, or the ISP to perform any services for you or offer you advice.  This entire site is for educational or informational purposes only.   You are not to use the forms, concepts, strategies, or knowledge without assistance from a professional.   The author, the corporation, the ISP, Bob Parrish CPA, Bob Parrish CPA, P.C. or other parties related to those or this site do not guarantee or warrantee in any manner the suitability, usefulness, accuracy, timeliness, or results of any portions of this site, nor the links contained in this site which link to other areas.   At times, information is taken from other sources and is believed to be accurate, but no verification or confirmation is performed.  Furthermore, if any federal or state law invalidates a portion of this disclaimer, the other portions still apply.   In addition, any allegations or actions are restricted to arbitration only and must be arbitrated by the Better Business Bureau in Sarasota Florida.  Reading of these pages constitutes complete acceptance and agreement with all disclaimer provisions on all pages of this site. ....... Thursday, February 22, 2007 02:28 AM  

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Learning Objectives (What You Asked) 

YOUR QUESTION(S)

What is rent income to the lessor, or landlord?  You may be surprised!

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What You Will Need  

1. Your contract, 

2. statements from a property manager if you have one, 

3. charges you have made to the lessee/renter, 

4. Paid bills may be helpful, especially for insurance, property taxes (both real and personal) and any capital improvement to the property,

5. A list and knowledge of the amounts the lessee or renter has paid for maintaining, or other obligations relating to the property such as property taxes, insurance, improvements, costs that become a part of the property or add to the value of the property.

Plain English Analysis What it does, Why it works - The Answer, Alternatives  

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• Plain English Analysis - Your Answers
  • What it Does, Explanation of this Topic and How It May Affect You
  • Why or How it works - What This Means To You
  • Alternatives
  • Cost v. Benefits Analysis

YOUR ANSWERS

What it does, Explanation of this topic and how it may affect you:

This is important because any underpayment of taxes is a surprise you do not need.  Interest and penalties can be costly - a cost most individuals or businesses do not need.

  The Internal Revenue Code may mandate the owner of the property add to income on the owner's tax return amounts that are considered costs of ownership, and perhaps other costs paid by the renter as well.

If the lessee, including a corporation owned by the lessor, pays these costs then one must study the Code and the transactions to make a determination about the inclusion of income on the property owner's tax return and deductibility by the lessee.

Start of Plain English Section

Why or How it works - Both Sides of the Equation and Examples:

Insurance, taxes and other costs of ownership

The two scenarios are:

1. The owner reduces the rent by the amount of the taxes and asks  the renter to pay the taxes

2. The owner charges enough rent so that s/he may pay the taxes

The general rules, which this regulation modifies, are 

1. only the person liable for the debt or to which taxes are assessed may claim a deduction for the expense

2. only the person paying the expense is allowed a tax deduction for the expense

If this general convention were to be adhered to without the exceptions noted in §1.162-11 and in 1.61.8 the deductions for the payments would be lost by both parties.

With either scenario, the expenses paid by the renter are deducted on the tax return of the renter as rent expenses.

The same taxes amount is added to the income of the property owner.  The amount of the taxxes are deducted by the property owner as taxes - a "wash".

Do not Fret!  This is not detrimental to you tax focused.  If the owner were to increase the rent to pay the expense, the rent income is larger by the amount of the expense and then it is reduced by the identical amount when the owner pays the amount of the expense.  

Look at an example, from the perspective of the owner:

Transaction	Renter Pays Taxes		Owner Pays Taxes
	Renter	Owner	Renter	Owner
Rent	-100	+200	-200	+200
Taxes	-100	-100		-100
Taxable	-200	+100	-200	+100

Taxes paid by a tenant to or for a landlord for business property are additional rent and constitute a deductible item to the tenant and taxable income to the landlord, the amount of the tax being deductible by the latter. (§1.162-11)  

When is rent paid deductible? Rent for the use or possession of property to which the taxpayer has not taken or is not taking title and in which she has no equity can qualify as a trade or business expense if the rent is paid in connection with the taxpayer's trade or business, it is ordinary and necessary, and it is paid or incurred during the taxable year is deductible.  1.162-1

Capital Improvements

Capital  improvements are the next topic.  Capital improvements open many questions.  See the tax case included herein.

If the lessor and lessee decide to substitute improvements for rent, the improvements are taxable to the lessor (after taking into consideration computations for residual values and present values) and deductible by the lessee.

IRS Position: It is my personal opinion, the IRS will usually challenge any move be the parties to shift tax burden or change the timing of the taxable events.  If an IRS challenge is more than you can manage financially or emotionally, the you must consider your decisions very carefully.  If you are of stout heart and stout pocketbook, then consider the positions of the contractual agreements, the court cases and the regulations.  The choice to have a lessee pay for capital improvements and exclude the cost of the improvements from the income of the owner / lessor is the choice the IRS, in my opinion, will challenge.

This section will be completed later ---

Start of Plain English Section

Alternatives

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Cost v. Benefit Analysis

Start of Plain English Section

Other

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Reserved

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Technical Analysis & Citations What It does, Why it works -

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• Technical Analysis

  • Law

  • Regs

  • Cases

  • Revenue Procedures

  • Revenue Rulings

  • Private Letter Rulings

Commentary

1.61-8(c) Expenditures By Lessee.

Start of Technical Analysis

Law

Start of Law Section

Start of Technical Analysis

Regs

SECTION 1.61-8. RENTS AND ROYALTIES.

(a) IN GENERAL. Gross income includes rentals received or accrued for the occupancy of real estate or the use of personal property. For the inclusion of rents in income for the purpose of the retirement income credit, see section 37 and the regulations thereunder. Gross income includes royalties. Royalties may be received from books, stories, plays, copyrights, trademarks, formulas, patents, and from the exploitation of natural resources, such as coal, gas, oil, copper, or timber. Payments received as a result of the transfer of patent rights may under some circumstances constitute capital gain instead of ordinary income. See section 1235 and the regulations thereunder. For special rules for certain income from natural resources, see Subchapter I (section 611 and following), Chapter 1 of the Code, and the regulations thereunder.

