1982 U.S. Tax Ct. LEXIS 110">*110
Ps, who operated a proprietorship engaged in the sale of real estate to customers in the ordinary course of their business, purchased in 1968 for $ 11,000 certain acres of unimproved waterfront land adjacent to Janes Island State Park in Maryland. From 1968 through 1972 they platted, subdivided, and preliminarily developed the property. In 1973, Ps received notice from the State of Maryland that it was interested in acquiring the property by condemnation. In 1974, condemnation proceedings were begun, which culminated in April 1975 in a settlement whereby Ps received $ 165,000. On their 1976 Federal income tax return, Ps reported half of the condemnation gain as ordinary income, but subsequently filed an amended return in an attempt to take advantage of the rollover provisions of
78 T.C. 623">*623 Respondent determined the following deficiency in and additions to petitioners' Federal income taxes: 78 T.C. 623">*624
Addition to tax | ||
Year | Deficiency | sec. 6653(a) 1 |
1975 | $ 42,940.64 | None |
1976 | None | $ 147.64 |
1977 | None | 109.86 |
The principal issue is whether the gain received by petitioners in 1975 from the State of Maryland incident to the condemnation of land owned by them adjacent to Janes Island State Park is taxable as ordinary income or as capital gain. The resolution of this issue depends upon whether the petitioners were holding the property for sale to customers in the ordinary course of their business immediately prior to receiving the notice of condemnation1982 U.S. Tax Ct. LEXIS 110">*114 and, if so, whether the condemnation notice, ipso facto, negated their intent to hold it for sale in the ordinary course of their real estate business and changed their intent into an investment purpose. A secondary issue is whether the petitioners' underpayments of tax for 1976 and 1977 were due to negligence or intentional disregard of rules and regulations.
FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly.
William B. Daugherty and Charlotte G. Daugherty (petitioners) are husband and wife who resided in Crisfield, Md., when they filed their petition in this case. They filed their joint Federal income tax returns for the years 1975, 1976, and 1977 with the Internal Revenue Service Center at Philadelphia, Pa.
William B. Daugherty (herein referred to individually as petitioner) has been in the real estate business (sales and rentals) since 1964 when he purchased a tract of land consisting of about 52 acres known as Heart's Ease. That property was subdivided with the intent to sell individual lots to customers in the ordinary course of business. About 30 lots of the Heart's Ease property have been sold.
Petitioner reported on Schedule C of his joint1982 U.S. Tax Ct. LEXIS 110">*115 Federal income tax returns, as ordinary income from the sale of 78 T.C. 623">*625 property to customers in the ordinary course of his business, the proceeds from the sale of lots making up the property known as Heart's Ease. In addition, petitioner has sold other miscellaneous properties to customers in the ordinary course of his business, the proceeds from which he reported on Schedule C of his Federal income tax returns.
In 1966 or 1967, the petitioners purchased 12 acres or less of waterfront property on which four log cabins were built for rental primarily during the summer season. One of these lots was sold at a profit to petitioners' former accountant, Richard Jones.
In June 1968, the petitioners purchased property consisting of 22.78 acres of land on the north side of Janes Island State Park (hereinafter referred to as the Janes Island property). This was unimproved waterfront land adjacent to Janes Island State Park. They paid $ 11,000 for it.
Petitioners have not substantiated the manner of purchase of the Janes Island property, i.e., whether by cash, check, or whether it was financed in whole or in part.
Within the 12 months following the purchase of the Janes Island property, 1982 U.S. Tax Ct. LEXIS 110">*116 the petitioners began development activities. On or about May 30, 1973, they recorded a subdivision plat with the Board of County Commissioners of Somerset County, Md., and the Somerset County Planning and Zoning Commission.
On or about March 11, 1974, the State of Maryland, Department of Natural Resources, filed a petition for condemnation against petitioners to acquire the Janes Island property, although petitioners had received official notice that the State of Maryland wanted the property at least 1 year prior to the initiation of the condemnation suit.
During the course of the condemnation proceedings, the State of Maryland propounded interrogatories which were answered by the defendants (petitioners here) in the condemnation suit.
