Summary
In Bowles Lunch, Inc. v. United States, 33 F. Supp. 235, 91 Ct.Cl. 292, (1940) the taxpayer's refund claim had been improperly characterized as a "loss on partial bad debt," although the claim set forth a detailed computation of the loss. It was held that the Government was fully advised regarding the basis of the taxpayer's claim and could not take advantage of the improper characterization.
Summary of this case from Andresen v. United StatesOpinion
No. 43486.
June 3, 1940.
John C. Boland, of Syracuse, N.Y., for plaintiff.
John A. Rees, of Washington, D.C., and Samuel O. Clark, Jr., Asst. Atty. Gen. (Robert N. Anderson and Fred K. Dyar, both of Washington, D.C., on the brief), for defendant.
WHALEY, Chief Justice, and LITTLETON, GREEN, and WHITAKER, Judges.
Proceeding by Bowles Lunch, Inc., against the United States to recover alleged overpayment of income taxes.
Judgment for plaintiff.
This case having been heard by the Court of Claims, the court, upon a stipulation of facts entered into between the parties, makes the following special findings of fact:
1. Plaintiff is now, and was at all times hereinafter mentioned, a corporation organized and existing under the laws of the State of Massachusetts, engaged primarily in the business of operating quick lunch rooms, but also in buying, leasing and selling improved real property and equipment in and upon and with which its several places of business were operated. One such place of business and property was and is located in Syracuse, New York, in a building known as the Lansing Building.
2. On March 15, 1932, plaintiff filed with the Collector of Internal Revenue for the District of Massachusetts its federal corporation income tax return for the calendar year 1931, made upon the accrual basis, reporting a total gross income of $262,502.03, deductions therefrom amounting to $155,139.92, a net taxable income of $107,362.11, and a tax thereon of $12,883.45. This tax was timely assessed and paid in quarterly installments during 1932.
Later the Commissioner assessed against plaintiff additional taxes of $706.50, which was paid to the Collector of Internal Revenue on April 15, 1933.
3. On June 12, 1934, plaintiff filed with the Collector of Internal Revenue its formal claim for refund of $10,369.09 of its 1931 tax and $45.93 of interest, stating as grounds, among other things, a claimed deduction of $101,014.32 resulting from repossession of certain mortgaged property, to which particular reference will hereinafter be made.
On July 5, 1934, plaintiff filed a further formal claim for refund for the year 1931, claiming deductions not here in controversy. This claim resulted in a refund of $147.43 of tax and $9.58 of interest paid thereon, together with accrued interest of $15.38. A Certificate of Overassessment in the same amount was delivered to the plaintiff together with a Treasury check dated December 15, 1934, in the amount of $172.39.
In arriving at the above overassessment of $147.43, the Commissioner of Internal Revenue determined the net income of the plaintiff for 1931 to be $112,021.04, with a resulting net tax liability of $13,442.52.
By registered letter dated December 27, 1934, plaintiff was advised of the disallowance and rejection of its refund claim filed June 12, 1934.
4. The facts relating to the claimed deduction of $101,014.32 mentioned in finding 3 above are as follows:
Plaintiff acquired from Henry L. Bowles and wife a certain piece of property known as the Lansing Building by deed dated December 22, 1920, at a cost of $380,200.
By deed dated March 2, 1928, plaintiff sold said building and the lunch room equipment contained therein to Robert Bersani for a total consideration of $425,000. The plaintiff reported a profit of $41,161.18 on this transaction in its income tax return for 1928, computed by deducting the cost from the selling price of $425,000.
5. Said sale was made subject to a first mortgage of $140,000, which the grantee assumed and agreed to pay. The grantee then secured from the holder of the first mortgage an additional loan of $50,000, secured by a second mortgage on the premises, and paid the entire proceeds thereof to the plaintiff to apply upon the purchase price of said premises. The said first and second mortgages, both being held by the same party, to all intents and purposes then became a first mortgage upon the premises, and hereinafter sometimes are referred to as the first mortgage.
The said grantee then gave the plaintiff a third mortgage (hereinafter sometimes referred to as the second mortgage) of $185,000, and paid the plaintiff an additional $50,000 in cash. The said $185,000 mortgage was payable as follows: $2,500 on September 15, 1928, $2,500 semi-annually thereafter until March 15, 1930, $5,000 on March 15, 1930, and $5,000 semi-annually thereafter until March 15, 1945, when the entire balance of said mortgage would become due and payable, with interest on said principal sum or any unpaid part thereof at the rate of 5½ percent per annum from March 15, 1928, payable semi-annually thereafter.
