Sec. 1.167(a)-1. (a) Reasonable allowance. Section 167(a) provides that a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property used in the trade or business or of property held by the taxpayer for the production of income shall be allowed as 1979 U.S. Tax Ct. LEXIS 145">*166 a depreciation deduction. The allowance is that amount which should be set aside for the taxable year in accordance with a reasonably consistent plan (not necessarily at a uniform rate), so that the aggregate of the amounts set aside, plus the salvage value, will, at the end of the estimated useful life of the depreciable property, equal the cost or other basis of the property as provided in section 167(g) and section 1.167(g)-1. * * *

(b) Useful life. For the purpose of section 167 the estimated useful life of an asset is not necessarily the useful life inherent in the asset but is the period over which the asset may reasonably be expected to be useful to the taxpayer in his trade or business or in the production of his income. This period shall be determined by reference to his experience with similar property taking into account present conditions and probable future developments.

Without question, the irrigation system is a vital, integral part of the economic value of the ranch. Absent the system, the ranch would be a bog of little or no worth; with it, the ranch can grow enough feed to fatten 3,300 weaners a year. The system was designed and, for the most part, built1979 U.S. Tax Ct. LEXIS 145">*167 in the 1930's. It has been in continuous operation since its completion.

While it is obvious from the fact that the dragline expenses at issue were incurred that the system was subject to wear and tear, it does not follow that the system was going to expire at some predictable time. In fact, while petitioner indicated that the ranch had not been maintained adequately by its previous owner, it made no effort to describe the condition of the system in terms of its longevity when the ranch was purchased. Furthermore, the evidence affirmatively shows the indeterminability of the system's useful life. The evidence shows that two maintenance policies were open to the partnership. It could institute a program of current repair. Such a program would preserve the system indefinitely. Alternatively, the partnership could decide to dragline periodically when and where necessary to prevent dysfunction. This second policy, the one actually adopted by the partnership, would also preserve the system indefinitely but would preclude the necessity of constant vigilance and maintenance. Both policies have the same effect -- the system is preserved and the ranch continued as a viable economic1979 U.S. Tax Ct. LEXIS 145">*168 unit. These points are relevant to our conclusion with 72 T.C. 1">*12 respect to the treatment to be accorded to the portions of the purchase price paid in 1972 that are properly allocable to the irrigation system.

We hold that the petitioner has failed to prove that the system or any of its nonhardware components had a definite life viewed from the perspective of the date of purchase. Thus, such items are not entitled to an allowance for depreciation. Sec. 1.167(a)-1(a), Income Tax Regs.

A much more difficult question concerns the treatment of the amounts spent by petitioner to keep the system operable, the so-called dragline expenses. In discussing these expenses we do not presume even to attempt to define as words of art such terms as "rehabilitate," "reconstruct," "clean," and "repair." Even though the parties did try to attribute some definitive meaning to the words, our determination does not depend on resolving the semantic problem.

We have noted that the partnership elected to operate the system according to a plan under which any particular system component was allowed to deteriorate until it was almost dysfunctional, at which time it was draglined. In this way the present1979 U.S. Tax Ct. LEXIS 145">*169 system will be maintained at generally its original hydraulic capacity for the foreseeable future. The institution of such a program, as opposed to one of annual maintenance, was its unquestioned right, and we intend no inference herein with respect to this exercise by the partnership of its sound business judgment. Our job is to discern the tax effect of this choice.

The partnership had no intention, and never has had any intention, to alter the ultimate hydraulic capacity of any of the system's canals, laterals, drains, or other ditches. It had no plans to increase, beyond current design limits, the strength of the ranch's levees and checks, or to relocate any canal, lateral, drain, ditch, levee, or check.

Petitioner described in detail at the trial herein how, having once been draglined, the ranch's ditches and levees gradually clog with sediment and tules. When this clogging had gone far enough to affect drastically the ditch's hydraulic capacity, i.e., when it was beginning to have an effect on the productivity of adjacent fields, the partnership cleaned the ditch. It can cost as much to dragline a preexisting ditch as it did to build it originally. Thus, petitioner claims1979 U.S. Tax Ct. LEXIS 145">*170 that the partnership should be allowed to depreciate all its ditches on their cost basis over 10 72 T.C. 1">*13 years and then capitalize and depreciate the costs of draglining the ditch to reopen it.

