Sec. 1.446-1 General rule for methods of accounting.

(c) Permissible methods -- (1) In general. Subject to the provisions of paragraphs (a) and (b) of this section, a taxpayer may compute his taxable income under any of the following methods of accounting:

* * * *

(iv) Combinations of the foregoing methods. (a) In accordance with the following rules, any combination of 1965 U.S. Tax Ct. LEXIS 89">*108 the foregoing methods of accounting will be 44 T.C. 159">*167 permitted in connection with a trade or business if such combination clearly reflects income and is consistently used. Where a combination of methods of accounting includes any special methods, such as those referred to in subdivision (iii) of this subparagraph, the taxpayer must comply with the requirements relating to such special methods. A taxpayer using an accrual method of accounting with respect to purchases and sales may use the cash method in computing all other items of income and expense. However, a taxpayer who uses the cash method of accounting in computing gross income from his trade or business shall use the cash method in computing expenses of such trade or business. Similarly, a taxpayer who uses an accrual method of accounting in computing business expenses shall use an accrual method in computing items affecting gross income from his trade or business.

(b) A taxpayer using one method of accounting in computing items of income and deductions of his trade or business may compute other items of income and deductions not connected with his trade or business under a different method of accounting.

The Commissioner's regulations 1965 U.S. Tax Ct. LEXIS 89">*109 under section 446 are replete with expressions of the requirement that methods of accounting be regular, consistent, and clearly reflect income. ^{101965 U.S. Tax Ct. LEXIS 89">*110 1965 U.S. Tax Ct. LEXIS 89">*111}

Petitioner has stipulated that his failure to include the fair market value of all first trust deed notes in the computation of taxable income 44 T.C. 159">*168 for the years in which they were received was erroneous. He has made no effort to present evidence as to how and why he determined that an arbitrary number of identical first trust deed notes received in each year were "deferred contracts" to be deducted from gross receipts, while the rest were to be included in the computation of taxable income.

The parties have stipulated a typical example of petitioner's practices in reporting his income from the sale of houses as follows:

As we understand the evidence presented to us, an arbitrary change of the number of first trust deed notes deducted in item (5) of the example, supra, would typify petitioner's practice from year to year. Petitioner claims this to have been his "regular" practice throughout the years. If this is so, then we find that petitioner has been regularly inconsistent throughout the years. As was said in Advertisers Exchange, Inc., 25 T.C. 1086">25 T.C. 1086 (1956), affirmed per curiam 240 F.2d 958 (C.A. 2, 1957), at page 1092:

44 T.C. 159">*169 Consistency is the key and is required regardless of the method or system of accounting used. Beacon Publishing Co., 21 T.C. 610">21 T.C. 610, revd. 218 F.2d 697; Curtis R. Andrews, 23 T.C. 1026">23 T.C. 1026; E. W. Schuessler, 24 T.C. 247">24 T.C. 247; United States v. Mitchell, 271 U.S. 9">271 U.S. 9; Cecil v. Commissioner, 100 F.2d 896. ¹¹

Petitioner has stipulated his income 1965 U.S. Tax Ct. LEXIS 89">*113 tax returns were prepared essentially on the cash receipts and disbursements basis and that the profit-and-loss schedule (Schedule C) was filed on a basis similar to a completed-contract method. The ordinary meaning of the cash receipts and disbursements method is set forth in section 1.446-1(c)(1)(i), Income Tax Regs.:

Sec 1.446-1 General rule for methods of accounting.

(c) Permissible methods -- (1) In general. * * *

(i) Cash receipts and disbursements method. Generally, under the cash receipts and disbursements method in the computation of taxable income, all items which constitute gross income (whether in the form of cash, property, or services) are to be included for the taxable year in which actually or constructively received. Expenditures are to be deducted for the taxable year in which actually made. * * * [Emphasis supplied.]

