Kaufman v. CIR, 10483.

• Citation: 372 F.2d 789
• Decision Date: 18 October 1966
• Docket Number: No. 10483.,10483.
• Parties: Herbert KAUFMAN, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: United States Courts of Appeals. United States Court of Appeals (4th Circuit)

372 F.2d 789 (1966)

Herbert KAUFMAN, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 10483.

United States Court of Appeals Fourth Circuit.

Argued June 22, 1966.

Decided October 18, 1966.

COPYRIGHT MATERIAL OMITTED

Stanley Worth, Washington, D. C. (Scott P. Crampton, and Korner, Doyle, Worth & Crampton, Washington, D. C., on brief), for petitioner.

Jonathan S. Cohen, Atty., Dept. of Justice (Richard M. Roberts, Acting Asst. Atty. Gen., Lee A. Jackson and David O. Walter, Attys., Dept. of Justice, on brief), for respondent.

Before HAYNSWORTH, Chief Judge, J. SPENCER BELL, Circuit Judge, and LEWIS, District Judge.

J. SPENCER BELL, Circuit Judge.

Petitioner is in the real estate business in Baltimore, Maryland. Real estate in Baltimore is frequently sold not in fee simple but by transfer of a leasehold interest under lease of the land for 99 years, renewable forever. See C. I. R. v. Simmers' Estate, 231 F.2d 909 (4 Cir. 1956). These leases generally provide that they may be redeemed by the lessee at any time after five years from their creation upon capitalization of the annual rental at a rate of 6%. Some older leases are not redeemable. The practical effect is to create a mortgage of indefinite duration which the owner of the leasehold may pay off but which the owner of the reversion may not call. Petitioner's main business is the purchase of existing improved leaseholds and their resale. After purchase he normally redeems the existing ground rent and at the time of resale sells the property subject to a new ground rent calling for an increased annual payment. Petitioner's properties are normally located in declining areas and his customers normally are not able to afford more than a nominal down payment.

Since July 1, 1951, the transactions have been initiated by executing a "Standard Land Installment Contract" governed by the provisions of the Maryland Land Installment Contract Law. Md.Code Art. 21, §§ 110-116 (1957). These contracts call for a weekly payment. Out of each payment was taken interest on the unpaid balance, ground rent, taxes, water rent, insurance premiums and other public charges. The part remaining increased the purchaser's equity. When the buyer had accumulated enough of an equity to obtain a mortgage from a savings and loan association the petitioner secured such a mortgage for him and transferred title. Should the buyer default before a mortgage was obtained the seller could foreclose and gain rights in personam against the purchaser for any deficiency. These contracts could be recorded. These later contracts differed from that used by the petitioner prior to July 1, 1951, in that the prior contracts had no provision for obtaining an in personam judgment. When a mortgage was obtained the savings and loan association usually insisted on security in addition to the underlying property. Normally the association would require that a part of the proceeds of the mortgage be hypothecated to it and deposited in interest bearing accounts. As long as the mortgage was not in default the interest on these hypothecated accounts could be withdrawn. When the amount remaining due on the mortgage was reduced to a specified level the hypothecated funds were released. In addition to those hypothecations left with the savings and loan association as a result of mortgages on property which he had sold, petitioner also purchased hypothecated sums under other mortgages. Whenever it appeared that petitioner would lose his hypothecated funds due to foreclosure of the mortgage the petitioner would purchase the mortgage.

This case involves the tax consequences of three fairly distinct transactions: the signing of the installment contract, the transfer of title and mortgage, the purchase of the mortgage and consequent release of hypothecations.

I

Before determining the tax consequences of the sale it is necessary to determine what the tax basis of the property sold should be. It is clear that there are two separate interests involved in the transaction: the right to use the property, and the reversion together with its concomitant right to ground rent payments.

