24 T.C. 1124">*1124 The respondent determined deficiencies in petitioners' income tax for the taxable year 1949 in the sum of $ 3,480.96 by disallowing a deduction of $ 12,000 claimed by them as rental expense paid for the use of 160 acres of farm land. The1955 U.S. Tax Ct. LEXIS 92">*93 only question presented is whether the payment by petitioners made under the "lease" was in fact rent or whether it constituted a partial payment on the purchase price of the property by means of which petitioners acquired an equity therein.

24 T.C. 1124">*1125 FINDINGS OF FACT.

Petitioners D. M. Haggard and Nila Haggard are husband and wife, residing in Phoenix, Arizona. The income and deductions here in issue were reported by petitioners on their return for 1949 filed with the collector of internal revenue for the district of Arizona.

Petitioners are engaged in operating a ranch in Maricopa County, Laveen, Arizona, consisting of approximately 1,500 acres. In early 1948, petitioners owned 1,340 acres, some of which adjoined acreage owned by John Butler. On February 9, 1948, Butler contacted Haggard, hereinafter sometimes referred to as petitioner, to ascertain if he was interested in purchasing 160 acres of farm land for $ 48,000. Petitioners had formerly tried to purchase the same property for approximately $ 100 to $ 150 per acre. After some discussion, Butler and Haggard went to the office of petitioners' attorney. Butler agreed to the suggestion of petitioners' attorney that the1955 U.S. Tax Ct. LEXIS 92">*94 transaction be handled by the execution of a "Lease" (under the terms of which petitioners would rent the property for the balance of 1948 for $ 10,000 and $ 12,000 for the year 1949) and an "Option" (for a separate consideration of $ 2,000) under the terms of which petitioners would have the right to purchase the 160 acres after January 1, 1950, and before January 10, 1950, for the sum of $ 24,000. Butler was concerned about the possible tax consequences of the proposed transaction, but was assured that the entire transaction was properly reportable for income tax purposes as a sale. Later, on the same day, the parties returned to Merrill's office and the "Lease" and "Option" agreements were executed simultaneously.

The pertinent provisions of the "Lease" are as follows:

To Have and to Hold the same to the said Lessees from date hereof to the 31st day of December, 1949.

And said Lessees, in consideration of the leasing the premises as above set forth, convenant and agree with the Lessors to pay the said Lessors as rent for the same the sum of TWENTY-TWO THOUSAND and no/100 ($ 22,000.00) DOLLARS, payable as follows, to-wit: The sum of TEN THOUSAND DOLLARS ($ 10,000.00) payable upon1955 U.S. Tax Ct. LEXIS 92">*95 the execution of this Lease, receipt whereof is hereby acknowledged by Lessors, and the further sum of TWELVE THOUSAND DOLLARS ($ 12,000.00) on the 1st day of January, 1949.

* * * *

It Is Mutually Understood and Agreed that during the term of this Lease, Lessees shall pay all taxes and assessments accuring [sic] against the said property.

The pertinent provisions of the "Option" are as follows:

That JOHN BUTLER and HESTER D. BUTLER, husband and wife of Maricopa County, State of Arizona, for and in consideration of the sum of TWO THOUSAND and no/100 ($ 2,000.00) DOLLARS to them in hand paid by D. M. HAGGARD of Maricopa County, Arizona, receipt of which is hereby acknowledged, hereby give, grant and by these presents do give and grant irrevocably, 24 T.C. 1124">*1126 unto the said D. M. Haggard, his heirs and assigns, the right and option to purchase, acquire receive and assume possession of the following described real estate and property, to-wit:

* * * *

This Option is given exerciseable [sic] as of the 1st day of January, 1950, and for a period of not to exceed ten days thereafter, and shall be exercised by Notice of Election to purchase hereunder by the said D. M. Haggard or his 1955 U.S. Tax Ct. LEXIS 92">*96 heirs or assigns, in writing to the said John Butler and/or Hester D. Butler, husband and wife, their heirs, administrators or executors, at least thirty days prior to any day within said eleven day period, and in case said notice shall be given in due time, then the said John Butler and Hester D. Butler agree to immediately execute and deliver a good and sufficient deed to purchaser together with Title Guaranty, * * *

The purchase price for said property is the sum of TWENTY-FOUR THOUSAND and no/100 ($ 24,000.00) DOLLARS payable upon election to purchase, which said purchase price shall be accepted, received and acknowledged by Sellers in full payment therefor.