While respondent does not precisely spell out his position, he states his view on brief that "the depreciation issue * * * should be disposed of by the Court's finding * * * that the earthwork at issue, given adequate maintenance, would have an indefinite useful life." Presumably he is taking the uncharacteristic position that the petitioner should deduct currently all expenses incurred to maintain the system.

Thus, we are faced with something of a conundrum, how do we treat a maintenance-type expense substantial in amount, which only restores its subject to its original operating condition, yet need be repeated only on the average of every 10 years and is performed on a subject of indefinite life. ⁴

1979 U.S. Tax Ct. LEXIS 145">*171 To permit a current deduction of such a large expenditure with a beneficial effect lasting on the average of 10 years would surely distort that years's income. Yet to deny even an amortization deduction for an expenditure with a specific demonstrable beneficial life on the grounds that its deductibility is contaminated by its relationship to an asset of indefinite life, i.e., the land, would similarly require an uneven reporting of income.

Since a basic premise of the income tax laws is to relate expenses to the income which they helped earn, a reasonable solution to our conundrum is to hold that the expenses in issue should be written off over their useful life. In short we would subscribe independent status to those expenditures on the basis that they create a free-standing intangible asset with an amortizable 10-year life.

In reaching this conclusion we turn to sections 162 and 263 for support. Section 162 reads in relevant part:

(a) In General. -- There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business * * *

Section 1.162-4, Income Tax Regs., says:

Sec. 1.162-4. Repairs.

The1979 U.S. Tax Ct. LEXIS 145">*172 cost of incidental repairs which neither materially add to the value of 72 T.C. 1">*14 the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted as an expense, provided the cost of acquisition or production or the gain or loss basis of the taxpayer's plant equipment, or other property, as the case may be, is not increased by the amount of such expenditures. Repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, shall either be capitalized and depreciated in accordance with section 167 or charged against the depreciation reserve if such an account is kept.

Section 263 says in material part:

SEC. 263. CAPITAL EXPENDITURES.

(a) General Rule. -- No deduction shall be allowed for --

(1) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. This paragraph shall not apply to --

* * * *

* * * *

(2) Any amount expended in restoring property or in making good the exhaustion thereof for which1979 U.S. Tax Ct. LEXIS 145">*173 an allowance is or has been made.

Section 263(a) refers only to expenditures which increase the value of any property or estate and to permanent improvements. The regulations add another category of capital expenditures, i.e., those that "substantially prolong the useful life" of the property or estate or adapt the property to a new use. Sec. 1.263(a)-1(b), Income Tax Regs.

Thus an expense which is "incidental" is currently deductible and is not a capital expenditure. If the repair is an improvement or replacement, or if it increases the property's value or substantially prolongs its useful life, it is capital in nature and is not currently deductible.

The cases have adopted a practical case-by-case approach in applying these principles to the facts before them. The seminal case of Illinois Merchants Trust Co., Executor v. Commissioner, 4 B.T.A. 103">4 B.T.A. 103 (1926), dealt with a petitioner who owned a building part of which was built on wooden pilings over the Chicago River. The water level of the Chicago River suddenly receded exposing the upper end of these wooden pilings to dry rot. Soon, as a result of dry rot, one end of the building began to collapse. 1979 U.S. Tax Ct. LEXIS 145">*174 To correct the problem, petitioner had to shore up the building, cut the rotten ends of the pilings off below the new water line, and then replace the severed sections with concrete pilings. The 72 T.C. 1">*15 taxpayer expensed the cost of these repairs arguing that they were only "incidental repairs." Respondent argued that the expenditures were capital in nature because they were "repairs in the nature of replacements." 4 B.T.A. 103">Illinois Merchants Trust Co., Executor v. Commissioner, supra at 106. In resolving the controversy we said at page 106:

In determining whether an expenditure is a capital one or is chargeable against operating income, it is necessary to bear in mind the purpose for which the expenditure was made. To repair is to restore to a sound state or to mend, while a replacement connotes a substitution. A repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition. It does not add to the value of the property, nor does it appreciably prolong its life.

The Board went on to find that the expenditures at issue "did not add to the value or prolong the expected life of the property over what [it1979 U.S. Tax Ct. LEXIS 145">*175 was] before the event which made the repairs necessary" and held for the taxpayer.