The highest, best, and most profitable use of the Janes Island property at and just before its condemnation was for subdivision and lot sales.
During the condemnation proceedings, the petitioners valued the Janes Island property on the basis of the total proceeds they would receive by selling it on a per lot basis.
78 T.C. 623">*626 In April 1975, the parties in the condemnation suit reached a basis for settlement pursuant to which, in the year 1975, petitioners1982 U.S. Tax Ct. LEXIS 110">*117 received $ 165,000 from the State of Maryland as proceeds for the sale of their Janes Island property.
Petitioner felt he had no recourse but to accept the State's settlement offer because the bank was "breathing down [his] neck" for some money, and he had to pay the bank.
Petitioners' 1977 Federal income tax return was prepared by Brooks L. Sterling, Sr., an accountant. During the audit of petitioners' taxable years 1975, 1976, and 1977, Mr. Sterling was employed as their accountant. He also represented them during the examination of their 1978 Federal income tax return.
Under the method of accounting used by petitioners, no balance sheet was maintained showing the purpose for which a piece of property was purchased or was being held.
Petitioners accounted on the cash method for property other than property carried as "inventory," and property accounted for on the cash method was expensed by them in the current year.
The Janes Island property was not expensed by petitioners in the year 1968 when purchased. Instead, it was treated as inventory.
The examining agent for the Internal Revenue Service was not advised that the Janes Island property was to be used as rental property until1982 U.S. Tax Ct. LEXIS 110">*118 after petitioners had retained legal counsel.
During the examination of petitioners' returns for the years 1975, 1976, and 1977, petitioner told the examining agent that when the State of Maryland contacted him about condemning the property, the community knew about it right away, it clouded his title, and he was not able to make any sales after that time.
During the audit examination, while on a physical tour of the Janes Island property, petitioner advised Revenue Agent Daniel Duffy that he could have sold the property 30 times over. He also advised the agent that in his type of business in a small community, it is not necessary to advertise.
Petitioners deducted as a cost of sales in their real estate business the principal payments on loans made to purchase real estate. The deduction of principal payments as a cost of 78 T.C. 623">*627 sales was not determinable from the petitioners' books alone but required, in addition, the examination of bank statements or loan schedules.
In a letter dated November 23, 1977, to respondent, the petitioners admitted that they were dealers in real estate and that they had reported half the proceeds of the condemnation on their 1976 Federal income tax1982 U.S. Tax Ct. LEXIS 110">*119 return as real estate business income. In 1978, the petitioners filed an amended Federal income tax return for the year 1976 claiming a refund based upon the alleged erroneous inclusion, as ordinary income, of half the condemnation proceeds from the sale of the Janes Island property.
Petitioners did not maintain records segregating property by category of investment, use in business, or property held for sale to customers in the ordinary course of business. Nor did they maintain books or records indicating that the Janes Island property was being held for investment purposes or for use in their business.
Of eight miscellaneous parcels of property purchased, petitioner stated that all which remain unsold are being held for investment. However, the actual sales of portions of the eight miscellaneous properties were treated by petitioners as having been held in the ordinary course of business, and they reported the sales proceeds as ordinary income on their joint Federal income tax returns.
ULTIMATE FINDINGS OF FACT
(1) Immediately prior to receiving notice of the intent of the State of Maryland to condemn the Janes Island property, the petitioners were holding such property for sale1982 U.S. Tax Ct. LEXIS 110">*120 to customers in the ordinary course of their business.
(2) Part of the underpayments of tax for the years 1976 and 1977 were due to petitioners' negligence or intentional disregard of rules and regulations.
OPINION
Petitioners realized gain from the condemnation by the State of Maryland on the sale of their Janes Island property. We must decide whether the gain received on the disposition of 78 T.C. 623">*628 the property is taxable to petitioners as ordinary income or as a capital gain.
