Opinion
Docket No. 40524.
1954-06-30
ETHEL S. AMEY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Maurice D. Dolphin, Esq. , for the petitioner. George E. Grimball, Jr., Esq. , for the respondent.
Payments made by a lessee of property to the mortgagee in reduction of the outstanding mortgage indebtedness constituted rental income to petitioner-lessor, even though petitioner was not personally liable on the mortgage. Maurice D. Dolphin, Esq., for the petitioner. George E. Grimball, Jr., Esq., for the respondent.
Respondent determined a deficiency of $3,862.07 in the income tax of petitioner for the calendar year 1944. The single issue to be decided is whether respondent properly included in petitioner's income one-half of the mortgage amortization payments made in 1944 by the lessee of the Peter Cooper Hotel to the mortgagee, petitioner having acquired a one-half interest in the hotel subject to the lease and mortgage but without assuming the mortgage.
The parties stipulated at the hearing that if respondent prevails on that issue he will be entitled to an increased deficiency based on the inclusion of $14,692.89 rather than the figure of $14,347.97 used in computing the original deficiency.
Other adjustments will be given effect under the Rule 50 computation. The stipulated facts are incorporated herein by this reference.
FINDINGS OF FACT.
The petitioner is an individual who filed her income tax return for 1944 with the collector of internal revenue for the third district of New York. She was a resident of New York City at that time.
Petitioner is and was during 1944 the owner of an undivided 50 per cent interest in the Peter Cooper Hotel in New York City and the land on which it stands.
On March 30, 1926, the land was owned by petitioner's uncle, Thomas Snell, now deceased. By indenture of lease dated March 30, 1926, Snell leased the land to the Peter Cooper-Lexington Corporation for approximately 21 years with options to renew the lease for three further 21-year periods. Under the terms of the lease, the lessee was required to demolish the existing buildings on the premises and to erect a new apartment hotel of a reasonable value of not less than $1,200,000. The lease authorized and empowered the lessee to borrow at its own cost and expense a sum not exceeding $950,000 secured by a mortgage on the fee of the premises, Snell agreeing to subject his interest to that mortgage.
The lease contained a further provision as to the mortgage as follows:
The Lessor shall not be required to make in such mortgage any covenant or representation of any kind whatsoever with or to any of the other parties thereto or with or to any one and shall not be liable in any event whatever to pay any of the bond or bonds secured thereby or any part of the indebtedness which may be evidenced by said bond or bonds and the Lessor shall be as free to consolidate, mortgage, sell, convey or transfer his property as an entirety or otherwise as though such mortgage had never been made or the bond or bonds or certificates referred to therein executed and issued, provided that none of the premises herein so to be mortgaged shall be conveyed, assigned, transferred or mortgaged by the Lessor except subject to the lien of such mortgage if any such then exist, and subject also to this lease.
On the termination of the lease, all buildings and improvements were to become the absolute property of the lessor under the terms of the lease.
Pursuant to the lease, Peter Cooper-Lexington Corporation secured a building loan of $925,000 from the Lawyers Title and Guaranty Company secured by its bond in that amount, dated September 20, 1926. The bond was secured by a mortgage covering the premises, executed by the corporation and Thomas Snell, dated September 20, 1926.
On January 4, 1928, Thomas Snell gave his bond in the sum of $25,000 to Jesse Sharp. The obligation represented by that bond was secured by a mortgage covering the premises at 123 East 38th Street and 128 East 39th Street in New York City, which premises were a part of the property on which the hotel was built.
Both of the aforementioned mortgages were assigned to the Greenwich Savings Bank in January 1928.
Thomas Snell died a resident of the city, county, and State of New York on May 5, 1931, and his last will and testament was duly admitted to probate in New York County on May 27, 1932. Under the provisions of that will, a legacy of $200,000 was given petitioner and her husband, Dr. J. W. Amey.
By an instrument dated January 18, 1934, the Peter Cooper-Lexington Corporation surrendered to the executors and trustees under the will of Thomas Snell and of its rights and interests in the premises. The Peter Cooper-Lexington Corporation was dissolved in 1939.