If we assume that petitioner filed his income tax returns on this method, then certainly his deduction from gross receipts of the face amount of an arbitrary number of the first trust deed notes received each year was inconsistent with the method and as a result prevented proper reflection of his income from the sale of houses. As we have already set 1965 U.S. Tax Ct. LEXIS 89">*114 forth, petitioner has stipulated all of such notes had a fair market value and that his practice was erroneous.

Petitioner contends he reported his receipts from the building of houses on a "deferred contract" basis while respondent contends petitioner really reported the receipts on an installment basis. Since we have reserved this question to be considered as issue 2 of this opinion, we merely note at this point that petitioner's practice was consistent with neither method. The rules for the treatment of a sale of real property on the installment method are set forth in section 1.453-5(a), Income Tax Regs.:

Sec. 1.453-5 Sale of real property treated on installment method.

(a) In general. In any transaction described in paragraph (b) (1) of § 1.453-4, that is, sales of real property in which there are no payments during the year of sale or the payments in that year do not exceed 30 percent of the selling price, the vendor may return as income from each such transaction in any taxable year that proportion of the installment payments actually received in that year which the gross profit (as described in paragraph (b) of § 1.453-1) realized or to be realized when the property is paid 1965 U.S. Tax Ct. LEXIS 89">*115 for bears to the total contract price. In any case, the sale of each lot or parcel of a subdivided tract must be treated as a separate transaction and gain or loss computed accordingly. (See paragraph (a) of § 1.61-6.)

44 T.C. 159">*170 An ordinary reading of these rules reveals that a taxpayer who reports income from the sale of real property on the installment method, each year reports as gain that proportion of the installment payments received in the year which the gross profit realized, or to be realized, on the sale bears to the total contract price. Thus, if a house cost $ 50,000 to build and was sold for $ 100,000, the gross profit realized (or to be realized) would be $ 50,000; assuming the sales contract provided for no downpayment in the year of sale and $ 10,000 payments in each of the succeeding 10 years, and the seller elected to return the receipts of the sale on the installment method, the seller would report as income $ 5,000 ($ 50,000/$ 100,000 X $ 10,000) in each year as payment was received; the unreported other half of the payments would be a return of basis to the seller. Petitioner's practice of excluding an arbitrary amount of notes from income each year while deducting the 1965 U.S. Tax Ct. LEXIS 89">*116 costs attributable to such notes in the same year was completely inconsonant with the installment method. Also, petitioner has completely disregarded the requirement set forth in the last sentence of section 1.453-5(a), Income Tax Regs., supra, that each sale be treated separately.

The rules for a deferred-payment sale of real property not on the installment method are set forth in section 1.453-6(a) (1) and (2), Income Tax Regs.:

Sec. 1.453-6 Deferred-payment sale of real property not on installment method.

(a) Value of obligations. (1) In transactions included in paragraph (b) (2) of § 1.453-4, that is, sales of real property involving deferred payments in which the payments received during the year of sale exceed 30 percent of the selling price, the obligations of the purchaser received by the vendor are to be considered as an amount realized to the extent of their fair market value in ascertaining the profit or loss from the transaction. Such obligations, however, are not considered in determining whether the payments during the year of sale exceed 30 percent of the selling price.

(2) If the obligations received by the vendor have no fair market value, the payments in cash or other 1965 U.S. Tax Ct. LEXIS 89">*117 property having a fair market value shall be applied against and reduce the basis of the property sold and, if in excess of such basis, shall be taxable to the extent of the excess. Gain or loss is realized when the obligations are disposed of or satisfied, the amount thereof being the difference between the reduced basis as provided in the preceding sentence and the amount realized therefor. Only in rare and extraordinary cases does property have no fair market value.

