Welsh Homes, Incorporated v. CIR

• Decision Date: 30 May 1960
• Docket Number: No. 8052.,8052.
• Citation: 279 F.2d 391
• Parties: WELSH HOMES, INCORPORATED, Petitioner and Cross-Respondent, v. COMMISSIONER OF INTERNAL REVENUE, Respondent and Cross-Petitioner.
• Court: U.S. Court of Appeals — Fourth Circuit

279 F.2d 391 (1960)

WELSH HOMES, INCORPORATED, Petitioner and Cross-Respondent, v. COMMISSIONER OF INTERNAL REVENUE, Respondent and Cross-Petitioner.

No. 8052.

United States Court of Appeals Fourth Circuit.

Argued April 27, 1960.

Decided May 30, 1960.

Mason G. Kassel, New York City, and Walter C. Mylander, Jr., Baltimore, Md. (Harry J. Rudick, New York City, William B. Davidson, Baltimore, Md., and David R. Frazer, Washington, D. C., on the brief), for petitioner and cross-respondent.

Karl Schmeidler, Atty., Dept. of Justice, Washington, D. C. (Charles K. Rice, Asst. Atty. Gen., and Lee A. Jackson and Melva M. Graney, Attys., Dept. of Justice, Washington, D. C., on the brief), for respondent and cross-petitioner.

Before SOPER, HAYNSWORTH and BOREMAN, Circuit Judges.

SOPER, Circuit Judge.

This petition for review is directed to a decision of the Tax Court which approved the Commissioner's computation of the taxable gain derived by a builder upon the sale of leasehold interests in land upon which he had erected buildings under the ground rent system in vogue in Baltimore, Maryland, described in our decision in Commissioner of Internal Revenue v. Simmers' Estate, 4 Cir., 231 F.2d 909. The facts in the pending case are on all fours with those in Simmers', wherein the decision of the Tax Court was affirmed. The decision of the Tax Court in the pending case reaffirms the general principle there laid down but computes the gain derived by the builder corporation in the transactions upon a different formula and substantially increases its tax obligations.

The taxpayer's operations are described in the following passage from the Simmers' case, 4 Cir., 231 F.2d 910:

"The taxpayer acquired unimproved land, divided it into lots and built a dwelling house on each lot. When the houses on a group of lots were completed the taxpayer first created ground rents on the lots by entering into an agreement of lease with a wholly owned or straw corporation, as lessee, covering the lots and improvements thereon for a term of ninety-nine years, renewable forever, at a specified rental on each lot. Subsequently, upon the sale of a house, the taxpayer caused the straw corporation to assign to the purchaser the lease on the premises sold. This course was followed because under the Maryland law the original lessee of the lot is liable for the payment of the ground rent during the entire term of the lease, but an assignee of the lessee is liable for the rent only during the period of his tenancy."

Since the ground rent or reversionary interest in each lot is readily salable the Commissioner contended in the Tax Court in the earlier case and in the pending case that the creation of a ground rent and the sale of the leasehold interest to the purchaser amount to a disposition or sale of the whole property and therefore the taxable gain from the transaction is the excess of the cash received from the purchaser plus the market value of the ground rent over the cost of the land and the building thereon. We rejected this contention in affirming the Tax Court in the Simmers' case, since the purchaser of the leasehold interest can not be compelled to redeem the ground rent and hence the builder does not realize a taxable gain on the reserved ground rent until it is sold or redeemed by the lessee. On the strength of the Simmers' case the Commissioner's contention was again rejected by the Tax Court in the pending case and is now rejected by us for the reasons given in our earlier decision.

There is however, a substantial difference between the two cases in the computation of the tax. In Simmers', after the principle had been established, the computation was agreed upon and its correctness was not questioned in the Tax Court or in this court on appeal. The taxable gain was arrived at by deducting the aggregate cost of building the houses from the aggregate selling price of the leasehold interests. In the present case a different method of computation was proposed by the Commissioner¹ and approved by the Tax Court and is now in issue here. It is based on the theory that in the transfer of a leasehold interest the purchaser acquires and the builder retains an interest in both the lot and the building; and since the leasehold interest has been carved out of the whole and its cost cannot be definitely shown, it must be ascertained by allocating the entire cost between the interest sold and the interest retained. For this purpose the ratio of the value of the leasehold to the aggregate value of the leasehold and the reversionary interest is first ascertained and then the ratio is applied to the aggregate cost of the land and the building. The result obtained represents the cost basis of the leasehold. Assume, for example, that a purchaser pays $12,000 for the leasehold interest in a lot improved by a dwelling subject to an annual ground rent of $120.00, which is capitalized under the Maryland law at 6 per cent and therefore has a value of at least $2,000. In such case the value of the whole property is $14,000. Assume, also, that the cost of the land was $500.00 and the cost of the house $10,000, or a total of $10,500. The ratio of the value of the leasehold to the value of the whole property is therefore twelve-fourteenths, and if this ratio is applied to the total outlay, the cost of the leasehold is found to be $9,000 and the taxable gain to be $3,000. If, on the other hand, the agreed upon calculation in the Simmers' case is applied, the taxable gain in this transaction would be the difference between the purchase price of $12,000 and $10,000, the cost of the building, or $2,000.²

The objection of the taxpayer to the computation now approved by the Tax Court is based principally, if not entirely, upon the broad proposition that the lessee has absolute ownership of the house for all purposes subject only to the payment of the ground rent and has no ownership in the land except the right to use it upon payment of the rent; and that the lessor owns the land and has no interest in the house except as additional security for the payment of the ground rent. The Maryland decisions, however, do not support this proposition, as we pointed out in Simmers'. For example, it was held in Moran v. Hammersla, 188 Md. 378, 381-382, 52 A.2d 727, that although the estate of the lessee is considered personal property, in practical effect the relation of the lessee to the property is that of owner of the land and improvements thereon subject to the payment of the annual rent and all taxes on the property. The ninety-nine year lease under which the ground rent is created expressly provides that the lessor leases the land to the lessee, his successors and assigns, together with the improvements thereon.

The matter is summed up correctly in the opinion of Judge Fisher of the Tax Court in these words (32 T.C. 253):

"Upon the creation of the ground rent, there are two interests in the property; the reversion, owned by the grantor, and the leasehold, owned by the purchaser. Ogle v. Reynolds, 75 Md. 145, 23 Atl. 137 (1891); Moran v. Hammersla, 188 Md. 378, 52 Atl.2d 727 (1947); Kolker v. Biggs, 203 Md. 137, 99 Atl.2d 743 (1953). The purchaser has, in reality, a dual standing; he is the owner of the leasehold interest in the property and he is the lessee of the reversionary interest. The grantor

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