Editor: Alan Wong, CPA
Partners & Partnerships
A partnership making an optional Sec. 754 basis adjustment for land subject to a long-term ground lease is permitted to adjust the basis of the land but may not allocate the basis adjustment to buildings or other depreciable assets the lessee constructed. A partnership is also not allowed to make an allocation to the leasehold interest to claim an amortization deduction for an accelerated tax benefit.
For estate and gift tax purposes, Regs. Sec. 20.2031-1(b) states that the value of every item of property includible in a decedent’s gross estate under Secs. 2031 through 2044 is its fair market value at the time of the decedent’s death unless an alternate valuation method is elected.
To determine the fair market value of land subject to a long-term ground lease held by a partnership, an appraiser would consider three recognized methods of valuation: (1) the cost approach; (2) the sales-comparison approach; and (3) the capitalization-of-income approach. The type of property being appraised dictates the method used. The capitalization-of-income approach is the method most frequently used when valuing land subject to a long-term ground lease. The capitalization-of-income approach uses an income projection and converts it into a value by using a discounted-cash-flow technique.
In Friend, 40 B.T.A. 768 (1939), a taxpayer’s estate received rental income from properties subject to long-term ground leases. The estate claimed it could deduct from the gross rentals amortization of the capitalized values of the rents to be received under the leases. The estate contended that the properties were separate assets, one being the leasehold estate with a much higher value than the other, the reversionary estate.
The court’s opinion stated that
We are not dealing here with the case of a taxpayer who has acquired by purchase or by inheritance a right to receive a periodic sum of money for a term of years. Clearly if a taxpayer had invested money in acquiring such right he would be entitled to deduct from the rents received each year an aliquot part of the cost of his investment; for he would be entitled under the statute to recover back the cost of his investment without being taxed thereon. [Friend, 40 B.T.A. at 771]
The Friend court noted that, as in Codman v. Miles, 28 F.2d 823 (4th Cir. 1928), cert. denied, 278 U.S. 654 (1929), the courts have held repeatedly that the mere right to receive income is not subject to exhaustion even though the right is limited to a term of years.
The contention that the value of the estate was each year depleted by exhaustion is intriguing rather than logical. What the plaintiff received and was entitled to receive was not the corpus of the property but the increment annually accruing therefrom. It is nowhere suggested that the corpus of the property, from which the income was derived, was in any way depleted. [Friend, 40 B.T.A. at 772, quoting Codman v. Miles]
The opinion further cited Farmer, 1 B.T.A. 711 (1925), where a taxpayer was depreciating land against rental income he was receiving for oil and gas exploration. The taxpayer contended that he should be allowed to allocate his purchase cost between the value of the land and the value of his privilege to lease the land for oil and gas exploration and that the leases constituted a severance and conveyance. The Board of Tax Appeals determined that “[a] fee simple title is the highest estate in land contemplated by the law. In such a title all lesser estates, right, titles, and interests merge. When all such interests so merge there is a complete solidification of title and the various interests going to constitute that title lose their identity and are no longer distinguishable” (Farmer, 1 B.T.A. at 713). The Board of Appeals agreed with the commissioner and disallowed the deduction.
The court cases mentioned above do not cite the current Sec. 167 or Regs. Sec. 1.197-2 (discussed below) because the cases predate those provisions, but the law in effect at the time of each of these cases provided for a depreciation deduction that mirrors the general rule of Sec. 167(a). The earlier laws did not, however, provide special rules for property subject to leases, as does Sec. 167(c)(2), and did not address leases, as does Regs. Sec. 1.197-2.
Application of the current Code and regulations leads to the same conclusion that the courts reached many years ago. Sec. 167(c)(2) states that if any property is acquired subject to a lease, no portion of the adjusted basis shall be allocated to the leasehold interest, and the entire adjusted basis shall be taken into account in determining the depreciation deduction (if any) with respect to the property subject to the lease. Regs. Secs. 1.197-2(c)(3) and 1.197-2(c)(8) state that an interest in land, including a fee interest, or an interest as a lessor or lessee is not a Sec. 197 intangible and is therefore not amortizable. Therefore, if a taxpayer steps up the basis in land subject to a ground lease, the entire step-up would have to be allocated to the land under current law.
While the law discussed here is not new, the issue is still relevant since long-term ground leases are common in the real estate industry. The accelerated tax benefit from the amortization of a leasehold estate would be a valuable tax shield, but the courts have denied the deduction numerous times (although not in recent cases), and the statute and regulation adopt that interpretation.
Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP, in New York City.
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