A Recent Tax Court Opinion... - Posted by JPiper

Posted by CurtNY on January 12, 2001 at 13:06:11:

JPiper & Dave,
Thanks for clearing that up. I also, noted the criteria and how it would effect lease options. My opinion is a lease option does not meet the same criteria as a contract for deed due to the fact the “tenant/buyer” does not have to pay the taxes, or insurance and does not have a contract to purchase rather an option to purchase. Although the tenant/ buyer does have some of the burdens, ie. maintenance, repairs etc… from what I understood the tenant buyer had to meet all the criteria for “burdens & benefits” of ownership. What is your “opinion” on this regarding lease options? Thanks again for the response, I think this may be over looked by many.

Thanks
CurtNY

A Recent Tax Court Opinion… - Posted by JPiper

Posted by JPiper on January 12, 2001 at 05:25:18:

My CPA faxed me a summary of a recent tax court opinion yesterday. I?m going to post some of the details of this below.

The tax court held that sales of residential real estate were complete for tax purposes when contracts for deed were executed despite the fact that warranty deeds for the property would only be conveyed to the buyer when full payment was made later.

The situation was that GIA (the summary I read referred to them in this fashion) was in the business of selling, financing, and renting residential real estate in Western Georgia, primarily to families with little or no credit history. They did this with contracts for deed. The typical contract required the buyer to make payments at interest rates of 11%-18% for a period of 20-25 years, pay all property taxes, insure the property, maintain the property, and assume all liabilities as if they had fee simple title. At the end of the payments the buyer received a warranty deed. A default by the buyer would cause the contract to terminate and entitle GIA to keep payments made by the buyer during the life the contract as liquidated damages.

GIA treated the contracts as voidable, executory contracts which did not reflect a closed and completed sale in the year the contract was signed. To reflect this payments received by GIA were treated as interest income to the extent provided in a promissory note signed in conjunction with the contract. The balance was treated as a DEPOSIT on the purchase. If a property was repoed before full payment, the deposit would be applied first to repairs, and any remaining deposit would be reported as miscellaneous income. GIA also claimed depreciation for the property during the payment period. Upon full payment GIA would recognize gain on the sale measured by the difference between the total sale price and the adjusted basis.

The tax court decided that factors which would be an indication of the benefitis and burdens of ownership include:

  1. a right to possession
  2. an obligation to pay taxes, assessments, and charges against the property
  3. a responsibility to insure the property
  4. a duty to maintain the condition of the property
  5. a right to improve the property without the seller?s consent
  6. bearing the responsibility of loss
  7. a right to obtain legal title at any time by paying the balance of the full purchase price

All of these factors were present in the contracts for deed used by GIA. The tax court evidently reversed a position it took in Baertschi (1967) 49TC289. My CPA is attempting to locate this case and send it to me.

In any case, GIA reported their income on a schedule C and used the accrual method of accounting. Since GIA?s right to the price stated in the contracts for deed was fixed and unqualified, each transaction was completed for tax purposes in the year the contract was signed.

While the summary didn?t mention the penalty here, my guess is that GIA was assessed with back interest and penalties on large amounts of unpaid taxes.

JPiper

Prefferential Installment Sales Treatment - Posted by ScottS

Posted by ScottS on January 12, 2001 at 21:52:24:

JPiper,

I was on another forum, learned some situations where people were setting up L/O’s to pay down like mortgages.

I asked about IRS recharacterization. The answer I received was that most of the time they( this person) elects to characterize it as a sale from the start. They reported that this exempts 60-80% off the principle from taxes.

Does this have anything to do with your Article?

Can you explain it to me.

Scott

Re: A Recent Tax Court Opinion… - Posted by Stacy (AZ)

Posted by Stacy (AZ) on January 12, 2001 at 16:27:52:

I wonder if we could use the list of factors to fashion a CFD that does not comply with all seven, as did the GIA contracts? For example, you listed the following factors:

  1. a right to improve the property without the seller?s consent

If specifically stated in the contract that any improvements must be approved by the seller, this one could be eliminated.

