Gutman v. Commissioner , 1 T.C. 365 ( 1942 )

Edna C. Gutman, Petitioner, v. Commissioner of Internal Revenue, Respondent

Gutman v. Commissioner

Docket Nos. 107985, 108938

United States Tax Court

1 T.C. 365; 1942 U.S. Tax Ct. LEXIS 5;

December 29, 1942, Promulgated

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Decision of no deficiency will be entered.

The petitioner, as beneficiary, was entitled to income from trust property, which was not paid in the taxable years because the trustee feared surcharge under decisions of the state court to the effect that income from real estate taken over under mortgage foreclosure should, with trust principal, be apportioned whenever the property was sold. Held that, the will creating the trust having provided no right in the trustee to deduct depreciation, the petitioner as beneficiary is entitled to deduct same; Sue Carol, 30 B. T. A. 443; held, further, that it does not follow that the petitioner is taxable upon the unreceived income.

Isidor Sack, Esq., for the petitioner.

John W. Fisher, Esq., for the respondent.

Disney, Judge.

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DISNEY

These proceedings, consolidated for hearing, involve income taxes for the calendar years 1937 and 1938, respectively. The Commissioner determined deficiencies in the amount of $ 886.01 for 1937 and $ 476.68 for 1938.

The principal issue is whether the petitioner was entitled to deduct depreciation for the taxable years in respect of certain improved real estate held as part of the corpus of a trust of which she was the sole life beneficiary. By amendment to his answers, filed at the hearing, the respondent raises an alternative issue, namely, if petitioner was entitled to the claimed deductions, should the income arising from the trust property be included in her income for the taxable years?

An agreed statement of most of the facts has been filed by the parties. We adopt and incorporate the same by reference and include material parts thereof in our findings of fact made from other evidence.

FINDINGS OF FACT.

The petitioner is an individual, residing in New York City. She filed her income tax returns on the cash basis with the collector of internal revenue for the second district of New York.

The petitioner's father, Jacob F. Cullman, died on July 4, 1901, leaving a will by which he devised two-fifths of his residuary estate to his executors upon the following trust:

* * * to receive the rents, issues, profits and income thereof during the life-time of my said daughter Edna and, during her minority, to apply the net rents, issues, profits and income thereof to her support, maintenance and education, and, from the time she attains majority until her death, to pay over to her the said net rents, issues, profits and income of said last mentioned two-fifths in at least semi-annual instalments; * * *

Provision was made for gifts over of the remainder interest upon the death of the petitioner.

During both of the years 1937 and 1938, two parcels of improved real estate comprised a part of the corpus of the trust estate. A third parcel was acquired on February 21, 1938, and was retained as a trust asset throughout the remainder of that year. These properties were all situated in New York City, and had been acquired by the trustees, or their nominee, in lieu of or as the result of the foreclosure of mortgages covering them and held by the trustees.

The first property, located at 141 West 116th Street, was acquired on June 13, 1934. At that time the mortgage covering it secured an unpaid principal balance of $ 18,500, and bore interest at the rate of 5 1/2 percent per annum. The second, located at 351 East 85th Street, was acquired on January 22, 1935. It had secured a mortgage in the amount of $ 15,000, which also bore interest at the rate of 5 1/2 percent per annum. The parcel acquired on February 21, 1938, was located at 20 Fulton Street. There remained unpaid on the mortgage covering it, the amount of $ 52,500. This last mortgage had borne interest at the rate of 4 percent per annum.

Attorney fees, arrearages in taxes and water rents, and the costs of certain structural changes and improvements deemed necessary to comply with local building regulations were paid by the trustees at the time of acquisition of the properties, as follows:

141 West 116th Street		351 East 85th Street		20 Fulton Street
Attorney fees	$ 140.00	Attorney fees	$ 135.70	Attorney fees	$ 2,946.25
Taxes and water
rents	1,022.64	Taxes	399.56	Taxes	2,121.68
Fire Escapes	252.00	Fire retarding
Fire retarding		wall	930.00
work	455.00
Total	1,869.64	Total	1,465.26	Total	5,067.93

In each instance, those payments were made out of principal funds of the estate.