In Mountain Fuel Supply Co. v. United States, 449 F.2d 816">449 F.2d 816 (10th Cir. 1971), the court dealt with the rehabilitation of gas pipelines. The taxpayer had expensed the costs of "digging up, cutting, removing, hauling, straightening, cleaning, spotwelding the corrosion pits, removal of defective sections, beveling, bending, reopening trenches, rewelding, relaying, testing and burying of all the old pipe returned to service." 449 F.2d 816">Mountain Fuel Supply Co. v. United States, supra at 818. Approximately 90 percent of the old pipes removed from the ground were reconditioned and replaced in service. The court held that these expenses were capital in nature. In reaching this conclusion the court focused on the fact that reconditioning the pipes increased their capacity to withstand loads of gas, imparted a new useful life to the pipes, and was done pursuant to a plan of rehabilitation "well defined in scope and * * * of considerable significance in view of [taxpayers] overall operations." 449 F.2d 816">Mountain Fuel Supply Co. v. United States, supra at 821, 822.1979 U.S. Tax Ct. LEXIS 145">*176

In contrast to the court in the Mountain Fuel Supply Co. case, the court in Niagara Mohawk Power Corp. v. United States, 214 Ct. Cl. 686">214 Ct. Cl. 686, 558 F.2d 1379">558 F.2d 1379 (1977), dealt with the costs of repairing leaks in pipes. The court there found that the repair expenses did "not increase the value of the cast iron pipelines in comparison with their original leak-free condition," Niagara Mohawk Power Corp. v. United States, 214 Ct. Cl. 686">214 Ct. Cl. at 699, 558 F.2d 1379">558 F.2d at 1387, and 72 T.C. 1">*16 did not increase the pipeline's useful life. Further, the court found that the repairs were not part of a systematic improvement plan.

This Court dealt with similar issues in the case of Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333">39 T.C. 333 (1962). In that case, petitioner had cleaned and lined with cement certain lengths of pipe. We found that (39 T.C. 333">39 T.C. 337):

The repair did not form a part of an overall plan of improvement[,] [the] cleaning and lining did not materially increase the useful life, value, or structural strength of the pipes involved, nor did it render1979 U.S. Tax Ct. LEXIS 145">*177 those pipes suitable for any new or additional use * * *

Not surprisingly, we concluded that the amounts in issue were currently deductible.

The ranch's ditches can be analogized to the pipelines discussed in the Mountain Fuel Supply Co. and Niagara Mohawk Power Corp. cases. In our case, the system has an indeterminable useful life and is of itself, therefore, nondepreciable. In Mountain Fuel Supply Co., the old pipe had been totally depreciated and had reached the end of its useful life. Both the pipe and the system were subject of great expenditures which were part of a plan of rehabilitation. While in the Mountain Fuel Supply Co. case the effects of these expenditures were inseparable from the pipe itself and would be of value only for a period equal to the new useful life of the pipe, in our case the expenditures create a separate amortizable intangible of a useful life much shorter than that of the system. In both cases, the costs must be capitalized.

In Bayou Verret Land Co. v. Commissioner, 450 F.2d 850">450 F.2d 850, 450 F.2d 850">857-858 (5th Cir. 1971), the court dealt with road work involving the rebuilding of a levee. Before the work was done, 1979 U.S. Tax Ct. LEXIS 145">*178 the levee was 50 to 78 percent under water. After its completion, the levee was uniform in height and topped with an all-weather road. The court found that the work done was not "ordinary" in the section 162 sense and had prolonged the levee's useful life. See Commissioner v. Tellier, 383 U.S. 687">383 U.S. 687, 383 U.S. 687">689-690 (1966). Petitioner, referring to the partnership's draglining work, said on brief "It is work not of ordinary and frequent character, but rather is extraordinary, done only once over a period of years." We agree. That is the reason these expenses cannot be currently deducted. This does not require, however, that we also hold that a system 72 T.C. 1">*17 already in existence for over 40 years and with no end in sight is depreciable on a 10-year basis.

Thus, the cases in this area have focused on both value and useful life and whether the particular expenditure at issue was made pursuant to a larger plan the purpose and effect of which was to increase the value or extend the useful life of the item involved. Those cases which have held an expense currently deductible have also found that the expense did not substantially increase the repaired item's 1979 U.S. Tax Ct. LEXIS 145">*179 value or original useful life. See Pacific Fruit Express Co. v. Commissioner, 60 T.C. 640">60 T.C. 640, 60 T.C. 640">646 (1973); Honigman v. Commissioner, 55 T.C. 1067">55 T.C. 1067, 55 T.C. 1067">1080 (1971).