(b) ADVANCE RENTALS; CANCELLATION PAYMENTS. Except as provided in section 467 and the regulations thereunder, gross income includes advance rentals, which must be included in income for the year of receipt regardless of the period covered or the method of accounting employed by the taxpayer. An amount received by a lessor from a lessee for cancelling a lease constitutes gross income for the year in which it is received, since it is essentially a substitute for rental payments. As to amounts received by a lessee for the cancellation of a lease, see section 1241 and the regulations thereunder.

(c) EXPENDITURES BY LESSEE. As a general rule, if a lessee pays any of the expenses of his lessor such payments are additional rental income of the lessor. If a lessee places improvements on real estate which constitute, in whole or in part, a substitute for rent, such improvements constitute rental income to the lessor. Whether or not improvements made by a lessee result in rental income to the lessor in a particular case depends upon the intention of the parties, which may be indicated either by the terms of the lease or by the surrounding circumstances. For the exclusion from gross income of income (other than rent) derived by a lessor of real property on the termination of a lease, representing the value of such property attributable to buildings erected or other improvements made by a lessee, see section 109 and the regulations thereunder. For the exclusion from gross income of a lessor corporation of certain of its income taxes on rental income paid by a lessee corporation under a lease entered into before January 1, 1954, see section 110 and the regulations thereunder.

SECTION 1.162-11. RENTALS.

(a) ACQUISITION OF A LEASEHOLD. If a leasehold is acquired for business purposes for a specified sum, the purchaser may take as a deduction in his return an aliquot part of such sum each year, based on the number of years the lease has to run. Taxes paid by a tenant to or for a landlord for business property are additional rent and constitute a deductible item to the tenant and taxable income to the landlord, the amount of the tax being deductible by the latter. For disallowance of deduction for income taxes paid by a lessee corporation pursuant to a lease arrangement with the lessor corporation, see section 110 and the regulations thereunder. See section 178 and the regulations thereunder for rules governing the effect to be given renewal options in amortizing the costs incurred after July 28, 1958 of acquiring a lease. See Sec. 1.197-2 for rules governing the amortization of costs to acquire limited interests in section 197 intangibles.

(b) IMPROVEMENTS BY LESSEE ON LESSOR'S PROPERTY.

(1) The cost to a lessee of erecting buildings or making permanent improvements on property of which he is the lessee is a capital investment, and is not deductible as a business expense. If the estimated useful life in the hands of the taxpayer of the building erected or of the improvements made, determined without regard to the terms of the lease, is longer than the remaining period of the lease, an annual deduction may be made from gross income of an amount equal to the total cost of such improvements divided by the number of years remaining in the term of the lease, and such deduction shall be in lieu of a deduction for depreciation. If, on the other hand, the useful life of such buildings or improvements in the hands of the taxpayer is equal to or shorter than the remaining period of the lease, this deduction shall be computed under the provisions of section 167 (relating to depreciation).

(2) If the lessee began improvements on leased property before July 28, 1958, or if the lessee was on such date and at all times thereafter under a binding legal obligation to make such improvements, the matter of spreading the cost of erecting buildings or making permanent improvements over the term of the original lease, together with the renewal period or periods depends upon the facts in the particular case, including the presence or absence of an obligation of renewal and the relationship between the parties. As a general rule, unless the lease has been renewed or the facts show with reasonable certainty that the lease will be renewed, the cost or other basis of the lease, or the cost of improvements shall be spread only over the number of years the lease has to run without taking into account any right of renewal. The provisions of this subparagraph may be illustrated by the following examples:

EXAMPLE (1). A subsidiary corporation leases land from its parent at a fair rental for a 25-year period. The subsidiary erects on the land valuable factory buildings having an estimated useful life of 50 years. These facts show with reasonable certainty that the lease will be renewed, even though the lease contains no option of renewal. Therefore, the cost of the buildings shall be depreciated over the estimated useful life of the buildings in accordance with section 167 and the regulations thereunder.

EXAMPLE (2). A retail merchandising corporation leases land at a fair rental from an unrelated lessor for the longest period that the lessor is willing to lease the land (30 years). The lessee erects on the land a department store having an estimated useful life of 40 years. These facts do not show with reasonable certainty that the lease will be renewed. Therefore, the cost of the building shall be spread over the remaining term of the lease. An annual deduction may be made of an amount equal to the cost of the building divided by the number of years remaining in the term of the lease, and such deduction shall be in lieu of a deduction for depreciation.

(3) See section 178 and the regulations thereunder for rules governing the effect to be given renewal options where a lessee begins improvements on leased property after July 28, 1958, other than improvements which on such date and at all times thereafter, the lessee was under a binding legal obligation to make.

1.162-1. BUSINESS EXPENSES.

(a) IN GENERAL. Business expenses deductible from gross income include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer's trade or business, except items which are used as the basis for a deduction or a credit under provisions of law other than section 162. The cost of goods purchased for resale, with proper adjustment for opening and closing inventories, is deducted from gross sales in computing gross income. See paragraph (a) of Section 1.161-3.