Net rents from the three properties aggregated $ 1,756.22 for the year 1937 and $ 2,687.17 for the year 1938. Counsel advised the trustees that, under decisions of the courts of New York, they might incur the risk of a surcharge if they made distribution of any part of current income until the properties were disposed of by sale. The trustees, accordingly, made no distribution of net rents to petitioner in either 1937 or 1938. On her income tax return for 1937, petitioner claimed a deduction of $ 810 for depreciation of the real estate so held by the trustees. A corresponding claim in the amount of $ 1,185 was made on her return for 1938.

Income of the trust was reported on the cash basis. The return for 1937 showed $ 30.25 as tax due. No claim for depreciation of the real estate comprising trust assets was claimed for either that year or 1938, but a depreciation deduction in the amount of $ 1,185 was allowed by the Commissioner for 1938. The deductions were denied to the petitioner on the ground that the income from the properties in question was not currently distributable to her, nor reported by her in her income tax returns for the taxable years. Certain other adjustments to her net income were made, and the deficiencies determined. In each proceeding, the only error assigned is the disallowance of the deductions for depreciation.

The will creating the trust in question contained no provision for apportionment of depreciation deductions between the life beneficiary and the trustees.

The parties have agreed that reasonable allowances for depreciation of the properties in question are $ 810 for 1937 and $ 1,185 for 1938.

OPINION.

We have here to decide whether under the facts herein involved the beneficiary of a trust, entitled under its terms to the trust income, may deduct depreciation upon property owned by the trust. The parties are in agreement that the amount deducted by the petitioner is reasonable depreciation, and only the right to deduct is in dispute. The peculiar facts involved are that, though the trustee in the taxable years collected certain rents, such income was from real estate which it had acquired as a result of, or in lieu of, mortgage foreclosures; and the trustee made no distribution of the rents collected because of fear of surcharge under certain decisions of the courts of New York, the situs of the property. The effect of the decisions is that real property acquired upon foreclosure of mortgage is the subject of a "mortgage salvage operation," that income during such operation is, until the property is finally sold, to be added to proceeds of sale, and the total apportioned between trust principal and income beneficiary. ; ; ; . The properties not having been disposed of, and such proportion, therefore, not having been ascertained, the trustee in the instant case made no distribution of income from the property to the petitioner during the taxable years.

The statute, section 23 (l), Revenue Acts of 1936 and 1938, ¹ provides that in the absence, as here, of pertinent provisions in the trust instrument, the allowable deduction for depreciation shall be apportioned between income beneficiaries and trustee "on the basis of the trust income allocable to each." The respondent contends that under the above facts there was no trust income allocable to the beneficiary-petitioner, therefore no deductible depreciation. The petitioner takes the view that the net rents were not currently distributable, that there was no "trust income" to allocate prior to ascertainment thereof at the end of the "mortgage salvage operation" under the decisions of the courts of New York, but that under the statute the depreciation deduction is apportioned between trustee and beneficiary "in accordance with the pertinent provisions of the instrument creating the trust," that the right to depreciation depends upon the trust instrument alone, that the instrument provides no withholding by the trustee of depreciation from income, and that, the income belonging ultimately to the beneficiary, though delayed, the beneficiary has the right to deduct depreciation.

No provision in the trust instrument before us provides apportionment of the depreciation deduction between beneficiary and trustee. The same was true in . Therein the trust instrument made no provision that the trustee deduct depreciation and the entire income was payable to the beneficiary. In the taxable year no income from the trust property was paid to the beneficiary. We held, nevertheless, after reviewing the history of the statute, that the petitioner, being the sole beneficiary of the trust, was entitled to the entire depreciation. Here also the petitioner-beneficiary received no income from the trust property. Yet, as in the Sue Carol case, she was, under the terms of the trust instrument, entitled to it, and therefore under that case, in general, entitled to the depreciation; and we do not find, in the situation here with respect to withholding of income by the trustee, because of fear of surcharge under the New York decisions, sound reason for distinguishing the Sue Carol case, or denying such depreciation. There was income from the property. The amount eventually payable to the beneficiary was not yet determinable, because of its source in mortgaged property taken over by the trustee; nevertheless, no one but the beneficiary was, under the Sue Carol case, entitled to deduct depreciation. The will provided no "trust income allocable" to the trustee; all was to go to the beneficiary. Subject to final determination of the amount, the petitioner as beneficiary had a right to all income. Even if there was none, as finally determined, yet she was, in our opinion, entitled to the depreciation under the Sue Carol case. We there quoted the Senate Finance Committee Report upon this subject as follows:

In the case of life tenant and remainderman the bill provides that the deductions should be imposed as in the case of a fee owner and shall be allowed to the life tenant during the time he holds the property and to the remainderman thereafter.