On May 24, 1934, J. W. Amey and the Manufacturers Trust Company, as executors of the last will and testament of Thomas Snell, deceased, Cooper Union for the Advancement of Science and Art, and the Manufacturers Trust Company, as trustees under the last will and testament of Thomas Snell, leased the hotel to Rosdniw Company, Inc., by indenture dated as of December 1, 1933. That lease provided, in part, that in addition to the payment of a cash rental, the lessee was to pay all interest and principal amortization payments on the outstanding mortgages on the premises during the term of the lease. After setting forth certain fixed rentals to be paid the lessor by the lessee, the lease provided, inter alia, as follows:
In addition to the foregoing rental, above described as minimum net rental, the Lessee undertakes and agrees to pay to the Lessor, for the period commencing October 1, 1944, to and including September 30, 1948, as additional rental a sum equal to twenty-five per cent. (25%) of the net profits as hereinafter defined, earned from the demised premises and all buildings thereon. Such net profits shall be determined and be payable as hereinafter provided, viz:
From the annual gross revenues of said demised premises and the buildings and structures thereon, there shall be deducted for such annual period the reasonable operating expenses thereof (exclusive of any officers' salaries or charges, however termed), all taxes water charges and assessments duly assessed and properly chargeable against said demised premises and paid during said year, including corporate income and New York State franchise taxes; interest and amortization, if any, actually paid upon or under the terms of any first mortgage or first mortgages upon the demised premises, in accordance with the provisions hereof, hereinafter set forth; ordinary repairs and alterations; one-fourth of all capital advances and furniture replacements made by the Lessee from and after October 1, 1944, with the written approval of the Lessor, which approval shall not be unreasonably or arbitrarily withheld; necessary and proper maintenance or management charges, which are not to exceed two and one-half per cent. (2 1/2%) of the gross income derived from the demised premises; and the minimum net rent of $25,000. per annum as hereinbefore set forth. The lease to Rosdniw Company, Inc., further provided:
The provisions herein contained requiring the Lessee to pay * * * mortgage interest, or mortgage amortization instalments, are herein contained upon the express condition that such payments and each of them required to be made by the Lessee shall be deemed to be additional rent hereunder, and in the event the Lessee shall default in the payment of any such charge and such default continue for a period of 30 days after payment of such charge shall become due, the Lessor shall have the right to declare a default under this lease and to proceed to enforce its rights hereunder with the same force and effect as is herein provided, and shall be vested with the same rights and powers, including the right to remove the Lessee through summary proceedings, with the same force and effect as is herein provided upon default in the payment of any rental reserved herein.
* * * * * * *
The Lessee further agrees to pay any and all instalments of principal on either or both of the aforementioned mortgages required by the mortgagee during the term of this lease to be paid in reduction of the principal amount of said mortgage or any extension, renewal or modification thereof, or any mortgage given instead or in lieu thereof, provided, however, that the Lessee shall not be required to pay the principal balances of said mortgages or either of them at the final maturity, if such principal balance is then in excess of 5% of the original face amount of the said mortgages respectively.
The Lessee shall pay the aforesaid sums, principal and interest as the same become due. If the same, or any part thereof, shall not be paid on the due date (exclusive of any period of grace) the Lessor may pay the same, and, at its option, treat such payment as additional rent owing under this lease. Default by the Lessee in the payment of said sums, or any of them, during the grace period, if any, provided in said mortgages, or the bonds secured thereby, shall be deemed, at the option of the Lessor, to be a default in the payment of the rent reserved hereunder, and the Lessor may proceed to recover possession of the demised premises upon the terms herein set forth in the event of non-payment of any reserved rent.
Pursuant to a decree of the Surrogate's Court of the County of New York dated October 28, 1940, and in settlement of certain claims to the aforementioned $200,000 legacy provided in Snell's will, the property was conveyed as of September 30, 1940, by the Manufacturers Trust Company as sole surviving executor of and trustee under the last will and testament of Thomas Snell, to Frederick B. Merkle and Albert N. Atkinson, as executors of the last will and testament of J. W. Amey, deceased, the petitioner, and Cooper Union for the Advancement of Science and Art. In the aforementioned decree, the surrogate determined that the amount due on the mortgages was $913,000 and that the fair and reasonable value of the property was $1,058,000. In the course of the surrogate's proceedings, the building was appraised at a value of $769,000. The decree further provided that the property was to be conveyed subject to the outstanding lease to Rosdniw Company, Inc.
There was no further change in the ownership of the property until May 18, 1942, when the petitioner, Ethel Snell Amey, acquired an additional 20/200 interest by conveyance from Frederick B. Merkle and Albert N. Atkinson, as executors of the last will and testament of J. W. Amey. Petitioner thereby increased her interest in the property to 50 per cent. That conveyance was made pursuant to a stipulation dated January 26, 1942, which provided, inter alia, that the share of the rental income from the property paid to petitioner should be proportionately increased, effective February 1, 1942.