Though petitioner claims this was the method he employed in reporting receipts from the sale of houses, petitioner's practice only vaguely resembled the deferred-payment treatment which requires the inclusion in income of the fair market value of all notes received. We agree with the conclusion of respondent's expert accounting witness that, whatever the method of accounting used by petitioners, there were 44 T.C. 159">*171 inconsistencies in its application and that the correction of those inconsistencies does not constitute a change of accounting method. We acknowledge that this testimony is not dispositive of the legal issue of whether or not respondent changed petitioner's method of accounting. However, general accounting principles 1965 U.S. Tax Ct. LEXIS 89">*118 cannot be ignored in determining whether petitioner had a "method" of accounting, what it was, and whether or not it was consistently applied. We find that petitioner used the cash receipts and disbursements method of accounting which he inconsistently applied to his receipts from the sale of houses; that the inconsistent application of such method resulted in an improper reflection of income; and that respondent did not change petitioner's method of accounting for the purposes of section 446 but merely corrected certain errors in his method which were resulting in the exclusion from gross receipts of certain amounts which should have been included therein. Consequently, the provisions of section 481^{121965 U.S. Tax Ct. LEXIS 89">*119} do not apply to respondent's correction of those errors in petitioner's accounting method.

On December 1, 1955, petitioner and Gladys divided their community property pursuant to a property settlement agreement which was included in a subsequent decree of divorce dated April 16, 1956. Petitioner and Gladys disposed of certain first trust deed notes to each other pursuant to the division of community property. By amended answer filed in docket No. 81795, respondent determined the notes disposed of between petitioner and Gladys were installment obligations within the meaning of section 453(d). Since this issue is raised affirmatively by respondent, he has the burden of proof. Rule 32, Tax Court Rules of Practice; Kimbell-Diamond Milling Co., 10 T.C. 7">10 T.C. 7, 10 T.C. 7">13 (1948); Hollywood Baseball Association, 42 T.C. 234">42 T.C. 234, 42 T.C. 234">264 (1964), on appeal (C.A. 9, Aug. 1965 U.S. Tax Ct. LEXIS 89">*120 31, 1964).

Respondent contends that although petitioner has labeled the first trust deed notes deducted from gross receipts as "deferred contracts," the notes were, and were treated as, installment obligations within the 44 T.C. 159">*172 meaning of section 44 of the Internal Revenue Code of 1939^{131965 U.S. Tax Ct. LEXIS 89">*121} and section 453. ^{141965 U.S. Tax Ct. LEXIS 89">*122 1965 U.S. Tax Ct. LEXIS 89">*123} Respondent further contends the disposition of these notes between petitioner and Gladys was a taxable disposition and that thus the provisions of section 453(d) apply. ¹⁵

44 T.C. 159">*173 Petitioner contends the 1965 U.S. Tax Ct. LEXIS 89">*124 notes involved were not installment obligations within the meaning of either section 44 of the 1939 Code or section 453; that respondent has the burden of proof as to this issue and has not carried it; and that, if respondent has carried his burden of proof, he has determined the deficiency for the wrong year, i.e., 1955 instead of 1956. In holding for the petitioner on this issue, we find respondent has not carried his burden of proving that the first trust deed notes disposed of between petitioner and Gladys were installment obligations.

As we have set forth above, petitioner's treatment of receipts from the sale of houses was consonant with neither the installment method as set forth in section 1.453-5, Income Tax Regs., nor the deferred-payment treatment not on the installment method set forth in section 1.453-6, Income Tax Regs.¹⁶

The parties have stipulated that petitioner's treatment of the receipts from the sale of houses was erroneous and petitioner should have included 1965 U.S. Tax Ct. LEXIS 89">*125 83 percent of the face value of each first trust deed note in the computation of taxable income for the years in which such notes were received. Respondent has adjusted petitioner's taxable income for the years in question in light of this determination. Thus, respondent has adjusted petitioner's practices to fit squarely within the guidelines set forth in section 1.446-1(c)(1)(i), Income Tax Regs., supra, relating to the cash receipts and disbursements method of accounting, which require that all items of gross income be included in the year of actual or constructive receipt.

There is no question that the fair market value of all the first trust deed notes should have been included in gross receipts for the purpose of computing petitioner's taxable income on the cash basis method. Section 61 and the regulations thereunder provide, in part:

SEC. 61. GROSS INCOME DEFINED.

(a) General Definition. -- Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:

* * * *

(2) Gross income derived from business; [Emphasis supplied.]

