Rev. Rul. 72-85

Advice has been requested regarding the proper treatment, for Federal income tax purposes, of the gain or loss upon the sale of a leasehold of land used in his trade or business by a taxpayer who is not a dealer in leases.

In 1959 the taxpayer leased certain land for a period of 40 years. The taxpayer erected a building on the leased premises in 1960. In the conduct of his trade or business, the taxpayer subleased all of the leased premises to several subtenants. In 1970, the taxpayer sold and assigned all of his interest in the leasehold, including his interest in the building, to a person other than the fee owner of the leased premises. The taxpayer's assignee agreed to assume performance of the terms of the lease. However, the taxpayer remained liable to the owner for performance of the terms of the lease by the assignee.

The question raised is whether the gain or loss upon the sale by the lessee (taxpayer) of the leasehold, including the improvements constructed by the lessee, qualifies for treatment under either section 1221 or 1231 of the Internal Revenue Code of 1954.

Section 1221(2) of the Code excludes from the term "capital asset" property of a character which is subject to the allowance for depreciation provided in section 167 of the Code, held by a taxpayer and used in his trade or business, and real property held by a taxpayer and used in his trade or business. Gains or losses from the sale or exchange of such property are not treated as gains or losses from the sale or exchange of capital assets, except to the extent provided in section 1231 of the Code and the Income Tax Regulations thereunder. See section 1.1221-1(b) of the Income Tax Regulations.

Section 1231(a) of the Code provides special treatment for the recognized gains and losses from sales or exchanges of property used in the trade or business. The provisions of section 1231(a) of the Code apply to property used in the trade or business of a character which is subject to the allowance for depreciation provided in section 167 of the Code and held for more than six months. The provisions of section 1231(a) of the Code also apply to real property used in the trade or business and held for more than six months.

A leasehold of land used in the trade or business may be property of a character which is subject to the allowance for depreciation provided in section 167 of the Code. See Century Electric Co. v. Commissioner, 192 F.2d 155, 160 (1951), certiorari denied, 342 U.S. 954 (1952); John Fackler v. Commissioner, 133 F.2d 509, 512 (1943); City Nat'l Bank Bldg. Co. v. Helvering, 98 F.2d 216, 219 (1938) and Tom F. Baker III v. Commissioner, 38 T.C. 9, 12 (1962).

A leasehold interest in land is also real property within the meaning of section 1231 of the Code. Under section 1250(c) of the Code, a leasehold of land is intangible real property. If it is depreciable property, such a leasehold is section 1250 property. See House Report 749, Eighty-eight Congress, C.B. 1964-1, (Part 2), 125, 401, and section 1.1250-1(e)(3) of the regulations. A leasehold of land used in the trade or business is section 1231 property even if it is of indefinite duration (and therefore is not depreciable) because it is real property. In enacting the predecessor of section 1231 of the Code (section 117(j) of the Internal Revenue Code of 1939, as added by section 151(b) of the Revenue Act of 1942, 56 Stat. 798) Congress provided the same tax treatment to gains and losses from the sale or exchange of property used in the trade or business, whether it is depreciable personal property such as factory equipment, depreciable real property such as the factory itself, or nondepreciable real property such as the land on which the factory stands, if held for more than six months. See House Report 2333, Seventy-seventh Congress, C.B. 1942-2, 372, at 415; Senate Report 1631, Seventy-seventh Congress, C.B. 1942-2, 504, at 545, and 594. Consistent therewith, the same rule applies to a leasehold interest in land used in the taxpayer's trade or business.

A leasehold that is used in the taxpayer's trade or business and is either real property or property of a character subject to the allowance for depreciation provided in section 167 of the Code is not a capital asset under section 1221 of the Code. However, the leasehold may meet the requirements of section 1231(b) of the Code as property used in the trade or business.

In the instant case, the taxpayer was engaged in the business of leasing real estate to customers, but was not in the business of selling leases. Therefore, although the leasehold was used in the taxpayer's trade or business it was not property of a kind properly includible in the taxpayer's inventory, nor property held primarily for sale to customers. Since the taxpayer's leasehold was property used in the trade or business held for more than six months, it qualifies as section 1231 property as real property, and as property of a character subject to the allowance for depreciation provided in section 167 of the Code. Accordingly, any gain or loss upon the sale of the taxpayer's leasehold of land will be treated under the provisions of section 1231 of the Code.

Since the taxpayer's interests in the leasehold and the building are section 1250 property, section 1250 of the Code will affect the tax consequences of any gain from the sale. If part of the property underlying the leasehold is section 1245 property, the leasehold is section 1245 property in part, and both sections 1245 and 1250 of the Code will affect the tax consequences of any gain from the sale. See sections 1.1245-1(a)(5) and 1.1250-3(d)(6) of the regulations.

Revenue Ruling 56-531, C.B. 1956-2, 983, which holds, in part, that the Service will acquiesce in McCue Bros. & Drummond, Inc. v. Commissioner, 19 T.C. 667 (1953), acquiescence C.B. 1956-2, 7, affirmed, 210 F.2d 572, certiorari denied, 348 U.S. 829 (1954); Louis W. Ray v. Commissioner, 18 T.C. 438 (1952), acquiescence C.B. 1956-2, 8, affirmed, 210 F.2d 390, certiorari denied, 348 U.S. 829 (1954); and Isidore Golonsky v. Commissioner, 16 T.C. 1450 (1951), acquiescence C.B. 1956-2, 6, affirmed, 200 F.2d 72, certiorari denied, 345 U.S. 939 (1953), which held that the gains realized upon the surrender of certain leases were entitled to treatment as sales of capital assets within the meaning of section 117 of the Internal Revenue Code of 1939, is clarified to hold that the sales of the leases in the above cases were sales of property used in the trade or business of the taxpayer. As such, the gains were properly treated as gains from the sales of capital assets under section 117(j) of the Internal Revenue Code of 1939 [section 1231 of the Internal Revenue Code of 1954], but the leases were not capital assets under section 117(a) of the Internal Revenue Code of 1939 [section 1221 of the Internal Revenue Code of 1954].

Revenue Ruling 60-4, C.B. 1960-1, 303, which holds that a leasehold that, at the time of its sale, has 30 or more years to run constitutes real property, is superseded by this Revenue Ruling.