Moss v. C.I.R.

• Decision Date: 28 October 1987
• Docket Number: No. 86-7398,86-7398
• Citation: 831 F.2d 833
• Parties: -5910, 56 USLW 2275, 87-2 USTC P 9590 Jerome S. MOSS, Sandra Moss, Sharon M. Alesia, Herb Alpert, and Lani Alpert, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 833

831 F.2d 833

60 A.F.T.R.2d 87-5910, 56 USLW 2275, 87-2

USTC P 9590

Jerome S. MOSS, Sandra Moss, Sharon M. Alesia, Herb Alpert and Lani Alpert, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 86-7398.

United States Court of Appeals Ninth Circuit.

Argued and Submitted June 1, 1987.

Decided Oct. 28, 1987.

John C. Fossum, Newport Beach, Cal., for petitioners-appellants.

Roger M. Olsen, Washington, D.C., for respondent-appellee.

Appeal from the Decision of the United States Tax Court.

Before SCHROEDER, ALARCON and NELSON, Circuit Judges.

NELSON, Circuit Judge:

By this appeal, Jerome and Sandra Moss, Sharon Alesia, and Herb and Lani Alpert ("taxpayers") challenge the tax court's holding in Moss v. Commissioner, 51 T.C.M. (CCH) 742 (1986), that the taxpayers must capitalize certain normally deductible repair expenses totaling $270,268 because the expenses were incurred in conjunction with an overall plan of capital improvements to a hotel. The parties have stipulated to most of the relevant facts, and the taxpayers do not contest the tax court's findings of other facts. We note jurisdiction under 26 U.S.C. Sec. 7482 (1982) and reverse.

FACTUAL BACKGROUND

The taxpayers are general and limited partners in Almo Hotel Company, Ltd. ("Almo"), a California limited partnership. In 1976, the tax year in question, Almo was Prior to 1975, the American Automobile Association ("AAA") consistently assigned the Hotel an "excellent" rating. ¹ Because hotels operate twenty-four hours a day, 365 days a year, they are continuously in need of maintenance work and refurbishing. A first-class hotel must therefore make repairs and replace furniture, furnishings, and equipment on an ongoing basis pursuant to an annual plan and budget. However, owing to financial difficulties encountered by Airportel and IAHS, part of the Hotel's normally ongoing program of capital replacements and repairs was deferred during the early 1970's. As a consequence, the Hotel's AAA rating slipped one level from "excellent" in the 1974/1975 AAA Tour Book to "very good" in the 1975/1976 AAA Tour Book.

the sole fee owner of the Hyatt House Hotel ("the Hotel"), located near the Los Angeles International Airport. The Hotel was constructed in 1963 and was known as the International Hotel prior to 1975. It is a thirteen-story, reinforced concrete building with approximately 620 guest rooms, two large restaurants, two cocktail lounges, a large ballroom, more than a dozen smaller conference rooms, and numerous retail stores. The Hotel was purchased in 1967 for $12,600,000 by Almo Enterprises, a California limited partnership having the same partners as Almo, and was transferred to Almo in 1975. The purchase price included the acquisition of the Hotel land and buildings only, and the furnishings, equipment, and supplies used in operating the Hotel were supplied and owned by the Hotel's tenant. At all relevant times, Almo leased the Hotel land and buildings under a master lease to Ariz, a California limited partnership. For management purposes, Ariz in turn subleased the Hotel to Airportel, Inc. ("Airportel"). Prior to 1975, Airportel's management performance was guaranteed by its then-parent corporation, International Airport Hotel Systems, Inc. ("IAHS"). As an IAHS subsidiary, Airportel operated the Hotel under a triple-net lease and was responsible for all repairs and maintenance, as well as for purchasing and replacing the furniture, fixtures, equipment, and machinery necessary to operate the hotel.

In 1975, Almo and Ariz released IAHS from its guarantor responsibilities in return for all of Airportel's stock and some cash and notes. Almo and Ariz then sought new management for the Hotel and negotiated with both Hilton Corporation ("Hilton") and Hyatt Corporation ("Hyatt"). Owing to Airportel's deferral of some repairs and capital replacements during the preceding two or three years, both Hilton and Hyatt recommended that approximately $2,000,000 in capital improvements and repairs be made to the Hotel.

In August 1975, Airportel (now owned by Almo and Ariz) entered into a written management agreement with Hyatt. Pursuant to the terms of the management agreement, Airportel agreed to spend up to $2,000,000 on capital improvements and repairs to be proposed later by Hyatt. In turn, Hyatt agreed to finance these improvements and repairs to the Hotel by lending $2,000,000 to Airportel. Due to concerns that the newly-acquired Airportel stock might be subject to unknown liabilities, Almo and Ariz formed a California joint venture called Almo/Ariz for the purpose of accepting Hyatt's loan and carrying out the improvements and repairs.

