Rev. Rul. 73-589

Advice has been requested as to the treatment, for Federal income tax purposes, of gain realized by taxpayers on the receipt of proceeds as the result of complete destruction of certain railroad cars under the circumstances described below.

The taxpayer owns and leases railroad rolling stock to others on a long term basis. In accordance with section 168 of the Internal Revenue Code of 1954, some of these cars had been partially certified as emergency facilities by the applicable certifying authority and had been operated under certificates of necessity. The taxpayer had claimed amortization deductions under section 168 on the certified portion of the cars and depreciation deductions under section 167 on the uncertified portion of the cars. In 1970, some of the cars were completely destroyed in collisions, derailments, or fires. Each of the cars destroyed had been held by the taxpayer for more than six months and used in its trade or business. Some of the cars destroyed had been subject to both amortization under section 168 and depreciation under section 167. The remainder of the cars destroyed were all subject to depreciation under section 167.

The total indemnification received exceeded the adjusted basis of the railroad cars so that the taxpayer realized a gain upon the transaction for Federal income tax purposes.

The specific questions in the instant case are (1) whether section 1238 of the Code applies to involuntary conversions, (2) whether any part of the gain realized upon the involuntary conversion of the railroad cars, described above, constitutes ordinary income under sections 1238 and 1245 of the Code, and (3) whether any part of the gain is subject to tax treatment under section 1231.

Section 1231 of the Code provides, in pertinent part, as follows:

(a) GENERAL RULE.--If, during the taxable year, the recognized gains on sales or exchanges of property used in the trade or business, plus the recognized gains from the compulsory or involuntary conversion (as a result of destruction in whole or in part, theft or seizure, or an exercise of the power of requisition or condemnation or the threat or imminence thereof) of property used in the trade or business and capital assets held for more than 6 months into other property or money, exceed the recognized losses from such sales, exchanges, and conversions, such gains and losses shall be considered as gains and losses from sales or exchanges of capital assets held for more than 6 months. * * *

Section 1238 of the Code provides that gain from the sale or exchange of property, to the extent that the adjusted basis of such property is less than its adjusted basis determined without regard to section 168 (relating to amortization deductions of emergency facilities), shall be considered as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231. See also section 1.1238-1 of the Income Tax Regulations.

Section 1245(a)(1) of the Code provides, in part, that if section 1245 property (which includes depreciable personal property such as machinery and equipment) is disposed of during a taxable year beginning after December 31, 1962, the amount by which the lower of the recomputed basis of the property or, in the case of a sale, exchange, or involuntary conversion, the amount realized, exceeds the adjusted basis of such property shall be treated as gain from the disposition of property that is neither a capital asset nor property described in section 1231. Such gain shall be recognized, notwithstanding any other provision of subtitle A of the Code.

As far as here pertinent, section 1245(a)(3) of the Code defines "section 1245 property" to include personal property which is or has been property of a character subject to the allowance for depreciation provided in section 167.

Section 1245(a)(2) of the Code and sections 1.1245-2(a)(3) and 1.1245-2(a)(6) of the regulations provide, in part, that, for the purpose of determining the recomputed basis of personal property, the amount of the adjustments reflected in the adjusted basis of the property is limited to all adjustments (including depreciation and amortization under sections 167 and 168) attributable to periods after December 31, 1961.

Section 1.1245-6(a) of the regulations provides that, since section 1245 of the Code overrides section 1231 (relating to property used in the trade or business), the gain recognized under section 1245(a)(1) upon a disposition will be treated as ordinary income and only the remaining gain from the disposition, if any, may be considered as gain from the disposition of a capital asset if section 1231 is applicable.

In Chicago, Burlington & Quincy Railroad Company v. United States, 455 F.2d 933 (Ct. Cl. 1972), rev'd and rem'd on other issues, 412 U.S. 401 (1973), page 428, freight cars owned by the taxpayer and used in the taxpayer's business for several years were destroyed in accidents in 1955. The freight cars were amortized under section 168 of the Code. As compensation for the loss, the taxpayer received an amount in excess of the adjusted basis of the cars, resulting in a gain. The Court held that the provisions of section 1238 were not applicable. The Court stated that the legislative history of section 1238 and its predecessor section indicated that they were intended to apply to voluntary sales and exchanges and not to involuntary transactions.

In view of the above, it is held that section 1238 of the Code does not apply to involuntary conversions. In the instant case, the gain attributable to that portion of the railroad cars destroyed upon which amortization was taken under section 168 is not subject to the provisions of section 1238. However, the gain attributable to each of the railroad cars destroyed which was subject to depreciation or amortization, or both, is subject to the provisions of section 1245 to the extent of depreciation and amortization allowed or allowable for periods after December 31, 1961. If such depreciation and amortization exceeds such gain, then all such gain is ordinary income. If such depreciation and amortization does not exceed such gain, then such gain is ordinary income to the extent of such depreciation and amortization and the remainder of such gain is governed by the provisions of section 1231. See Rev. Rul. 72-141, 1972-1 C.B. 266.

The instant case is distinguishable from Rev. Rul. 64-100, 1964-1 (Part 1) C.B. 130, which holds that an involuntary conversion resulting from the complete destruction by fire of a building used in the taxpayer's trade or business, or of other property as defined in section 337 of the Code, constitutes a "sale or exchange" for purposes of section 337(a). Rev. Rul. 64-100, by its express language, limits its application to section 337 in order to effectuate the clear purpose of that section to avoid double taxation (tax the corporation, then later the stockholders), a situation not here involved.

Rev. Rul. 64-100 is distinguished.