Applying the principles of these cases to the peculiar facts before us we consider several points to be important: The subject expenditures are part of a systematic plan under which most of the earthworks on the ranch will be draglined. Thus the dragline expenditures have a significant impact on the value of the system. A cleaned ditch or reworked levee is of more value than is one in need of repair. A more efficient system renders the ranch more productive and valuable. We also believe that, to the extent that the expenditures have the effect of replacing the previously wasted intangible created by the last draglining of the subject ditch or levee, they have a substantial impact on the value of the system, as well as producing a separate item of value. Related to this point is the magnitude of the expenditures themselves. Petitioner indicates that it can cost as much to dragline a ditch as it did to construct one originally. See Zumwalt v. Commissioner, 25 B.T.A. 566">25 B.T.A. 566 (1932).1979 U.S. Tax Ct. LEXIS 145">*180

Secondly, we consider important the fact that the expenditures in issue produce an item of value which is not used up by the end of the taxable year in which made. Indeed, many of these expenditures produce value which is used up only gradually over the course of up to 30 years. Thirdly, these expenditures will affect the ranch's production of income over a course of many years. In the case of, for example, general field ditches, these expenditures will have an effect on the ditch's efficiency and hence on the ranch's production of income for up to 10 years. Finally, we note that the item of value produced wastes over a predeterminable useful life (see n. 4 supra). Any particular ditch, levee, or canal is less efficient and more clogged with sediment and tule growth at the end of any year than it was the year before. Each year, part of the value and effect of the last 72 T.C. 1">*18 draglining operation on that part of the system is used up -- until at the end of 10 years the whole value has been used up and the ditch again needs to be draglined. In sum, these expenditures are more than merely "incidental." They are, rather, in the nature of capital "replacement" expenditures1979 U.S. Tax Ct. LEXIS 145">*181 which must be capitalized and amortized over their appropriate useful lives, i.e., 5 years for field checks, 10 years for ditches, 30 years for large levees and canals. ⁵ See n. 4 supra. See sec. 1.167(a)-3, Income Tax Regs.

1979 U.S. Tax Ct. LEXIS 145">*182 Turning now to the matter of the depreciable basis of the irrigation system's hardware, i.e., its valves, pipes, pumps, concrete dams, etc. (for which the parties have stipulated a 20-year useful life), it is necessary to determine the actual fair market value of the ranch and its component parts as of its sale date, November 1, 1972. If the amount actually paid for the ranch and its component parts differs from the ranch's fair market value as of the sale date, then the basis allocation for depreciation purposes must be based on the relative actual fair market value of the ranch and its component parts. Sec. 1.167(a)-5, Income Tax Regs.

Both parties had valuation experts who testified at the hearing held herein. Respondent's expert, Philip G. Rodwell (Rodwell), valued the ranch at $ 7 million or approximately $ 2,500,000 more than petitioner actually paid for it. Rodwell allocated most of this increased value to the M.C.'s land -- which is, of course, not depreciable. For valuation purposes, Rodwell refused to attribute a value to the irrigation system independent from the land. Rodwell would thus increase the value of the M.C.'s nondepreciable assets in relation to the ranch's1979 U.S. Tax Ct. LEXIS 145">*183 depreciable assets. This change in the percentage values of the depreciable and nondepreciable items would effect a reduction in cost basis allowable to the depreciable items in the system: While the 72 T.C. 1">*19 partnership allocated $ 943,389.63 of its purchase price to the system including its earthenworks, respondent would give the system hardware a fair market value on date of purchase of $ 271,000. Since $ 271,000 is 3.87 percent of $ 7 million, respondent would give petitioner a cost basis in the system hardware of 3.87 percent of $ 5,050,000 or $ 195,000.

