- 13 -
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...)
Page: Previous 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 NextLast modified: May 25, 2011