6. Said Bersani sold and conveyed an undivided one-half interest in and to said premises to N. Edward Rosenberg and Leah Rosenberg, his wife, as tenants by the entirety, by deed dated October 26, 1928, which recited that the premises were thereby conveyed "subject to the existing leases now on said premises" and also "subject to a first mortgage in the amount of $190,000 held by the First Trust Deposit Company and a mortgage for $182,500 held by Bowles Lunch, Inc., both of which said mortgages parties of the second part assume and agree to pay."
Title to the undivided one-half interest then remaining in said Bersani was subsequently vested, after several transfers by warranty deeds, all duly recorded, in 115 Salina Corporation, a New York corporation, by warranty deed dated July 7, 1930.
Title to the undivided one-half interest then remaining in the said Rosenbergs was subsequently vested, after several transfers by warranty deeds, all duly recorded, in Ge-Ro Realty Corporation, a New York corporation, by warranty deed dated June 21, 1930. None of the grantees in the deeds subsequent to the Rosenberg deed, dated October 26, 1928, became personally obligated to pay the mortgages above mentioned upon said premises.
7. The said Ge-Ro Realty Corporation and 115 Salina Corporation met the payments upon the plaintiff's mortgage above mentioned until September 15, 1930, when the payment of principal then due was defaulted.
8. Upon threat of foreclosure, 115 Salina Corporation conveyed title to its one-half interest in said premises to Caleb W. Bowles, plaintiff's nominee, by deed dated February 19, 1931. This latter deed recited that the premises were thereby conveyed, "Subject to mortgages, taxes and all existing leases. The party of the first part reserves the right to collect, receive and retain the February 1931 rents. This conveyance is made further subject to an unpaid oil bill of not to exceed $200, which bill the second party assumes and agrees to pay."
Ge-Ro Realty Corporation also conveyed its undivided one-half interest in said premises to Caleb W. Bowles, plaintiff's nominee, by warranty deed dated February 19, 1931. This latter deed recited that the premises were thereby conveyed "subject to mortgages, taxes and all existing leases."
No consideration was passed for the last two mentioned deeds except that the parties personally liable on plaintiff's mortgage were released from their obligation thereon.
The plaintiff during 1931 became, ever since has been, and still is, the owner of said premises.
9. The said Robert Bersani and Mary Bersani, his wife, and the said N. Edward Rosenberg and Leah Rosenberg, his wife, were all insolvent and execution proof at the time of these transactions in 1931 and they all subsequently filed petitions in and were discharged of their debts in bankruptcy. No dividend was paid in any of said four bankruptcy cases.
10. The unpaid balance of the principal of plaintiff's second mortgage was $172,500 and accrued interest thereon was $4,058.53 when said property was repossessed by plaintiff. The fair market value of the property at the time of its reacquisition in 1931 was $300,000.
Plaintiff reacquired title to said property subject to prior encumbrances and costs of acquisition aggregating $205,414.32 as follows:
First mortgage ................... $190,000.00 Accrued interest thereon ......... 1,561.65 City, County and State taxes ..... 10,802.32 Reacquisition costs .............. 3,050.35 ___________ $205,414.32
11. As of December 31, 1930, the ledger of Bowles Lunch, Inc., included the second mortgage of $172,500 in an account called "Mortgage Receivable — Second Mortgage," with a debit balance of $172,500. The ledger also included as of December 31, 1930, in an account called "Accrued Interest Receivable" a debit of $2,767.19, which represented accrued interest receivable on the second mortgage of $172,500 for the period September 15, 1930, to December 31, 1930, inclusive.
During 1931 the amount of $2,767.19 was charged to profit and loss and deducted in plaintiff's 1931 Federal income tax return. This deduction was disallowed by the Treasury Department. The accrued interest receivable on the second mortgage of $172,500 for the period January 1 to February 19, 1931, in the amount of $1,291.34 was included by the Commissioner as part of the plaintiff's net income of $112,021.04 for 1931.
Under date of May 31, 1931, an entry was made on the journal of Bowles Lunch, Inc., as follows:
Lansing Building — Real Estate $172,500.00 Mortgages Receivable, 2nd Mtg. .................. $172,500.00
The credit entry was posted to the account in which the $172,500 mortgage was recorded, thus closing the account, which was balanced and ruled off. The debit entry was posted to a new account entitled "Lansing Building — Real Estate."