(a) In general. 1965 U.S. Tax Ct. LEXIS 89">*126 In a manufacturing, merchandising, or mining business, "gross income" means the total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources. * * * The cost of goods sold should be determined in accordance with the method of accounting consistently used by the taxpayer. [Emphasis supplied.]

44 T.C. 159">*174 Section 1001 and the regulations thereunder provide, in part:

SEC. 1001. DETERMINATION OF AMOUNT OF AND RECOGNITION OF GAIN OR LOSS.

(a) Computation of Gain or Loss. -- The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.

(b) Amount Realized. -- The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received. * * * [Emphasis supplied.] Sec. 1.1001-1 Computation of gain or loss.

(a) General rule. Except as otherwise provided in subtitle A of the Code, the gain or loss 1965 U.S. Tax Ct. LEXIS 89">*127 realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent, is treated as income or as loss sustained. The amount realized from a sale or other disposition of property is the sum of any money received plus the fair market value of any property (other than money) received. The fair market value of property is a question of fact, but only in rare and extraordinary cases will property be considered to have no fair market value. * * * [Emphasis supplied.]

Of course, a cash basis taxpayer may report deferred payments on the installment method. Under section 44 of the Internal Revenue Code of 1939¹⁷ taxpayers had the option of returning sales income on the installment basis under rules set forth in the Commissioner's regulations under such section. Section 453¹⁸ gives taxpayers the same option with the further requirement, set forth in section 1.453-1(a), Income Tax Regs., that a taxpayer must make an affirmative election. Petitioner has neither reported his receipts from the sale of houses nor elected to report such receipts on the installment method.

Petitioner, 1965 U.S. Tax Ct. LEXIS 89">*128 as we have shown above, did not employ the installment method and respondent's adjustments have completely obliterated whatever resemblance petitioner's practices bore to such method. In holding that respondent has not carried his burden of proof as to this issue, we find it unnecessary to determine whether the dispositions of notes between petitioner and Gladys were taxable or whether respondent determined the deficiency for the proper taxable year.

The third issue is whether the discount income received by petitioner should be returned as a proportion of each payment received or only after there has been a complete return of principal. This question has arisen because of the parties' stipulation that the first trust deed notes had a fair market value of 83 percent of face value.

44 T.C. 159">*175 Petitioner contends he is entitled to a complete return of his 83-percent principal before he must report the 17-percent discount income. Respondent contends the first trust deed notes are not speculative and, therefore, petitioner must treat 17 percent of each payment as income.

The parties agree that if the first trust deed notes are held not to be speculative in nature, 17 percent of each payment 1965 U.S. Tax Ct. LEXIS 89">*129 on the notes will be discount income. Shafpa Realty Corporation, 8 B.T.A. 283">8 B.T.A. 283 (1927). Petitioner, in contending that the notes in question were speculative, cites Morton Liftin, 36 T.C. 909">36 T.C. 909 (1961), affd. 317 F.2d 234 (C.A. 4, 1963), and Phillips v. Frank, 295 F.2d 629 (C.A. 9, 1961). Respondent cites the same cases for the proposition that the notes were not speculative.

In 36 T.C. 909">Morton Liftin, supra, cash basis taxpayers received periodic payments in 1954, 1955, and 1956 on 84 interest-bearing second deed of trust notes which were purchased at discounts of up to 45 percent. The Commissioner determined a proportionate part of each principal payment received on each note, measured by the percentage of discount at which the note was purchased, constituted ordinary income to the taxpayer in the year of payment. Taxpayers claimed they were entitled to a complete return of the amount paid for the contracts before the discount income was to be returned. In holding for the petitioner, the Court said, in part, at page 911:

After a consideration of the cited cases and also of the general statutory provisions (see May D. Hatch, supra [14 T.C. 237] at 242-243), we conclude that a rule of law 1965 U.S. Tax Ct. LEXIS 89">*130 applicable to the instant case may be stated as follows: Where a taxpayer acquires at a discount contractual obligations calling for periodic payments of parts of the face amount of principal due, where the taxpayer's cost of such obligations is definitely ascertainable, and where there is no "doubt whether the [contracts] [will] be completely carried out" (Hatch v. Commissioner, supra [190 F.2d 254, reversing in part May D. Hatch, supra] at 257), it is proper to allocate such payments, part to be considered as a return of cost and part to be considered as the receipt of discount income; but, conversely, where it is shown that the amount of realizable discount gain is uncertain or that there is "doubt whether the contract [will] be completely carried out," the payments should be considered as a return of cost until the full amount thereof has been recovered, and no allocation should be made as between such cost and discount income.

In the instant case the petitioner, who of course has the burden of proof, has shown to our satisfaction that the amount of realizable discount income to be derived from the contractual obligations here in question was uncertain. That the notes were highly 1965 U.S. Tax Ct. LEXIS 89">*131 speculative is evidenced by the substantial discounts (up to 45 percent) at which they were purchased, and the quality of the security which was junior to a first deed of trust (up to 60 to 80 percent of the selling price of the property). The evidence is that makers of the notes had but small equities in the properties covered by the deeds of trust because of their small cash payments to the sellers. When purchasing notes petitioner gave consideration to the length of time the loan was to run, to the holder's equity in the property, sometimes to his credit standing, and generally to the location and 44 T.C. 159">*176 condition of the property covered by the trust deed after what he called "an outside inspection." During the few years in question about 19 of the 84 notes were disposed of, about half of them were disposed of by payment in full while the other half were disposed of by foreclosure, the acceptance by the petitioner of a deed, or the acceptance by the petitioner of less than face for an early payoff. It was petitioner's experience that the latter half of the notes so disposed of resulted in his receiving less than the face value of the notes. [Emphasis supplied.]

The Court of Appeals, 1965 U.S. Tax Ct. LEXIS 89">*132 in affirming, said in part, at pages 234-235:

The Tax Court's redetermination was based upon the fully warranted and pivotal factual finding: that, as asserted by the taxpayers, the notes were "highly speculative" and "the amount of realizable discount gain", therefore, remained uncertain until collections on the principal of the notes exceeded their cost to the taxpayers.

In Phillips v. Frank, supra, cash basis taxpayers received periodic payments in 1955, 1956, and 1957 on real estate contracts or first trust deeds which they had purchased at a discount. The Commissioner determined that a percentage of each payment, in proportion to the total discount, was discount income. Taxpayer claimed he was entitled to a complete return of the amount paid for the contracts before any discount income was to be returned. The District Court found for the Commissioner. The Court of Appeals in reversing the District Court's decision said in part, at pages 633, 634:

The taxpayer recognizes that when periodic payments on each contract equal the purchase price of such contract, payments received by taxpayer in each year subsequent thereto must be treated as ordinary income in the year of receipt. 1965 U.S. Tax Ct. LEXIS 89">*133 Such is the law. Lee v. Commissioner of Internal Revenue, 7 Cir., 1941, 119 F.2d 946. The simple question presented on this appeal is: Did the cash basis taxpayer receive during the years under review any payments of which a portion should be allocated to and considered for tax purposes as payment of a portion of the profit which the taxpayer hopes to realize? Taxpayer received for his capital invested the right to receive the unpaid balances due on such contract. What were such rights worth when purchased?

There is no evidence in the record that such rights had any market value, fair or unfair, or any other value in excess of taxpayer's costs. There is no evidence in the record that taxpayer at any time could have sold such contracts at a profit. The only source from which he might reasonably expect to realize any part of his profit is from periodic payments subsequent to the return to him of his invested capital. The fact that the likelihood of realizing a profit might increase as the amount of his investment decreases from receipt of periodic payments does not convert any part of such payments into payments on the hoped for or expected profit. Clearly, the payments received 1965 U.S. Tax Ct. LEXIS 89">*134 by taxpayer during the period under review aggregating less than his costs constitute a return of capital. A return of capital is not income. [Emphasis supplied.]

