Macabe Co. v. Commissioners of Internal Revenue

• Decision Date: 29 September 1964
• Docket Number: Docket Nos. 4781-62— 4785-62.
• Citation: 42 T.C. 1105
• Parties: MACABE COMPANY, INC., ET AL.,1 PETITIONERS, v. COMMISSIONERS OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

42 T.C. 1105

MACABE COMPANY, INC., ET AL.,1 PETITIONERS,

v.COMMISSIONERS OF INTERNAL REVENUE, RESPONDENT

Docket Nos. 4781-62— 4785-62.

Tax Court of the United States.

Filed September 29, 1964.

A corporation, several days before the close of its fiscal year, sold an office building it had owned for 9 years at a price in excess of its depreciated basis. The sale occurred substantially prior to the expiration of the building's useful life as estimated by the corporation. Held, under the circumstances of this case, the amount received for the building upon its sale does not constitute or otherwise determine its salvage value, and the corporation is entitled to a depreciation deduction in the year of sale.

Nathan L. Cohen, for the petitioners.

Nathan L. Cohen, for the petitioners.

John D. Picco, for the respondent.Fay, Judge:

The respondent determined a deficiency of $45,935.83 in the income tax of petitioner Macabe Co., Inc. (hereinafter some- times referred to as the petitioner), for its fiscal year ended July 31, 1958.² The deficiency results from the disallowance of a depreciation deduction on an office building owned by petitioner in the year it sold the building. Respondent contends that petitioner is not entitled to depreciation on the building in the year of sale because the aggregate depreciation taken by petitioner thereon in prior years, plus an amount respondent regards as the salvage value of the building, exceeds the petitioner's original cost therein. It is respondent's position that the salvage value of the building is to be determined by reference to the sales proceeds received by petitioner. In order to decide whether petitioner is entitled to the depreciation deduction claimed, we must first decide whether, under the circumstances of this case, the amount received by petitioner upon the sale is relevant to or determines the salvage value of the building.

It has been stipulated that if the respondent's disallowance of the depreciation deduction claimed by the petitioner for its fiscal year ended July 31, 1958, is sustained by this Court, the amount of the deficiency determined by respondent is correct. The parties have further agreed that the petitioners involved in docket Nos. 4782-62 to 4785-62, inclusive, would be liable for any such deficiency as the transferees of the assets of Macabe Co., Inc., pursuant to section 6901.³

All of the facts have been stipulated, are so found, and are incorporated herein by this reference. Those necessary to an understanding of our inquiry are recited below.

The petitioner was incorporated under Oregon law on or about February 15, 1947. It timely filed its income tax return for its fiscal year ended July 31, 1958, with the district director of internal revenue, district of Oregon.

The petitioner acquired in 1946⁴ a plot of land in downtown Portland, Oreg., together with a building thereon, originally constructed in 1904 as a seven-story brick warehouse but converted into a ramp garage during the early 1930's. The petitioner then proceeded to demolish the building on said land, leaving only the original structural steel frames, foundations, basement, and brick exterior walls. ceramic-tile-faced, eight-story office building. When completed in 1949, the building was assigned a basis of $2,835,161.55 and the land a basis of $77,204.64.

Between the years 1949 and 1958 the fair market value of downtown Portland rental properties (into which category the building falls) increased substantially.

One of the principal stockholders of the petitioner died on August 15, 1957. Motivated in part by the cash requirements of the estate of the deceased stockholder, the directors and stockholders of the petitioner resolved to sell the building and land and liquidate the petitioner pursuant to section 337. On July 25, 1958, 6 days prior to the expiration of its fiscal year, the petitioner sold the building and land for $3,900,000 under an agreement which provided that it would pay all of the building operating expenses and retain all of the operating income therefrom to and including July 31, 1958, the end of its fiscal year. Thereafter the building was operated by the purchaser.

After the payment of its then ascertained liabilities, the petitioner, pursuant to its plan of liquidation under section 337, distributed its remaining assets to the individual petitioners involved in docket Nos. 4782-62 to 4785-62, inclusive, who at that time were petitioner's sole stockholders.

