Lincoln in the U.S. District Court, District of New Jersey. On November 18, 1959, the U.S. District Court adjudicated Lincoln bankrupt. The U.S. District Court enjoined the public foreclosure sales that had been scheduled for November 19, 1959, and ordered an investigation to determine the consideration for the second mortgage on the chattels. On November 30, 1959, the U.S. District Court, pending the outcome of the bankruptcy proceedings, restrained foreclosure of the mortgages held by Mike-Pol.

On December 28, 1959, the trustee in bankruptcy challenged the validity of the second mortgage on the leasehold, the second mortgage on the chattels, the first mortgage on the leasehold, and the first mortgage on the chattels, on the grounds of usury, and questioned the amounts due on account of the notes for $184,000 and on account of the notes for $416,000.

Mike-Pol operated the motel in a fiduciary capacity as mortgagee in possession from November 1959 until April 1960. In April 1960, MikePol, as mortgagee in possession, surrendered possession of the motel to Palpar. Palpar took possession of the motel as mortgagee in possession under the first mortgage on the leasehold and the first mortgage on the chattels. Palpar operated the motel in a fiduciary capacity as mortgagee in possession from April 1960 to February 6, 1961. During 1959 and 1960, Palpar received payments of $41,000 from Lincoln and $41,200 from Mike-Pol and itself, as mortgagees in possession, with respect to the $416,000 notes, reducing the face amount of such notes to $333,800. Palpar treated these receipts on its corporate income tax returns for such years as repayments of principal.

During the period Mike-Pol operated the motel, Pollotta approached Morris in regard to working at the motel. Morris was engaged in the real estate business as a broker and, in that capacity, had become acquainted with Cohn. She had no motel experience at that time and worked for Pollotta at the switchboard and as a desk clerk for only a few months. Subsequently, Morris was approached by Cohn to discuss the possibility of their purchasing the motel and her managing it.

During October 1960, Cohn wrote a series of letters to the New Jersey secretary of state requesting clearance of a name for a corporation which he proposed to organize for the purpose of consummating the purchase of the motel assets from the trustee in bankruptcy. Simultaneously, Cohn made an offer by form letter to each of the Cohn group personally to purchase their respective shares of Palpar stock and Palpar notes at the rate of $7,500 for each 5,000 shares and $5,000 note. The offer was intended to return to each the cash invested in Palpar less the amount they previously had collected. The offer was subject to the condition, inter alia, that Cohn or his nominee or assignee acquire

all of the right, title, and interest of the trustee in bankruptcy in the motel assets for the sum of $25,000.

By letter dated November 1, 1960, Cohn or his nominee or assignee also made an offer to purchase for the sum of $97,500 Palpar stock, Palpar notes, and the unpaid balance of the $184,000 notes held by Mike-Pol.

Between February 1, 1961, and April 13, 1961, Cohn personally acquired the Palpar stock and Palpar 2-year, 6-percent notes owned by the investors comprising the Cohn group for the sum of $97,500.

During February 1961, Cohn also acquired from Mike-Pol its Palpar stock, its Palpar notes, and the notes secured by the second mortgage upon payment of the sum of $97,500. The price paid to Mike-Pol for the Palpar stock and Palpar notes, and the $184,000 notes was not separately negotiated. Cohn would not acquire the Palpar stock and Palpar notes without also acquiring the $184,000 notes. At all times material herein, Michael Pollotta and the members of his family who organized Mike-Pol were, and for many years had been, clients of Cohn. The investors comprising the Cohn group who had subscribed to the stock and purchased the notes of Palpar were also clients and/or business associates of Cohn.

On October 25, 1960, Cohn submitted an offer to Sanford Silverman, attorney for the trustee in bankruptcy, to purchase all of the trustee's right, title, and interest in and to the motel assets subject to the liens representing the security for the $416,000 notes and $184,000 notes, for $25,000, subject further to the condition that the trustee terminate the litigation involving such notes. Silverman also represented at least two-thirds of the general creditors of Lincoln.

On December 28, 1960, Silverman filed a petition and order to show cause in the bankruptcy proceeding. On December 29, 1960, the U.S. District Court entered an order to show cause addressed to the creditors of Lincoln returnable on January 19, 1961, why the trustee in bankruptcy should not accept an offer of $25,000 for his interest in all the motel assets of Lincoln and mailed notice thereof to all creditors. Silverman mailed a copy of the show-cause order to Cohn on December 31, 1960. Cohn, upon receipt of the copy of the order to show cause, telephoned Silverman and advised him that the offer had not been made by Mike-Pol and Palpar. Silverman advised Cohn that to correct the various papers to reflect the identity of the real purchaser would entail filing a new petition and new order to show cause and a new mailing to creditors upon a minimum of 10 days' notice.

On January 19, 1961, the referee in bankruptcy signed an order authorizing the trustee in bankruptcy to accept the offer of $25,000 for the motel assets of Lincoln.

On or about January 23, 1961, Cohn obtained clearance from the secretary for the use of the corporate name "Gateway Motor Courts, Inc." On January 27, 1961, Cohn and Morris, as equal stockholders, organized a corporation named Gateway Motor Inn, Inc.

By letter dated February 2, 1961, Cohn advised Silverman, counsel for the trustee in bankruptcy, that the acceptance of the offer made by Mike-Pol and Palpar to purchase the assets of Lincoln from the trustee in bankruptcy had been assigned to Gateway. Cohn requested Silverman to prepare the bill of sale designating Gateway as the purchaser. In reply, Silverman advised Cohn that he would prepare the bill of sale in the name of Palpar and Mike-Pol in order to be consistent with the order.

