Patton, Norman T.

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Case Western Reserve University School of Law

Case Western Reserve Law ReviewVolume 11 | Issue 21960Problems of Casualty Losses, Insurance,Improvements and Repairs, and DepreciationNorman T. PattonFollow this and additional works at: https://scholarlycommons.law.case.edu/caselrevPart of the Law CommonsThis Symposium is brought to you for free and open access by the Student Journals at Case Western Reserve University School of Law ScholarlyCommons. It has been accepted for inclusion in Case Western Reserve Law Review by an authorized administrator of Case Western Reserve UniversitySchool of Law Scholarly Commons.Recommended CitationNorman T. Patton, Problems of Casualty Losses, Insurance, Improvements and Repairs, and Depreciation, 11 Wes. Res. L. Rev. 194 (1960)Available at: https://scholarlycommons.law.case.edu/caselrev/vol11/iss2/8WESTERN RESERVE LAW REVIEWTax Problems Incident To the Management ofAcquired Real EstateIIIPROBLEMS OF CASUALTY LOSSES, INSURANCE, IMPROVEMENTSAND REPAIRS, AND DEPRECIATIONNorman T. PattonCASUALTY LOSSESProposed Treasury Regulations published on October 8, 1959,make significant changes in the casualty losses allowed on businessproperty.' Without a doubt, the most important is the recognitiongiven to a 1956 court of appeals2 decision which held that the com-putation of the loss deduction is the same for business property as fornon-business property. The Proposed Treasury Regulations elimi-nate the requirement, whichhas been enforced by the In-THE AUTHOR (B.A., 1941, Western Reserve ternal Revenue Service forUniversity, LL.B., 1950, Cleveland MarshallLaw School) is a Cleveland attorney, many years, that a partialbusiness casualty loss belimited to a fraction of theadjusted basis of the property, even though the actual economic lossis much larger.'The Proposed Treasury Regulations continue the general rulethat the deduction in the case of any casualty loss is the lesser of:(1) the decrease in fair market value immediately before and im-mediately after the casualty, or (2) the amount of the adjusted basisof the property.4With respect to methods of determining the amount of loss, theProposed Treasury Regulations state that:The cost of repairs to the damaged property is acceptable as evidenceof the loss of value if the taxpayer shows that (a) the repairs are neces-sary to restore the property to its condition immediately before the casualty,(b) the amount spent for such repairs is not excessive, (c) the repairsdo not care for more than the damage suffered, and (d) the repairs donot increase the value of the property.51. Proposed Treas. Reg. § 1.165, 24 Fed. Reg. 8177 (1959).2. Alcoma Ass'n v. United States, 239 F.2d 365 (5th Cir. 1956).3. Proposed Treas. Reg. § 1.165-7 (a) (1), 24 Fed. Reg. 8181 (1959).4. Proposed Treas. Reg. § 1.165-7(b) (1), 24 Fed. Reg. 8182 (1959).5. Proposed Treas. Reg. § 1.165-7 (a) (2) (ii), 24 Fed. Reg. 8181 (1959).[MarchMANAGEMENT OF REAL ESTATEThis recognition of cost of repairs as proper evidence for determiningthe amount of a casualty loss will provide taxpayers with a readilyavailable and realistic basis for determining the amount of loss sus-tained in those cases where restoration is made.A new distinction between business and non-business property re-quires that where a loss is incurred on business property the amountof the loss must be determined by reference to each single identifiableproperty damaged or destroyed.' On the other hand, a loss incurredon non-business property need not be segregated and may be de-termined by reference to the whole. Examples contained in the Pro-posed Treasury Regulations point out the effect of this distinction,which is that aggregation of assets, permitted with non-business prop-erty, will lessen the effect of the "adjusted basis" limitation as tonon-business property, while segregation of assets on business prop-erty will make this limitation more restrictive as to business property.The Proposed Treasury Regulations provide that no portion of aloss shall be considered sustained if there is a reasonable prospect ofrecovery.7  