The opinion of the court was delivered by: BICKS
This is a suit for the refund of personal federal income taxes paid by the plaintiffs, Arthur and Tessie Ujvari. They claim that they are entitled under Sections 23(s) and 122(a), (d)(5) of the Internal Revenue Code of 1939
to a deduction for a net operating loss carryover arising out of the confiscation by the Hungarian government of rental property owned and operated in a trade or business by plaintiff Arthur Ujvari.
Deductions in the sum of $ 13,018.81 having already been allowed for the years 1951 and 1952; this suit involves only the years 1953, 1954, 1955 and 1957. Based on an alleged loss of $ 48,520, which is to be deducted from the taxable income for these years,
plaintiffs' refund claim totals $ 3,567.40.
Plaintiff Arthur Ujvari came to this country in 1940 and has never returned to Hungary. In 1943 he inherited from his father a one-half interest in certain property in Hungary. This property was confiscated by the Hungarian Communist government in 1952. The sole issue in the case is the proper tax basis of this property, namely the fair market value at the time of the inheritance in 1943 less depreciation of the buildings to 1952. Internal Revenue Code of 1939, §§ 23(i), 113(a)(5), (b).
The property is situated at 41 Kossuth Lajosutes in Keszethely, Hungary, a town of 15,000 to 20,000 population about 120 miles southwest of Budapest in the Lake Balaton resort area. It is on the main thoroughfare of the city, opposite a church and high school. The plot on which the buildings are located is approximately 25,000 square feet with a frontage of about 80 feet and a depth of about 350 feet. There are two structures on the plot. The first of these is an L-shaped building, the front wing facing the street having two stories, and the rear wing on the right of the rear courtyard having only one story. The main building is comprised of 3 large and 2 small stores on the ground floor and a total of eight apartments of varying sizes in both wings. In addition, there was a small house in the courtyard consisting of a single four room apartment.
The main building, whose ground floor was approximately 90 years old and whose upper story was added around 1900, was made of brick with tile roofing. The apartments were described as having high ceilings and parquet floors and were supplied with water and electricity. However, there was no central heating and wood burning ovens were necessary.
The property had been operated after the death of the father by the plaintiff's sister, Janka Frimm, the owner of the other half-interest. Mrs. Frimm testified that the gross rentals received amounted to 19,200 pengos a year but that there was no net rental income derived from the property, the cost of repairs and management being so high that it was necessary to request that additional funds be sent from Mr. Ujvari in America. She testified that she desired to raise the rents but was prevented from so doing by rent control laws then in force in Hungary.
The plaintiffs called Mr. Lasszo E. Acsay as their expert witness. Formerly a Hungarian architect in Budapest, he had testified in a number of pest, he had testified in a number of confiscations of other Hungarian properties. Mr. Acsay estimated the value of the buildings to be 75,000 pengos. This estimate was based on reproduction cost new less 75% Depreciation. He stated that it was a rule in Canada and in all of Europe that any building in use has a value of at least 25% Of its reproduction cost. On cross-examination he testified that this estimate would be unaffected by the fact that there was no rental income, this being considered only when he wanted to increase value. As an alternative method of valuation, he contended that the gross income of rental property multiplied by eight would yield a minimum value. He testified that such a rule is used in Hungary for the purpose of tax assessment when there is a transfer of property and considering the nature of the property here at issue, the appropriate multiplier would be twelve, and the buildings therefore worth 200,400 pengos.
The government's expert, Mr. Mario Triolo, testified that the best method of valuation when dealing with rental properties is the income capitalization method rather than reproduction cost. In response to a hypothetical question based on plaintiffs' proof, he found that the buildings involved herein had little or no value.
