Category: Real Estate; Sales & Exchanges
Subject: Basis Issues
Title: Disputed Contract Amounts--Inclusion in Basis
IRC Sections: 1012, 1231
Filename: 1245.html
Date Produced: 07/95

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Background
Taxpayer (TP) made substantial renovations (approximately $1 million) to a rental house, and included the $1 million contract price of the renovations in basis. TP subsequently sold the house. Included as part of the basis was a substantial disputed amount (about $205,000) as between TP and the contractor who performed the renovations.

The disputed amount has not been paid or settled to this day, some four years after the renovation work was completed. The contractor has not pursued the disputed amount, and it is not known one way or the other whether the statute of limitations under local law would even allow the contractor to pursue TP at this point.

Issue
Can TP include the whole contract price in basis?

Answer
I see no support for this position in the literature.

Discussion
Cost is the engine that drives basis. IRC Section 1012. Cost is defined in Regulation Section 1.1012-1 as the amount paid in cash or other property. It seems to me fundamentally inconsistent to contend on the one hand that there is no liability with respect to the disputed amount, and on the other to contend that the disputed amount represents an obligation to pay cash or other property with respect to the renovation.

The case of Brighton Recreations, Inc. v. Commr., 70 TCM 127, TC Memo 1961-29 (1961), deals with a dispute between the operator of a ski lift and a contractor hired to construct a new lift. Because of a dispute over the quality of the work, the taxpayer refused to pay the entire contract price. The disputed amount was resolved prior to trial in part by settlement between the parties and in part by the running of the statute of limitations on the contractor's claim. The court held the taxpayer could not include the full contract price of the ski lift in depreciable basis.

One could attempt to distinguish Brighton by arguing that in this case there has been no final disposition of the claim; however, at this point it seems me that any distinctions drawn between the Brighton facts and TP's facts would almost be distinctions without differences. The very best one can say about Brighton is that it does not help the taxpayer's position in this case. At worst, it strongly supports the contrary viewpoint.

You also asked what would happen if TP ultimately does pay something with respect to the disputed amount. It is well settled that subsequently incurred expenses related to a previously disposed asset follow the same character as the income or loss from the original disposition of the asset. See F.D. Arrowsmith, 52-2 USTC ¶9527, 344 U.S. 6. Presumably the disposition of the rental house gave rise to Section 1231 gain or loss. Accordingly, any subsequent payments on the disputed liability would create a Section 1231 loss.