The property in question was originally purchased by Butler in November 1945, for a total price of $ 40,000, $ 10,000 down and the remaining balance in annual installments of $ 5,000. During 1946 Butler farmed the property, earning a profit of between $ 25 to $ 30 per acre or $ 4,000 to $ 4,800 from the entire farm property. The following year he rented out the 160 acres for $ 4,000, but was required to pay $ 156 in assessments plus taxes and thus obtained a net profit of about $ 3,844 for that year. The net profit was less1955 U.S. Tax Ct. LEXIS 92">*97 than the annual payment of $ 5,000 plus interest which was due on the purchase price. At the end of 1947, Butler had made a total profit of from $ 7,844 to $ 8,644 for the 2 years during which he owned the property. During the same period, he paid the mortgagee $ 10,000 plus interest for 2 years.

In late 1947 or early 1948, the mortgagee was pressing Butler for an overdue payment on the purchase price of the property. To meet this obligation, Butler listed the 160 acres of farm land with a Phoenix realtor at $ 48,000. A number of prospective purchasers responded to this listing but none made an acceptable offer to buy until the first week in February 1949. About February 2, 1949, a week before the execution of the "Lease" and "Option" agreements with petitioner, Butler received an offer from the son and son-in-law of one Talby to purchase the property for $ 48,000. The terms of the offer were $ 8,000 down and the balance in 10 equal payments. Before accepting the proposal, Butler, realizing that petitioners owned acreage adjacent to the property, decided to offer the land to them. In the event they were not interested in the "deal," Butler intended to accept the existing proposition. 1955 U.S. Tax Ct. LEXIS 92">*98 Thereafter, on February 9, 1948, Butler met with petitioners in Phoenix, Arizona, to discuss the "deal." Later that day they executed the "Lease" and "Option" agreements, and pursuant to the "Lease," on that same day petitioners paid Butler $ 10,000 as "rent." On January 1, 1949, petitioners paid Butler the other $ 12,000 rental payment.

24 T.C. 1124">*1127 In 1947, the fair or reasonable rental for the property would have been from $ 3,000 to $ 4,000 a year. In February 1948, the rental that could reasonably have been expected from this property would have been about $ 5,000 a year.

On April 1, 1949, Butler borrowed $ 12,000 from the Valley National Bank of Phoenix, Arizona, and mortgaged property as collateral. On the same day, petitioners, as optionees of the property, executed a "subordination agreement" in which they agreed that their option would be subordinate to a mortgage on the property, Butler and his wife being the mortgagors, and the Valley National Bank of Phoenix the mortgagee.

The proceeds of this loan were used by Butler, in part, to pay off the existing mortgage on the property. On January 20, 1950, after petitioners assumed the entire amount Butler owed to the Valley1955 U.S. Tax Ct. LEXIS 92">*99 National Bank, and paid Butler the final sum of $ 12,000, a warranty deed was executed by Butler conveying title to the property to petitioners.

Following the execution of the "Lease" and "Option" agreements, Butler retained a firm of certified public accountants in Phoenix, Arizona, to prepare his 1948 Federal income tax return. Butler was advised to report the transaction as a sale and on Butler's income tax return for 1948, the "Lease" and "Option" agreements were so treated. One-half of the net gain was reported as taxable.

Petitioners, on the other hand, treated the sum of $ 12,000 paid to Butler on January 1, 1949, as rental expense, payable pursuant to the "Lease," and deducted this amount from their gross income. Respondent determined that this payment constituted an installment on the purchase price of the property, and was not deductible under section 23 (a) (1) (A) of the Internal Revenue Code of 1939.

Petitioners, through the annual "rental" payments, were intending to and did in fact build up a substantial equity interest in the 160-acre farm tract.

OPINION.