Section 1202 provides favorable tax treatment for a long-term capital gain which, during the year 1975, was defined in section 1222(3) as gain derived from the sale or exchange of a capital asset held for more than 6 months. Section 1221 first defines the term "capital asset" as "property held by the taxpayer (whether or not connected with his trade or business)" and then excludes certain types of property from capital asset status. The first two statutory exceptions are:
(1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property1982 U.S. Tax Ct. LEXIS 110">*121 held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;
(2) property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business;
In addition, section 1231(a) provides that under certain circumstances, the proceeds from the involuntary conversion of property used in the trade or business and capital assets held for more than 6 months shall be considered as a long-term capital gain. But section 1231(b) provides that the term "property used in the trade or business" does not include "property of a kind which would properly be includible in the inventory of the taxpayer if on hand at the close of the taxable year" or "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business."
The purpose of the exceptions specified in section 1221(1) and (2) is to differentiate gains derived from the everyday operation of a business from those derived from appreciation in value over a substantial period of time.
To decide whether particular property is a capital asset, courts have considered several factors:
(1) 1982 U.S. Tax Ct. LEXIS 110">*123 the nature and purpose of the acquisition of the property and the duration of the ownership; (2) the extent and nature of the taxpayer's efforts to sell the property; (3) the number, extent, continuity and substantiality of the sales; (4) the extent of subdividing, developing, and advertising to increase sales; (5) the use of a business office for the sale of the property; (6) the character and degree of supervision or control exercised by the taxpayer over any representative selling the property; and (7) the time and effort the taxpayer habitually devoted to the sales. * * * [
These factors, however, have no independent significance and only form a part of the entire situation presented.
The purpose for which a taxpayer holds property at a particular time is, of course, subject to change. But generally it is the
Where, as here, there is a condemnation sale of property, we think it is important to determine first the taxpayer's purpose for holding the property immediately prior to the receipt of the notice of condemnation.
Initially, we have approached such issues against the backdrop of the Supreme Court's admonition that courts should narrowly construe the definition of a capital asset and, as a corollary, to interpret its definitional exclusions broadly.
Using the factors of the
We reject the petitioner's testimony1982 U.S. Tax Ct. LEXIS 110">*126 that his intent from the time of purchase was to develop the Janes Island property by building vacation cabins for rental on it. In our judgment, this assertion is not supported by the record. It was first made by the petitioner near the end of the audit examination and after retaining legal counsel. On their Federal income tax return for 1976, the petitioners reported half of the condemnation proceeds as ordinary income from the sale of property in the ordinary course of their business. In a letter dated November 23, 1977, the petitioners advised the respondent that, although they had reported a portion of the condemnation proceeds on their 1976 return as income earned from being a dealer in real estate, they were going to try to take advantage of the reinvestment provisions of
Certainly an important way of determining a taxpayer's intent in holding property, especially when he is, like petitioner, in the business of buying and selling real estate, is to examine how particular property was handled on his books and records. 2 Here, Brooks L. Sterling, the petitioner's accountant during the examination of the years at issue, testified that he examined the petitioner's books and records. When questioned about the Janes Island property, Mr. Sterling stated that the petitioner's method of accounting did not include the use of a balance sheet. Mr. Sterling indicated that petitioner did not have any records showing a separation of various properties according to the purpose for which they were held except that inventory property was not currently expensed. Mr. Sterling then indicated that the Janes Island property was an inventory item because it was "never written off." These statements were made under oath in a deposition taken on August 24, 1981. Later, on September 19, 1981, Mr. Sterling, after reviewing his testimony and considering its 78 T.C. 623">*632 consequences, 1982 U.S. Tax Ct. LEXIS 110">*128 initiated changes in his deposition stating that he "should have said investment instead of inventory." However, in the same deposition, on pages 5 and 8 of Exhibit 11, Mr. Sterling gave testimony which would lead one to believe that the first time he was apprised of the fact that the Janes Island property was being held for investment purposes was when the petitioner made such a statement in the presence of the examining agent in 1979.
