4th Cir. 1965, 353 F.2d 13. There the contract covered the use of machines for a construction project that was to be completed within 24 months. The lessors had placed the payments in a suspense account to be held until the option was lapsed or exercised. The periodic payments represented a fair return for the use of the equipment; however, the leases contained an option to purchase with a provision that rental would be applied to the purchase price if the option was exercised. The court noted that the short term of the contract resulted in at most a delay to the third year in recognizing income to the lessors. After holding that the payments must be characterized when received, the court held that they were ordinary income, that is to be treated as rental, despite the fact that they were to be applied in toto to the eventual price. The transaction was thus treated as a lease.
By the criteria used in the Revenue Rulings and the cases, the transaction negotiated by Universal and Reading & Bates, and the document prepared to reflect it, was an amalgam. It cannot be said that, in economic reality, the rental clauses merely plated the metal of a sale, or that the transaction assayed as a lease all the way through.
Both parties wanted, for different reasons, to have a document they could call a lease. Neither appears initially to have had tax manipulation in mind.
Some indication that the intention was not to transfer title is reflected by the fact that the risk of loss was on Universal; Universal could encumber the property. Another significant aspect of the transaction is that Reading & Bates' owners undertook no financial exposure in the transaction and in reality could abandon the drilling rig and the transaction at any time without significant loss. Thus the lessee would not acquire title after payment of the rentals it was required to make. If indeed this destitute corporation can be said to have been "required" in economic fact to pay anything, the charter was not for a relatively short period of use, (see paragraph 3 of the regulations; a contract is a binding obligation to pay in the future only if the party obligated has the resources to meet the payments); the payments did constitute a large proportion of the total sum required to be paid for transfer of title, but the balance, $750,000, was in any event, not negligible. It might be on hand in the savings fund at the end of the term, but there was no assurance in advance that it would be. The agreed charter payments did not materially exceed the current fair rental value of the vessel. The final price was not nominal in relation to the predictable value of the property, as it could be determined at the time of the original agreement.
The difference between this transaction and the nonrecourse mortgage on a sale, or a conditional sales contract for land, to which the government seeks to analogize it, was that the original owner retained the right to encumber the property, and assumed the risk of loss, even though the charter party provided reimbursement to the lessee for a portion of the rental it had paid in the event of loss.
In addition, it should be noted that under admiralty law title to the barge would not have passed to Reading & Bates under the agreement. Kane v. M/V Leda, E.D. La. 1972, 355 F. Supp. 796, aff'd, 5th Cir. 1975, 491 F.2d 899. Finally, the property's useful life extended beyond the lease term. The property would not be consumed in use.
Full weight has been given to the indicia that point in another direction, but the evidence, on net balance, appears to me to weigh more in the direction of lease than of sale. Since alloyed verdicts won't assay, it must be treated as a lease. On this issue, the taxpayer is entitled to judgment.
II. The Real Estate Transaction
On August 31, 1962, Universal purchased the land and buildings situated at the northwest corner of the intersection of Carondelet and Gravier Streets in the City of New Orleans for $825,000. This is known as the Cotton Exchange Building.
On its books Universal allocated the amount paid for the Cotton Exchange as $200,000 for land; $625,000 for building. Accordingly, it computed its depreciation expense with reference to the building on the basis of $625,000. The government contends that the allocation of the acquisition cost paid by Universal should be $357,787 for land; $467,213 for building. Accordingly, it contends that Universal should have based its depreciation expense on a cost of $467,213.
Universal introduced an appraisal report dated February 10, 1975, that valued the land at $211,150 as of August 21, 1962. But it offered no evidence of the value of the improvements. The government introduced an appraisal report that valued the land at $415,200, and the building at $659,303 (cost approach) and $581,543 (income approach) as of September 1, 1962.
Universal has the burden of proving, by a preponderance of the competent evidence, the correct amount of depreciation that it is due on the Cotton Exchange Building. Its burden is to establish the depreciable amount, as opposed to the lump sum value of land underlying the building, or the value of land and building as a whole. The Treasury Regulations on income tax, § 1.167(a)-5 (26 C.F.R.), state in part:
Apportionment of basis. In the case of the acquisition on or after March 1, 1913, of a combination of depreciable and nondepreciable property for a lump sum, as for example, buildings and land, the basis for depreciation cannot exceed an amount which bears the same proportion to the lump sum as the value of the depreciable property at the time of acquisition bears to the value of the entire property at that time. * * *
Treasury Regulations on income tax have the effect of law, as long as they are reasonable, not plainly inconsistent with the statute that authorizes them, and are duly promulgated. Maryland Casualty Co. v. United States, 1921, 251 U.S. 342, 64 L. Ed. 297, 40 S. Ct. 155; Commissioner v. South Texas Lumber Co., 1947, 333 U.S. 496, 92 L. Ed. 831, 68 S. Ct. 695. The propriety and correctness of Regulations Section 1.167(a)-5, supra, has been approved in Aschaffenburg v. United States, E.D. La. 1974, 381 F. Supp. 510.
The application of the Regulation requires a determination of three elements:
(1) The amount of the "lump sum," or actual purchase price of the land and building;