The lease to Rosdniw Company, Inc., was modified by an agreement dated October 29, 1943, entered into by the owners of the Peter Cooper Hotel, including petitioner, and Rosdniw Company, Inc., which provided as follows:
The parties hereto agree that the Second paragraph on page 4 of the lease of the premises, dated December 1, 1933, between J. Willis Amey and Manufacturers Trust Company, as Executors under the Last Will and Testament of Thomas Snell, deceased, Manufacturers Trust Company, as Trustee under the said Last Will and Testament, and Cooper Union for the Advancement of Science and Art, as lessors, and Rosdniw Company, Inc., as lessee, which reads:
‘$2,083.33 per month on the first day of each month from the 1st day of October 1940 to and including the 1st day of September 1948’
be, and it hereby is amended to read as follows:
‘$2,083.33 per month from the 1st day of October 1940 to and including the 1st day of September 1942; $1,322.50 per month from the 1st day of October 1942 to and including the 1st day of September 1944; and in addition thereto the lessee shall pay to the lessors on October 1, 1943, a sum equal to the reduction in interest on the mortgages on said premises paid by the lessee during the preceding twelve (12) months resulting from the amortization of said mortgages paid between October 1, 1942 and September 30, 1943; and in addition thereto the lessee shall pay to the lessors on September 30, 1944, a sum equal to the reduction in interest on the mortgages on said premises paid by the lessee during the preceding twelve months resulting from the amortization of said mortgages paid between October 1, 1942 and September 30, 1944; and $2,083.33 per month from the 1st day of October 1944 to and including the 1st day of September 1948; each of said payments to be made in advance on the first day of each month.’
and except as hereinabove provided, all the other terms and conditions of the lease of said hotel are to remain in full force and effect.
The lease was further modified by agreement dated July 1, 1944, which altered the amounts of cash rental payments due under the lease, provided for the exercise by the lessee of its option to extend the lease, restated the lessee's continued obligation to pay the interest and amortization payments under the mortgages, and further provided as follows:
(a) In addition to the foregoing rental, herein referred to as minimum net rental, the Lessee undertakes and agrees to pay to the Lessor for the period commencing July 1, 1944 to and including September 30, 1969, as additional rental, a sum equal to 33 1/3% of the net income earned in each fiscal year from the demised premises and all buildings thereon.
(b) Such net income shall be determined and be payable as hereinafter provided, it being the intention of the parties that this definition shall supersede the provisions of said lease and for the purpose of computing net income there shall be deducted and paid out of the gross income:
* * * * * * *
vi. Interest and principal instalments paid by the Lessee to the holder of the consolidated mortgages on the demised premises in accordance with the terms of the above-mentioned agreement dated July 1, 1944, or any other agreement relating thereto executed by the respective parties hereto.
On July 1, 1944, the Greenwich Savings Bank entered into a mortgage spreader, consolidation, and extension agreement, in writing, with Frederick B. Merkle and Albert N. Atkinson, as trustees under the last will and testament of J. W. Amey, the petitioner, Cooper Union for the Advancement of Science and Art, and Rosdniw Company, Inc. Under that agreement, the lessee was obligated to make the amortization and interest payments under the mortgage and it was expressly provided that the rights of the mortgagee against the petitioner and her coowners of the property would be limited to foreclosure of the mortgage and that petitioner and her coowners would not be liable in any event for a deficiency judgment or to make any other payment whatsoever to the mortgagee.
Rosdniw Company, Inc., paid the sum of $29,385.78 in 1944 to the Greenwich Savings Bank on account of amortization of the mortgage.
For the years 1943 and 1944, the petitioner took a deduction from her cash rental income from the property for depreciation, using as a basis $384,500, or 50 per cent of the appraised value undiminished by the outstanding mortgage on the property. Her share of the cash rental paid in 1944 amounted to $6,967.50.
OPINION.
ARUNDELL, Judge:
The petitioner acquired a 50 per cent interest in an apartment hotel, subject to a long-term lease and to two substantial mortgages on the hotel property. Under the terms of that lease, the lessee was to pay cash rentals to the owners of the property and, in addition, to pay the interest and principal amortization required by the holder of the two mortgages.
During the year in question, 1944, the lessee paid $29,385.78 to the Greenwich Savings Bank on account of amortization of the mortgage. The single question to be decided is whether that payment by the lessee to the bank resulted in the receipt of ordinary income by petitioner.
We are of the opinion that under the circumstances here present, the amortization payments must be treated as ordinary income to petitioner in 1944 to the extent of her one-half interest in the hotel.
