52 T.C. 394">*394 Respondent has determined deficiencies in petitioners' Federal income taxes for the calendar years 1969 U.S. Tax Ct. LEXIS 116">*118 1960 and 1961 in the amounts of $ 16,807.34 and $ 47,453.81, respectively.

The issues for decision are:

Whether the taxpayers sold their entire farm for cash, or whether they exchanged part of it for property of like kind. If there was an exchange, the amount of the unrecognized gross sales price attributable to petitioners' exchange must be determined.

52 T.C. 394">*395 The amount which petitioners received for the sale of their residence located on the farm.

Whether any amount of cash received in connection with the sale of the farm represented interest income to petitioners.

Whether $ 5,000 and $ 6,000 amounts received by petitioners' attorneys during 1960 and 1961, respectively, in connection with the farm sale, represented income to petitioners and, if so, whether such amounts also constituted deductible expenditures.

The correct allocation and deductibility of selling expenses which petitioners incurred in the sale of their farm.

FINDINGS OF FACT

Some of the facts are stipulated and they are so found.

Petitioners Leslie Q. Coupe and Maybelle Coupe (hereinafter sometimes called the Coupes or Leslie and Maybelle, respectively), husband and wife, resided in Galt, Calif., at the time the petition in the 1969 U.S. Tax Ct. LEXIS 116">*119 instant case was filed. Their joint Federal income tax returns for the calendar years 1960 and 1961 were filed with the district director of internal revenue at San Francisco, Calif.

Leslie and Maybelle are farmers. In 1945 they purchased 188.943 acres of farmland near Elk Grove, Calif. (hereinafter sometimes called the Elk Grove property). During all pertinent times the land was farmed continuously and primarily held for the purpose of farming.

In 1958 and 1959 Leslie and Maybelle received two unsolicited offers from a neighbor to buy the Elk Grove property for first $ 250 per acre and then $ 800 per acre. They refused both offers. On March 12, 1960, the Coupes granted an option to Malcolm K. Grant (hereinafter sometimes referred to as Grant), a real estate broker, to purchase the farm for $ 2,250 per acre. This option eventually led to a contract between the Coupes and Southern Pacific Co. (hereinafter sometimes referred to as S.P.), which called for the Coupes to sell the Elk Grove property for $ 2,500 per acre. The relevant provisions of this agreement are reproduced below:

This Agreement, made this 1st day of June, 1960, by and between LESLIE QUENTIN COUPE and MAYBELLE COUPE, 1969 U.S. Tax Ct. LEXIS 116">*120 husband and wife, Sellers, and SOUTHERN PACIFIC COMPANY, a corporation, Buyer;

Witnesseth:

Sellers hereby agree to sell and Buyer agrees to buy, subject to terms hereof, that real property situate, lying and being in the County of Sacramento, State of California, described as follows:

* * * *

1. Sellers, at their expense, will cause said property to be surveyed by a registered civil engineer who shall furnish a mutually satisfactory and simplified metes and bounds description of the property, and who shall determine the number of acres in said property. The metes and bounds description shall replace the above description for all purposes hereunder.

52 T.C. 394">*396 2. Purchase price of the land or any part or parcel thereof shall be Two Thousand, Five Hundred (2,500) Dollars per acre acreage to be determined by the aforementioned survey.

3. Buyer shall acquire title to, and Sellers shall convey said property in parcels, as follows:

(a) Upon execution of this agreement, Buyer shall deposit the sum of Twenty-five Thousand (25,000) Dollars in escrow; Sellers shall as soon as practicable convey to Buyer a portion or parcel with area equal to twenty-nine (29) per cent of the total area of said land, the location 1969 U.S. Tax Ct. LEXIS 116">*121 of said portion to be mutually agreed by the parties. At the time of such conveyance Buyer will pay the balance of the purchase price of said twenty-nine (29) per cent portion over and above the initial payment of Twenty-Five Thousand (25,000) Dollars, and this first escrow shall close. It is understood the portions herein referred to are not undivided interests in the whole of said land, but rather parcels within said land.

(b) Buyer shall acquire at least twenty-five (25) per cent of the remainder of the area of said land in each of the four (4) years following the conveyance set forth in (a) above, paying therefor at the rate herein specified, provided, that Buyer may accelerate acquisition in any manner it desires after one (1) year from the conveyance set forth in (a), and provided further that payment may be made by an exchange transaction as hereafter described.

4. Buyer shall pay interest at the rate of six (6) per cent per annum on unpaid portions of the total purchase price for all the land.

5. Buyer shall have the right to pay for any acquisition covered in 3(b) hereof by a conveyance of property, hereafter called "exchange property", of value equal to or less than the price 1969 U.S. Tax Ct. LEXIS 116">*122 of the parcel being acquired. If the value of such exchange property is less than the price of the parcel acquired, Buyer shall pay the difference in cash. It is understood, however, Buyer shall pay by means of exchange property only if at the time of such transaction a purchaser stands ready, willing and able to buy such exchange property from Sellers. The value of the exchange property to Sellers shall be measured by the price offered by such purchaser.

6. After execution of this agreement Sellers shall remain in possession of all of the property without rental or other payment to Buyer for a period of one hundred eighty (180) days. Thereafter Buyer shall have possession of all of the property without rental or other payment to Sellers, and together with all rights incident thereto, including the right to lease, to receive rental, and to conduct operations of every sort.

7. Sellers shall make all conveyances hereunder by good and sufficient grant deed, free and clear of all encumbrances except easements of record.

8. Sellers shall provide and pay for policy or policies of title insurance for Buyer. Sellers shall pay for all revenue stamps and any broker's or other commissions due 1969 U.S. Tax Ct. LEXIS 116">*123 on this transaction. Current taxes shall be pro-rated as of the date first herein written. Buyer shall pay all recording fees. Other expenses shall be in accordance with usual practice in Sacramento County, California.

9 This agreement shall inure to the benefit of and be binding upon the successors and assigns of the Sellers and the assigns of Buyer.

In Witness Whereof, Sellers and Buyers have executed these presents the day and year first herein written.

(S) Leslie Quentin Coupe

(S) Maybelle Coupe

Southern Pacific Company.