Both of the above decisions were based on the fact that the obligations in question were highly speculative. In 36 T.C. 909">Morton Liftin, supra, it was found that the notes were speculative because they were acquired at up to 45-percent discount, were junior securities, payment was uncertain, 44 T.C. 159">*177 and of the notes disposed of, one-half were through foreclosure or receipt of an amount less than face. The contracts in Phillips v. Frank, supra, were of a similarly speculative nature because it was found that the contracts were difficult to sell, had no fair market value, and losses through default were experienced. Petitioner cites as support for his argument the language on page 634 of Phillips v. Frank, supra, which reads:

The fact that the likelihood of realizing a profit might increase as the amount of his investment decreases from receipt of periodic payments does not convert any part of such payments into payments on the hoped for or expected profit. * * *

However, petitioner ignores the fact that the immediately preceding language 1965 U.S. Tax Ct. LEXIS 89">*135 sets forth that the contracts in question had no fair market value and were difficult to sell. Petitioner himself agrees that: (1) All the first trust deed notes he received had a fair market value of 83 percent of face value; (2) no foreclosures ever occurred with respect to any of the 50 notes he received from 1947 through 1956; (3) on occasion the notes, although not seasoned, ¹⁹ were valued and accepted at face amount by independent parties (in fact, as we have set forth above, petitioner himself valued those notes which he did not exclude from gross receipts at 100 percent of face value); and (4) the value of the property securing all of the notes was always in excess of the unpaid balances on the notes.

Petitioner contends the fact that the interest rate on the first trust deed notes received in 1955 and 1956 was 5 percent, while the prevailing marketplace rate of interest on similar notes in the same years was at least 6 1965 U.S. Tax Ct. LEXIS 89">*136 percent, lends weight to his argument that the rates were speculative. It is true that the makers of the notes had only small equities in the houses because they paid only small downpayments and the notes were paid out over periods of as long as 18 years. However, we believe that petitioner's excellent experience with the notes and the apparent facility with which he was able to obtain financing from financial institutions (who accepted the identical first trust deed notes as collateral) countervail these factors. To add further weight to our decision that the notes were not speculative, we have petitioner's counsel's statement, made during his introduction of this issue at trial, that --

It so happened that a good portion of these trust deed notes have been paid off in full, and, therefore, the question more or less becomes moot as far as the petitioner is concerned.

We do not agree that the question is moot although counsel's admission as to the petitioner's excellent experience with the notes does emphasize their nonspeculative nature.

44 T.C. 159">*178 We cannot find, as did the courts in 36 T.C. 909">Morton Liftin, supra, and Phillips v. Frank, supra, that the notes in question were speculative. The discount 1965 U.S. Tax Ct. LEXIS 89">*137 income from the notes was 17 percent. In Darby Investment Corporation v. Commissioner, 315 F.2d 551 (C.A. 6, 1963), affirming 37 T.C. 839">37 T.C. 839 (1962), not only did the discount involved amount to approximately 26 percent but other relevant factors indicated that the risk of recovery was more substantial than in this case. The court, in ruling for the Commissioner, very appropriately stated at page 552:

The sole issue is whether the petitioner must include as income received with each monthly payment under the contracts, in addition to interest, realized discount income in proportion to the difference between the petitioner's cost and the principal balance due upon the face of such contracts at the date of their purchase. * * *

* * * *

Determination of the issue turns on the question of whether the investment in the contracts is of such a speculative nature that the purchaser, the petitioner herein, cannot be reasonably certain of ever recovering his cost. Burnet, Commissioner of Internal Revenue v. Logan, 283 U.S. 404">283 U.S. 404 * * *

In our view, petitioner has not established a reasonable uncertainty of ever recovering his cost but rather has stipulated sufficient facts to prove that the first trust 1965 U.S. Tax Ct. LEXIS 89">*138 deed notes were anything but speculative. Consequently, we hold that petitioner must report 17 percent of each periodic payment on all first trust deed notes received in the years in question as discount income.

Decisions will be entered under Rule 50.