The Treasury regulations define fair market value as 'the price at which * * * property would change hands between a willing buyer and a willing seller, neither being under compulsion to buy or to sell.' Treasury Regs. 108, § 86.19(a); now Treas. Reg. § 25.2512-1. Application of this standard is always a difficult one, made all the more hazardous when the property is in distant and unfamiliar surroundings. Absent evidence of sales of similar properties or real offers to buy or sell the property in question, any estimate as to market value must at best be speculative in nature. The problem is further complicated by the fact that different valuation techniques in current use frequently lead to disparate estimates of value. That such is the case is dramatically illustrated by the facts here. The government's expert, using the net income capitalization technique, has concluded that these buildings have little or no value. Plaintiffs' expert, basing his estimate on reproduction cost less depreciation or on gross income capitalization, would find the buildings to have significant value. No suggestions as to any means of reconciling or compromising these estimates has been offered to this Court. It thus becomes necessary to turn to an evaluation of the relative merits of these methods.
It would appear to be an established rule when dealing with rental property that the replacement cost of property ordinarily sets only the approximate upper limit to its value. See generally 1 Bonbright, The Valuation of Property 150-176 (1937); 2 Orgel, Valuation under Eminent Domain, §§ 188-199 (2d ed. 1953). The proper technique, as a general matter, is to value the property at the lower of replacement cost or income capitalization. See People ex rel. Lehigh Valley R. Co. v. Harris, 168 Misc. 685, 6 N.Y.S.2d 794 (Sup.Ct.1935). The use of replacement cost depends heavily on the notion that what it would cost the owner of the property to replace it with a similar property on another location is at least some evidence as it its value. However, where the facts are such as to make it unlikely that the present owner would consider the expenditure of any capital to replace a structure having no demonstrated earning power, such an assumption has little validity. On the other hand, from a prospective purchaser's viewpoint, it would be highly unlikely that he would be willing to pay a sum for the structure bearing no relation whatever to past and possible future earnings thereon, especially when increases in rents to remunerative rates were prohibited by law.
On the facts of this case, the conclusion that the buildings in question had little or no value when they were expropriated seems inescapable. The buildings were 90 years old, there was no central heating and there had been no net rental income for a period of several years. There is no evidence to indicate that the repairs made by plaintiff and his sister during these years were due to any extraordinary circumstances. On the contrary, the high expenditures relative to income were more likely those that become necessary as a building nears the end of its useful life. Although the Court is mindful of the fact that it is dealing with property in a foreign country where a 90-year-old structure might be considered more valuable than a similar property in this country, the earnings picture is convincing evidence to this Court that the structure had little or no value. The Court is of the opinion that the reproduction cost estimate offered by the plaintiffs is highly unreliable as an estimate of value. See Bowie Lumber Co. v. United States, 155 F.2d 225 (5th Cir., 1946). In those instances where reproduction cost is acceptable as a measure, it has been suggested that extreme care should be taken to assure that full deductions are made for depreciation and other forms of obsolescence. See 2 Orgel, supra at § 199. This Court is not prepared to accept the unsupported contention that any building in use is at least worth 25% Of its reproduction cost.
It is necessary to dispose briefly of plaintiffs' contention that a capitalization of gross rentals, at a rate lower than that which would be applied to net rentals, is a proper alternative method of valuation. Courts using the income capitalization technique frequently do not make clear whether they are dealing with net or gross rentals. Although it may be the case that there is frequently a sufficient correlation between net and gross rentals to make capitalization of the latter a significant measure of value, see Somers v. City of Meriden, 119 Conn. 5, 174 A. 184, 95 A.L.R. 434 (1934), it is clear that its use in the present case is merely a device to avoid the fact that there are no net rentals on which an appropriate estimate of value could be based. Under such circumstances, capitalization of gross rentals is of no probity on the question of value.
Mr. Acsay testified that the land should be valued at the rate of 150 pengos per square fathom. An area of 25,000 square feet, equal to approximately 700 square fathoms, would be worth 105,000 pengos. Mr. Acsay's estimate of the value of the land was 180,000 pengos. This was based on an area of 43,500 square feet, a figure he claims that Mr. Ujvari gave him and that he estimated from a small snapshot of the building. However, Mr. Ujvari's refund claim filed with the Internal Revenue Service, his complaint in this action and his direct testimony all indicate an approximate area of 25,000 square feet. In view of ...