By [Illegible], Vice President

Attest:

[Illegible], Assistant Secretary

52 T.C. 394">*397 In a separate agreement, the Coupes agreed to pay Grant a commission of 10 percent of the sales price, payable one-half at the close of the first escrow under paragraph 3(a), and the balance at the close of the escrow under paragraph 3(b).

After signing the above agreement, the Coupes went over its provisions and noticed that while paragraph 3 called for a series of conveyances for cash, paragraph 5 provided for the possibility of an exchange of properties rather than a cash payment by S.P. for all conveyances after the first one. Since the Coupes wished to continue to farm after they had disposed 1969 U.S. Tax Ct. LEXIS 116">*124 of the Elk Grove property, they contacted Edwin B. Polhemus (hereinafter sometimes referred to as Polhemus), an attorney, with regard to arranging an exchange whereby they could receive farm property for the Elk Grove property. Prior to contacting Polhemus, the Coupes had not been represented by counsel.

Polhemus advised the Coupes that it would be possible for them to delay paying a capital gains tax on the sale of the Elk Grove property if they exchanged it for property of like kind. After reviewing the above agreement he informed the Coupes that he thought it would be possible to have S.P. acquire properties which it could then use for an exchange under paragraph 5. This type of arrangement was agreeable to the Coupes and they authorized Polhemus to see if he could find suitable properties and arrange the exchange. Shortly thereafter Polhemus was joined by another attorney, John L. Brannely (hereinafter sometimes referred to as Brannely), for the purpose of arranging and transacting the exchanges.

Polhemus attempted to persuade S.P. to modify the sales agreements' terms to provide for S.P.'s purchase of suitable exchange properties, and during the same period of time he made arrangements 1969 U.S. Tax Ct. LEXIS 116">*125 for the purchase of two parcels of farmland which the Coupes had chosen for the exchanges.

On July 7, 1960, Polhemus and Brannely, acting as "trustees and agents for an undisclosed principal," obtained an option on a farm owned by Paul and Jessie McEnerney (hereinafter referred to as the McEnerney property). The option called for a cash downpayment of $ 19,800 on a total purchase price of $ 66,000. The remaining $ 46,200 was to be secured by a note and deed of trust on the McEnerney property. At the time Polhemus and Brannely executed the agreement, they intended that the undisclosed principal would be S.P. and not the Coupes.

On July 15, Brannely made an offer to Polhemus to purchase farmland from the Estate of Elizabeth Sala, deceased (hereinafter referred to as the Sala property), for $ 55,000. The offer was made to Polhemus, as he was administrator of the estate, and was accepted by him subject 52 T.C. 394">*398 to court approval. Polhemus had recommended the property to the Coupes, but informed them that, under the provisions of the California law, he as administrator could exchange it only for cash. A sale of the property to Brannely for cash and Brannely's sale of the property to S.P. for 1969 U.S. Tax Ct. LEXIS 116">*126 exchange of the property with the Coupes was thus agreed upon as the most practical course to pursue. Though Brannely agreed to purchase the property for purposes of the exchange, he was not acting as agent for the Coupes in the purchase and was willing to retain the property if an exchange with the Coupes or sale to S.P. did not materialize.

Polhemus attempted but failed to have S.P. agree to take title in its name to either the McEnerney or Sala property for purposes of exchanging property for the Elk Grove property, however, he was able to persuade S.P. to allow the Coupes to exchange an Elk Grove parcel of land for the McEnerney and Sala properties with third parties and then have S.P. purchase the Elk Grove parcels from those third parties.

Under the June 1 sales agreement between S.P. and the Coupes, supra, the Elk Grove property was to be conveyed in a series of transactions. Under paragraph 3(a), 29 percent of the Elk Grove property was to be transferred to S.P. for cash as soon as practicable and the balance a minimum of 1 year thereafter. Pursuant to the provisions of that agreement, on August 2, 1960, S.P. placed $ 111,982.50 in escrow with the Alameda County-East Bay Title 1969 U.S. Tax Ct. LEXIS 116">*127 Co. (hereinafter referred to as East Bay), which amount added to a prior $ 25,000 deposit called for by the agreement totaled $ 136,982.50 in full satisfaction of S.P.'s obligation under paragraph 3(a). The escrow instructions were in accord with the June 1 agreement, with the exception that the instructions provided that the escrow amount was to be paid to the Elk Groveowners of record rather than to the Coupes. That paragraph reads as follows:

We have been informed that the Coupes desire to convey the property described in Item #3 in exchange for other property they desire and that this party or parties will convey to Alameda County-East Bay Title Company. Therefore, you are instructed to cause the total sum of $ 136,982.50, which includes the $ 25,000 now on deposit with Western Title Guaranty Company, to be paid to owners of record when property outlined in Item #3 above is conveyed to Alameda County-East Bay Title Company for account of Southern Pacific Company under usual form of holding agreement and Western Title Guaranty Company is prepared to issue its standard form of policy of title insurance in amount $ 136,982.50 showing title vested in Alameda County-East Bay Title 1969 U.S. Tax Ct. LEXIS 116">*128 Company, free and clear of all encumbrances except easements of record and taxes for fiscal year 1960-61 a lien not yet due and payable.

Between August 2 and 8, 1960, escrows were established with instructions furnished to the Western Title Guaranty Co. by S.P. or 52 T.C. 394">*399 East Bay, the Coupes, the McEnerneys, and John Brannely, which resulted in the following grant deeds being recorded simultaneously on August 9, 1960, and escrows closed as of that date:

As a result of these transactions, the $ 136,982.50 paid to East Bay by S.P. was distributed as follows: Estate of Sala, $ 55,000; Paul and Jessie McEnerney, $ 19,800; Leslie and Maybelle Coupe, 1969 U.S. Tax Ct. LEXIS 116">*129 $ 62,182.50. From the Coupes' $ 62,182.50 the following expenses were deducted by the escrow agent as charges against the various escrows as follows:

On December 28, 1960, S.P. instructed the East Bay Title Co. that it was completing the Elk Grove property purchase and that, inter alia, East Bay was to pay $ 335,375 plus interest of $ 7,657.73 in accordance with the terms of the June 1, 1960, agreement. As in the instructions for the transfer of the 29-percent interest, reference was made to the owners of record of the Elk Grove property rather than to the Coupes for purposes of title transfer and payment of expenses. The instructions specified that the transaction 1969 U.S. Tax Ct. LEXIS 116">*130 was to be completed on or before January 3, 1961.