Among the items included in business expenses are management expenses, commissions (but see section 263 and the regulations thereunder), labor, supplies, incidental repairs, operating expenses of automobiles used in the trade or business, traveling expenses while away from home solely in the pursuit of a trade or business (see Section 1.162-2), advertising and other selling expenses, together with insurance premiums against fire, storm, theft, accident, or other similar losses in the case of a business, and rental for the use of business property. No such item shall be included in business expenses, however, to the extent that it is used by the taxpayer in computing the cost of property included in its inventory or used in determining the gain or loss basis of its plant, equipment, or other property. See section 1054 and the regulations thereunder. A deduction for an expense paid or incurred after December 30, 1969, which would otherwise be allowable under section 162 shall not be denied on the grounds that allowance of such deduction would frustrate a sharply defined public policy. See section 162(c), (f), and (g) and the regulations thereunder. The full amount of the allowable deduction for ordinary and necessary expenses in carrying on a business is deductible, even though such expenses exceed the gross income derived during the taxable year from such business. In the case of any sports program to which section 114 (relating to sports programs conducted for the American National Red Cross) applies, expenses described in section 114(a)(2) shall be allowable as deductions under section 162(a) only to the extent that such expenses exceed the amount excluded from gross income under section 114(a).

(b) CROSS REFERENCES.

(1) For charitable contributions by individuals and corporations not deductible under section 162, see Section 1.162-15.

(2) For items not deductible, see sections 261-276, inclusive, and the regulations thereunder.

(3) For research and experimental expenditures, see section 174 and regulations thereunder.

(4) For soil and water conservation expenditures, see section 175 and regulations thereunder.

(5) For expenditures attributable to grant or loan by United States for encouragement of exploration for, or development or mining of, critical and strategic minerals or metals, see section 621 and regulations thereunder.

(6) For treatment of certain rental payments with respect to public utility property, see section 167(1) and Section 1.167(1)-3.

(7) For limitations on the deductibility of miscellaneous itemized deductions, see section 67 and Sections 1.67-1T through 1.67-4T.

(8) For the timing of deductions with respect to notional principal contracts, see section 1.446-3.

Start of Regs Section

Start of Technical Analysis

Cases

The following case decision concerns the intent of the parties that no rent income should be included and excludes the improvements from rent income of the lessor, but only after many challenges by the IRS.

GRACE H. CUNNINGHAM, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

EUGENE F. CUNNINGHAM AND GRACE H. CUNNINGHAM, HUSBAND AND WIFE,

PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket Nos. 55090, 55091. Filed June 17, 1957.

 

IMPROVEMENTS BY LESSEE ON LESSOR'S PROPERTY--SEC. 22(a) AND (b)(11),

I.R.C. 1939.--The owner of real estate leased the property to a corporation of which she was a principal stockholder, manager, and financial backer. Under the lease the corporation was to make certain improvements upon the lots, pay the taxes on the property, and transfer title to the improvements to the lessor at the termination of the lease. 

The evidence establishes that the parties did not intend that the value of the improvements should constitute rent, but that the improvements were intended to benefit the business of the corporation. Held, that the petitioners did not realize taxable income as a result of such improvements either at the time of construction thereof or upon termination of the lease.

Raymond D. Ogden, Esq., for the petitioners.

John H. Welch, Esq., for the respondent.

 

ATKINS, Judge: The respondent determined deficiencies in income tax for the years 1946 and 1952 in the respective amounts of $6,725.59 and $9,528.54. The question presented for decision is whether any amount should be included in gross income of the petitioners in either 1946 or 1952, on account of improvements constructed in 1946 by a lessee under a 6-year lease expiring in 1952, and, if so, the amount to be included.

 

FINDINGS OF FACT.

Some of the facts are stipulated and are so found, the stipulation being incorporated herein by this reference. The petitioners are husband and wife residing in Seattle, Washington.  The petitioner Grace H. Cunningham filed her income tax return for the year 1946 with the collector of internal revenue at Tacoma, Washington.  The two petitioners filed a joint income tax return for the year 1952 with the director of internal revenue at Tacoma, Washington. Hereinafter the term petitioner refers to the petitioner Grace H. Cunningham. 

The petitioner in 1928 started a steel-manufacturing enterprise which was incorporated in 1936 as the American Manufacturing Company, Inc. She has continuously been one of the principal owners of the stock and its general manager and financial backer. Her brother, T. M. Gepford, has been and now is president and executive head of the company. Her husband, the petitioner Eugene F. Cunningham, has been vice president and a member of the board of directors. The company is in the business of manufacturing heavy machinery.

The property of the American Manufacturing Company is situated in block 2103 of the Tacoma Land Company's Fifth Addition in the city of Tacoma.  Immediately to the east of such property, and separated therefrom by an alley 40 feet in width, are situated lots 7 to 12, inclusive, of block 2102, which in 1936 were owned by Martin A. and Mary E. Petrich. At that time those lots were not level, in some places being as much as 30 to 40 feet below grade, and had little usable surface. For many years they had constituted a dumping ground for rubbish and scrap. In 1936 American Manufacturing Company under an oral agreement with the owners acquired the right to use those lots for open storage of steel and other materials and to make such fills thereon as might be necessary. By 1943 or 1944 the lots had been filled so as to become usable over their entire area. The American Manufacturing Company did not, up to that time, pay any rent or taxes thereon. For a portion of 1943 it paid $10 per month for the use of lots 8 to 12 under an oral agreement, after having installed an annealing oven on a portion of lots 8 to 12. The American Manufacturing Company agreed at that time to remove the annealing oven as soon as its use was terminated.

In 1943 the American Manufacturing Company erected a craneway on lot 9 of block 2102 to be used for the moving of heavy equipment. The dimensions of lot 9 are 25 feet by 120 feet. A slab of cement 25 feet in width and approximately 60 feet in length was laid down and the craneway was then erected of wood with columns running the full length of 120 feet. The company was still in need of additional working space for steel-cutting equipment. In October 1944 the company owed a bank $41,000.  At January 1, 1946, it owed banks about $172,000 and Cunningham Steel Foundry (owned by the petitioner Eugene F. Cunningham) $25,000. At the end of 1946 it owed banks about $184,000. The petitioner was endorser and guarantor of the bank loans.

