be charged to expense. A building or a piece of machinery or other equipment, as a whole, may deteriorate in value and usefulness by reason of wear and tear regardless of the fact that certain minor component parts may be renewed, restored or replaced. The depreciation deduction contemplates the creation of a fund that will renew, restore or replace the original property, when it has become worn out or exhausted, regardless of the renewal and restoration of parts that may have been made in the meantime. Hence, in addition to the depreciation deduction, the expense of incidental repairs which do not add to the value of the property, but merely keep it in an operating condition, may be deducted as expense in the year in which the repairs are made.23

RENEWALS TO PROPERTY. It is possible in some instances that worn out parts of a machine or similar equipment may be renewed, one after another, until the original machine or equipment is swallowed up in the renewed parts and the machine or equipment is then in as good operating condition as it was originally. In such cases, if the cost of renewed parts is charged to operating expense, no deduction on account of depreciation should be claimed as to such machine or equipment. Thus, in the case of pipelines, by replacing one joint of pipe after another all may be replaced and, if the expense of replacements is deducted as an operating expense, no depreciation fund should be set up for the purpose of restoring the pipeline as a whole. On the other hand, if a reserve is set up to cover property that may be renewed or restored part by part until the whole is renewed,

23 Letter from Treasury Department dated September 19, 1916; I. T. S. 1917, ¶¶ 1356 to 1358.

the cost of the renewed part should be charged to the depreciation reserve fund and not to expense.24

Rate of Depreciation. The annual allowance for depreciation, is required by law to be "resonable." No fixed rates are prescribed. The rule which has been established contemplates that the taxpayer shall determine his annual deduction by dividing the cost of the property by the probable number of years constituting its life, in the manner indicated above, the result being the amount which may be deducted annually.25

DEPRECIATION OF APARTMENT HOUSES. In the case of an apartment house it was held by the court that where the Government had allowed 3% of the cost as annual depreciation the burden was on the owner to show that the amount so allowed was too small, the court considering the rate to be reasonable in this case.26

Annual Allowance Must Be Entered on Books. A reasonable allowance for depreciation must be determined upon a basis of the cost of the property and the

24 Letter from Treasury Department dated September 19, 1916; I. T. S. 1917, ¶¶ 1359 to 1361.

25 T. D. 2152. A collector who told taxpayers in his district that the amount of depreciation on frame buildings was limited to 3%, and in case of brick buildings to 2%, was informed by the Commissioner of Internal Revenue that while these rates might not be far from a reasonable and fair measure of depreciation sustained on such buildings, the rates should not be considered as the "limit, as the probable number of years constituting the life of the building might make the rate more or less than the figures stated. Letter from Treasury Department dated May 22, 1916; I. T. S. 1917, ¶ 1381.

26 Cohen v. Lowe, 234 Fed. 474.

probable number of years constituting its life. The amount of allowable depreciation deduction, thus ascertained, should be credited to a depreciation reserve account, against which account will be charged the cost of renewing or replacing the property with respect to which depreciation is claimed.27 Such depreciation liability must be reflected in the annual balance sheet.28 A journal entry alone is not sufficient.29 Neither the 1909 Law nor the 1913 Law required that in order to secure a deduction for depreciation the amount claimed should be written off. It was, nevertheless, held by the Treasury Department that a depreciation deduction, in order to be allowable, must be so entered upon the books of a corporation as to constitute a liability against its assets. Where a corporation had claimed depreciation without writing off the amount on its books the corporation was permitted to reopen its books, if it so desired, and make such entries as would constitute the amount a liability against the assets of the company, and a charge against the income of the year in which the return was made. Revenue agents were directed to give the taxpayer sufficient time to make such correct entries before the claim for depreciation was disallowed. If a corporation refused or neglected to reopen its books and write off the depreciation claimed in a return the amount claimed was disallowed. If the correct entries were made for preceding years, the amount entered for each year had to be such as would have been entered at the time the books

27 Letter from Treasury Department dated September 19, 1916; I. T. S. 1917, ¶ 1355; Reg. 33, Art. 130.

28 Letter from Treasury Department dated February 12, 1915; I. T. S. 1917, ¶ 1405.

29 Letter from Treasury Department dated May 18, 1916; I. T. S. 1917,

1428.

were closed.30 In a later ruling it was held that, under these acts, writing off of depreciation would not be insisted upon in the adjustment of returns filed for the years 1909 to 1915 inclusive.31 The 1916 Law does not expressly require individuals to enter on their books the annual allowance for depreciation but with respect to domestic corporations it does expressly provide that all losses, including the allowance for depreciation, must be "charged off" within the year.32 As to foreign corporations the Law is silent.

Reserves for Depreciation. In early rulings it was held that depreciation set up on the books and deducted from gross income could not be used for any purpose other than making good the loss sustained by reason of the wear and tear or exhaustion of the property and that if any portion of the depreciation set up was diverted to any purpose other than making good the loss sustained by reason of such depreciation the amount would be disallowed. It was also held that the invest

30 Letter to Collectors dated August 27, 1914; I. T. S. 1917, 1368.

31 T. D. 2481, dated April 10, 1917. In the meantime the courts had held, under the 1909 Law, that the contention that no allowance for depreciation could be claimed unless it was entered on the books of the company, recorded from time to time, was without force (U. S. v. Nipissing Mines Co., 202 Fed. 803) and that the fact that a deduction was incorrectly carried on the books in surplus account did not justify the Government in disallowing it. Forty-Fort Coal Co. v. Kirkendall, 233 Fed. 704. The Supreme Court of the United States declined, in Strattons' Independence Limited v. Howbert, to answer the question as to whether or not a book entry was necessary, since the question was not properly brought before the court in that proceeding.

32 See Act of September 8, 1916, §§ 5 (a), 6 (a), 12 (a) and 12 (b).

ment of depreciation reserve funds in additions, betterments and improvements was not contemplated by the law.33 The present ruling holds that the words "charged off," in the statute, mean that the allowance for depreciation is to be credited to an appropriate reserve account and be carried as a liability against the assets, to the end that when the total of these credits equals the capital investment account no further deductions will be allowed. There is no requirement of law that the funds represented by these reserve liabilities shall be held intact or remain idle against the day when they may be used in making good the depreciation of the property with respect to which the deduction is claimed, or in restoring the capital investment in the depleted assets. The depreciation reserve may be invested in assets of any kind.34

Deduction by Lessees. Where a corporation issues all of its capital stock for cash and expends this capital in the erection of a building upon a plot of land which it holds under lease, the lease requiring the lessee to erect, operate and maintain a building and providing that at the end of the lease the building and improvements then on the land shall be surrendered to the lessor without compensation, the lessee may claim depreciation on the building through annual deductions based on the cost of the building and its estimated life, or the life of the lease, whichever is the shorter.35 This rule would hold true in the case of any tenant who invests capital in permanent improvements or buildings on the real estate of the landlord, unless it is expressly provided by

33 Reg. 33, Arts. 132 and 133, T. D. 2137.

34 T. D. 2481.

35 Letter from Treasury Department dated February 27, 1917; I. T. S. 1917, ¶ 2064.