The question of the reasonableness of this prospect is afactual one. Where only a part of the loss is expected to be recov-ered, the balance is considered as being sustained and must be de-ducted in the year the loss occurs.In the event a loss is deducted, and reimbursement through insur-ance or otherwise is received in a later year, the taxpayer must in-clude such reimbursement in gross income in the year received, sub-ject to an adjustment."The section of the Proposed Treasury Regulations dealing withcasualty losses provides that its rules are applicable to any taxableyear beginning after the date of publication in final form. It furtherprovides that a taxpayer has the option to amend his income tax re-turn for any open year in order to recompute his casualty loss in ac-cordance with the provisions of the new regulations.9 Immediateaction to effect this option may be necessary with respect to any yearwhich soon may be closed by the running of the statute of limitations.INSURANCEInsurance on real estate used in business must be viewed from twoaspects: first, the cost of carrying insurance, and second, the effecton the amount recoverable in the event the property is damaged ordestroyed. Premiums, of course, are deductible as an ordinary andnecessary business expense and generally present no tax problem. 10One exception arises in the case of a cash basis taxpayer when the6. Proposed Treas. Reg. 1.165-7(b) (2), 24 Fed. Reg. 8182 (1959).7. Proposed Treas. Reg. 1.165-1 (d) (2) (i), 24 Fed. Reg. 8178 (1959).8. Proposed Treas. Reg. § 1.165-1(d) (2) (iii), 24 Fed. Reg. 8178 (1959).9. Proposed Treas. Reg. § 1.165-7(e), 24 Fed. Reg. 8182 (1959).10. INT. REv. CODE OF 1954, § 162.1960]WESTERN RESERVE LAW REVIEWpremium paid is for insurance that extends beyond the year of pay-ment. The position of the Internal Revenue Service is that suchpremiums must be treated as a deferred charge and be deducted overthe period of years benefited.1 However, the Eighth Circuit al-lowed the total premium to be deducted in the year of payment whenthe taxpayer had consistently followed this practice. 2Where the proceeds of insurance on damaged or destroyed busi-ness property exceed the recognized tax loss, a taxpayer may have aninvoluntary conversion if he reinvests the proceeds to replace theproperty, 3 or he may have a section 1231 gain,' 4 or he may have acombination of both results.Where insurance proceeds are less than the recognized tax loss,the insurance proceeds reduce the amount of the loss. This loss is asection 1231 loss.' 5 However, an amendment to the Internal Rev-enue Code in 1958 provides that an ordinary loss results when busi-ness property is damaged or destroyed and there is no insurancerecovery.' 6The distinction between insurance against loss of property and in-surance against loss of income is important from a tax standpoint, asrecovery of the latter always results in ordinary income. 7 Use andoccupancy, and business interruption insurance contracts may pro-duce either result, depending upon the particular contract. Thus, thetax result should be considered at the time the insurance is pur-chased.' 8IMPROVEMENTS AND REPAIRSOne of the most frequent causes of controversy between tax-payers and the Internal Revenue Service is the factual question ofwhether a particular expenditure is an improvement or a repair; orstated another way, whether the expenditure results in a capital assetor in a current deduction.The code'9 and the regulations thereunder provide broad ruleswith respect to this problem. Generally, expenditures that prolongthe life of property or that adapt property to a new or different useare of a capital nature, 20 whereas expenditures that keep property in11. G.C.M. 23587, 1943 CuM. BULL. 213.12. Waldheim Realty & Investment Co. v. Commissioner, 245 F.2d 823 (8th Cir. 1957).13. INT. REv. CODE OF 1954, § 1033.14. INT. REv. CODE OF 1954, 51231 (a).15. INT. REv. CODE OF 1954, 51231(a) (1).16. INT. REv. CODE OF 1954, 51231(a).17. Oppenheim's, Inc. v. Kavanaugh, 90 F. Supp. 107 (E.D. Mich. 1950); Piedmont-Mr.Airy Guano Co., 3 B.T.A. 1009 (1926), acq., V-2 CUM. BULL. 3 (1926).18. See Merritt, How