On October 26, 1944, the petitioner purchased lots 7 to 12 of block 2102 at a price of $8,000. At that time the American Manufacturing Company was expanding rapidly. Immediately following the purchase of the property by the petitioner, the American Manufacturing Company at its own cost placed an adequate roof over the superstructure of the craneway and also enclosed the entire south side of the craneway, 120 feet, with large windows supported by hollow cement tile blocks. This constituted the cheapest type of construction permitted by the building code of the city of Tacoma.

In November 1945 the petitioner Eugene F. Cunningham desired to erect a warehouse building on lots 4, 5, and 6 of block 2102. The petitioner Grace H. Cunningham had no interest in such lots nor in the building to be constructed thereon. Petitioner Eugene F. Cunningham needed more area for the contemplated building and purchased lot 7 of block 2102 from the petitioner for $1,333.33. He then erected a cement warehouse building 120 feet long and 100 feet wide, known as the Graybar Building, which was ready for occupancy by May 1946. The southerly wall of the building constituted the dividing line between lots 7 and 8. 

The petitioner, being the largest stockholder and manager of American Manufacturing Company, was desirous of permitting the company to expand its business and obtain the necessary room by changing the craneway into a complete structure. In the latter part of December 1945 she entered into an oral lease with the American Manufacturing Company covering lots 8 to 12 of block 2102. It was agreed that the American Manufacturing Company could use lot 8 which adjoined the Graybar Building and lot 9 for the purpose of enclosing both lots 8 and 9 as one large area 50 feet by 120 feet, this to be done by closing the two 50-foot ends by use of large doors and using the south wall of the Graybar Building as the north wall of the enclosure. The terms of this oral lease are substantially set forth in the minutes of a meeting of the board of directors of the American Manufacturing Company held on December 15, 1945. Such minutes contain the following: 

The President also announced that said Grace H. Cunningham was desirous of leasing said property to the American Manufacturing Company, Inc. on the following basis:

That the American Manufacturing Company would construct a building on said property at its own expense, would pay all the taxes, and at the end of a six year period, said lease would be terminated and the building on the property would revert to the owner of the real property, Grace H.  Cunningham. That there would be no rent paid for said lease but that the consideration for the lease was the transfer of the building to Grace H. Cunningham at the end of the term of the lease. Therefore, after full discussion having been had, the following resolution was unanimously adopted:

"BE IT RESOLVED, that the proper officers of the American Manufacturing Company, Inc. be instructed to prepare the proper instruments to lease from Grace H. Cunningham, Lots 8, 9, 10, 11 and 12, Block 2102, Tacoma Land Company, Fifth addition, Tacoma, Washington, for a period of six years commencing with the 2nd day of January, 1946. That the terms and conditions of said lease be such that the consideration for said lease would be the transfer of any and all interests that the American Manufacturing Company, Inc. had in the building to be constructed on the premises to be transferred to Grace H. Cunningham. That American Manufacturing Company, Inc. would immediately commence construction of a building on said premises of the approximate value of $25,000.00. That the proper officers of the American Manufacturing Company, Inc. also be instructed to pay the taxes on said property for the term of the lease."

The lease was later reduced to writing in a written lease dated March 17, 1947. Such lease provides for a term of 6 years from January 2, 1946, to January 2, 1952. Therein it is recited: 

The consideration for said lease being that the lessee will pay taxes on the above described property for a period of six years and will transfer, at the end of the period of the lease, all right, title and interest which said lessee has in a building which lessee has constructed and paid for on the above described property.

* * * * * * *

And at the expiration of said term, the said lessee will quit and surrender the said premises in good state and condition as they now are (ordinary wear and damage by the elements or fire excepted).

Prior to January 1, 1946, the American Manufacturing Company had expended $2,800 for roofing of the craneway on lot 9 and the enclosure of the south wall with hollow tile and glass windows, and $2,755 for grading and paving the alley. Subsequent to the effective date of the lease, January 2, 1946, the American Manufacturing Company expended $11,097 as cost of improvements which, pursuant to the lease, were to revert to the petitioner at the end of the lease period. Another craneway was built located on lot 8, next to the Graybar Building, a floor was laid, a roof was constructed over lot 8 (resulting in a roof over both lots 8 and 9), and doors were installed at the ends of the structure located on both lots 8 and 9. The improvements placed upon the property by the American Manufacturing Company which under the terms of the lease were to revert to the petitioner are improvements attached to the realty. 

On March 29, 1946, the petitioner Eugene F. Cunningham, as First party, and the petitioner and the American Manufacturing Company, Inc., as second parties, entered into a party wall agreement. It was therein recited that the parties are the owners of adjoining pieces of property. Therein it was agreed that the south wall of the Graybar Building should be thereafter the common property of the parties to the agreement and that the covenants contained in the agreement should run with the land. Since the Graybar Building was not as tall as the building on the petitioner's lots, it was necessary to extend the height of the wall by several feet. The party wall was completed in 1946 at some time prior to the execution of the party wall agreement on March 29, 1946. The American Manufacturing Company paid an amount of $4,734 in connection with the party wall. The party wall agreement was made as a part of or in connection with the oral lease. 

On January 2, 1952, the American Manufacturing Company released all right, title, and interest in and to the improvements, to the petitioner.

This release did not change or purport to change the rights of the parties under the party wall agreement. On January 14, 1952, the petitioners, as husband and wife and as a community, executed a new lease with the American Manufacturing Company covering lots 8 and 9 and the east 40 feet of lot 10 in block 2102, together with improvements for a period of 10 years from and after January 1, 1952. The lessee agreed to pay $10 per month and all taxes of every kind against the property and any and all other expenses of any kind or character incident to the occupation or maintenance of the premises. The lessee agreed that any additions or repairs or improvements placed upon the building should, at the expiration of the lease, become the property of the lessors. It further agreed to keep the building fully insured in an amount satisfactory to the lessors. 