For each year from 1949 through its fiscal year ended July 31, 1957, the petitioner claimed a depreciation deduction with respect to the building in the amount of $85,054.85. In computing the annual depreciation allowance for the building, the petitioner employed the straight-line method, using an estimated useful life of 33 1/3 years,⁵ and estimated that the building after 78 years of service would have a zero salvage value. As of the commencement of its fiscal year ended July 31, 1958, the petitioner had theretofore claimed depreciation on the building in the aggregate amount of $755,099.89.⁶ In its final income tax return covering the year of the sale, the petitioner computed depreciation on the building for the entire year, claiming a deduction therefor in the amount of $85,054.85 and reported a capital gain of $1,699,350.15, being the excess of the sales price over its basis in the land and its depreciated basis in the building as of July 31, 1958. The amount received for the building upon its sale exceeded its adjusted basis as of the start of the year of sale.⁷

Under the circumstances of this case, the petitioner's estimate of a zero salvage value for the building was reasonable.

Respondent, relying on Cohn v. United States, 259 F.2d 371 (C.A. 6, 1958), and section 1.167, Income Tax Regs., disallowed the depreciation deduction taken by the petitioner with respect to the building in the year of its sale. Aside from claiming in the same notice of deficiency that, with respect to petitioner's fiscal year ended July 31, 1957, the year prior to that in which the sale occurred, the useful life of the building should be increased from 33 1/3 years to 40 years, respondent did not attempt to redetermine or recompute the useful life of the building as of the year of its sale.⁸

Respondent contends that petitioner is not entitled to a depreciation deduction for the building in its fiscal year, ended July 31, 1958, because (1) the sales proceeds received by petitioner show that the building had not depreciated, but had appreciated in value and (2) petitioner had fully recovered before the end of that year (by virtue of the sales proceeds for the building) more than its undepreciated basis in the building as of the beginning of said year. Respondent maintains that this disallowance is necessary to carry out the underlying purpose of section 167, which sanctions the tax-free recovery of the cost of depreciable property used in the taxpayer's trade or business or held for the production of income. See H. Rept. No. 1337, to accompany H. R. 8300 (Pub. L. 591), 83d Cong., 2d Sess., p. 22. It is the respondent's position that if a depreciation deduction were allowed in the year of sale when the sales price equals or exceeds a taxpayer's undepreciated basis as of the beginning of said year, the taxpayer would, in effect, be recovering, a tax free, more than the cost to him of the asset. In making this argument, respondent relies upon Cohn v. United States, supra; Randolph D. Rouse, 39 T.C. 70 (1962); Massey Motors v. United States, 364 U.S. 92 (1960); and Hertz Corp. v. United States, 364 U.S. 122 (1960). Respondent's contention has, because of its simplicity, a beguiling appeal to it. However, a closer scrutiny of respondent's argument convinces us that it is incorrect for two reasons. First of all, the reasoning underlying respondent's position is unsound because it fails to take into account the distinction between (1) and concept of ‘depreciation’ or the gradual exhaustion of property and (2) the concepts of ‘appreciation’ or ‘depreciation’ in the value of property because of market conditions such as scarcity, inflation, or the like. Moreover, respondent, in disallowing the depreciation deduction claimed by petitioner, has failed to comply with the underlying intent of section 167 and the specific provisions of his own regulations thereunder.

We find merit in petitioner's argument that the granting of a reasonable allowance for depreciation is a matter separate and distinct from the computation of gain upon the sale of property formerly held in the taxpayer's trade or business or for the production of income. The concepts of depreciation through the process of exhaustion, on the one hand, and of appreciation or depreciation because of market conditions, on the other hand, are mutually exclusive. Respondent, however, has sought to equate the two. The purpose of the depreciation allowance is to permit a taxpayer to recover, by deductions against his income, his cost or investment in any depreciable asset. United States v. Ludley, 274 U.S. 295 (1927). Depreciation, as that term is used in section 167, ⁹ occurs through use and the passage of time; such depreciation occurs regardless of market conditions which might otherwise enhance or diminish the value of an asset. In the instant case, the building continued to depreciate in petitioner's hands right up to the time of the sale. Respondent's contention that petitioner should be regarded as having recouped its investment in the building by its receipt of the sales proceeds and that petitioner is not entitled to a depreciation deduction in the year of sale is totally inconsistent with the specific design of the Internal Revenue Code of 1954. The 1954 Code contains two separate and distinct sets of provisions, each setting forth the particular tax consequences applicable to the separate and distinct phenomena of (1) depreciation through exhaustion and...