Though the June 1 agreement provided that the final purchase of the Elk Grove property was not to occur until 1 year from the completion of the first escrow, the Coupes were amenable to an early completion of the agreement. In the meantime two other parcels of farmland had been found which petitioners wished to obtain. For 52 T.C. 394">*400 convenience these properties will be referred to as the Schauer and the Bettencourt property, respectively. In an attempt to further reduce the Coupes' currently taxable capital gain, Polhemus also felt that an exchange of Elk Grove property for the $ 46,200 deed of trust note on the McEnerney property plus the interest thereon would qualify for nonrecognition treatment. In addition he decided that if the Coupes sold the 1.936 acres, which constituted their residence, separately for $ 20,000, rather than for the $ 2,500 per acre called for by the June 1 agreement, they would be able to further postpone part of this gain under section 1034 of the Code, ¹ which provides for nonrecognition of gain on the sale of a residence to the extent that it is replaced by a residence of equal or greater value within 1 year of 1969 U.S. Tax Ct. LEXIS 116">*131 the date of sale.

In order to accomplish the above objectives, prior to any transactions involving the proposed 1961 transactions, the Coupes agreed with Polhemus and Brannely that the latter would no longer be the Coupes' attorneys. Any services performed by them for the Coupes' benefit would be merely as an accommodation. Instead of attorneys' fees being paid to them, it was intended that the attorneys realize a $ 6,000 profit in regards to the proposed exchanges. In fact, however, in the following transactions and negotiations, Polhemus prepared a number of escrow instructions for the Coupes and at times represented himself to others as the Coupes' attorney.

Between December 22, 1960, and January 3, 1961, various escrows were established and instructions submitted, and on January 10, 1961, the following grant deeds were recorded:

52 T.C. 394">*401 In addition the $ 46,200 McEnerney property deed of trust and note was assigned to Brannely (and wife), who in turn assigned their interest to petitioners.

The $ 343,032.73 paid by S.P. was distributed by the escrow agent as follows:

The $ 135,646.93 which petitioners received was distributed as follows:

On November 1, 1960, the Coupes 1969 U.S. Tax Ct. LEXIS 116">*133 moved their household goods to their new residence on the McEnerney property. Their livestock stayed on the Elk Grove property until early in 1961. At the date of trial the Coupes continued to live on the McEnerney property and raise beef cattle and hay. They also continued to own the other properties received in the 1960 and 1961 transactions. The Sala property was leased to a dairy for $ 2,400 per year and used in connection with the dairy business; the Bettencourt property was sharecropped for one-third of the seed produced; and the Schauer property was leased for $ 3,600 a year and used to grow crops.

On their Federal income tax return for the calendar year 1960, the Coupes reported the 1960 transaction as follows: 52 T.C. 394">*402

On their Federal income tax return for the calendar year 1961, the Coupes reported the 1961 transaction as follows:

In his statutory notice of deficiency, respondent determined the Coupes' capital gain on the sale of the Elk Grove property as follows, accompanied by the following explanations:

On your 1960 income tax return you reported the exchange of 7.92 acres of your farm, the exchange of 22 acres of your farm, and the sale of 24,873 acres of your farm. You considered the exchanges 1969 U.S. Tax Ct. LEXIS 116">*135 as tax free and reported a long-term capital gain on the sale. It has been determined that all this property was sold; therefore, the gain is all taxable as long-term capital gain. In the computation of the gain claimed expenses have been reduced from $ 31,242.00 to $ 15,137.86. This is based on allowing 10% sales commission, survey costs based on an allocation of the entire cost on an acreage basis, and allowing title insurance, revenue stamps and recording expenses only on the final transfer of the property. The payment of $ 5,000.00 to Polhemus and Brannely is not an allowable expense of sale. 52 T.C. 394">*403

On your 1961 income tax return you reported the sale of your residence for $ 20,000.00 and the sale and exchange 1969 U.S. Tax Ct. LEXIS 116">*136 of 132.214 acres of your farm for $ 323,033.00. You reported only a portion of the gain on these two transactions as taxable long-term capital gains based on your purchase of a new residence and based on your contention that you received two other properties in exchange for a portion of the reported sales price. It has been determined that you sold the entire property of 134.150 acres for $ 2,500.00 per acre for a total of $ 335,375.00 and that you received taxable interest income of $ 7,657.73 on the transaction. $ 4,840.00 of the sales price is allocated to the residence property of 1.936 acres and, as you purchased a new residence for an amount in excess of $ 4,840.00, no taxable gain results on the residence portion of the sale. The gain on the balance of the property (132.214 acres) is all taxable to you as long-term capital gain. Expenses are allowed in the computation of the gain based on 10% sales commission, a pro rata share of the survey expenses, and title insurance, revenue stamps and recording expenses incurred in the final transfer of the property. The amount of $ 6,000.00 received by Polhemus and Brannely is not an allowable expense of sale.

1969 U.S. Tax Ct. LEXIS 116">*137 52 T.C. 394">*404 OPINION

On June 1, 1960, petitioners entered into an agreement with Southern Pacific Co. (S.P.) to sell S.P. their 188.943-acre farm (Elk Grove property) for $ 2,500 per acre, plus interest. S.P. made an initial $ 25,000 deposit. Thereafter in two separate escrow transactions (terminating on August 9, 1960, and January 10, 1961, respectively), S.P. paid in the amounts of $ 111,982.50 and $ 343,032.73, respectively, with the instruction that such amounts were to be paid to the title holders of the Elk Grove property. The latter amount included $ 7,657.73 in interest. S.P. thereafter received Elk Grove parcels of 54.793 acres and 134.150 acres in 1960 and 1961, respectively.

Rather than simply transferring title in the Elk Grove property to S.P. and receiving cash, however, petitioners arranged to have it transferred to S.P. after they had entered into certain exchanges for said property, simultaneously with the closing of the two escrows with S.P. After the exchanges were completed they had received title to four parcels of property, called the McEnerney, Sala, Schauer, and Bettencourt properties, respectively. In addition they received cash and a note secured by a deed of trust 1969 U.S. Tax Ct. LEXIS 116">*138 on the McEnerney property.