  1. bearing the responsibility of loss

If the underlying Hazard Insurance policy is in the seller’s name, and the buyers only have a contents policy, it seems this one may be eliminated. Also, if the hazard ins. is in the seller’s name, and there is no mention of the buyer being responsible for insuring against loss, this probably eliminates #3:

  1. a responsibility to insure the property

I wonder if there are others that could be eliminated by crafting a better CFD? And, I wonder if this would significantly reduce the possibility of the tax court causing problems (only meeting four of the seven indicators)?

Stacy

English - Posted by CurtNY

Posted by CurtNY on January 12, 2001 at 10:04:19:

Now can someone put that into english? Does this mean an investor has to pay tax on the difference between the sales price and the cost basis, even though they won’t be recieving the full purhase price that year?Hope someone can shed some light.

Thanks
CurtNY

Keith/GIA - Posted by JHyre in Ohio

Posted by JHyre in Ohio on January 12, 2001 at 06:28:30:

TC, [CCH Dec. 54,169] , James W. and Laura L. Keith v. Commissioner, [Proprietorships: Sales of property: Methods of accounting: Accrual method: Computation of gains and losses:
Net operating loss carrybacks.], (Dec. 28, 2000)
James W. and Laura L. Keith v. Commissioner

Docket No. 11426-98., 115 TC --, No. 42., Filed December 28, 2000

[Appealable, barring stipulation to the contrary, to CA-11.–CCH.]

[Code Secs. 172 , 446 , and 451 ]

[Proprietorships: Sales of property: Methods of accounting: Accrual method: Computation of gains and losses: Net operating loss carrybacks.]Prior to and during the years in issue, GIA,
a proprietorship owned by P wife, sold residential real property by means of contracts for deed. Under these agreements, the buyers obtained possession; assumed responsibility for
taxes, insurance, and maintenance; and became obligated to make monthly payments, with interest, of the purchase price. A warranty deed would be delivered to the buyers by GIA only
upon full payment, and any default by the buyers prior thereto would render the contracts null and void, with GIA retaining all amounts paid as liquidated damages.In accounting for
these transactions, Ps reported the gain attributable to the contracts for deed in the year in which full payment was received and title transferred. Only interest payments were included in
income for tax purposes until such time. GIA also depreciated the subject properties during the term of each contract.Held: Each contract for deed effected a completed sale for tax
purposes in the year of execution, and income attributable to such disposition must be recognized and reported for that taxable year.Held, further, the net operating loss carryovers
claimed by Ps must be adjusted to take into account income which should have been reported in years preceding those at issue, for contracts entered during such prior periods.Held,
further, Baertschi v. Commissioner [Dec. 28,718], 49 T.C. 289 (1967), revd. [69-2 USTC ¶9461] 412 F.2d 494 (6th Cir. 1969), will no longer be followed.

William J. White, for the petitioners. Nancy E. Hooten and Mark S. Mesler, for the respondent.

OPINION

NIMS, Judge:

Respondent determined the following deficiencies and penalties with respect to petitioners? Federal income taxes for the taxable years 1993, 1994, and 1995:

Income Tax Penalty
Taxable Year Deficiency Sec. 6662(a)

1993 … $ 74,925.00 $ 14,985
1994 … 127,304.00 25,461
1995 … 106,261.54 21,252

After concessions, the issues remaining for decision are:

(1) The proper method of accounting for, and timing of recognition of gain attributable to, sales of property by means of contracts for deed; and

(2) the reduction of net operating loss carryovers from years preceding the years in issue to reflect income attributable to contracts for deed executed in those prior years.

Additionally, the parties have agreed that a third issue, the availability of depreciation deductions for properties subject to such contracts for deed, is dependent upon and will be
resolved by our decision regarding petitioners? accounting method. The parties have stipulated the amounts to be allowed as depreciation deductions in the event of a ruling either for
petitioners or for respondent.

Unless otherwise indicated, all section references are to sections of the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.

Background

This case was submitted fully stipulated pursuant to Rule 122, and the facts are so found. The stipulations of the parties, with accompanying exhibits, are incorporated herein by this
reference. Petitioners resided in Moultrie, Georgia, during each of the years in issue and at the time their petition was filed in this case.

