McShain v. Comm'r of Internal Revenue

Decision Date14 March 1979
Docket Number9649–75.,Docket Nos. 4767–74
CourtU.S. Tax Court
PartiesJOHN McSHAIN AND MARY McSHAIN, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

OPINION TEXT STARTS HERE

Held, under the facts and circumstances of this case, a second leasehold mortgage note had no ascertainable fair market value in 1970 for purposes of determining whether there was a gain on a sale within the meaning of sec. 1001, I.R.C. 1954. John F. Kennedy and Charles V. Stoelker, Jr., for the petitioners.

Howard W. Gordon, for the respondent.

SIMPSON, Judge:

The Commissioner determined deficiencies in the petitioners' Federal income taxes as follows:

+--------------------+
                ¦Year  ¦Deficiency   ¦
                +------+-------------¦
                ¦      ¦             ¦
                +------+-------------¦
                ¦1967  ¦$654,059.86  ¦
                +------+-------------¦
                ¦1969  ¦52,706.03    ¦
                +------+-------------¦
                ¦1970  ¦1,685,711.49 ¦
                +--------------------+
                

Most of the issues have been settled, conceded, or previously decided by this Court. McShain v. Commissioner, 68 T.C. 154 (1977); McShain v. Commissioner, 65 T.C. 686 (1976). The issue remaining for decision is whether a second leasehold mortgage note had an ascertainable fair market value in 1970 for purposes of determining whether there was a gain on a sale within the meaning of section 1001, I.R.C. 1954.1 In view of our resolution of such issue, we need not decide whether such note was the equivalent of cash.

FINDINGS OF FACT

Some of the facts were stipulated, and those facts are so found.

The petitioners, John and Mary McShain, husband and wife, maintained their mailing address in Philadelphia, Pa., at the time they filed their petitions in this case. They filed their joint Federal income tax returns for 1967, 1969, and 1970 with the District Director of Internal Revenue, Philadelphia, Pa. During the years in issue, the petitioners maintained their books and records by use of the cash method of accounting.

During 1950, Mr. McShain acquired an 85-percent interest in a tract of real estate in Washington, D.C. (the Washington property). In 1967, the United States of America condemned such property and awarded Mr. McShain $2,890,000 for the loss of his interest therein. The realized gain attributable to such condemnation was $2,616,000.

To avoid recognition of such gain, the petitioners elected to invoke section 1033(a)(3). Such election was made in an express statement attached to their 1967 Federal income tax return, in which the petitioners indicated they would timely reinvest the condemnation proceeds in qualified property.

During 1967, Mr. McShain investigated the possibility of building a large hotel in the Philadelphia area. After conducting a feasibility study, he obtained construction financing from the Philadelphia National Bank to build the hotel. On November 30, 1967, Mr. McShain filed a mortgage loan application with Penn Mutual Life Insurance Co. (Penn Mutual) to secure the permanent financing for the hotel. Subsequently, in December 1967, Mr. McShain obtained two loans from Penn Mutual totaling $8 million, and he executed two notes and a mortgage securing such notes. The first loan was for $6 million and was evidenced by a $6 million nonrecourse note, i.e., the holder of the note could only proceed against the property securing the note in the event of a default. The second loan was for $2 million and was evidenced by a $2 million full recourse note, i.e., the holder of the note could proceed against Mr. McShain personally, as well as the property securing the note, in the event of a default. One of the conditions for approval of the loan was that there be no secondary financing of the mortgaged premises.

During 1968, the petitioners reiterated their prior election in a letter to the District Director, Philadelphia, Pa., in which they sought an extension of time for completion of the replacement building. An extension was granted, giving the petitioners until December 31, 1969, to complete construction. Within the extended replacement period, the petitioners reinvested the condemnation proceeds.

The replacement property was a 22-story hotel constructed by Mr. McShain's wholly owned construction company, John McShain, Inc. The hotel was operated as a Holiday Inn (the Philadelphia Inn) under a franchise license from Holiday Inns of America. The construction costs of such property were as follows:

+---------------------------------+
                ¦Building              ¦$6,548,275¦
                +----------------------+----------¦
                ¦Elevators             ¦382,972   ¦
                +----------------------+----------¦
                ¦Furniture and fixtures¦1,825,968 ¦
                +----------------------+----------¦
                ¦Total                 ¦8,757,215 ¦
                +---------------------------------+
                

