Category: Real Estate Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Background Professional individual owns a commercial building which is leased to his professional corporation (PC) for use as office space. PC made substantial leasehold improvements to the property. Now, the existing office space is no longer suitable, and the PC will establish office space elsewhere. I assume there is a formal, written lease between the individual and PC and the lease term has either expired or the lease will be formally terminated. Issue Can the PC take an abandonment loss with respect to the improvements?
While the conclusion is not free from doubt, it appears that PC can write off the leasehold improvements. See the discussion below regarding the manner in which the lease is terminated. Discussion It seems to the circumstances at hand represents a fairly typical scenario regarding abandonment of leasehold improvements. The taxpayer, PC, incurred costs to make its office space suitable for its needs. Now, those needs have changed, and the present space is no longer adequate. PC is in effect turning its back on its investment in the leasehold improvements by moving out of the existing office space into different space somewhere else. This is a classic abandonment of tenant leasehold improvements. It is well-settled that the tenant can write off the remaining undepreciated cost of the leasehold improvements. See Cassatt v. Comr., 137 F.2d 745, 749 (3d Cir. 1943), aff'g 47 B.T.A. 400 (1942); Coffey v. Comr., 21 B.T.A. 1242, 1244 (1931), acq., 1931-2 C.B. 14; Strauss v. U.S., 199 F. Supp. 845 (W.D. La. 1961). You have raised the concern of Section 267(a) disallowance because the parties, the individual and PC, are related. Specifically, you cite Standard Commodities Import and Export Corp., TC Memo 1982-408, 44 TCM 513. I think Section 267 does not disallow PC's loss and the current situation is distinguishable from Standard Commodities; however, I agree there is a risk that the Standard Commodities line of reasoning could be twisted to fit these circumstances. I urge you to explicitly disclose this risk to your client, preferably in writing. In general, Section 267(a) disallows losses on a sale or exchange of property between certain related parties. In Standard, an individual owned a leasehold interest in a certain property. The individual then made substantial leasehold improvements on behalf of a tenant, a sublessee, which tenant was related to the individual. The tenant's business did not go well. The individual then transferred for consideration the rights and obligations under the lease, including the sublease, to his controlled corporation, a different entity than the tenant. The controlled corporation (Standard Commodities) attempted to find a new sublessee for the property. Failing that, and in financial difficulty itself, Standard transferred the rights and obligations under the lease back to the individual in exchange for a release of Standard's obligations to the individual. The taxpayer in the case, Standard Commodities, contended that the leasehold improvements were abandoned prior to the retransfer of the leasehold interest back to the individual. The IRS argued that there was no abandonment, and the loss was from the sale of the interest (including the improvements) by Standard to its controlling shareholder. The Tax Court sided with the IRS on both arguments and disallowed the loss. The situation in Standard Commodities is materially different from the facts at hand. In Standard Commodities, there was clearly a transfer of property from the corporation to the shareholder, and there was clearly consideration associated with that transferrelease of the corporation's obligations to the shareholder. In that case, it was fairly easy to reach the conclusion that an exchange took place. Finding that no abandonment had taken place prior to the transfer, Section 267 easily came into play. The present situation is different in that there is no overt transfer of property for consideration from PC to the individual. However, I think there is a risk that the Standard Commodities holding could be applied to this situation. If the lease is being terminated in this case--as opposed to simply expiring at the end of its term--then presumably the PC has an obligation under the lease to the individual shareholder. Presumably, local law provides that ownership of non-removable tenant improvements reverts to the lessor at termination of the lease. Could such a reversion accompanied by a simultaneous release of the corporation's obligations under the lease be viewed as an exchange? There is a transfer of propertythe improvementsfor considerationthe release of obligations. I think the parties can substantially mitigate this risk by having the corporation pay the individual a demonstrably arms-length amount to settle the outstanding lease obligation. Pay whatever is customary in the local market as a fair settlement taking into account whatever the lease says regarding termination, if anything. I suggest at minimum paying the present value of any payments called for in the remaining lease term unless the lease agreement calls for something different. The idea is to avoid the release of the corporation's obligations being viewed as quid pro quo for the reversion of the leasehold improvements to the individual. Make it clear in the lease termination agreement that the amount of consideration determined is the only consideration given for full and unconditional release of the corporation's obligations under the lease. |