1982 U.S. Tax Ct. LEXIS 110">*129 Accepting either the accountant's initial testimony that the property was carried as inventory, or the corrected testimony as to what the accountant "should have said" about the property's being held for "investment," it is clear that the property was not (as testified to at trial) being held for "use in a trade or business." Where the petitioner's books and records make no distinction as to the manner of holding the property, that is a factor indicative of, in the case of a dealer in real estate, holding the property for sale to customers in the ordinary course of business. While it is true that one can be in the real estate business with certain properties and at the same time hold other properties for investment, it is incumbent upon such a real estate dealer to make a clear distinction on his books and records of the various properties held by him and, where he fails to make such a segregation, he is subject to ordinary income treatment for sales or dispositions of such property. See
Of course, the best evidence of how the property was carried on the books and records of petitioner would be the books and records themselves. Just prior to trial, the petitioner's books and records were located in his possession. They were not produced at the trial, thus creating the inference to be drawn that if they had been produced, they would have been adverse to the position taken by petitioners herein. See
At first blush, the lack of advertising of the property and the lack of sales of lots seem to indicate that the property was not being held for sale to customers in the ordinary course of business. However, where advertising appears to be unnecessary, the lack of advertising is not probative of the fact that a 78 T.C. 623">*633 taxpayer is not holding property for sale in the ordinary course of his business.
Petitioner's statement that no parcels of the property were sold is obviated by the fact that it was condemned by the State of Maryland before it was fully developed. In this respect, the petitioner acknowledged that when the State of Maryland contacted him concerning its desire to obtain the Janes Island property, the community knew about it, the title to the property was clouded, and he was not able to make any sales after that time. We are not persuaded that when the petitioner dealt with the Janes Island property he was wearing the hat of an "investor" rather than that of a "dealer." 3
Having reached the ultimate conclusion, based upon the subordinate facts herein, that immediately prior to receipt of the condemnation notice, the Janes Island property was being held for sale to customers in the ordinary course of petitioner's business, we are confronted squarely with the issue as to whether the receipt of the notice of the State of Maryland's intent to condemn the Janes Island property automatically 78 T.C. 623">*634 negated the intent of petitioners1982 U.S. Tax Ct. LEXIS 110">*133 to hold the property for sale in the ordinary course of their real estate business for Federal income tax purposes.
The resolution of this issue by the courts has been inconsistent and tortuous. The early section 1221(1) condemnation cases, while recognizing and discussing several evidentiary factors, did not recognize the condemnation, itself, as a possible cause of the taxpayer's alleged change in purpose. In
Next, we dealt with the condemnation issue in
We regard the holding of the
In our
Both the
A condemnation notice does not change land held primarily for sale to customers in the ordinary course of business into a capital asset. See
Further, if there had been no condemnation, the land which was part of the development would have been sold as such and the proceeds treated as ordinary business income. When the condemnation took place, the owner sought to establish a value, for purposes of the condemnation award, that reflected what the owner would have received if the land had been sold as developed. Consequently, to treat the income actually received, which in large part reflected the intent and plan of the owner, as capital gains rather than ordinary income would appear to be inequitable. What development occurred on the remainder1982 U.S. Tax Ct. LEXIS 110">*139 of the 100 acres prior to notice of condemnation necessarily enhanced the value of the 16 acres condemned. This is illustrated by the fact that the pro-rated purchase price of the 16 acres was $ 10,032.62 and the condemnee received $ 97,650.63. In view of the present concern about the uneven impost of the tax laws, it does not appear warranted to interpret the law in such manner as to confer still another benefit not clearly mandated by the statute and regulations, and as stated above, there is no case authority for doing so. * * *
After the Third Circuit's reversal of
* * * *
In our view, the condemnation element did not bring any unexpected customers to the partnership's door, but rather served as the means by which the sale was conducted. We see no reason then why the gain produced by the sales to its governmental customers should be treated any differently than the gain realized by sales to its other customers. Petitioners' argument must be denied.
[Emphasis supplied.]
Our
1982 U.S. Tax Ct. LEXIS 110">*142 The results reached by this Court in
1982 U.S. Tax Ct. LEXIS 110">*144 We think the approach we took in
The same tracing principle applies in determining the tax consequences of the sale of a going business. In
Except as provided by statute, there is no basis for differentiating between voluntary and involuntary sales, such as condemnation. Cf.