On their Federal income tax return for the years 1960 and 1961, petitioners reported their transfers of the Elk Grove property, in part, as tax-free exchanges of property for property of like kind under section 1031 ³ of the Code, in part as a partially tax-free sale of their residence for $ 20,000, and its replacement by another residence costing $ 18,000, under section 1034 ^{41969 U.S. Tax Ct. LEXIS 116">*140} of the Code, and the balance as a currently taxable sale of property to S.P., upon which they reported their gain as shown in the Findings of Fact. Petitioners are now also contending that their transfer of part of the Elk Grove property for the McEnerney deed-of-trust note also constituted a tax-free exchange under section 1031. In his statutory notice of deficiency, respondent determined the amount of petitioners' capital gains arising from the two transactions and, with the exception of the transfer 52 T.C. 394">*405 of 1.936 Elk Grove acres for the McEnerney residence, further determined that the gains constituted currently taxable income to petitioners in 1960 and 1961. Assigning a sales price of $ 4,840 for the Elk Grove residence (1.936 acres at $ 2,500 per acre), respondent determined that 1969 U.S. Tax Ct. LEXIS 116">*139 petitioners' capital gain from its sale qualified for nonrecognition treatment under section 1034 of the Code, as petitioners had replaced their residence with one of an equal or greater cost than the $ 4,840 sales price. Respondent also determined that petitioners received $ 7,657.73 in interest income in 1961.

In his statutory notice, respondent allowed certain selling expenses to be deducted from the sales price received by petitioner on the determined taxable transactions. In so doing he disallowed certain expenses and reallocated others which petitioner had deducted from the gross sales price of the various parcels in determining their gain.

It is now well settled that when a taxpayer who is holding property for productive use in a trade or business enters into an agreement to sell the property for cash, but before there is substantial implementation of the transaction, arranges to exchange the property for other property of like kind, he receives the nonrecognition benefits of section 1031. Coastal Terminals, Inc. v. United States, 320 F.2d 333 (C.A. 4, 1963); James Alderson, 38 T.C. 215">38 T.C. 215 (1962), reversed on other grounds 1969 U.S. Tax Ct. LEXIS 116">*141 317 F.2d 790 (C.A. 9, 1963); Carlton v. United States, 385 F.2d 238 (C.A. 5, 1967). Of crucial importance in such an exchange is the requirement that title to the parcel transferred by the taxpayer in fact be transferred in consideration for property received. See Carlton v. United States, supra.In the instant case, petitioners arranged to have their Elk Grove property exchanged in a variation of a so-called 4-way exchange. Involved in this type of exchange is a taxpayer desiring to exchange property, a prospective purchaser of the taxpayer's property, a prospective seller of the property the taxpayer wishes to receive in exchange, and a fourth party. In a simultaneously executed transaction (usually done through escrow) the fourth party receives the taxpayer's property and sells that property to the prospective purchaser. With the funds he receives, he purchases the prospective seller's property and then transfers that property to the taxpayer. When the smoke has cleared, the taxpayer has exchanged his property in a so-called 1031 transaction, the prospective purchaser has the taxpayer's property, the prospective seller has cash, and the fourth party, with the exception of 1969 U.S. Tax Ct. LEXIS 116">*142 agreed compensation, nothing. See Mercantile Trust Co. of Baltimore et al., Executors, 32 B.T.A. 82">32 B.T.A. 82 (1935).

The instant transactions involved, in addition to petitioners, S.P. as the prospective purchaser of the taxpayer's property, the owners of the McEnerney, Sala, Bettencourt, and Schauer properties as the 52 T.C. 394">*406 prospective sellers, and Polhemus and Brannely as the fourth party. With the exception of the McEnerney property, petitioners transferred Elk Grove property to Polhemus and/or Brannely, who transferred the property to S.P. ^{51969 U.S. Tax Ct. LEXIS 116">*143} for cash. With the cash Polhemus and/or Brannely purchased the above properties and transferred them to petitioners. In the case of the 1960 McEnerney transaction, petitioners exchanged the Elk Grove property with the McEnerneys for the McEnerney property and the McEnerneys transferred the Elk Grove property to S.P. for cash. Since the net result of the transactions was petitioners' receipt of property for property of like kind, petitioners contend that they have met the requirements of section 1031.

Respondent contends that the above actions were little more than a transparent attempt on petitioners part to restructure a taxable transaction into a nontaxable one. The fact remains, however, that when it came time to transfer title to the Elk Grove property, petitioners did not transfer it to S.P., but to other individuals, and insofar as the consideration which they received for the transfer constituted title to property of like kind, they had exchanged their property in tax-free exchanges under section 1031. The deed-of-trust note and the cash they received will be discussed infra.

We have not overlooked the fact that with the exception of the McEnerney exchange, the exchanges in issue were with Polhemus and Brannely. Respondent strenuously argues that at all times these men were petitioners' attorneys. From this he concludes that they were also their agents in all of the transactions. He argues that since title in an agent is the equivalent of title in the principal, there could have been no exchange of property between petitioners and Polhemus and Brannely; and that the sale to S.P. by Polhemus and Brannely as petitioners' agents was simply a 1969 U.S. Tax Ct. LEXIS 116">*144 sale by petitioners.

We agree that the exchange would be meaningless for purposes of section 1031 if Polhemus and Brannely were petitioners' agents for purposes of carrying out the transactions. See 32 B.T.A. 82">Mercantile Trust Co. of Baltimore, et al., Executors, supra at 85. But the undisputed evidence establishes that, for the purpose of carrying out the exchanges, Polhemus and Brannely did not intend to be and were not petitioners' agents, but were effectively acting as agents for and on behalf of S.P.