Petitioner claims a fair market value as of November 1, 1972, for the ranch of $ 4,333,000. This valuation claim was presented by petitioner's expert Elmer Kolberg (Kolberg). Kolberg used the so-called "comparable sales" method of valuing the ranch as of November 1, 1972, the date the partnership purchased it. This method does not appear to be inconsistent with the approach taken by respondent's expert. ⁶ The "comparable sales" method functions by: (1) Locating ranches as physically similar (comparable) as possible to the subject ranch which (2) have been sold on the open market in noncollusive, nonforced sales for cash1979 U.S. Tax Ct. LEXIS 145">*184 or cash equivalent, within (3) a reasonable time of the date for which a value of the subject property is desired. Once these ranches are located, those features of the ranch being valued which are most pertinent to its value are compared to those same features on the comparable ranches. Since no two sales and no two ranches can be identical, the value of those features of the comparable ranches which are relevant to the value of the subject ranch are adjusted until they are of a condition or quality equivalent to those of the subject ranch. The effect of these adjustments on the estimated value of the comparable ranches will give the valuator an indication of the value of the subject property on the relevant date. Like most valuation techniques, the comparable sales method is far from an exact science. However, it is based upon the commonsense approach of taking the actual sales prices of properties similar to the subject property and then relating these prices to the subject property. We believe this valuation method to be a reasonable one and will use it here. This Court has used it often in the past. See Estate of Fawcett v. Commissioner, 64 T.C. 889">64 T.C. 889, 64 T.C. 889">899 (1975);1979 U.S. Tax Ct. LEXIS 145">*185 Estate of Nail v. Commissioner, 59 T.C. 187">59 T.C. 187, 59 T.C. 187">193 (1972).

The validity of the comparable sales valuation method depends to a great extent upon the comparables selected and the 72 T.C. 1">*20 reasonableness of the adjustments made thereto. Of the two valuation reports before us, the one by petitioner's expert Kolberg is the most useful in determining the ranch's November 1, 1972, fair market value. Kolberg began by isolating seven comparable sales one of which was the sale of the ranch itself in 1967. Kolberg attempted to limit his comparables to ranches with carrying capacities of over 3,000 AU's. Kolberg testified that it was his opinion, based upon his experience, that ranches over that size were of a totally different sort than ranches under that size. By thus limiting his comparables, Kolberg hoped to eliminate carrying capacity as a 1979 U.S. Tax Ct. LEXIS 145">*186 comparable needing adjustment. ⁷

Kolberg then listed nine factors or comparables which he considered and adjusted in deriving his total value for the ranch of $ 4,333,000. These comparables include the ratio of fee-owned to leased land; the ranch's dependency on BLM permits; the ratio of irrigated to range land; the ranch's location (its proximity to highways, schools, hospitals, population centers, etc.); the ranch's recreational possibilities (called by Kolberg "amenities"); its probable efficiency of cattle production (i.e., whether the cattle had to be trucked between ranges, etc.); the ranch's water rights and its efficiency in its use of water; the ranch's physical improvements such as buildings, residences (and presumably feedlots); whether the comparable ranch was forced-sold or not; and finally, the time of the sale (so that factors such as inflation and increasing land values could1979 U.S. Tax Ct. LEXIS 145">*187 be factored in).

Each of these factors was compared to its counterpart on the M.C. and either revalued, or devalued, to reflect Kolberg's estimate of the increase or decrease in the sales price of the comparable ranch that would have occurred had the factor been of the quality possessed by the ranch. This refined comparable ranch, and its estimated value, was then compared to the ranch, and a value for the ranch as of the applicable date, November 1, 1972, derived.

It would appear that, in the comparable sales method of valuation, the actual percent adjustment for any one factor is dependent to a great degree upon the appraiser's own professional 72 T.C. 1">*21 judgment. We are satisfied that Kolberg's selection of comparables was reasonable and that his adjustments thereto were based upon sound judgment and a detailed knowledge of all the properties mentioned in his report.

In contrast to Kolberg's report, respondent's expert was much more conclusory in presenting his opinion. Although he too listed a series of ranches the values of which he felt would substantiate his final estimation of M.C.'s value at $ 7 million, the Court was not informed of his reasoning in reaching that final1979 U.S. Tax Ct. LEXIS 145">*188 price. Further, we note that the reliability of this expert's opinion was severely compromised by several errors in his calculations which surfaced during the trial held herein.

Thus, we accept petitioner's valuation of the ranch -- with some adjustments. We do not think that petitioner's expert took sufficient account of the increase in irrigated acres which occurred between 1967 and 1972. These acres should increase crop production north of Highway 140 and, therefore, should create a supply of grains in excess of that available in previous years -- a supply which may be used in the ranch's feedlot. We have already noted that feedlot income is approximately equal to general ranch income. While the feedlot may not be appropriately located for commercial use, it fits in well with the Wolfsens' plan for vertical integration of their operations. Given increased crop production, the total carrying capacity for the base ranch may be increased which could cause a reflective increase in the M.C.'s allotment of BLM AUM's. Further, the incidence of importing weaners for fattening on the M.C. could increase.

We settle on a value for the ranch of $ 5 million.

Decision will be entered1979 U.S. Tax Ct. LEXIS 145">*189 under Rule 155.