Finally, with respect to condemnation proceeds, the Code envisions the possibility of ordinary income treatment of gains realized on the condemnation of inventory or property held for 78 T.C. 623">*640 sale in the ordinary 1982 U.S. Tax Ct. LEXIS 110">*147 course of business. Section 1231(a) provides in part for capital gain treatment of gains recognized upon the condemnation of property used in the taxpayer's trade or business. Section 1231(b)(1)(B), which defines such property, specifically provides that real estate which is held by the taxpayer "primarily for sale to customers in the ordinary course of his trade or business" cannot qualify for capital gain treatment under section 1231. Hence, our strict adherence to the per se rule of
Accordingly, we will follow the decision of the Court of Appeals for the Third Circuit in
After consideration of all the facts and circumstances present in this case, we conclude that the petitioners held their Janes Island property for sale to customers in the ordinary course of their business when the condemnation sale to the State1982 U.S. Tax Ct. LEXIS 110">*148 of Maryland was consummated in April 1975. Therefore, the gain therefrom is taxable as ordinary income.
On their 1976 and 1977 Federal income tax returns, the petitioners deducted as a business expense not only the interest on certain loans but also the principal. This was clearly impermissible. This practice caused an understatement of petitioners' income in both years on which was based a deficiency assessment agreed to by them before they filed their petition in this case.
Petitioner testified at trial that although the treatment of payments on principal loan payments was incorrect, he had presented all of his books to his accountant on whom he relied for the proper preparation of the tax returns for the years in question based upon his books and records. Hence, the position is taken that although the records were incorrect, there was no intent to mislead the return preparer and, in fact, the petitioner relied upon the return preparer to ferret out and correct any mistakes which he might find in such records.
78 T.C. 623">*641 Petitioners have the burden of proving that no part of any underpayment of tax was due to negligence or intentional1982 U.S. Tax Ct. LEXIS 110">*149 disregard of respondent's rules and regulations.
While petitioner may have presented to the return preparer all of the books and records, the examining agent testified that one, examining the books alone, would not have been able to determine the discrepancy which caused the underpayment in 1976 and 1977. He testified that he could not make the determination that loan principal had been erroneously deducted until he had examined petitioners' bank statements and loan schedules for the relevant years. In other words, it required an audit of petitioners' 1982 U.S. Tax Ct. LEXIS 110">*150 books and records, as well as third party records, rather than a mere perusal. Petitioners presented no evidence of the fact that their return preparer was responsible for an audit of their books and records, or third party records, rather than preparation of returns from books and records. They have not satisfied their burden of establishing that they supplied their return preparer with the "correct" information and that the incorrect returns were a result of the preparer's mistakes. See
Accordingly, we sustain respondent's determination with respect to the additions to tax under section 6653(a).
Fay,
Goffe,
1. All section references are to the Internal Revenue Code of 1954 as amended and in effect for the years in issue, unless otherwise indicated.↩
2. See Goggans & Englebrecht, "Investors vs. Dealers," 9 J. Real Est. Tax., No. 2, p. 169, where the authors commented at p. 175:
"Generally, the same considerations apply to dealers as to investors in determining the propriety of capital gain treatment -- that is, whether any improvements were made, lack of sales and promotional effort, etc.
"A dealer in real estate will have to overcome the presumption that a particular sale is not a further extension of his selling activities.
[Emphasis supplied.]↩
3. It is significant, we think, that the amounts paid by the State of Maryland for the lots in the Janes Island property represented virtually the same amounts which would have been paid to petitioners by nongovernmental customers who were in the market for choice lots of subdivided waterfront land.
4. See
"The taxpayers make a further argument that even if the property was held for sale in the ordinary course of business, once the State of California began condemnation proceedings, their holding of the condemned parcel changed to one for investment because the taxpayers could no longer sell the property. The circuits are presently in disagreement as to the effects of condemnation in these circumstances. The Fifth Circuit agrees with the taxpayers' argument,
5. It is true that a taxpayer may change his purpose for holding property. He may decide to develop and sell property which was initially purchased and held for investment, and the gain in such a case would properly be taxed as ordinary income (
6. In real estate transactions, a sale to any purchaser, including a condemning governmental body, is, in effect, a sale to a "customer." See