To uphold respondent's position, we would have to find that Polhemus and Brannely entered into the various agreements to purchase the exchange properties and receive title thereto on behalf of the petitioners. The evidence establishes, however, that in fact Polhemus 52 T.C. 394">*407 and Brannely first attempted to have S.P. obtain title to the exchange properties, but when that failed, to have title vest solely in themselves. Being fully aware of the consequences of having title vest in petitioners, they deliberately structured all transactions so that petitioners could not obtain even a vestige of title, legal or equitable, to the exchange properties by virtue of any agreements Polheums and Brannely entered 1969 U.S. Tax Ct. LEXIS 116">*145 into. Thus, all transactions prior to the actual exchange of Elk Grove property for the exchange properties were in the names of Polhemus and Brannely, as agents for an undisclosed principal (intended to be S.P.) and at no time prior to the final conveyances, intended to be the petitioners.

Though the evidence shows that S.P. refused to take title to the properties in its own name, it also shows that S.P. was willing to allow Polhemus and Brannely to accept and convey title to the exchange properties on behalf of and in place of S.P. It agreed to accept conveyances from the title holders of Elk Grove rather than from petitioners, and when the 1960 and 1961 escrow transactions were consummated, Polhemus, Brannely, and McEnerneys did accept and convey title to the various parcels for S.P. and, in accord with the understanding with S.P., conveyed the Elk Grove parcels to it. We find and hold from this entire record, for the tax consequences flowing therefrom, that Polhemus, Brannely, and the McEnerneys were S.P.'s agents for the various transactions here considered.

Whether S.P. itself acquired legal or equitable title to any of the exchange properties we need not decide, for it is clear 1969 U.S. Tax Ct. LEXIS 116">*146 that in the instant case petitioners first obtained title to the exchange properties as a result of the simultaneous escrow exchanges of August 9, 1960, and January 10, 1961. Polhemus ⁶ and the petitioners both testified that for purposes of the exchanges they agreed that any title in the exchange properties vesting in Polhemus and Brannely was not to convey any title, legal or equitable, to the petitioners. In fact, if the proposed exchanges had not taken place Polhemus and Brannely were willing to and did take the risk of being left with title to the properties in their own names, and having to hold them for investment.

Such an arrangement was perfectly valid. Even if Polhemus and Brannely stood in a fiduciary relationship with petitioners, under California law one who stands in a fiduciary relationship with another may engage in an activity adverse or potentially adverse to that of his principal if he makes full disclosure to and receives the consent of his principal, see 2 Cal. Jur. 2d, Agency, sec. 108. Polhemus and Brannely specifically satisfied this requirement so that there could be, and was, no agency between themselves and petitioners 1969 U.S. Tax Ct. LEXIS 116">*147 even though they maintained an attorney-client relationship.

52 T.C. 394">*408 There is also no question but that when Polhemus and Brannely entered into agreements to purchase property in their own names or as agents for an undisclosed principal, under California law they became personally liable under the agreements, because the agreements under those circumstances are considered to be theirs for purposes of affixing liability under them. See 2 Cal. Jur. 2d, Agency, sec. 139.

To say that Polhemus and Brannely were petitioners' agents when they entered into the various agreements would be in direct contradiction to the fact that they had agreed not to be such, and were in fact de facto agents of S.P., obtaining title to the properties for that company, not petitioners. The only juristic facts in the instant case involve bona fide exchanges of Elk Grove properties and the exchange properties between petitioners, Polhemus and Brannely and the McEnerneys. With respect to the exchange properties, there was no sale for cash under California law between S.P. and the petitioners and we so find and hold. To hold otherwise would be to create a legal fiction which did not occur and substitute it for the substantive 1969 U.S. Tax Ct. LEXIS 116">*148 facts which did. As we pointed out in 32 B.T.A. 82">Mercantile Trust Co. of Baltimore et al., Executors, supra at 86-87:

Respondent admits that the transaction was carried out in a legal manner, and that no fraud was perpetrated. We cannot find that it was a mere device, essentially fictitious. The several agreements and deeds executed, and the cash payments made by the four interested parties were not simulated transactions. They were intended to and did constitute juristic facts -- not fictions. The agreements created fixed liabilities. The deeds transferred legal title. The cash payments were real. Petitioners actually conveyed the Baltimore Street property to the Title Co. They likewise received from that company, in exchange, the Lexington Street property and $ 33,000. These real transactions must here be given their normal effect. So, our single inquiry is whether these facts bring the petitioners in the pending transaction within the scope of the quoted statutory provisions. Gregory v. Helvering, 293 U.S. 465">293 U.S. 465; Royal Marcher, 32 B.T.A. 76">32 B.T.A. 76.

The obvious purpose and effect of these provisions, as well as their predecessors, in the Revenue Act of 1921, section 202(c)(1), n2 (d)(1), n3 1969 U.S. Tax Ct. LEXIS 116">*149 and (e), n4 and the amendment of the Act of March 4, 1923, was to permit the postponement of recognition of taxable gain or loss upon an exchange there described until the disposition of the property received in the exchange. In the ultimate analysis of the present transaction, this was all petitioners intended or accomplished.

The present exchange was not connected with a corporate reorganization. Neither in the last-quoted provisions nor in their successors, here applicable, does there appear any express or implied indication of a legislative intent to premise the nonrecognition of gain or loss there provided upon any other condition than that stated specifically therein. Compare 293 U.S. 465">Gregory v. Helvering, supra, which construed subsections (g) and (i)(1)(B) of the same section (112) and Revenue Act (1928) here under consideration. Nonrecognition of gain or loss 52 T.C. 394">*409 does not depend here upon the impossibility of a sale of the property by the taxpayer. The only condition precedent to that nonrecognition is the actual exchange of property held for investment for like property to be held for investment, with or without so-called "boot." Cf. John S. Garvan, 23 B.T.A. 817">23 B.T.A. 817; George E. Hamilton, 30 B.T.A. 160">30 B.T.A. 160; 1969 U.S. Tax Ct. LEXIS 116">*150 Loughborough Development Corporation, 29 B.T.A. 95">29 B.T.A. 95; W. H. Hartman Co., 20 B.T.A. 302">20 B.T.A. 302; Sarther Grocery Co., 22 B.T.A. 1273">22 B.T.A. 1273.

In the cited case of 293 U.S. 465">Gregory v. Helvering, supra, the Supreme Court determined the taxable status of the questioned transaction "by what actually occurred" -- the receipt of the taxed stock by the taxpayer. To sustain respondent upon the present record, we would be compelled to ignore the exchange that actually occurred, and tax, as received by the taxpayers, money never, in fact, received by or for them, in a sale that did not occur. We cannot here thus substitute fiction for fact.