Since January 1, 1952, the American Manufacturing Company has paid rent of $10 per month, together with taxes, for lots 8 and 9 and the east 40 feet of lot 10 of block 2102. 

The only specified cash rent as such that was ever paid up to January 1, 1952, for the use of any part of the properties was $10 per month for a portion of the year 1943, which was prior to the time the petitioner purchased lots 8 to 12.

The American Manufacturing Company capitalized the total cost of improvements on these lots at $21,904.33 on its books and corporation income tax returns, and claimed a depreciation deduction of one-sixth of that amount in each of the taxable years 1946 to 1951, inclusive. 

The assessed valuation of the lots, exclusive of improvements, as determined by the county assessor for the various years involved in the first lease period was $2,800 and the average rate of taxation during such period was roughly 6.5 per cent. The average annual tax during such period, exclusive of improvements, was $182. The taxes on lots 8 to 12, inclusive, including improvements, for the years 1946 to 1950, were as follows:

1946, paid in 1947 $218.11

1947, paid in 1948 677.11

1948, paid in 1949 588.46

1949, paid in 1950 689.63

1950, paid in 1951 620.71

The annual cost of insurance was $66.66. The policy does not protect the petitioner nor does she carry insurance on the property. 

In determining the deficiency for the year 1946 the respondent added to  reported taxable income the amount of $14,714.60 as rental income, stating that "the cost of improvements placed in 1946 upon Lots 8, 9, 10, 11 and 12 * * * constituted taxable income to you in 1946 as lessor, to the extent of the fair market value subject to the lease, of such improvements, which, pursuant to the lease instrument, was to revert to you at the end of the six year term." His computation of the amount of $14,714.60 was as follows:

Cost of improvements--1946 $21,904.33

Less: Depreciation for 6-year term of

lease at 2 1/2% per year 3,285.66

----------

Depreciated or adjusted basis Jan. 2, 1952 18,618.67

Present value of $1 payable at end of

6 years at 4% .790314

----------

Fair market value of improvements Jan. 2, 1946 14,714.60

In determining the deficiency for the year 1952 the respondent added to reported taxable income the amount of $18,071.06 as rental income, stating that "the cost of improvements * * * constituted taxable income to you in 1952 as lessor, to the extent of the fair market value of such improvements, which, pursuant to the lease instrument, reverted to you at the end of the six year term." The amount of $18,071.06 was computed by the respondent as follows:

Cost of improvements--1946 $21,904.38

Less: Depreciation for 6-year

term of lease at 2 1/2% per year 3,285.66

----------

Fair market value of improvements Jan. 2, 1952 18,618.67

Less: Depreciation for 1952 on above improvements 547.61

----------

Increase in income 18,071.06

 

Included in the above cost of $21,904.33 is the amount of $4,734 paid by the American Manufacturing Company to constitute the south wall of the Graybar Building, a party wall. Also included is the amount of $2,755 the cost of construction and hard-surfacing of the alley. This $2,755 does not constitute a proper part of the cost of the building. 

The parties to the lease did not intend that the value of the improvements made by the lessee should, and it did not, represent, in whole or in part, rent at the time of construction or at the termination of the lease.

OPINION.

The question presented for decision is whether income was derived either by the petitioner Grace H. Cunningham in 1946 when the lessee, American Manufacturing Company, made improvements on her property, or by her and her husband, the petitioner Eugene F. Cunningham, on account thereof in 1952 at the termination of the lease, at which time the property was held as community property. There is not before us for decision any question as to whether taxable income was derived by the petitioners as a result of other requirements of the lease such as the payment by the lessee of taxes on the property. 

The respondent concedes that in determining deficiencies for both 1946 and 1952 he has acted inconsistently and that income was derived in only one year, contending primarily that the proper year was 1946, but in the alternative that income was derived in 1952. 

The petitioners contend that under the circumstances here presented no income was derived in either year. Alternatively, they contend that income could have been derived only in 1952 and that the amount of income has been erroneously computed.

We are concerned with section 22(a) and (b)(11) of the Internal Revenue Code of 1939. Section 22(a) provides:

GENERAL DEFINITION.--"Gross income" includes gains, profits, and income derived from salaries, wages, or compensation for personal service (including personal service as an officer or employee of a state, or any political subdivision thereof, or any agency or instrumentality of any one or more of the foregoing), of whatever kind and in whatever form paid, or from professions, vocations, trades, businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property; also from interest, rent, dividends, securities, or the transaction of any business carried on for gain or profits, or gains or profits and income derived from any source whatever. * * *

Section 22(b)(11) provides:

EXCLUSIONS FROM GROSS INCOME.--The following items shall not be included in gross income and shall be exempt from taxation under this chapter:

* * * * * * *

IMPROVEMENTS BY LESSEE ON LESSOR'S PROPERTY.--Income, other than rent, derived by a lessor of real property upon the termination of a lease, representing the value of such property attributable to buildings erected or other improvements made by the lessee.

