Hunt & Sons, Inc. - Page 13




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          value of the properties by applying a flat 10-percent                       
          “capitalization” rate to the fair market value.3  Mr. Harris                
          based his “capitalization” rate on conversations with several               
          people who had experience with ground leases with major oil                 
          companies, all of whom indicated that annual ground lease rates             
          were a flat 10 percent of the current fair market value of the              
          land.4  Mr. Harris made no adjustment in the rental                         

               3The parties’ experts referred to the rate applied to the              
          fair market value to compute the first year’s annual rent as a              
          “capitalization rate”.  A true capitalization rate is a rate used           
          to convert a perpetual stream of income into a discounted present           
          value.  Narver v. Commissioner, 75 T.C. 53, 91 n.17 (1980), affd.           
          670 F.2d 855 (9th Cir. 1982); Lanier v. Commissioner, T.C. Memo.            
          1998-7.  We nevertheless recognize that it is common practice to            
          refer to both the capitalization rate and its inverse as the “cap           
          rate”.                                                                      
               4Mr. Harris’s appraisal (and the appraisals of the other               
          experts) did not take into account that these properties were               
          subject to existing ground leases, some of which were made in               
          earlier years.  For example, the Watt Avenue lease was entered              
          into in 1990 and provided for annual escalations based on                   
          increases in the consumer price index, none of which were                   
          apparently made.  Instead of determining the rent for the years             
          in issue on the basis of market conditions existing at the time             
          the leases were entered into, Mr. Harris determined the current             
          fair market lease rate for a new lease.  The parties should have            
          taken into consideration any change in market conditions. “[A]              
          transaction must not be disregarded simply because it was not at            
          arm’s length.”  Sun Props., Inc. v. United States, 220 F.2d 171,            
          174 (5th Cir. 1955).  Our role is merely to limit deductions to             
          the amount that would have been paid if the parties had entered             
          into the transactions at arms length.  “In the absence of arm’s             
          length negotiations ‘an inquiry into what constitutes reasonable            
          rental is necessary to determine whether the sum paid is in                 
          excess of what the lessee would have been required to pay had he            
          dealt at arm's length with a stranger.’”  Sparks Nugget, Inc. v.            
          Commissioner, 458 F.2d 631, 635 (9th Cir. 1972) (quoting Place v.           
          Commissioner, 17 T.C. 199, 203 (1951), affd. 199 F.2d 373 (6th              
                                                             (continued...)           





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