On March 2, 1928, the plaintiff, a Massachusetts corporation, sold a piece of real estate and certain other property for a certain consideration, a part of which was secured by a mortgage on the property. Later, in 1931, the plaintiff repossessed the property. The question presented is whether or not it is entitled to a deduction of a loss or of a bad debt arising out of the transaction. The essential facts are as follows:
The plaintiff on the date stated sold to Robert Bersani a piece of real estate known as the Lansing Building and certain lunch room equipment contained therein for a total consideration of $425,000 (upon which transaction it reported a profit in its income tax return for 1928 of $41,161.18). This consideration was paid by the assumption of a first mortgage on the property of $140,000, by the payment of $100,000 in cash, and by the execution of a third mortgage of $185,000. Of the $100,000 paid in cash, $50,000 was secured from the first mortgagee on a second mortgage on the premises.
In its income tax return for 1931 plaintiff claimed no deduction on account of this transaction, but on June 12, 1934, it filed a claim for refund of $10,369.09, plus interest of $45.93, on the ground, among others, that it was entitled to a deduction from gross income of $101,014.32 on account of the repossession of this property. This claim was denied and this suit was brought.
The plaintiff claims the deduction either as a bad debt under section 23(j) of the Revenue Act of 1928 ( 45 Stat. 791), or as a loss under section 23(f) of that Act, 26 U.S.C.A. Int.Rev. Acts,
It is stipulated that the market value of the property at the time it was repossessed was $300,000. There was then outstanding against it first and second mortgages, the principal of which aggregated $190,000, accrued interest on the first mortgage of $1,561.65, City, County and State taxes of $10,802.32, and it cost plaintiff $3,050.35 to reacquire the property. By its reacquisition, therefore, plaintiff acquired an equity of $94,585.68. It claims as a bad debt the difference between this equity and the amount of the mortgage, plus accrued interest, $176,558.53, or $81,972.85. In the alternative, it claims a loss of this amount.
The stipulation of facts, which is all the evidence in the case, states that each of the conveyances to the plaintiff was made "subject to mortgages, taxes and all existing leases." It also states that "no consideration was passed for the last two mentioned deeds except that the parties personally liable on plaintiff's mortgage were released from their obligation thereon." Since the parties personally liable were released from liability and the property was reconveyed to the mortgagee, the liability was extinguished, the debt was wiped out. Since there was no longer a debt, the plaintiff is not entitled to a deduction under section 23(j).
The plaintiff claims a deduction for a partial bad debt under that portion of section 23(j) which reads as follows: "And when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt to be charged off in part."
This section, however, has in mind a transaction to be completed in the future, and not one already completed. When the plaintiff accepted the property in satisfaction of the debt, the debt was extinguished and, therefore, there can be no deduction for a bad debt.
None of the cases cited by plaintiff in its brief are in point. In none of them was there involved a reconveyance to the mortgagee of the property in satisfaction of the mortgage debt.
If the plaintiff is entitled to a deduction at all in this case, it is entitled to it as a loss under section 23(f). The plaintiff relies on article 354 of regulations 74. This regulation provides that where property is repossessed in consideration of the cancellation of all or a part of the indebtedness against it, a gain or loss will result — "* * * measured by the difference between the fair market value of the property and the basis in the hands of the vendor of the obligations of the purchaser (generally, the fair market value thereof which was previously recognized in computing income) which were applied by the vendor to the purchase or bid price of the property."
Under this regulation the plaintiff says that it is entitled to the difference between its mortgage debt and the fair market value of the equity acquired. In computing its profit when it sold the property the plaintiff treated the notes secured by the third mortgage as worth their face value. Under the regulation, in computing its loss on a reacquisition of the property it is entitled to use this same value. If the regulation is valid, the plaintiff is entitled to a deduction of a loss measured by the difference in the face of the unpaid notes and the agreed market value of the equity in the property acquired.
The provisions of the Revenue Acts succeeding the Revenue Act of 1928 with relation to the deduction of losses are substantially the same as the provision of the Revenue Act of 1928, under which the regulation relied upon was promulgated. Provisions similar to that in the above article appear in regulations 77 under the 1932 Act (article 354), in regulations 86 under the 1934 Act (article 44-4), in regulations 94 under the 1936 Act (article 44-4), and regulations 101 under the 1938 Act (article 44-4). See, also, T.D. 4832, 1938-2 C.B. 155. Legislative sanction has, therefore, been presumptively given to the regulation.