The respondent has disallowed a deduction of a payment made by petitioners under a "Lease," executed in conjunction1955 U.S. Tax Ct. LEXIS 92">*100 with an "Option" to purchase, on the ground that the payment was not rental expense within the meaning of section 23 (a) (1) (A) of the Internal Revenue Code of 1939, which restricts deductions to rentals or other payments for the use or possession of property "to which the taxpayer has not taken or is not taking title or in which he has no equity." The sole issue to be decided is whether the so-called "rental" payment was in fact a payment of rent under the lease and deductible as such, or a partial payment of the purchase price of the property. We hold for the respondent for the reasons stated hereinafter.

24 T.C. 1124">*1128 Petitioners contend that they did not acquire an equity interest in the property as a result of the $ 12,000 payment under the lease agreement because the fair market value of the property when the "Lease" was executed was considerably less than the agreed purchase price under the "Option." They further argue that only the economic relation of the value of the property existing at the time the documents were executed is determinative of the issue here, and that the intention of the parties is only supplemental, if relevant at all. The precise problem posed of characterizing1955 U.S. Tax Ct. LEXIS 92">*101 a payment made pursuant to a lease-option arrangement has been before this Court on numerous occasions, and regardless of the form or nomenclature of the transaction, we have treated similar "rental" payments as partial payments of the purchase price of the property involved, if by virtue of the payment the taxpayer has acquired, or will acquire title to or an equity in the property. Alexander W. Smith, Jr., Executor, 20 B. T. A. 27 (1930); Chicago Stoker Corporation, 14 T.C. 441 (1950). The principle extending throughout the cases heretofore decided by us on like issues is that where the "lessee" as a result of the "rental" payment, acquires something of value in relation to the over-all transaction, other than the mere use of the property, he is building up an equity in the property, and the payments do not, therefore, come within the definition of rent in section 23 (a) (1) (A), supra. Judson Mills, 11 T.C. 25 (1948); Truman Bowen, 12 T.C. 446 (1949).

The most recent consideration of this issue was in Breece Veneer & Panel Co., 22 T.C. 1386 (1954)1955 U.S. Tax Ct. LEXIS 92">*102 (on appeal C. A. 7). There, petitioner entered into a "Lease" and "Option to Purchase" agreement with the R. F. C. with respect to certain property, in part of which it was at the time conducting its business. Under the agreement, petitioner was to pay "as rent" $ 100,000 in 60 monthly installments, after which it had the option to purchase the property for $ 50,000. The Court held, despite the explicit language of the lease agreement, that since the "rental" payments materially exceeded the current fair rental value of the property, and since the aggregate payments paid prior to the exercise of the option were disproportionate to the relatively small final amount required to acquire title, petitioner was building up a substantial equity interest in the property, as intended by the parties, and that the payments, in reality, were being applied to the agreed purchase price of the property. We are of the opinion that the rationale there expressed is applicable here. Judson Mills, supra;Robert A. Taft, 27 B. T. A. 808, 812 (1933); Holeproof Hosiery Co., 11 B. T. A. 547 (1928).

We pointed out1955 U.S. Tax Ct. LEXIS 92">*103 in Breece Veneer & Panel Co., supra, and Chicago Stoker Corporation, supra, that the payments there in question (as in the instant case) may have dual potentialities, that is, they may 24 T.C. 1124">*1129 emerge as partial payments of the agreed purchase price on the one hand or rent for the use of the property on the other. As emphasized in those cases, it is difficult to categorize the payments for income tax purposes. To properly discern the true character of the payment, therefore, it is necessary to ascertain the intention of the parties as evidenced by the written agreements, read in the light of the attending facts and circumstances existing at the time the agreement was executed.

Here, the record shows that Butler had purchased the property in 1945 for $ 40,000. In 1948 he was primarily interested in selling it, and listed the property with a realty firm for a price of $ 48,000. At the time he contacted petitioners, he had an offer from the Talby group for that amount and was prepared to sell to them on the basis of a downpayment of $ 8,000 with the balance in 10 equal annual payments if he could not arrange with petitioners1955 U.S. Tax Ct. LEXIS 92">*104 on more favorable terms at least as to deferred payments. The total sums paid by petitioners precisely equaled the same amount of $ 48,000, and we think it clear, upon consideration of the whole record, that at the time the agreements were executed, Butler would not have considered making an outright sale for $ 24,000. We likewise think it is clear that the payments in 1948 and 1949 were in excess of the fair rental value of the property and were fixed at amounts which, when added to the option payment of $ 2,000 and the ultimate "sale price" of $ 24,000, would equal the $ 48,000 which Butler demanded.