[Footnotes omitted.]

Respondent next contends that by the time the exchanges took place Elk Grove property title was effectively in S.P. and petitioners no longer had the requisite economic interest to convey to either Polhemus, Brannely, or the McEnerneys. In this regard, respondent makes the following argument:

Although federal law determines the tax consequences of a taxpayer's interest in property, the nature of that interest is determined by state law. Aquilino v. United States, 363 U.S. 509">363 U.S. 509 (1960); Commissioner. v. Crichton, 122 F.2d 181 (5th Cir. 1941). Under applicable California1969 U.S. Tax Ct. LEXIS 116">*151 law, the execution of the Sales Contract by petitioners effectively disposed of their Elk Grove Farm: SP became the equitable owner of the property, and petitioners were vested with a contractual right to receive the sales proceeds, coupled with a vendor's security title subject to divestment upon performance of the Sales Contract. 50 Cal. Jur. 2d, Vendor and Purchaser, secs. 92-94, 118; 18 Cal. Jur. 2d, Equitable Conversion, sec. 12. Hence, petitioners' rights under the Sales Contract were a chose in action, a right to cash, the subsequent exchange of which would not qualify as like kind of property under section 1031. Commissioner v. P. G. Lake, Inc., 356 U.S. 260">356 U.S. 260 (1958). [Emphasis supplied.] ⁷

As was pointed out in Coastal Terminals, Inc. v. United States, supra at 337, the transactions in this area are viewed as a whole and are not to be broken down into their components for the purpose of examining the quality of the interests in the various properties at any given time. The statute only requires that as the end 1969 U.S. Tax Ct. LEXIS 116">*152 result of an agreement, property be received as consideration for property transferred by the taxpayer without his receipt of, or control over, cash. All that is required is that taxpayer retain his bundle of rights in the property until the exchange takes place. If the statute were to be interpreted as respondent contends, all agreements which in the first instance call for cash as consideration for the transfer of property, even if followed by a bona fide exchange, would fail to qualify for section 1031 treatment, 52 T.C. 394">*410 as the taxpayer would have no more than a chose in action at the time of the exchange in those cases also.

That the statute is not to be interpreted as respondent contends is shown by the decision in Coastal Terminals, Inc., supra, where a sales agreement followed by the substitution of property for a promise to pay cash was upheld as a valid 1031 exchange, since in the final analysis only property was received for property. It is to be noted that in that case the property to be exchanged was not even in existence at the time the agreement was entered into.

Our opinion in John M. Rogers, 44 T.C. 126">44 T.C. 126 (1965), affd. 377 F.2d 534 (C.A. 9, 1967), though using language similar 1969 U.S. Tax Ct. LEXIS 116">*153 to that in respondent's brief, is inapposite. In that case, Standard Oil exercised an option to purchase taxpayer's property, deposited cash for the taxpayer's account in escrow, and demanded title to the property on December 26. It was not until the following January 19, that the taxpayer exchanged title with a third party and that party transferred title to Standard Oil. By that time, however, there was nothing for the taxpayer to convey or receive, as the cash paid for the property was at the taxpayer's disposal and only Standard Oil had the right to title to the property. In the instant case, in the 1960 transaction, S.P. specifically agreed to allow petitioner to exchange Elk Grove parcels prior to its receiving title to the Elk Grove property and instructed the escrow agent to pay cash to the title holder (rather than to the petitioners) when the property was placed in escrow. This arrangement, as performed by the parties, resulted in a modification of the original agreement, Cal. Civ. Code secs. 1698, 1700 (West 1954); 38 T.C. 215">James Alderson, supra at 221, and we find and hold that it was sufficient to recast the agreement between S.P. and petitioners so that petitioners did transfer 1969 U.S. Tax Ct. LEXIS 116">*154 title to the owners of the exchange properties.

The 1961 transactions were also the result of a modification of the original sales agreement, which allowed petitioners to exchange Elk Grove property for property of like kind rather than for cash. Respondent contends that S.P., in its escrow instructions for that transaction, did not agree to substitute anybody for petitioners as sellers of the Elk Grove property and consequently did not agree to purchase the property from anyone else. But no matter what S.P.'s escrow instructions, the transaction by which S.P. obtained title to Elk Grove was that property's conveyance by Polhemus and Brannely to S.P. on January 10, 1961. Since the June 1 sales agreement did not give S.P. the right to the Elk Grove property until 1 year after the August 9, 1960, conveyance, S.P. could not have demanded title from petitioners for approximately 8 more months without the modification of the agreement as performed. Unlike the situation in Rogers, S.P. had no right to title in the Elk Grove property even after it placed the purchase 52 T.C. 394">*411 price in escrow and unlike the taxpayers in Rogers, petitioners had valid title to convey to Polhemus and Brannely. As 1969 U.S. Tax Ct. LEXIS 116">*155 in the 1960 transaction, Brannely and Polhemus' title had substance and their transfer of Elk Grove title to S.P. was not the meaningless formality that it was in Rogers.

At the time of the agreement with S.P., the Elk Grove property was held for productive use in the farming business and the property received when the exchange took place was of like kind. The property petitioners received was in exchange for the Elk Grove property. Thus we find and hold that petitioners' 1960 exchange of their Elk Grove property for the McEnerney property and the Sala properties, and the 1961 exchange of their Elk Grove property for the Schauer and Bettencourt properties, satisfied the provisions of section 1031.

With the exception of an adjustment as to allowance of a deduction for attorneys' fees, we hold for respondent on the remaining issues.

Petitioners' claim that their exchange of Elk Grove property for the McEnerney deed-of-trust note was a tax-free exchange under section 1031 must fail, as section 1031 specifically excludes exchanges of notes from nonrecognition treatment. Indeed, even if exchanges of notes were not excluded by the statute, the exchange in the instant case was not an exchange 1969 U.S. Tax Ct. LEXIS 116">*156 of notes, but was an exchange of land for a note and therefore did not constitute an exchange of property for property of like kind. See Imperator Realty Co., 24 B.T.A. 1010">24 B.T.A. 1010 (1931). We therefore hold that the exchange for the deed-of-trust note constituted a taxable transaction.

