The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By David I. Kempler, Esq., and Elizabeth Carrott Minnigh, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
In Alphonso v. Comr.,1 the Second Circuit held that Taxpayer had a property interest in the common grounds of the property of a cooperative housing apartment in which the taxpayer owned stock, and thus the property requirement set forth in §165(c)(3) was satisfied. The Second Circuit, however, remanded for consideration of whether the claimed loss was a "casualty" for purposes of §165. Importantly, the Second Circuit's finding of property rights was predicated on the specific rights granted under the proprietary lease.
Section 165 of the Code permits a deduction for any uncompensated loss sustained during the taxable year. For individual taxpayers, the allowable §165 losses are restricted to: (i) losses incurred in a trade or business, (ii) losses incurred in any transaction entered into for profit, though not connected with a trade or business, and (3) losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. The term "property" is not defined in the Code; rather "in the application of a federal revenue act, state law controls in determining the nature of the legal interest which the taxpayer had in the property."2
Taxpayer owned stock in, and was a resident of, a cooperative housing apartment building located in New York City. In May 2005, a retaining wall owned by the cooperative collapsed, causing significant damage. The cooperative levied an assessment against each of its stockholders, including a $26,390 assessment against Taxpayer, to cover a portion of the damage caused by the collapse of the retaining wall.
On her 2005 Form 1040, U.S. Individual Income Tax Return, Taxpayer claimed a casualty loss of $26,390, and as a result took a casualty loss deduction of $23,188. The IRS disallowed the claimed casualty loss and the taxpayer's claimed deduction, finding that: the cause of the collapse of the retaining wall was the result of a gradual weakening of the wall, which did not constitute a casualty loss under §165(c)(3) and, further, that because the collapse of the retaining wall occurred on the cooperative's property, any casualty loss deduction must be claimed by the corporation, not by the stockholders, because the stockholders did not have a property interest in the retaining wall.
In March 2011, in Alphonso v. Comr.,3 the U.S. Tax Court held that the assessment was not deductible by Taxpayer as a casualty loss under §165(a). In support of its conclusion, the Tax Court stated that the cooperative housing documents did not support a finding that the taxpayer "possessed a leasehold interest, an easement, or any other property interest" that would entitle her to a deduction under §165(a) or (c)(3) for damage to the common grounds.
On appeal, Taxpayer contended that the Tax Court erred in ruling that she held no property interest in the cooperative grounds sufficient to justify her claimed casualty loss deduction. Specifically, Taxpayer asserted that she, along with the other tenant-stockholders, possessed shared property rights in the cooperative complex, which were exclusive as against the general public and constituted an equitable interest in the grounds sufficient to entitle her to the deduction.
Section 216(b)(1)(B) defines a "cooperative housing corporation" as one in which each stockholder is entitled by reason of his or her ownership of stock "to occupy for dwelling purposes a house, or an apartment in a building, owned or leased by such corporation." Generally, losses incurred by a corporation are not deductible by its stockholders. Section 216(a), however, allows tenant-stockholders to deduct their respective shares of a cooperative's mortgage and real estate interest expenses. Moreover, §121(d)(4) specifically provides that stock in a cooperative housing corporation can be defined as a principal residence for the purpose of the nonrecognition of a portion in capital gains on the sale of a principal residence by a taxpayer.
Under New York law, an ownership interest in a cooperative apartment building is both "ownership of a proprietary lease" and a "shareholder interest in the co-operative corporation," which dual interests "are inseparable."4 Consistent with these principles, the Second Circuit in Holmes v. U.S.,5 held that shares in a cooperative housing corporation constituted "property" indistinguishable from ownership interests in "a house, apartment, or condominium… and other property appurtenant" thereto.
New York law recognizes that a tenant-stockholder has a right to use the cooperative's common areas.6 Under the proprietary lease, Taxpayer had an exclusive right to reside in the apartment represented by her shares of stock and, under the house rules, which were incorporated in the propriety lease, also had the right to make use of the common grounds. The IRS conceded that, in the case of a condominium in which the tenants owned the grounds as tenants in common, casualty loss deductions for damage to the grounds would be allowed for the tenant. However, the IRS contended that the split between the right to use the residence and the right to use the common grounds meant that her right to use the grounds was merely a right of use and not a property interest like the right to use the residence.
The Second Circuit concluded that, although Taxpayer's right to use the grounds was not exclusive with respect to her fellow tenants, it was part of her leasehold interest. Therefore, the Second Circuit held that under New York law, Taxpayer's right to use the grounds, shared was a property interest in the grounds. Accordingly, the Second Circuit found that Taxpayer had satisfied the property requirement set forth in §165(c)(3). However, the Second Circuit remanded for a determination of whether the claimed losses arose from a "casualty" within the meaning of §165.
Because the Second Circuit's decision focused on the specific rights to use the common areas granted under the proprietary lease, cooperative boards should review their leases to ensure that the leases provide lessees with property rights in common areas of the cooperative property.
For more information, in the Tax Management Portfolios, see McCoy, 527 T.M., Loss Deductions, and in Tax Practice Series, see ¶2350, Losses.
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