In the case of property held in trust the deduction is to be given to the beneficiary unless his share of the distributable income is reduced because of the depreciation of the trust property, in which case, and to the extent that it is so reduced, the deduction shall be allowed to the trustee.

And, commenting thereon, we said:

From the legislative history above set forth, it is clear that Congress intended to grant to both life tenants and beneficiaries under trust instruments the same privilege of deducting the depreciation allowance as that enjoyed by any other individual. * * * [

In other words, the beneficiary, like "any other individual," is entitled to depreciation in accordance with his beneficial ownership. To the extent that he is entitled to income, he is to be considered the equitable owner of the property. Of course, if such equitable interest is cut down by a provision that the trustee may deduct because of depreciation in paying over the income, it is obvious that the beneficiary has a lesser equitable interest, but, in the absence of such a provision, the petitioner here is to be regarded as the equitable owner of the estate. As such, she is entitled to deduct depreciation only if, as we said in the Sue Carol case, she is to have "the same privilege of deducting the depreciation allowance as that enjoyed by any other individual." The fact that she does not actually receive the rents from the property because of fear of surcharge by the trustee, or even the fact that she may not be entitled to receive them until some later time, under the New York decisions, does not divest her of the equitable interest which she, and not the trustee, was given by the trust instrument. It is as if she held equitable interest, but that under some lease rent for the taxable year was not to be paid, for example, until the end of a five-year period. She would, none the less, be the owner of the equitable interest and entitled to deduct the depreciation as such owner, just as any other owner of property, including the holder of a life estate, would be entitled to do.

The effect of the New York decisions is not to cut down the beneficiary's equitable interest, for she is entitled to the income of the property, undiminished by any interest on the part of the trustee to retain therefrom because of depreciation. Such decisions merely cause the impounding of rents from the property until some later time, and a possible diminution in the amount of the beneficiary's income out of such rents, for the reason that the result of the "mortgage salvage operation," may be to place some of such rents in the category of trust corpus as opposed to income. In other words, in such a case the amount of trust income payable to the beneficiary during the taxable year is contingent. Nevertheless, the amount thereof, when the contingency is finally resolved by the completion of the mortgage salvage operation, is all payable to the beneficiary as the complete equitable owner of the right to "income" from the property. In short, no trust income is allocable to the trustee. The mortgage salvage operation under the New York law merely protects the trust corpus. All trust income, either under the trust instrument or under the state decisions, is, in our opinion, allocable to the beneficiary, the petitioner, and we conclude that the Commissioner erred in denying her the right to depreciation.

The respondent, in amendments to answers, filed at the time of hearing, contends in the alternative that if we hold the petitioner entitled to the deduction for depreciation there is then to be included in her gross income the income from the trust properties. The respondent does not brief the point, other than to say that it follows as a matter of course, upon the reasoning that deduction for depreciation follows the income. We do not agree. Depreciation is allowed by one section, section 23 (l) of the Revenue Acts of 1936 and 1938. Taxability of income to the petitioner falls under section 161 (a) (2) and section 162 (b) of the same acts, providing taxation of income currently distributable to the beneficiary. Under the law of New York, it was not so currently distributable, for the amount of trust income could not be known until the end of the "mortgage salvage operation." To charge the petitioner with income in the amount of rents which she did not receive, and might never receive, at the end of the mortgage salvage operation, would violate the realism in the law of taxation of income.

Decision of no deficiency will be entered.

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Footnotes

• 1. SEC. 23. DEDUCTIONS FROM GROSS INCOME.

  In computing net income there shall be allowed as deductions:

  * * * *

  (l) Depreciation. -- A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence. In the case of property held by one person for life with remainder to another person, the deduction shall be computed as if the life tenant were the absolute owner of the property and shall be allowed to the life tenant. In the case of property held in trust the allowable deduction shall be apportioned between the income beneficiaries and the trustee in accordance with the pertinent provisions of the instrument creating the trust, or in the absence of such provisions, on the basis of the trust income allocable to each.↩