Petitioners' attempts to structure the 1961 transaction so that they would receive $ 20,000 for their residence, and not recognize the $ 7,657.73 interest payment by S.P. or the $ 6,000 "profit" by Polhemus and Brannely from the amount S.P. paid into escrow are without substance.

The evidence presented by petitioners clearly established that these transactions were structured as they were primarily for tax-avoidance purposes. Since section 1031 requires only that property of like kind be exchanged, we upheld petitioners' exchanges with Polhemus and Brannely as nontaxable. However, in light of the close relationship existing between those men and the petitioners, the intricate planning on the part of Polhemus for petitioners' benefit, and the lack of any substantial adverse interest in their negotiations, their dealings cannot be described as "arm's length." If there is substance to the transaction, the form 1969 U.S. Tax Ct. LEXIS 116">*157 specifically prescribed by the statute controls. Herman Glazer, 44 T.C. 541">44 T.C. 541, 44 T.C. 541">545 (1965); Victor H. Heyn, 39 T.C. 719">39 T.C. 719 (1963).

We do not find a rational basis to support petitioners' attempt to attach a $ 20,000 sales price to their residence located on 1.936 acres 52 T.C. 394">*412 of the Elk Grove property. At the time they transferred their property to Brannely and Polhemus, petitioners had agreed to sell their Elk Grove property for $ 2,500 per acre, no matter what structures were on any particular parcel. Consequently, all they could expect to receive was $ 4,840 (either in cash, or exchange property) for the 1.936-acre parcel containing their residence. Polhemus and Brannely were well aware that they had no choice other than to convey that parcel to S.P. upon receiving it and that they would receive $ 4,840 from S.P. for the parcel.

The $ 15,160 difference which petitioners received was simply a part of the funds to which they were entitled for conveying the balance of the Elk Grove property at $ 2,500 per acre. Consequently, we have upheld respondent's determination that petitioners received $ 4,840 for the residence and could use only that figure for purposes of computing the nonrecognized gain 1969 U.S. Tax Ct. LEXIS 116">*158 under section 1034 of the Code. For similar reasons, we also find that the sales price of each Elk Grove acre transferred was $ 2,500.

We similarly reject the contention that Polhemus and Brannely made a $ 6,000 "profit" on the 1961 transaction rather than earning a legal fee. Though Polhemus and Brannely did accept certain risks in receiving and conveying title to the property, we find that that figure was the amount which Polhemus and Brannely were to receive for their efforts in arranging the 1961 transactions for petitioners' benefit. To consider that amount to be "profit" to Polhemus and Brannely on a judicious purchase of realty when the ultimate sales price was known to all parties, and the holding period of fleeting length, would ignore the tremendous efforts which they spent in arranging the various transactions as petitioners' attorneys. Thus, we find that the $ 6,000 amount was in fact a legal fee paid out of petitioners' proceeds from selling its Elk Grove property. It was not a reduction of the Elk Grove property's sales price. Consequently, we find and hold that that amount is to be considered as part of the sales price received by petitioners.

Petitioners' attempt 1969 U.S. Tax Ct. LEXIS 116">*159 to avoid reporting the $ 7,657.73 in interest paid by S.P. pursuant to the June 1 agreement and received by petitioners does not have any basis in form. That amount represents interest accruing on S.P.'s obligation to purchase the Elk Grove property under paragraph 4 of the June 1, 1960, agreement. Though petitioners transferred record title to the Elk Grove property to Polhemus and Brannely, there is not one scintilla of evidence to show that petitioners ever transferred their right to receive the interest to them. Consequently, at all times, petitioners retained the right to collect $ 7,657.73 in interest from S.P. Polhemus and Brannely's receipt 52 T.C. 394">*413 of the amount through the escrow process meant nothing more than that they were conduits for petitioners and their conveyance of such amount to petitioners was in no way connected with any exchange of any properties. We thus find and hold that petitioners had and received $ 7,657.73 in interest income in 1961.

Having determined the nature of the transactions surrounding petitioners' disposition of their Elk Grove property, the only issue remaining is the allowable expenses petitioners may claim in regard to the presently taxable transfers 1969 U.S. Tax Ct. LEXIS 116">*160 of their Elk Grove property, i.e., 24.873 acres in 1960 and 70.614 acres in 1961. Since the McEnerney, Sala, Bettencourt, and Schauer transactions, along with petitioners' sale of their old residence and replacement with a new one, were tax-deferred transactions, and expenses pertaining to the related Elk Grove property dispositions were not currently deductible, we need not and do not decide the amount of the unrecognized gain on those transactions. Consequently, the following pertains only to those items affecting the currently taxable transactions.

In his statutory notice of deficiency, respondent allocated petitioners total sales commissions to Grant and total survey costs of the Elk Grove property equally over each of the 188.943 acres and allowed them as selling expenses in the year the various parcels were sold. He also allocated the 1961 title insurance, revenue stamps, and recording expenses equally to each acre transferred by petitioners. Petitioners offer no serious objection to these allocations and, in light of the lack of any evidence in support of a different allocation, we find them to be entirely proper. See Wellesley A. Ayling, 32 T.C. 704">32 T.C. 704 (1959); Fairfield Plaza, Inc., 39 T.C. 706">39 T.C. 706 (1963). 1969 U.S. Tax Ct. LEXIS 116">*161 Petitioners' escrow statements for 1960 in regard to the 24.873 acres transferred to S.P. show charges of $ 346, $ 68.75, and $ 2.80 for title insurance, revenue stamps, and recording fees, respectively. Respondent allowed these amounts as deductible expenses and we find that the escrow statements accurately reflected the cost of transferring that parcel. Thus, we allow the above-stated costs as deductible selling expenses.

Respondent disallowed any deduction as a selling expense of the $ 5,000 and $ 6,000 payments to Brannely and Polhemus in 1960 and 1961, respectively. Respondent also disallowed the $ 114.40 payment constituting the cost of the title fee in connection with McEnerney note transaction. Respondent determined all three of these items to be expenses incurred in the acquisition of property.