The capital improvements and repairs were commenced in November 1975, and were completed in 1976, with the Hotel continuing to operate throughout that period. About 400 of the Hotel's 620 guest rooms underwent both a "hard remodel" (beds, chairs, tables, and lamps) and a "soft remodel" (new carpeting, drapes, and bedspreads). Additionally, most of the Hotel's public areas were remodeled. The foregoing capital improvements cost a total of $1,486,915. ² Almo/Ariz capitalized these In conjunction with the remodeling, Almo/Ariz also spent about $400,000 of the Hyatt loan on repairs and maintenance work, including the repainting and repapering of the remodeled guest rooms and public areas. Pursuant to 26 U.S.C. Sec. 162(a) (1982), Almo/Ariz treated the expenditure as an ordinary and necessary repair expense, deducting from its income $132,140 in 1975 and $270,268 in 1976.

                improvements pursuant to 26 U.S.C. Sec. 263(a)(1) (1982), depreciated the cost over a seven-year useful life, and leased the improvements to Airportel. 3   The Commissioner has not challenged the tax treatment of the foregoing expenditures
                

The $270,268 deducted by Almo/Ariz in 1976 is the subject of this appeal. ⁴ Portions of the $270,268 flowed through Almo/Ariz and Almo to the taxpayers, who deducted their proportionate shares on their personal income tax returns for 1976. However, the Commissioner assessed deficiencies against the taxpayers, claiming that the $270,268 should have been capitalized and depreciated over the Hotel structure's remaining thirty-year useful life. In the taxpayers' appeal to the tax court, the Commissioner conceded that "the particular items deducted by Almo/Ariz as repairs 'were of the type (i.e., painting, wallcovering, etc.) of items that normally qualify as repair expense items.' " Moss, 51 T.C.M. (CCH) at 746. However, the tax court held in favor of the Commissioner, finding that the repairs were made in conjunction with a plan of capital improvements to the Hotel property and were thus required to be capitalized. Id. at 747.

THE PLAN OF REHABILITATION DOCTRINE

Generally speaking, expenditures for ordinary and necessary repairs may be deducted in the year incurred, while expenditures for permanent improvements or betterments made to increase the value of any property must be capitalized and depreciated over the useful life of the improvement. See 26 U.S.C. Secs. 162(a), 263(a)(1) (1982). ⁵ The often-litigated distinction between repair expenses and capital improvements has been characterized as the difference between "keeping" and "putting" a capital asset in good condition:

The test which normally is to be applied is that if the improvements were made to "put" the particular capital asset in efficient operating condition, then they are capital in nature. If, however, they were made merely to "keep" the asset in efficient operating condition, then they are repairs and are deductible.

Estate of Walling v. Commissioner, 373 F.2d 190, 192-93 (3d Cir.1967). According to the Commissioner's 1976 repair regulation, "[t]he cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted as an expense." 26 C.F.R. Sec. 1.162-4 (1976). However, amounts expended in restoring property must be capitalized if they add to the value of the property, substantially prolong its life, or adapt the property to a new or different use. 26 C.F.R. Sec. 1.263(a)-1(a), (b) (1976).

In this case, the Commissioner concedes that the items expensed by the taxpayers "were of the type ... that normally qualify as repair expense items." However, a number of cases have recognized that, for tax purposes, the characterization of an expenditure as a deductible repair or as a capital improvement depends on the context To fix a door or patch plaster might very well be treated as an expense when it is an incidental minor item arising in the use of the property in carrying on business, and yet ... be properly capitalized when involved in a greater plan of rehabilitation, enlargement and improvement of the entire property.

                in which the expenditure is made.    See, e.g., Stoeltzing v. Commissioner, 266 F.2d 374, 377 (3d Cir.1959);  Jones v. Commissioner, 242 F.2d 616, 619 (5th Cir.1957);  Cox v. Commissioner, 17 T.C. 1287, 1293 (1952);  Cowell v. Commissioner, 18 B.T.A. 997, 1002 (1930).  For example
                

Cowell, 18 B.T.A. at 1002. These cases also analogize to the treatment of repair-like expenditures incurred in the construction of a new asset. As observed in Stoeltzing, 266 F.2d at 377:

If [the taxpayer] had erected a completely new building, items of work which the contractor might have undertaken to prepare the building for occupancy such as carting away refuse or painting or even washing windows, could hardly be separated from the whole cost and deducted as expenses. ⁶

In light of the contextual nature of the inquiry, "the courts have superimposed upon the criteria in the [Commissioner's] repair regulation an overriding precept that an expenditure made for an item which is part of a 'general plan' of rehabilitation, modernization, and improvement of the property, must be capitalized, even...