On February 6, 1961, Gateway drew a check on its checking account in the amount of $25,000 payable to the order of the trustee in bankruptcy and delivered it to Silverman. Silverman delivered the bill of sale and a release with respect to the trustee's alleged claims. Palpar, as mortgagee in possession, thereupon surrendered possession to Gateway of the motel.

By letter dated February 20, 1961, Cohn forwarded lessor a copy of the recorded assignment of the lease from Mike-Pol to Gateway, together with an agreement executed by Gateway in favor of lessor in which Gateway agreed to comply with the terms of the lease.

For Federal income tax purposes, Gateway computed its initial basis for depreciation of the motel assets acquired from the trustee in bankruptcy as follows:

From December 3, 1958, to February 6, 1961, Palpar received payments in cash on account of the $416,000 notes in the following amounts during the following fiscal years of Palpar:

Between November 1, 1958, and October 31, 1960, Palpar paid pro rata to the Cohn group and Mike-Pol a total of $71,398.60.

In May 1961, Palpar adopted a plan of liquidation under section 333 of the Internal Revenue Code of 1954, as amended. Pursuant to such plan, Palpar distributed to Cohn the unpaid balance of the notes amounting to $333,800.

During the taxable years 1961 to 1964 inclusive, the motel consisted of 52 units and a swimming pool. The motel did not have sufficient rooms to acquire a nationally advertised franchise such as a Holiday Inn or Howard Johnson. The motel was situated on a tract of land containing 7.185 acres. The parcel had been leased pursuant to the lease, which provided, among other things, that the lessee could only use the land for the purposes of a motel business (during the first 20 years of the term), that any mortgage of the motel would be subordinate to the lease, and that the lessor could terminate the lease in the event of any attempted taking or other similar action with respect to the premises.

The initial construction cost of the motel, excluding furnishings and land, approximated $305,000, plus extras. Furnishings approximated $80,000.

Shortly after Gateway purchased the motel, approximately $100,000 was expended for repairs and improvements. Subsequently, an additional sum approximating $250,000 was invested in connection with the addition of 36 units.

During the period November 11, 1959, to October 31, 1960, the motel generated gross income of $208,135 and a cash flow of approximately $75,000. For the period February 1, 1961, to January 31, 1962, the motel had gross revenues of $225,847 and a cash flow of $88,039, consisting of $24,047 profit plus $35,487 depreciation plus $28,505 mortgage-interest service.

For the period February 1, 1962, to January 31, 1963, the motel had gross revenues of $266,304 and a cash flow of $85,708, consisting of $11,704 profit plus $45,499 depreciation plus $28,505 mortgage-interest service.

For the period February 1, 1963, to January 31, 1964, the motel had gross revenues of $297,116 and a cash flow of $83,086, consisting of $4,539 profit plus $50,042 depreciation plus $28,505 mortgage-interest service.

As of February 1961, the fair market value of the $333,800 of notes of Lincoln held by Palpar and secured by a first lien on the leasehold did not exceed the sum of $195,000. The $173,962 of notes of Lincoln secured by a subordinated mortgage on the leasehold were worthless. The fair market value of the leasehold, including both the motel and its furnishings, acquired by Gateway was $333,800.

OPINION

Docket No. 6480-67

In docket No. 6480-67, the Court is called upon to determine the basis for depreciation of the motel in the hands of Gateway. Section 167 (g) provides that the basis for depreciation shall be the adjusted basis provided in section 1011 for the purpose of determining the gain on the sale or disposition of the property. Insofar as material herein, section 1011 provides that the basis for determining gain shall be determined under section 1012. As determined under section 1012, the basis of Gateway for purposes of depreciation of the motel is prescribed as the cost of such property.

Gateway claims to have acquired the motel from the trustees in bankruptcy for the payment of $25,000 in cash, subject to non-interestbearing notes in the principal amount of $333,800 secured by a first lien on the motel, and to non-interest-bearing notes in the principal amount of $173,962 secured by a second lien on the motel. Gateway claims that its "cost" in the acquisition of the motel thus consisted of the sum of $25,000 plus the unpaid balance of both series of notes, relying on Crane v. Commissioner, 331 U.S. 1 (1947), and Manuel D. Mayerson, 47 T.C. 340 (1966).

The respondent argues, inter alia, that the motel was acquired in the first instance by the holder of the secured notes in what was tantamount to a voluntary foreclosure. On that assumption, respondent contends that basis for the property is fair market value. When Gateway subsequently acquired the motel, it took over that basis. In support of this position, respondent relies on I.T. 3548, 1942-1 C.B. 74, and sec. 1.166-6, Income Tax Regs. In addition, the respondent contends that the notes were, in part, worthless and that even under the Crane rule there should be excluded any liabilities which exceeded the value of the property.

In considering this issue, we need only look to the situation that prevailed at the time that Gateway acquired the motel. Lincoln held the leasehold. The motel had been substantially completed. Lincoln was hopelessly insolvent. Its obligations included the sum of $333,800 secured by a first lien on the motel, the sum of $173,962 secured by a second lien on the motel, and the sum of $78,980.49 in unsecured claims. In a forced sale, it was doubtful whether the motel could be sold for as much as $250,000.

It is clear from the record that assuming the validity of the notes secured by a first lien on the motel-and the parties do not question their validity-neither Mike-Pol as the holder of the subordinated notes nor the unsecured creditors stood to recover anything in the event of a foreclosure sale. For all practical purposes, the subordinated