 

The question of whether and when a lessor derives taxable income as a result of improvements made by a lessee has, through the years, been a troublesome one and has been the subject of much litigation and also of legislation. A brief discussion of the historical background is helpful. In M. E. Blatt Co. v. United States, 305 U.S. 267 (1938), the owner of real estate leased the property in 1930 for use as a moving picture theater for a term of 10 years, beginning upon completion of improvements to be made. The lessor agreed to make certain alterations and the lessee agreed to install the latest type of moving picture apparatus and other furniture and equipment necessary for the successful operation of a modern theater, to become the property of the lessor at the expiration, or sooner termination, of the lease. The lessee agreed to pay for certain of the improvements. The Commissioner added to the taxpayer's income for the first year of the lease one-tenth of the estimated depreciated value at the termination of the lease of the alterations and improvements paid for by the lessee. The Supreme Court held that no income was derived in such year either as rental or otherwise, stating in part: There is nothing in the findings to suggest that cost of any improvement made by lessee was rent or an expenditure not properly to be attributed to its capital or maintenance account as distinguished from operating expense. While the lease required it to make improvements necessary for successful operation, no item was specified, nor the time or amount of any expenditure. The requirement was one making for success of the business to be done on the leased premises. It well may have been deemed by lessor essential or appropriate to secure payment of the rent stipulated in the lease. Even when required, improvements by lessee will not be deemed rent unless intention that they shall be is plainly disclosed. Rent is "a fixed sum, or property amounting to a fixed sum, to be paid at stated times for the use of property * * *; it does not include payments, uncertain both as to amount and time, made for the cost of improvements * * *." The facts found are clearly not sufficient to sustain the lower court's holding to the effect that the making of improvements by lessee was payment of rent. It remains to be considered whether the amount in question represented taxable income, other than rent, in the first year of the term.

* * * * * * *

Granting that the improvements incredibled the value of the building, that enhancement is not realized income of lessor. So far as concerns taxable income, the value of the improvements is not distinguishable from excess, if any there may be, of value over cost of improvement made by lessor. Each was an addition to capital; not income within the meaning of the statute. Treasury Regulations can add nothing to income as defined by Congress. 

But, assuming that at some time value of the improvements would be income of lessor, it can not be reasonably assigned to the year in which they were installed. The commissioner found that at the end of the term some would be worthless and excluded them. He also excluded depreciation of other items. These exclusions imply that elements which will not outlast lessee's right to use are not at any time income of lessor. The inclusion of the remaining value is to hold that petitioner's right to have them as a part of the building at expiration of lease constitutes income in the first year of the term in an amount equal to their estimated value at the end of the term without any deduction to obtain present worth as of date of installation. It may be assumed that, subject to the lease, lessor became owner of the improvements at the time they were made. But it had no right to use or dispose of them during the term. Mere acquisition of that sort did not amount to contemporaneous realization of gain within the meaning of the statute. 

In Helvering v. Bruun, 309 U.S. 461 (1940), the taxpayer as owner had in 1915 leased land and a building thereon for a term of 99 years. The lessee had the right under certain conditions to remove buildings, provided that no building should be removed or torn down after the lease became forfeited or during the last 3 1/2 years of the term. The lessee was to surrender the land, upon termination of the lease, with all buildings and improvements thereon. In 1929 the lessee removed the existing building and constructed a new one. In 1933 the lease was canceled for default and the lessor regained possession of the land and building. The Commissioner determined that in 1933 the taxpayer realized a net gain in the amount of the net fair market value of the new building. In that case the Supreme Court upheld that determination, stating in part: The course of administrative practice and judicial decision in respect of the question presented has not been uniform. In 1917 the Treasury ruled that the adjusted value of improvements installed upon leased premises is income to the lessor upon the termination of the lease. The ruling was incorporated in two succeeding editions of the Treasury Regulations. In 1919 the Circuit Court of appeals for the Ninth Circuit held in Miller v. Gearin, 258 F. 225, that the regulation was invalid as the gain, if taxable at all, must be taxed as of the year when the improvements were completed.

The regulations were accordingly amended to impose a tax upon the gain in the year of completion of the improvements, measured by their anticipated value at the termination of the lease and discounted for the duration of the lease. Subsequently the regulations permitted the lessor to spread the depreciated value of the improvements over the remaining life of the lease, reporting an aliquot part each year, with provision that, upon premature termination, a tax should be imposed upon the excess of the then value of the improvements over the amount theretofore returned. 

In 1935 the Circuit Court of Appeals for the Second Circuit decided in Hewitt Realty Co. v. Commissioner, 76 F.2d 880 * * * that a landlord received no taxable income in a year, during the term of the lease, in which his tenant erected a building on the leased land. The court, while recognizing that the lessor need not receive money to be taxable, based its decision that no taxable gain was realized in that case on the fact that the improvement was not portable or detachable from the land, and if removed would be worthless except as bricks, iron, and mortar. * * * 

This decision invalidated the regulations then in force.

* * * * * * *

The circumstances of the instant case differentiate it from the Blatt and Hewitt cases; but the petitioner's [Commissioner's] contention that gain was realized when the respondent [the taxpayer], through forfeiture of the lease, obtained untrammeled title, possession and control of the premises, with the added increment of value added by the new building, runs counter to the decision in the Miller case and to the reasoning in the Hewitt case.

* * * * * * *

We hold that the petitioner was right in assessing the gain as realized in 1933.

* * * * * * *

The respondent can not successfully contend that the definition of gross income in Sec. 22(a) of the Revenue Act of 1932 is not broad enough to embrace the gain in question. That definition follows closely the Sixteenth amendment. * * *

* * * * * * *

Here, as a result of a business transaction, the respondent received back his land with a new building on it, which added an ascertainable amount to its value. It is not necessary to recognition of taxable gain that he should be able to sever the improvement begetting the gain from his original capital. * * * 

After the Supreme Court's decision in the Bruun case there remained no question that the value of improvements made by a lessee constituted taxable income to the lessor, under the broad definition of income contained in section 22(a), at the date of termination of the lease. Lewis v. Pope Estate Co., (C.A. 9, 1940) 116 F.2d 328, certiorari denied 314 U.S. 630; Greenwood Packing Plant v. Commissioner, (C.A. 4, 1942) 131 F.2d 787; and Trask v. Hoey, (C.A. 2, 1949) 177 F.2d 940. 

