Hort owned an office building
that was being leased by Irving Trust. They had a fifteen-year lease, but
decided to close that office. By mutual agreement, they paid Hort $140k
to break the lease.
Hort calculated the
difference between the present value of the future unpaid rent and the
$140k, and figured that he had lost $21.4k.
When he filed his taxes, Hort
claimed a loss of $21.4k. The IRS disagreed.
The IRS argued that the
$140k must be included in Hort's adjusted gross income. The IRS argued that this was effectively a
rental payment, and rental payments are ordinary income.
Hort argued that he could
offset the lost value of the canceled lease against the consideration
received by him for the cancellation.
Hort argued that he was not
in the trade or business of making money by breaking leases.
The Tax Court found for the
IRS. Hort appealed.
The Appellate Court affirmed.
Hort appealed.
The US Supreme Court affirmed.
The US Supreme Court looked
to the relevant part of the tax code (then 26 U.S.C. §22(a), now §61(a)), and found that rent was explicitly included
in the things that are gross income.
The Court found that the
$140k was just a substitute for the rent Hort would have received.
Therefore it too should be considered gross income.
The Court found that the
failure to realize income does not amount to a loss.
For example, if you are
trying to rent a building and you can't find a renter, you can't deduct
the rent payments you didn't get as a loss.
If you could, then you
could just buy an apartment, advertise it for a million dollars a
month, find no renters, and then claim a million dollar loss!
One could have also argued
that there was no asset that survived the sale, therefore Hort had not exchanged an asset and therefore could not claim a capital
gain on the sale.
See Pounds v. United
States (372 F.2d 342 (1967)).
Basically, this case said that
future rental income is not a capital asset, and when you give it up (by breaking a lease), you have not sold
a capital asset.
For comparison see, Metropolitan
Bldg. Co. v. Commissioner (282 F.2d
592 (1960). In that case Metropolitan was a tenant who sold their lease
to a third party. Since Metropolitan had a property interest in the
lease, and sold that interest, they had indeed sold a capital asset
and could count the sale as a capital gain.