the Proceeds of Use and Occupancy, or Business Interruption, Insur-ance Are Taxed, 36 TAXES 306 (1958).19. INT. REV. CODE OF 1954, §5 162, 263.20. Treas. Reg. § 1.263(a)-1 (1958).r[MarchMANAGEMENT OF REAL ESTATEordinary, efficient operating condition are in the nature of a currentrepair and may be expensed."'The amount of an expenditure is not a factor in the applicationof these rules. In any case, the particular circumstances surroundingthe expenditure must be analyzed when this question exists. If ex-penditures are made for a combination of improvement and repairs,it is essential that the taxpayer maintain adequate records with re-spect to each type of expenditure. 22 Improvements on business prop-erty are capital items, and may be depreciated.DEPRECIATIONAn important long-range decision with respect to depreciationmust be made in the first tax return filed after an acquisition of realproperty has been made. This decision should be made only aftercomplete analysis of the effect of depreciation on taxable income andon the cash made available for use in the business. Both of thesewill vary with the method of depreciation that is selected.When items are capitalized, the taxpayer may, without formalelection, select a method of depreciation. 23 It is important to recog-nize that once a depreciation method is selected, then, with one ex-ception which is discussed below, the method cannot be changedwithout securing permission from the Commissioner of InternalRevenue.24Each asset may be considered separate and apart from all otherassets for the purpose of computing depreciation. Therefore, it ispossible for a taxpayer who acquires a number of separate depreci-able assets in one year to use a different method of depreciation as toeach asset.25Where real property is acquired, a taxpayer may depreciate thewhole (with the exception of land) as a single asset, or may apportionthe cost of the various assets acquired (e.g., the building, plumbing,and other fixtures) and depreciate them separately. 28 Where an ap-portionment is made, various methods of depreciation and variouslives may apply to each classification established.Methods of DepreciationThe 1954 Internal Revenue Code provides that a taxpayer mayuse the straight line, sum of the years-digits, declining balance, or any21. Treas. Reg. § 1.162-4 (1958).22. H. S. Crocker Co., 15 B.TA. 175 (1929), acq., VIII-2 CuM. BULL. 12 (1929). Butalso see Home News Publishing Co., 18 B.T.A. 1008 (1930).23. Treas. Reg. 55 1.167(b)-0(a), r) (1956).24. Treas. Reg. § 1.167(e)-1 (1956).25. Treas. Reg. § 1.167(a)-7(c) (1956).26. E. M. Godson, 15 P-H Tax Ct Men. 614 (1946).19601WESTERN RESERVE LAW REVIEWother method of depreciation with certain restrictions.2 The twoaccelerated methods (sum of the years-digits and declining balance)may be used only when the property: (1) has a life in excess of threeyears (which should include all real property) and is new since 1953,or (2) has been constructed or reconstructed, and was finished after1953.The declining balance method permits the use of a rate not inexcess of twice the rate as computed by the straight line method andrequires that this rate be applied to the adjusted basis of the property.The result is that the same percentage is used each year, but it is ap-plied to a basis that "declines" each year by the amount of the pre-viously allowed depreciation, so that the maximum depreciation al-lowance is received in the first year and then becomes less and lesseach succeeding year.29  As an exception to the general rule, a changefrom the declining balance method to the straight line method is per-mitted without securing the permission of the Commissioner. 