Thereafter, however, Congress, by section 101 of the Revenue Act of 1942, enacted section 22(b)(11), quoted hereinabove, to modify the effect of the Bruun case by limiting the recognition of income on termination of the lease to that which constituted rent.  <<ENDNOTE 3>>

The Revenue Act of 1942 also added subsection (c) to section 113 of the Internal Revenue Code to provide that the basis of real property should not be increased or diminished on account of income derived by a lessor and excludible from gross income under section 22(b)(11). Section 29.22(b)(11)-1 of Regulations 111, promulgated under section 22(b)(11) of the 1939 Code, as amended, provides in part: SEC. 29.22(b)(11)-1. EXCLUSION FROM GROSS INCOME OF LESSOR OF REAL PROPERTY OF VALUE OF IMPROVEMENTS ERECTED BY LESSEE.--Income derived by a lessor of real property upon the termination, through forfeiture or otherwise, of the lease of such property and attributable to buildings erected or other improvements made by the lessee upon the leased property is excluded from gross income. However, where the facts disclose that such buildings or improvements represent in whole or in part a liquidation in kind of lease rentals, the exclusion from gross income shall not apply to the extent that such buildings or improvements represent such liquidation. 

The exclusion applies only with respect to the income realized by the lessor upon the termination of the lease and has no application to income, if any, in the form of rent, which may be derived by a lessor during the period of the lease and attributable to buildings erected or other improvements made by the lessee. * * * 

Such regulations, including an example set forth therein, clearly indicate that neither at the termination of a lease nor at any time during the period of the lease does a lessor derive taxable income as a result of improvements upon leased premises, unless the income attributable to them constitutes rental income. On the other hand regulations do in effect provide that taxable income may be derived by a lessor on account of improvements by the lessee during the period of the lease if any such income represents rental. It is apparently upon the basis of this regulation that the respondent makes his principal contention that the petitioner in the instant case derived income in 1946 from the construction of the improvements. The petitioner argues strongly that under the authorities set forth hereinabove a lessor may not be considered as deriving income prior to termination of the lease, whether as rent or otherwise. 

In the view we take of the instant case, we find it unnecessary to decide that question. It is clear that neither the statute nor the regulations purport to treat as taxable income to the lessor at any time the value of improvements unless such value represents rent. 

In M. E. Blatt Co. v. United States, supra, the Supreme Court has clearly stated that whether the value of such improvements constitutes rent depends upon the intention of the parties, and that even when the improvements are required by the terms of the lease this value will not be deemed rent unless the intention that it shall be such is plainly disclosed. Such intent in our opinion is to be derived not only from the terms of the lease but from the surrounding circumstances. This is recognized by the respondent in his published ruling I.T. 4009, 1950-1 C.B. 13. 

In the instant case, while the lease, both in its oral and written form, provides that the consideration for the lease was to be in part the transfer, at the end of the term of the lease, of the building to the petitioner, we note that the contemporaneous construction of the lease by the directors, as shown in their minutes, is that there would be no rent paid for the lease. Consistently, the company, as lessee, did not treat the cost of the improvements as rental, but treated such cost on its books and in its income tax returns as a capital outlay and amortized it over the term of the lease. 

The petitioner Grace H. Cunningham in 1928 started the steel-manufacturing enterprise which was incorporated in 1936 as the American Manufacturing Company, Inc. She was one of the principal stockholders, and its manager and financial backer, and had endorsed and guaranteed its bank loans, amounting at one time to about $184,000. Her brother was president and her husband, Eugene F. Cunningham, was vice president. At the time the petitioner purchased the land and entered into the lease, the company was in dire need of room for expansion. It had previously used the lots for outdoor storage without paying rental to the prior owners, except a nominal rental for a portion of the year 1943. 

After the petitioner acquired the property and before the oral lease was entered into, the company placed a roof over the craneway and enclosed one side thereof. After the date of the lease it continued to make other improvements to this structure as described in the Findings of Fact. 

The petitioner testified that the reason she bought the lots and leased them to the company was in order that her company would have working space in that locality and not be forced to move, and that she had no intention of charging rent. She stated that the company was to use the lots for nothing, provided it paid the taxes. She also testified that she considered the improvements to be of a special type of construction to meet the particular need of the business of the company, that they did not have any value to anyone else except someone in a similar manufacturing business and that there was no other company in the city doing similar manufacturing. She stated that as the property owner she did not consider that the improvements had any value and that if she had not been connected with the company she would have required an agreement on the part of the lessee to remove the improvements. The petitioner Eugene F. Cunningham testified that in 1945 the company was not in a financial position to buy the lots. When the lease terminated in 1952 and title to the improvements was acquired by the petitioners, they entered into a new written lease with the company covering substantially the same properties for a period of 10 years at an agreed rental of $10 per month, the lessee to pay all taxes and maintenance and any new improvements to become the property of the lessors at the end of the term. 

We are satisfied from this testimony and from the acts of the parties to the lease that they did not intend that the value of the improvements should constitute rent either at the time of construction or at the termination of the lease. We have therefore concluded and found as a fact that the value of such improvements made by the lessee did not represent rent at the time of construction or upon termination of the lease. It follows that the petitioners did not derive income attributable to such improvements either in 1946 or in 1952.

Decision will be entered

for the petitioners.

 

<<ENDNOTES>>

1/ In 1946 the petitioner Grace H. Cunningham held certain lots involved herein as her sole and separate property, but at some time prior to January 1, 1952, such lots, except one which had been sold, were converted to community property by proper instruments of conveyance.

2/ Treasury Decision 4980, 1940-2 C.B. 42, was promulgated on July 2, 1940, amending section 19.22(a)-13 of Regulations 103 to read in part as follows:

Improvements by lessee.--If buildings are erected or other improvements are made by a lessee, the lessor shall include in gross income as of the date he acquires possession or control of the real estate with such improvements thereon, at the termination of the lease by forfeiture or otherwise, an amount equal to the excess of the value as of such date of the real estate with such improvements thereon over the value as of such date of the real estate without such improvements.