The Philadelphia Inn was constructed on property owned by Country Club Estates, Inc. (Country Club), which was wholly owned by Atlantic City Ambassador Hotel Corp., which in turn was 95-percent owned by Mr. McShain. On November 24, 1969, Mr. McShain entered into a lease agreement with Country Club for a term of 35 years. Such lease also provided that Mr. McShain was required to pay annual rental of $64,000, to complete a building that would be used for hotel or motel purposes, to keep the building in good repair, to pay taxes, assessments, and utility bills, and to obtain Country Club's approval prior to subletting the premises. Upon breach of the lease, Country Club could, at its option, demand that Mr. McShain pay immediately, as liquidated damages, the rent due for the entire unexpired term of the lease.

On December 30, 1969, Mr. McShain entered into a contract with Harry B. Helmsley for the sale of his leasehold interest in the Philadelphia Inn. The stated purchase price was $13 million and was payable as follows: (1) $200,000 paid by the purchaser upon execution of the contract; (2) $1,800,000 paid by the purchaser at the closing; (3) $8 million by the purchaser taking subject to the first mortgage held by Penn Mutual; and (4) the balance by the purchaser (or his assigns) making, executing, and delivering a nonrecourse note (the note) in the amount of $3 million secured by a second leasehold mortgage. Mr. Helmsley assigned his interest in the contract to City Line & Monument Corp. (City Line), a corporation indirectly wholly owned by him.

City Line executed the note and the leasehold mortgage, and the sale of the leasehold interest to City Line was consummated on March 10, 1970. The note provided for constant monthly payments of $22,500, commencing May 1, 1970, and ending on March 1, 1985, when the remaining principal of the note would become due. Each monthly payment was to be applied first to interest at the rate of 7 1/2 percent per annum on the reduced principal balance and then in reduction of the principal amount of the loan. On March 1, 1985, the remaining balance of the leasehold mortgage note would be $1,825,905.79. In addition, Mr. McShain assigned his interest in the lease with Country Club to City Line, and then Country Club and City Line amended the lease to provide, inter alia, for a 50-year term.

About the same time that City Line acquired the Philadelphia Inn from Mr. McShain, another assignee of Mr. Helmsley acquired the Atlantic City Holiday Inn from a corporation controlled by Mr. McShain. The stated purchase price of $12 million was to be paid as follows: (1) $200,000 paid by the purchaser upon execution of the contract; (2) $2,440,000 paid by the purchaser at the closing; (3) $4,301,318.12 by the purchaser taking subject to a first mortgage; and (4) $5,058,681.88 by the purchaser making, executing, and delivering a purchase-money note secured by a second mortgage.

On their 1970 Federal income tax return, the petitioners reported the gain from the sale of Mr. McShain's leasehold interest in the Philadelphia Inn on the installment method of accounting under section 453. They reported the selling price as $13 million, and the only payment received by them in 1970 as $2,011,320.46. Despite their election under section 1033 to defer recognition of gain on the condemnation of the Washington property in 1967, the petitioners neglected to reduce their cost basis in the replacement property by the amount of the unrecognized gain as required by such section. After making appropriate adjustments for depreciation and sales tax deductions, and after reducing the basis of the replacement property by the nonrecognized gain under section 1033, the petitioners' adjusted basis in the leasehold interest at the time it was sold to City Line was $5,633,611.46.

In 1971, Mr. McShain was apprised by his accountant of the alleged error concerning the failure of the petitioners to reduce the basis of the Philadelphia Inn by the gain not recognized under section 1033. However, no action was taken with respect to this matter prior to the time that the Commissioner audited the petitioners' returns for 1969 and 1970.

In his notice of deficiency, the Commissioner determined that the petitioners must reduce their basis in the replacement property by $2,616,000 (the amount of the unrecognized gain under section 1033), that $2,281,929.24 (the amount by which the mortgage on the replacement property exceeded their basis) must be included as an additional payment received by them in 1970, and that, therefore, they were not entitled to report the gain on the sale of the Philadelphia Inn by use of the installment method since their first-year payments exceeded 30 percent of the selling price.

Thereafter, upon advice of counsel, the petitioners sought to revoke their prior election under section 1033. In McShain v. Commissioner, 65 T.C. 686, 693 (1976), we held that the petitioners' attempt to revoke their section 1033(a)(3) election was untimely. We specifically noted, however, that an issue not presented at that time was whether the replacement property qualified as ‘property similar or related in service or use’ to the condemned property.

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