In support of petitioners' position that they did not acquire an equity in the property as a result of the "rental" payment, they argue that the fair market value was below a reasonable estimate of the property's future worth. They urge that the property on February 9, 1948, had a fair market value not in excess of $ 21,750 and the agreed purchase price established by the "Option" was $ 24,000. The figure of $ 21,750 urged as the fair market value was based upon the testimony of an expert witness produced by petitioners. An analysis of his testimony demonstrates that the valuation1955 U.S. Tax Ct. LEXIS 92">*105 so suggested is not to be accepted as determinative. It is, of course, widely at variance with what both the Talby group and petitioners were willing to pay. The witness pointed out a number of circumstances which might have resulted in greatly differing valuations of the property as a whole, and a variance of as much as 100 per cent in rental value. Moreover, he testified that in valuing the property he had given no consideration to the significant factor of the right to the use of water which was essential to the productivity of the land. His reason for this omission was his assumption that such right was not "appertinent" to the land in question. He made it clear that if such right was appertinent, the value thereof must be added to his valuation of $ 21,750. He did 24 T.C. 1124">*1130 not, however, testify what the value of such a right was, and there is no other testimony in the record from which it might be determined, so that we have no basis on his evidence to find a total fair market value including such right.

The burden of proof was, of course, upon petitioners. The record fails to establish whether or not there was a right (appertinent to the land) to the adequate use1955 U.S. Tax Ct. LEXIS 92">*106 of water. It is clear from a consideration of the whole record, however, that there was some arrangement for water supply which was satisfactory to petitioners. We add that we think it reasonable to assume that an experienced farmer like Haggard, who was familiar with the particular property, its requirements, and conditions in the area in which it was located, would not otherwise have entered into the transaction.

In view of the foregoing, we cannot accept the valuation suggested by the expert witness. On the other hand, while subject in each instance to some deferment of payment, we have a precise amount which two willing buyers were willing to pay, and which Butler, a willing seller, was willing to accept. For the purposes of this case we are not required to determine an exact valuation. No doubt the price of $ 48,000 may have been subject to some discount if the entire transaction had been for cash. We think it clear, however, that the value was much closer to $ 48,000 than it was to $ 21,750. Even if the discount for cash would have been as much as 20 per cent (which we doubt), the payments by petitioners in 1948 and 1949 would have been clearly in excess of fair rental1955 U.S. Tax Ct. LEXIS 92">*107 value and would have served to create an equity in the property of which Haggard was in a position to avail himself under the terms of the agreements. We add that, while petitioners' expert witness testified to widely varying potential rental values depending upon varying circumstances, we think that, upon his testimony, the fair rental value, for the practical purposes confronting us, was not in excess of $ 5,000 for 1948 or 1949.

A significant aspect of the over-all transaction indicative of petitioners' intent to acquire an equity interest in the property is the fact that, under the lease, the aggregate of the "rental" payments constituted 91 per cent of the purchase price stated in the option. Moreover, the total of annual "rental" payments of $ 22,000 is about 46 per cent of the total considerations passing from Haggard to Butler under the terms of the contracts. We think it evident that a rental charge so disproportionate to the term of user in relation to the fair market value of the property is suggestive of the acquisition of an equity interest. Truman Bowen, supra, 463.

Petitioners rely strongly upon Benton v. Commissioner, (C. A. 5, 1952) 197 F.2d 745, 751.1955 U.S. Tax Ct. LEXIS 92">*108 The factual situation in the instant case differs materially from that in the Benton case, which, in our opinion, is not here controlling.

24 T.C. 1124">*1131 In the light of the foregoing and upon consideration of the record as a whole, we are convinced that through the annual rental payments petitioners were in fact acquiring a substantial equity in the property, and that it was so intended by the parties. Accordingly, we hold that the payment in question is not deductible under section 23 (a) (1) (A), supra, and the respondent did not err in disallowing the claimed deduction therefor.

Decision will be entered under Rule 50.