There are three ways in which the petitioner proceeded: (1) The petitioner would in some instances purchase a leasehold subject to a ground rent and then resell the leasehold subject to the same pre-existing ground rent; (2) the petitioner in other instances purchased property in fee simple and then sold a leasehold subject to a newly created ground rent; and (3) the petitioner in still other instances would purchase a leasehold subject to a ground rent, redeem the ground rent, make a new lease and sell the leasehold. Petitioner here had transactions in all three categories. The computation of the basis in the first two cases is clear. In the first category the reversion never came into the hands of the petitioner; the basis of the leasehold is simply the price he paid. The second is controlled by the decision of this court in Welsh Homes, Inc. v. C. I. R., 279 F.2d 391 (1960). In that case the taxpayer had acquired land in fee simple, built houses on it, and then sold the property subject to a ground rent. There we found that though the cost of erecting the house was known and the cost of the land was known, the purchaser of the leasehold took an interest in both the building and the land and that, therefore, to determine the basis of the leasehold the aggregate cost of the building and land must be reallocated between the leasehold and reversion retained rather than simply including the cost of the building as the basis of the leasehold and the cost of the land as the basis of the reversion retained. The government argues that the Welsh Homes allocation should also be applied to the third situation since when the petitioner redeemed the ground rent under Maryland law his interests merged into a fee simple. Starr v. Ministers & Trustees of Starr M. Church, 112 Md. 171, 76 A. 595 (1910). See Storey v. Ulman, 88 Md. 244, 41 A. 120 (1898), putting him into the same position as if he had originally purchased the land in fee simple.

On the other hand, the taxpayer contends that the basis of the leasehold should be the cost of the original leasehold plus the cost of any improvements, and that the basis of the new ground rent should be the cost of redeeming the original ground rent. He points out that allocation is unnecessary where the cost items for separable interests are identifiable, see 3A Mertens § 21.32, and argues that this principle applies here.¹

We disagree with the taxpayer's contention. It is true that courts are not bound by technical state laws of merger, see Bell v. Harrison, 212 F.2d 253 (7th Cir. 1954), but as a practical matter, there is no material difference between this case and Welsh Homes. Whether property is purchased subject to a mortgage or to a ground rent, the encumbrance must be paid off in order to acquire full ownership of the land. At this point, the purchaser occupies precisely the same economic position as the taxpayer in Welsh Homes. Any subsequently created interests will be derived from the same undivided whole and the value of each such interest derives from the total value of the whole, not from the individual components. It is therefore illusory to attribute the cost of the old ground rent solely to the basis of the new ground rent, or to attribute the cost of the old leasehold solely to the basis of the new leasehold. The ratio of the newly created leasehold to the reversion will hardly ever be the same as the ratio of the old interests in the property, for the very purpose of making the new lease with a different ground rent was to alter that ratio.²

Similarly, additional improvements affect both the new leasehold and the new reversion and cannot be attributed solely to the basis of either unit. We therefor affirm the tax court's use of the Welsh Homes formula in this case.

II

Pursuant to Regulations 118, § 39.44-3(c), petitioner has reported income on installment sales on a cash receipts and disbursements basis. Having elected to report on this basis, the taxpayer is entitled to defer the reporting of income from each transaction until he has received from the buyer cash or other property in excess of his cost basis. The real questions in determining the petitioner's tax liability at points during his transactions are whether the instruments he receives have fair market value and thus are receipts of income to a cash basis taxpayer.

The tax court concluded, in agreement with the Commissioner, that upon execution of a sales contract of the type used prior to July 1, 1951, no property having a fair market value was realized. Petitioner agrees with this finding. Upon execution of the post July 1951 Standard Land Installment Contract property having a fair market value was realized. Petitioner contends that there can be only one correct method of reporting income from sales of real property by the taxpayer; that the government cannot treat pre and post July 1951 contracts differently. This contention is in error. If there are significant differences in the contracts, there may be significant differences in their tax treatment. The post 1951 contracts give in personam rights in the nature of those under a mortgage while the pre 1951 contracts contain no such rights. Schapiro v. Jefferson, 203 Md. 372, 100 A.2d 794 (1953). The post 1951 contracts are standard form contracts for which a market exists; the earlier contracts were improvised by the petitioner.

The Commissioner originally determined that the post 1951 contracts had a value of 100% of their face amount at signing. This is clearly erroneous. The tax court said:

"While, as we

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