On appeal from the Tax Court of New Jersey, whose opinion is reported at 21 N.J. Tax 220. (Tax Ct. 2004).
Before Judges Lintner, Parker and Yannotti.
The opinion of the court was delivered by: Yannotti, J.A.D.
NOT FOR PUBLICATION WITHOUT THE APPROVAL OF THE APPELLATE DIVISION
Argued (A-3424-03T1) January 3, 2005
Argued (A-3423-03T1) February 14, 2005
These related appeals concern the manner in which net gain from the sale or disposition of rental property should be determined under the New Jersey Gross Income Tax Act, N.J.S.A. 54A:1-1, et seq. The Act provides in pertinent part that, in determining net gain or loss, the basis of the property shall be the adjusted basis used for federal income tax purposes. N.J.S.A. 54A:5-1(c). Relying upon the Supreme Court's decision in Koch v. Director, Division of Taxation, 157 N.J. 1 (1999), the Tax Court held that the federal adjusted basis must be increased by the cumulative amount of the allowed and allowable depreciation deductions that were not utilized by the taxpayers in computing net income from the respective properties in the years of their ownership. The judge further determined that the basis adjustment is the amount of the depreciation deductions that were not used to offset gross receipts after first deducting operating expenses in each tax year. Moroney v. Director, Division of Taxation, 21 N.J. Tax 220, 229 (Tax Ct. 2004).
Based on these conclusions, the Tax Court entered a judgment setting aside a deficiency assessment issued by the Director of the Division of Taxation to plaintiffs John J. Moroney and Mary T. Moroney, and a judgment ordering the Director to refund taxes previously paid by plaintiffs Thomas J. Denitzio and Susan B. Denitzio. The Director appeals. We consolidate the appeals for purposes of decision and now affirm the Tax Court's judgments.
In 1986, the Moroneys acquired certain real property in Hillsdale, New Jersey at a price of $327,399. The Moroneys sold the property in 1994 for $245,000. On their New Jersey gross income tax return for the 1994 tax year, the Moroneys reported a loss on the sale of the property in the amount of $82,399, which was the difference between the purchase price and the amount received for the sale. The Moroneys used the cost of the property as the basis for determining gain or loss from the sale because, in each year that they owned the property, operating expenses exceeded rental income from the property.
The Director determined, however, that the adjusted basis of the property was $274,073 and the cumulative allowed and allowable depreciation on the property for the period of the Moroneys' ownership was $104,330, resulting in a final adjusted basis in the amount of $169,743. The Director subtracted that amount from the sales price of $245,000 and found that the Moroneys realized a net gain of $75,257, requiring the payment of additional taxes in the amount of $10,484.
The Denitzios purchased rental property in Westfield, New Jersey in 1985. They sold the property in 1995 for $265,000. The Denitzios filed a New Jersey gross income tax return for the 1995 tax year in which they reported that the adjusted basis of the property was $143,367 and the gain from the sale was $121,633. The basis reported by the Denitzios on their 1995 taX return was the adjusted basis used for federal income taX purposes, which was computed by reducing the cumulative amount of the deductions for depreciation that were allowed or allowable in the years in which the Denitzios owned the property. In 1999, the Denitzios filed an amended return in which they re-calculated and reduced the gain on the property to $49,640 by adding back an amount equal to the depreciation expense that they claimed had not been utilized in determining net income from the property. The Denitizos sought a tax refund in the amount of $4,849.
The Director granted the Denitzios a partial refund. The Director agreed that the federal adjusted basis of the property should be adjusted by adding the cumulative amount of depreciation expense that was not utilized by the taxpayers while they owned the property. According to the Director, the amount of depreciation that was not utilized is the amount by which depreciation exceeds gross receipts in any given tax year. The Director found that, because the Denitzios reported depreciation that exceeded gross receipts for all years other than 1992, 1993 and 1994, they only enjoyed a tax benefit from depreciation expense in those three tax years in the cumulative amount of $9,928. The Director therefore granted a refund in the amount of $64 and denied the balance of the claim.
The taxpayers filed timely challenges to the Director's determinations and the Tax Court reversed. In an opinion addressing both appeals, the judge noted that the Director had recognized that Koch required adjustments to the federal adjusted basis to reflect the amount of depreciation that was not used by the taxpayers for New Jersey gross income tax purposes. Moroney, supra, 21 N.J. Tax at 226. The judge found, however, that the Director's method for computing unused depreciation was inconsistent with the"essence" of the Koch decision. As the judge noted, under the Director's approach, depreciation is the first deduction from gross receipts. The judge explained that, by calculating unused depreciation in that manner, the taxpayer"derives a tax benefit from depreciation up to the amount of gross income, but no tax benefit from depreciation in excess of gross income." Ibid. The judge concluded that Koch required that, in computing the amount of the adjustments, the first deduction from gross income should be out-of-pocket expenses. Therefore, the amount of unutilized depreciation is the cumulative amount of allowed or allowable depreciation that offsets income remaining after deduction of operating expenses in each tax year. Id. at 229.
The Director appeals and argues that Koch does not require an adjustment to the federal basis for unutilized depreciation deductions. The Director further contends that the Tax Court erred in rejecting his ...