The United States District Court for the Northern District of Ohio, in the unreported case of Louis P. Wentz v. Frank F. Gentsch, decided July 29, 1940, held, under similar circumstances, that the amortization payments made by the lessee to the mortgagee were taxable in the year paid as ordinary income to the lessor. The situation in that case differed from that before us in that there the lessee was personally obligated on the mortgage note. The petitioner concedes the correctness of the decision in Wentz v. Gentsch but asserts that the lack of the lessee's personal obligation in the case at bar requires a different result. We cannot agree.
In Crane v. Commissioner, 331 U. S. 1, the Supreme Court said:
We are rather concerned with the reality that an owner of property, mortgaged at a figure less than that at which the property will sell, must and will treat the conditions of the mortgage exactly as if they were his personal obligations.
While recognizing the fact that the Crane case dealt with a somewhat different question of law, we think the quoted language singularly appropriate to the situation before us. The most cursory reading of the lease negotiated by the executors and trustees of the estate of petitioner's uncle, Thomas Snell, compels the conclusion that they were treating the mortgages as if they were obligations of the estate. If the lease had provided only for the payment of a large cash rental by the lessee to the estate, there could be no question of the taxability of that rental as ordinary income. The executors and trustees would, under those circumstances, have been confronted with the alternative of meeting the mortgage payments themselves or facing foreclosure on the mortgages.
We think it manifest that a lessor may not avoid or even postpone his tax liability by the expedient of requiring the lessee to divert a portion of the rental payments to amortization of mortgages on the leased premises regardless of whether the lessor is or is not personally liable on those mortgages. Cf. Crane v. Commissioner, supra, and Commissioner v. Fortee Properties, Inc., (C. A. 2) 211 F. 2d 915, reversing 19 T. C. 99. Property acquired subject to unassumed mortgages could be leased at a nominal cash rental with the bulk of the normal rental going directly to the mortgagee, resulting in periodic increases in the lessor's equity in the property without the payment of tax by the lessor.
There can be little doubt that the parties to the lease considered the amortization payments as a part of the rental. The lease specifically provided that the payments ‘* * * shall be deemed to be additional rent hereunder, * * *’ and that the failure of the lessee to make the amortization payments would create the same rights in the lessor as a default in the cash rental. It is also worth noting that while the amortization payments amounted to $29,385.78 in 1944, petitioner's one-half interest in the cash rental paid in the same year amounted to only $6,967.50. Clearly, the mortgage payments were a very important part of the consideration for the lease. During the year in question, petitioner entered into a mortgage spreader, consolidation, and extension agreement with the lessee and other interested parties wherein the obligation of the lessee to make amortization payments was restated.
There is nothing in the record to indicate that the fair value of the property was not at all times in excess of the amounts owing under the mortgages. This was clearly the case in 1940 at the time of the surrogate's decree, as set forth in the stipulated facts. It is reasonable to assume that if there were no equity in the property during the year before us, the petitioner would have so informed us. Under those circumstances, petitioner was benefited every time the lessee made an amortization payment by a corresponding increase in her equity in the property. Certainly, the bank holding the mortgages was withholding foreclosure proceedings only because of the amortization payments. If the lessee had ceased making the payments, the petitioner would have had to pay them as it they had been her own obligations, notwithstanding the fact that she did not assume the mortgages.
The proposition that payments by a lessee may be taxed as rental income to the lessor even though paid directly to a third party is by no means novel. Where the lessee paid the lessor's taxes as well as cash rentals, the lessor was held to have received rental income to the extent of the taxes so paid. United States v. Boston & M. R. R., 279 U. S. 732. As early as 1917 it was held that where a lessee pays dividends directly to the shareholders of a lessor corporation in lieu of cash rentals, those payments are taxable as income of the lessor. West End St. Ry. Co. v. Malley, 246 F. 625, certiorari denied 246 U. S. 671.
Petitioner's argument on brief is essentially that the amounts attributable to amortization paid to the bank by the lessee should be reflected in adjustments of petitioner's basis if and when the property is disposed of rather than treated as ordinary income. We find no merit in this theory where the amounts in question were actually nothing more than a form of rental payments. It is interesting to note in this case that petitioner is taking depreciation based on the full value of the property and is thus recovering her capital.
Respondent properly included in petitioner's income for 1944 that portion of the amortization payments attributable to her by reason of her 50 per cent ownership of the property in question.
Reviewed by the Court.
Decision will be entered under Rule 50.