Daily Development for Friday, May 21, 1999

By: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
prandolph@cctr.umkc.edu

The following items were contributed by our Real Estate Tax Issues reporter, Lois Van Deusen, of Newark, New Jersey, who has been one of our longest and most reliable reporters.

FEDERAL INCOME TAX; DECUCTIONS; CAPITALIZATION OF PRE-PRODUCTION COSTS; REAL ESTATE TAXES: Developer is a "producer" of real property, even though he has not undertaken any material development activities due to adverse market conditions, and accordingly, should have capitalized real property taxes. Reichel v. Comm., 112 T.C. No. 2, 53,205 (1999). In analyzing the legislative history, the Court noted that "Congress intended the term 'produce' to be broadly construed . . . from the acquisition of the property, through the time of production, until the time of disposition" (emphasis in original).

FEDERAL INCOME TAX; DEDUCTIONS; RETIREMENT OF DEPRECIABLE ASSETS:

Taxpayers are not entitled to a deduction equal to the adjusted basis of a demolished building where the loss incurred on account of the taxpayers' decision to demolish the building, rather than on a sudden and unexpected loss of the building's usefulness. Gates v. U.S., 98-2 U.S.T.C., 50,814. Taxpayers demolished building in 1991, based on discovery of asbestos and occurrence of vandalism in 1988. The Court distinguished the case from DeCou v. Comm., 103 T.C. 80 (1994) where the owner immediately bought-out remaining leases and sealed and demolished the building after discovering latent defects. The loss in DeCou was allowed since it occurred prior to demolition, not on account of the demolition.

FEDERAL INCOME TAX; DEDUCTIONS; ENVIRONMENTAL REMEDIATION EXPENSES: IRS issues guidelines for deducting, rather than capitalizing, Qualified

Environmental Remediation Expenditures ("QER") under IRC § 198. REV. PROC. 98-47. A QER is an expenditure otherwise chargeable to a capital account, paid or incurred on or after August 5, 1997, in connection with the abatement or control of hazardous substances at a qualified site. A qualified site is a brown field site designated as such by a state agency. The election must be made on or before the due date of the return for the year in which the expense was incurred, but a transition rule deems the election made for returns filed on or before October 14, 1998.

FEDERAL INCOME TAX; DEDUCTIONS; AT-RISK RULES; QUALIFIED NON-RECOURSE FINANCING: A new regulation clarifies at-risk rules under IRC § 465(b) with respect to qualified non-recourse financing and personal liability of owners. T.D. 8777 (1998), 49,707. The amount at risk with respect to the activity of holding real property is the taxpayer's share of qualified non-recourse financing secured by such property. The regulation allows the taxpayer to disregard (i) property that is incidental to the holding of real property, or (ii) other property of which the aggregate fair market

value is less than 10% of all property securing the financing. Under a look-through rule for partnerships (and limited liability companies), a borrower is deemed to own partnership assets in proportion to the borrower's equity interest. The partnership's liability for repayment is disregarded if (i) only partnerships are personally liable for repayment; (ii) only qualified property is owned; and (iii) the lender may enforce its remedies only against the property secured by the non-recourse financing.

FEDERAL INCOME TAX; DEDUCTIONS; LEASES MODIFICATION EXPENSES: Lessee bank's payment of $2.5 million "rollover charge" to terminate a five year lease for a mainframe computer after the first year and execute a new lease for a more advanced system is an integrated event, effectively making the rollover charge a lease modification fee which should be capitalized over the term of the new lease. U.S. Bancorp and Its Consol. Subs. v. Comm., 111 T.C. No. 10, 52,871. Relying on INDOPCO, Inc. v. Comm., 503 U.S. 79 (1992), the Court noted that an important component in determining whether an expenditure should be capitalized is whether the taxpayer receives benefits beyond the year of payment. For lease termination payments, there are two factual possibilities: the lease is terminated and no subsequent lease is entered into between the parties; or, the lease is terminated and a new lease is created for the same property. In the former case, a termination payment is not made to produce future income but to cover the costs and damages of termination; accordingly, it is a necessary and proper expense. The present case is effectively a lease modification and falls closer to the later case. Payment of the rollover charge causes the lessee to realize the future benefit of the new lease and should therefore be capitalized, not deducted.

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

Items in the Daily Development section generally are extracted from the Quarterly Report on Developments in Real Estate Law, published by the ABA Section on Real Property, Probate & Trust Law. Subscriptions to the Quarterly Report are available to Section members only. The cost is nominal. For the last six years, these Reports have been collated, updated, indexed and bound into an Annual Survey of Developments in Real Estate Law, volumes 1‑6, published by the ABA Press. The Annual Survey volumes are available for sale to the public. For the Report or the Survey, contact Maria Tabor at the ABA. (312) 988 5590 or mtabor@staff.abanet.org

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