Section 61(a)(3) includes in a taxpayer’s “gross income” “gains derived from dealings in property.” This provision does not tell us how to determine what those gains might be. For that, we turn to §§ 1001(a and b). Read it. (The word “over” frequently appears in the Code as a directive to subtract whatever is described.) Section 1001(a) directs you to § 1011. Read it. Section 1011 directs you to §§ 1012 and 1016. Read § 1012(a) and 1016(a).
Fluctuations in Value
The value of property may fluctuate over the time taxpayer owns it. If its value increases, taxpayer must recognize taxable gain upon its sale. If its value decreases, § 165(a) might permit taxpayer to reduce his or her gross income by the amount of the loss upon its sale. If its value increases and taxpayer could have sold it but does not – does taxpayer realize a tax loss when s/he later sells it for more than his/her basis but less than the fmv it once had?
The effect of subtracting “adjusted basis” is to exclude that amount from taxpayer’s “gross income” and so from his/her income tax burden. That money of course had already been subject to income tax at the time the taxpayer put it into his/her “store of property rights” and so should not be subject to tax again.
We begin with a case dealing with a loss from a dealing in property.
Hort v. CIR, 313 U.S. 28 (1941)
MR. JUSTICE MURPHY delivered the opinion of the Court.
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Petitioner acquired the property, a lot and ten-story office building, by devise from his father in 1928. At the time he became owner, the premises were leased to a firm which had sublet the main floor to the Irving Trust Co. In 1927, five years before the head lease expired, the Irving Trust Co. and petitioner’s father executed a contract in which the latter agreed to lease the main floor and basement to the former for a term of fifteen years at an annual rental of $25,000, the term to commence at the expiration of the head lease.
In 1933, the Irving Trust Co. found it unprofitable to maintain a branch in petitioner’s building. After some negotiations, petitioner and the Trust Co. agreed to cancel the lease in consideration of a payment to petitioner of $140,000. Petitioner did not include this amount in gross income in his income tax return for 1933. On the contrary, he reported a loss of $21,494.75 on the theory that the amount he received as consideration for the cancellation was $21,494.75 less than the difference between the present value of the unmatured rental payments and the fair rental value of the main floor and basement for the unexpired term of the lease. ...
The Commissioner included the entire $140,000 in gross income, disallowed the asserted loss, ... and assessed a deficiency. The Board of Tax Appeals affirmed. 39 B.T.A. 922. The Circuit Court of Appeals affirmed per curiam ... [W]e granted certiorari limited to the question whether, “in computing net gain or loss for income tax purposes, a taxpayer [can] offset the value of the lease canceled against the consideration received by him for the cancellation.”
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The amount received by petitioner for cancellation of the lease must be included in his gross income in its entirety. Section [61] [footnote omitted] ... expressly defines gross income to include “gains, profits, and income derived from ... rent, ... or gains or profits and income from any source whatever.” Plainly this definition reached the rent paid prior to cancellation, just as it would have embraced subsequent payments if the lease had never been canceled. It would have included a prepayment of the discounted value of unmatured rental payments whether received at the inception of the lease or at any time thereafter. Similarly, it would have extended to the proceeds of a suit to recover damages had the Irving Trust Co. breached the lease instead of concluding a settlement. [citations omitted] That the amount petitioner received resulted from negotiations ending in cancellation of the lease, rather than from a suit to enforce it, cannot alter the fact that basically the payment was merely a substitute for the rent reserved in the lease. So far as the application of [§ 61(a)] is concerned, it is immaterial that petitioner chose to accept an amount less than the strict present value of the unmatured rental payments, rather than to engage in litigation, possibly uncertain and expensive.
The consideration received for cancellation of the lease was not a return of capital. We assume that the lease was “property,” whatever that signifies abstractly. ... Simply because the lease was “property,” the amount received for its cancellation was not a return of capital, quite apart from the fact that “property” and “capital” are not necessarily synonymous in the Revenue Act of 1932 or in common usage. Where, as in this case, the disputed amount was essentially a substitute for rental payments which [§ 61(a)] expressly characterizes as gross income, it must be regarded as ordinary income, and it is immaterial that, for some purposes, the contract creating the right to such payments may be treated as “property” or “capital.”
....
We conclude that petitioner must report as gross income the entire amount received for cancellation of the lease, without regard to the claimed disparity between that amount and the difference between the present value of the unmatured rental payments and the fair rental value of the property for the unexpired period of the lease. The cancellation of the lease involved nothing more than relinquishment of the right to future rental payments in return for a present substitute payment and possession of the leased premises. Undoubtedly it diminished the amount of gross income petitioner expected to realize, but, to that extent, he was relieved of the duty to pay income tax. Nothing in [§ 165] [footnote omitted] indicates that Congress intended to allow petitioner to reduce ordinary income actually received and reported by the amount of income he failed to realize. [citations omitted] We may assume that petitioner was injured insofar as the cancellation of the lease affected the value of the realty. But that would become a deductible loss only when its extent had been fixed by a closed transaction. [citations omitted]
The judgment of the Circuit Court of Appeals is affirmed.
Notes and Questions:
1. Taxpayer measured his gain/loss with the benefit of the bargain as his reference point. An accountant or financial officer would not evaluate the buyout of the lease in this case any differently than taxpayer did. If a lessor’s interest has a certain value and the lessor sells it for less than that value, why can’t the lessor recognize a tax loss?
- Evidently it was a good lease for the lessor. The present value of the contracted rents was greater than the fair rental value of the property.
- $140,000 was $21,500 less than the anticipated value of the lease.
Lump sum payments
On occasion, taxpayer may accept a lump sum payment in lieu of receiving periodic payments. The tax law characterizes the lump sum in the same manner as it would have characterized the periodic payments. For example, a life insurance salesman who sells his/her right to receive future commissions for a lump sum must treat the lump sum as commission income. We saw the Court apply this principle in Glenshaw Glass when it treated a lump sum payment in lieu of profits as if it were profit.
2. The Tax Code taxes all income once unless specifically provided otherwise. Basis is the means by which a taxpayer keeps score with the government concerning what accessions to wealth have already been subject to tax.
- How does the Court’s opinion implement these principles?
- How did taxpayer’s contentions fail to implement these principles?
- What exactly was taxpayer’s basis in its lessor’s interest in the leasehold?
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