3/ The Ways and Means Committee Report (H. Rept. No. 2333, 77th Cong., 2d Sess.) and the Finance Committee Report (S. Rept. No. 1631, 77th Cong., 2d Sess.), state as follows, 1942-2 C.B. 425:

In Helvering v. Bruun (309 U.S. 461, (1940) * * *) it was held that buildings or other improvements made by a lessee constitute income to a lessor to the extent of the value of such improvements at the time the lease is forfeited and the lessor secures control and possession of the property. Your committee believes it advisable to exclude (except in cases in which such improvements represent a liquidation in kind of lease rentals) from the gross income of the lessor income attributable to such improvements. Such exclusion from gross income of the lessor does not mean that the enhancement in value in the hands of the lessor will not be ultimately taxed. By reason of the fact that the gross income attributable to the value of the improvements is not recognized, the basis of the property in the hands of the lessor will not be increased by such items.

 

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Tax Killers  

This is about Activity Based Taxplanning - maximizing deductions, minimizing cash outlay and maximizing the amount of cash retained and the net worth.  Activity Based Taxplanning (ABT) is a methodology developed by Bob Parrish CPA, that assists people with the tax issues by focusing on the activity (or actions - events) that are being undertaken or contemplated (or have already taken place).  The,  research is compiled from the myriad of sources to help you complete the activity with the least tax cost, while maintaining compliance the tax laws, other laws and regulations and place yourself in a position to protect your objectives.

Tax is a subject that many view in order to cut costs.  Taxes are a cost just as any other cost.  It happens this cost is somewhat intangible and is defined by legislation without a tangible item to view and control.  The money is spent and the control of the expenditure is more appropriately administered by someone trained in the law.

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Cost Killers   Management Info Sys, Cost Acctg, Activity Based Costing)

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Preparing for your CPA, attorney, or preparing to start your own What to gather - 

  

How to Prepare For the CPA or Legal Counsel - Save the Professional Time - Save Your Money

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• What to gather - an Organizer and Prepare for your CPA, Attorney or Financial Adviser

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1041 Organizer

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Forms - checklists, time-line to do, etc. Assistance - What To Do - 

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OVERVIEW OF PROCEDURES

GENERAL SETUP & STARTUP

Draft the rental agreement - consider all the ramification you have learned in this document

If one entity is a corporation obtain the minute book and draft minutes approving actions regarding the rental agreement

Write a procedure instructing how to account for (see the rental agreement) each check or deposit, attach a copy of the check to paid bills

Prepare or have prepared monthly rental statements showing dates, amounts and explanations of amounts paid by the lessee.  The lessor is usually responsible for this or the property manager.  This statement is a   "bridge" between the property owner and the renter describing all the business transactions for a specified time period.

If you are interested in the financial accounting please go to that section.  Financial Accounting: Bookkeeping & Financials

PRINT FORMS AND DOCUMENTS NEEDED

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LIST OF DOCUMENTS NEEDED

ORGANIZER

ENTRANCE INTERVIEW

EXIT INTERVIEW

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OBTAIN THE ORGANIZER AND BE CERTAIN ALL INFORMATION IS AVAILABLE

GATHER AND SORT THE INFORMATION

OBTAIN THE WORKPAPER TITLE SHEETS

OBTAIN THE PRESENTATION TITLE SHEETS

OPEN ALL STANDARD DOCUMENTS

OVERVIEW THE ENTRANCE INTERVIEW FORM

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PRESENTATION STANDARDS

DETERMINE THE CORRECT PRESENTATION STANDARD TO USE

ENGAGEMENT LETTER AND DISCLAIMER

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WHAT THE ENGAGEMENT IS LIMITED TO

WHAT SERVICES WERE PERFORMED

HOW THIS HELPS & BENEFITS

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BEFORE FINALIZING THE WORK PROCESS CONSIDER THE FOLLOWING

Compliance

Paying Bills or other events

The professional should perform functions the client does not have time for

The  professional should perform necessary functions the client staff does not have training for

Reduce Costs

Reduce Risks

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Setting guidelines for defining when variances from the guideline warrant policy or procedure changes

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LIST OF THE STANDARD FORMS AND W/P NEEDED

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PLACE BLANK FORMS IN THE CORRECT SEQUENCE

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Actions Checklist

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Required Documents and attachments

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FINAL OVERVIEW BEFORE THE JOBS IS ENDED & CLOSED

LOOK AT THE ORIGINAL QUESTION - has it been answered, were more questions added?

THE ANSWER - limit the answer to a short paragraph of about 7 sentences.  Did this solve the issue?  The ANSWER is not considered the SOLUTION

THE SOLUTION - understand the objective or goal and restate it.  Were the goals met?  What might prevent obtaining the goals. Do the benefits outweigh the costs?  Reduce Costs?  Reduce Risks?  Setting Goals or objectives:

Setting methods for monitoring

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FINAL STEPS

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Financial Accounting: Bookkeeping & Financials 

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Financial Statement Presentation

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Accounting on the renters books:

Accounting on the owner's books:

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What Kind of Records to Keep

Renters Books

Paid bills with copies of the checks attached.  Paid bills will include the statement for the rent due. Retain the rental agreement.  If the lessor / Renter is a corporation keep the minutes approving the execution of the agreement.  It is also a good Idea to keep photographs of the condition of the property before entering and upon leaving.  Furthermore, you will need to have a "walk-through" inspection report upon initial lease each year and upon termination.

You might also want to periodically inspect the tax role and mortgage records to know that there is no problem with unpaid taxes or debt on the property, mechanics liens, etc.

Owners Books

Retain a copy of the rental agreement.  Retain receipts for bills paid by the renter if the liability can be attached to your property or if you agreed the purchase is to become the property of the landlord upon termination of the lease.  Keep a record of the charges to the renter and the payments by the renter - for example the monthly rent and payment thereof.  A billing must be sent to the renter each month.

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