The regulation has been approved and applied by the Board of Tax Appeals. Home State Bank v. Commissioner, 15 B.T.A. 121; Henry Heldt v. Commissioner, 16 B.T.A. 1035.
But it is said the principle of the opinion of the Supreme Court in Helvering v. Midland Mut. Life Insurance Co., 300 U.S. 216, 57 S.Ct. 423, 81 L.Ed. 612, 108 A.L.R. 436, is contrary to the regulations. In that case the Supreme Court held that where a mortgagee at a foreclosure sale bids in the property for the principal of the debt, plus interest, he is deemed to have received the interest and is taxable on it, notwithstanding the fact that the value of the property acquired might have been less than the principal and accrued interest. The court saw no difference between a purchase by a mortgagee and a purchase by a stranger. Since the mortgagee would have been taxable on the interest had a stranger bid the amount of the debt plus accrued interest, the court was of opinion that it was likewise taxable if such a bid was made by it.
The Circuit Court of Appeals for the First Circuit, in Hadley Falls Trust Co. v. United States, 110 F.2d 887, saw no inconsistency between this opinion and article 193 of regulations 74, which contains, in part, substantially the same provisions as article 354 above.
The Circuit Court of Appeals for the Eighth Circuit, in Helvering v. Missouri State Life Ins. Co., 78 F.2d 778, which also dealt with the receipt of interest on a reacquisition of the property, drew a distinction between property reacquired by the mortgagee at a foreclosure sale and property voluntarily reconveyed to it in consideration of the cancellation of the indebtedness. Where the property was reacquired at a foreclosure sale on a bid by the mortgagee of the principal of the debt and interest, the court held the mortgagee was taxable on the interest; but, on the other hand, it held that where it reacquired the property by voluntary reconveyance in consideration of the cancellation of the debt and interest, it did not receive the interest unless the value of the property was at least equal to the amount of the principal and interest. See Lucey, Receiver of National Life Insurance Co. v. United States, 78 Ct.Cl. 369, 390, 4 F. Supp. 1000.
We express no opinion as to the deductibility of a loss where property is reacquired at a foreclosure sale. But we are of opinion that where the property is voluntarily reconveyed in consideration of the cancellation of the indebtedness, a loss does occur if the market value of the property is less than the valuation of the mortgage notes used in computing the profit on the original sale. Where property is reacquired at a foreclosure sale the bidding is competitive, and it may be assumed that the bidder was required to bid as high as he did in order to acquire the property. If so, it may be presumed that the market value of the property was not less than the amount bid. Lucey, Receiver of National Life Insurance Co. v. United States, 78 Ct.Cl. at page 391, 4 F. Supp. 1000. On the other hand, we think no such presumption arises where there is a voluntary reconveyance and where it appears that the mortgagor is insolvent. In such case the mortgagee cancels the indebtedness, not necessarily because the property reacquired is worth the amount of the debt, but because he is unable to realize any more. If in such case, as a matter of fact, the market value of the property is less than the amount of his debt, it would seem to follow that a loss results. The regulations, frequently reaffirmed, so provide. We see nothing in Helvering v. Midland Mut. Life Insurance Co. supra, which conflicts with the regulation relied on, as applied to the facts of this case.
We hold, accordingly, that the plaintiff is entitled to deduct as a loss the difference between the face of the notes $172,500 plus accrued interest of $4,058.53, and the stipulated fair market value of plaintiff's equity in the property, $94,585.68, or the sum of $81,972.85.
The defendant, however, says that the plaintiff in its claim for refund made claim for a bad debt and not for a loss. The heading under which it makes this claim reads: "Loss on Acquisition of Real Estate." Under this heading it computes its loss by deducting from the amount of the second mortgage what it claims is the value of the property acquired. It is true that it designates this as "loss on partial bad debt," but this is merely an improper designation. The claim as made is a claim properly falling under section 23(f). The defendant was fully advised as to the basis of plaintiff's claim and, therefore, we think it cannot take advantage of the fact that plaintiff improperly characterized it.
It results that the plaintiff is entitled to recover of the defendant the sum of $9,836.74, with interest as provided by law. It is so ordered.