Metropolitan Building Company v. Commissioner of Internal Revenue
282 F.2d 592, 6 A.F.T.R.2d (RIA) 5493, 1960 U.S. App. LEXIS 3778 (1960)
Rule of Law:
A payment received by a lessee for the transfer and release of its entire leasehold interest to the owner, even when facilitated by a sublessee seeking a direct lease, constitutes a sale or exchange of a capital asset and is taxable as capital gain, not as ordinary income equivalent to rent.
Facts:
- The University of Washington owned real estate in downtown Seattle.
- Metropolitan Building Company acquired a lease from the University in 1907 for this property, set to expire on November 1, 1954.
- On August 1, 1922, Metropolitan subleased a portion of its property to a sublessee, later acquired by The Olympic, Inc., with this sublease expiring on October 31, 1954.
- The Olympic Hotel was constructed on the premises covered by the sublease.
- In 1952, The Olympic, Inc. proposed to the University of Washington to procure a release of Metropolitan’s leasehold interest in the Olympic Hotel property and then enter into a new, direct, long-term lease with the University.
- The University of Washington subsequently requested Metropolitan to release its leasehold rights.
- Metropolitan’s Board of Directors authorized the sale of its leasehold rights for the Olympic Hotel area.
- Metropolitan conveyed, quitclaimed, assigned, and released all its right, title, and interest in that portion of the leasehold to the State of Washington (acting for the University), receiving $137,000 from The Olympic, Inc. for the transfer.
Procedural Posture:
- The Commissioner of Internal Revenue ruled that the $137,000 payment received by Metropolitan Building Company was the equivalent of rental and taxable as ordinary income.
- Metropolitan Building Company instituted a proceeding in the Tax Court for re-determination of deficiencies in income and excess profits taxes.
- The Tax Court affirmed the ruling of the Commissioner.
- Metropolitan Building Company petitioned the United States Court of Appeals for the Ninth Circuit for review of the Tax Court's decision.
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Issue:
Is a lump-sum payment received by a lessee from a sublessee, for releasing its entire leasehold interest back to the property owner, taxable as ordinary income or as capital gain from the sale of a capital asset?
Opinions:
Majority - Merrill, Circuit Judge
Yes, the lump-sum payment received by Metropolitan Building Company for releasing its entire leasehold interest is taxable as capital gain from the sale of a capital asset. The court reasoned that the payment was for the purchase of Metropolitan's entire leasehold interest, not merely a discharge of The Olympic, Inc.'s obligation to pay future rental as a substitute for ordinary income. Distinguishing Hort v. Commissioner, which involved a lessor receiving payment for cancelling a lease (taxable as ordinary income because it was a liquidation of the right to future rental income), this case involved a disposition of the income-producing property itself. Citing precedents like Commissioner of Internal Revenue v. Golonsky, the court affirmed that the giving up of a lease by a tenant for consideration constitutes a sale or exchange under the Internal Revenue Code. The court rejected the Commissioner's distinction that the consideration came from the sublessee (the party obligated to pay rent) rather than the lessor, asserting that "it is not the person of the payor which controls the nature of the transaction in our view. Rather, it is the fact that the transaction constituted a bona fide transfer, for a legitimate business purpose, of the leasehold in its entirety." The business purpose of the transaction would not have been met by merely releasing a right to future income.
Analysis:
This case clarifies the crucial distinction in tax law between receiving a payment for the cancellation of a lease (which is ordinary income, as a substitute for future rent) and receiving a payment for the sale or assignment of a leasehold interest (which is capital gain, as the disposition of a capital asset). It emphasizes that the substance of the transaction—whether it's the transfer of an entire property interest or merely the liquidation of a right to future income—governs its tax treatment, rather than the identity of the payor. This distinction provides a roadmap for lessees seeking to monetize their leasehold interests, potentially allowing them to benefit from lower capital gains tax rates, provided the transaction genuinely involves the transfer of the entire interest.