30 Animportant aspect of the declining balance method is that the salvagevalue need not be deducted from the basis to which the rate is ap-plied."'The second accelerated method is the sum of the years-digits,which again produces the maximum depreciation in the first year andprogressively lower depreciation in each subsequent year. The sum ofthe years-digits name refers to the denominator of the fraction whichis the sum of the years of useful life to the user.32 The numerator forany year is the number of years remaining as of the beginning of theyear, and, of course, changes each year. This fraction is applied tothe cost (usually the purchase price) of the property, less salvage.3327. INT. REV. CODE OF 1954, § 167(b).28. INT. REv. CODE OF 1954, § 167(c).29. Treas. Reg. § 1.167(b)-2 (1956).30. INT. REv. CODE OF 1954, § 167 (c). This subsection is applicable in the absence ofan agreement with the Commissioner as to the method of depreciation, as provided for in sub-section 167 (d).31. While salvage value need not be deducted from this basis initially, Treasury Regulations(§ 1.167 (b)-2 (1956)) provide that in no event may an asset be depreciated below a reason-able salvage value. This position was upheld by the Third Circuit Court of Appeals against thecontention that depreciation deductions could be taken over the useful life of the item and thencapital gain treatment be given to the amount by which the sale price exceeded the adjustedbasis. Hertz Corp. v. United States, 268 F.2d 604 (3d Cir. 1959), cert. granted, 361 U.S.811 (1959). See also note 35 infra.32. In regard to any method of depreciation, it is not definitely settled whether "useful life"as used in § 167 of the Internal Revenue Code means the "useful life to the taxpayer," or the"physical or economic life of the asset." The Treasury Regulations state (§ 1.167 (a)-1(a))and two cases have held (Hertz Corp. v. United States, 268 F.2d 604 (3d Cit. 1959); UnitedStates v. Massey Motors, Inc., 264 F.2d 552 (5th Cir. 1959) ) that the former definition isproper, while another court (Evans v. Commissioner, 264 F.2d 502 (9th Cit. 1959) ) appliedthe latter definition. However, the Supreme Court has granted certiorari in the Hertz case(361 U.S. 811 (1959).33. Treas. Reg. § 1.167(b)-3 (1956).[MarchMANAGEMENT OF REAL ESTATESalvageSalvage must be considered in computing any depreciation allow-ance, unless the declining balance method is used. Its purpose is torecognize that portion of the cost of an asset that will be recoveredupon disposition, and consequently cannot be recovered through de-preciation. Salvage may be a fixed dollar amount that will reducethe basis to which the depreciation rate (or fraction) is applied, orsalvage may be reflected by using a life longer than the useful lifeto a taxpayer.34 If the declining balance method is used, the regula-tions provide that even though salvage is not taken into account whendetermining the annual allowance, in no event will an asset be depre-ciated below a reasonable salvage value.35Advantages of Fast DepreciationReference was made above to the effect of depreciation on cashmade available to the business. Depreciation, being a non-cash item,must be added back to the net income in order to determine theamount of cash that will be available for the cash requirements of thebusiness, including debt financing. In addition, the larger deprecia-tion deduction available in the early life of an asset provides addi-tional cash savings because of the reduction in federal income taxes.One other advantage of accelerating depreciation is the tax sav-ings through capital gain treatment under section 1231, which savingsresult when business assets which have been subjected to accelerateddepreciation are sold for an amount in excess of the adjusted basis.36The effect is that depreciation deductions which reduced ordinary in-come are converted into capital gain with a resultant tax savings ofthe difference between ordinary rates and the capital gain rate.3734. Treas. Reg. § 1.167(a)-1(c) (1956).35. Treas. Reg. 5 1.167(b)-2 (1956). But see note 31 supra.36. INT. REv. CODE OF 1954, § 1231.37. However, this advantageous treatment may not be available, or may be of limited value,depending upon the determination of the questions concerning salvage and useful life. Seenotes 31, 32, and 35 supra.1960]

Problems of Casualty Losses, Insurance, Improvements and Repairs, and Depreciation

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Problems of Casualty Losses, Insurance, Improvements and Repairs, and Depreciation

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