We uphold respondent's disallowance of the $ 114.40 title fee in connection with the McEnerney note as a selling expense, as it is clear that that expenditure was for the purpose of perfecting petitioners' title in the McEnerney property. It was not a cost of disposing of the Elk Grove property.

52 T.C. 394">*414 Respondent's disallowance of the $ 5,000 and $ 6,000 amounts received by Brannely and 1969 U.S. Tax Ct. LEXIS 116">*162 Polhemus in 1960 and 1961 finds support in Polhemus' testimony that both he and Brannely were hired for, and their efforts were almost entirely directed toward arranging the exchange of the properties. Respondent contends that under such circumstances any portion of either payment considered to be for petitioners' disposition of Elk Grove property is negligible and should be disregarded. The record, however, does indicate that Polhemus spent a substantial amount of time in preparing the necessary documents required for the disposition of Elk Grove, and we find and hold that of the amounts received by Polhemus and Brannely during 1960 and 1961, $ 1,000 and $ 1,200, respectively, represent selling expenses pertaining to the dispositions of Elk Grove property; the $ 1,000 amount to be allocated equally over the 54.793 acres transferred in 1960 and the $ 1,200 amount to be allocated equally over the 134.150 acres transferred in 1961. Cohan v. Commissioner, 39 F.2d 540. The balance of the amounts ($ 4,000 in 1960 and $ 4,800 in 1961) was paid in connection with the acquisition of the Sala, McEnerney, Bettencourt, and Schauer properties and as such are currently nondeductible expenditures. 1969 U.S. Tax Ct. LEXIS 116">*163 Petitioners would have us separately allow a portion of the $ 5,000 and $ 6,000 payments as currently deductible fees incurred in obtaining tax advice, but both fees pertain to a capital transaction and can therefore only represent a part of the basis of the property acquired, or a selling expense of the property sold. Cf. Rev. Rule 67-125, 1967-1 C.B. 31.

Decision will be entered under Rule 50.

Simpson, J., concurring: I agree with the results of the majority opinion, but my reasons are somewhat different.

Occasionally, the tax consequences of a transaction are governed by the form in which it is cast. Commissioner v. Lester, 366 U.S. 299">366 U.S. 299 (1961); Chester L. Tinsman, 47 T.C. 560">47 T.C. 560 (1967). However, generally, tax consequences turn upon substance. Taxpayers are not permitted to circumvent the restrictions in the law by mere formal compliance; nor should they be deprived of a tax benefit when in substance they are entitled to it merely because they accidentally or unwisely chose the wrong form. If tax consequences were based upon form, the results would be a capricious application of the tax law. Relying upon substance results in a more equitable application of the law.

In my 1969 U.S. Tax Ct. LEXIS 116">*164 opinion, the substance of the transactions in this case is that the petitioners exchanged business property which they desired to relinquish for other business property which they wished to operate. 52 T.C. 394">*415 I see no reason for reading the statute restrictively and limiting it to a bilateral exchange of properties. The petitioners desired to transfer their property and found a purchaser who wished to acquire it. However, the purchaser owned no property suitable for an exchange and did not wish to take title to any such property merely for the purpose of trading it. Thus, the petitioners paid their attorneys to find other property which they could accept in exchange, and the attorneys effected the necessary exchanges. In summary, the petitioners were the moving force; it was through their planning and efforts that the exchanges were arranged. In my view, it should make no difference whether the traded property was first transferred to the agents of S. P. so that S. P.'s agents could effect a bilateral exchange with the petitioners. To hold that section 1031 applies when the traded property is first transferred to S. P. or their agent, but not otherwise, places a premium on formal compliance 1969 U.S. Tax Ct. LEXIS 116">*165 with the law. So long as the ultimate effect of the several exchanges of property is that the petitioners have transferred business property and acquired like business property, I believe section 1031 should apply.

If the petitioners had sustained a loss as a result of the transactions and were arguing that it should be recognized, I would not be beguiled by all that took place in this case; I would hold that the step transaction doctrine should be applied, that in substance there was an exchange of business property for business property, and that the loss is not allowable. In my judgment, an even-handed application of the law calls for us also to apply the step-transaction doctrine when the taxpayer realizes a gain.

Raum, J., dissenting: I cannot agree that there was an "exchange" of property in this case. Plainly, there is no "exchange" under section 1031 where the seller of property merely uses the proceeds of sale to purchase other like property, cf. Trenton Cotton Oil Co. v. Commissioner, 147 F.2d 33, 36 (C.A. 6); John M. Rogers, 44 T.C. 126">44 T.C. 126, affirmed per curiam 377 F.2d 534 (C.A. 9), notwithstanding that there may be an "exchange" where the seller persuades the purchaser 1969 U.S. Tax Ct. LEXIS 116">*166 to acquire other property desired by the seller and to substitute such other property for the purchase price, cf. Coastal Terminals, Inc. v. United States, 320 F.2d 333 (C.A. 4). The difficulty here is that the purchaser, Southern Pacific Co., was unwilling in turn to purchase other properties to be used in "exchange" for the Elk Grove property that it was purchasing from petitioners. The majority opinion gets around this difficulty by concluding that Polhemus and Brannely, petitioners' attorneys who purchased the other properties, were acting as agents for Southern Pacific, a conclusion that appears to me to be wholly 52 T.C. 394">*416 unsupported. Polhemus and Brannely were not agents for Southern Pacific, and there was no "exchange" of like properties between petitioners and Southern Pacific.

Nor is there any support for the theory suggested in the concurring opinion, relying "upon substance" to achieve "a more equitable application of the law." Concededly, the statute as written does not apply where the seller merely uses the proceeds of the sale to buy other property. And that is all that occurred here. The fact that an exchange could theoretically have been arranged so as to make the statute 1969 U.S. Tax Ct. LEXIS 116">*167 applicable may be unfortunate for petitioners, but that unhappy result is brought about by Southern Pacific's unwillingness to participate in such manner. I can see no reason for rewriting the statute; its terms are specific. See Trenton Cotton Oil Co. v. Commissioner, 147 F. 2d at 36. Where Congress wanted to permit nonrecognition upon the reinvestment of proceeds, it expressly did so in the case of the sale of a residence in the closely related provisions of section 1034.