Formation of Greenville Insurance Agency (GIA)

Petitioner James W. Keith is a radiologist, and petitioner Laura L. Keith is a dentist. Mrs. Keith is also the owner of a proprietorship known as Greenville Insurance Agency (GIA). Mrs.
Keith established the business in 1983 on the advice of her father, J.D. Latzak, as a vehicle to create potential tax savings. GIA was formed primarily to sell insurance, to purchase real
estate for resale or rent, and to broker mortgages. Since its genesis, GIA has been run by Mr. Latzak who, because of large judgment creditors, could not conduct business or hold assets
in his name. Although neither of the Keiths possesses an insurance license or has experience in real estate transactions, Mr. Latzak is a licensed insurance agent and an experienced
broker. We previously addressed the treatment of insurance commissions and mortgage placement fees earned incident to GIA?s operations for years 1984 through 1988 in Latzak v.
Commissioner [Dec. 50,070(M) ], T.C. Memo. 1994-416. We now focus on the reporting of income attributable to the company?s sales of real property.

GIA?s Real Estate Transactions

During the years at issue, GIA was in the business of selling, financing, and renting residential real property. The sales were effected by means of contracts for deed. The record
reflects 18 such contracts entered into between 1989 and 1995, 12 of which were executed in the 1993 to 1995 period presently before the Court. The following is representative of these
agreements:

CONTRACT FOR DEED

GEORGIA, MERIWETHER COUNTY

This agreement entered into by the seller and the buyer(s). The seller hereby
agrees to convey to the buyer(s) fee simple title to a certain property
described on Exhibit ?A? to this contract, at which time all of the
conditions of the sale described below are met by the buyer.

SELLER: Greenville Insurance Agency, a proprietorship, which is registered
and domiciled in Meriwether County, Ga., maintaining an office open
to the public at 109 Court Square, Greenville, Georgia 30222.

BUYER(S): -------------------------------------------------------------------



SELLING PRICE: -------------------- DOWN PAYMENT --------------------

BALANCE of $ ________________ to be evidenced by a promissory note plus
interest at _______ % interest payable in _____ monthly installments of
$ __________ per month, starting ______________ and ending _____________
.

SPECIAL STIPULATIONS TO THE CONDITIONAL SALE:

(1) The buyer(s) shall pay the prorated [year of execution] property
taxes, and all future property taxes promptly when due.

(2) The buyer(s) shall not permit the general condition of the property to
deteriorate in value any futher [sic] than its delivered condition.

(3) The buyer(s) shall perform any and all required maintenance on the
property.

(4) The buyer(s) shall assume all liabilities as if they had fee simple
title.

(5) The property is to be used as a primary single family residence for
the buyer(s), and for no other purpose.

(6) The buyer may not transfer or assign their [sic] rights or interest in
this contract.

(6a) Fire Insurance in the amount of $ _______________ from a company
approved by the Seller must be kept in force at all times, seller
named as loss payee, until all terms are met by buyer.

(7) Payment of the monthly installments of $ _____________ are required to
be tendered to the seller at its offices stated above or other place
so designated by the seller or its assigns, and payable in United
States Currency, on or before the due date. Any payment accepted more
than ten (10) days beyond the due date will require an additional
charge of 10% of the amount payable, and the acceptance of same will
not modify or novate any other terms and conditions and will not act
as a waiver of the sellers [sic] right to declare the contract in
default and null and void and of no effect.

The seller agrees to convey to the buyer(s), a Warranty Deed, free of any
leins [sic] and encumbrances within ten (10) days after all of the terms and
conditions of this agreement are met by the buyer(s).

Should the buyer(s) elect to acelerate [sic] this agreement, then the terms
and conditions of the promissory note executed contemporaneously with this
agreement by the buyer(s) would determine the amount to be tendered by the
buyer(s) for the acceleration in order to prematurely obtain a warranty
deed.

Should the buyer(s) default or breach or not meet any of the conditions of
the terms herein specified, then this contract and the note attached
evidenced by this contract will be immediately declared NULL & VOID, and no
futher [sic] benefits or equities would be accrued to the buyer(s), except
that the buyer(s) would be liable for any monies unpaid under the terms and
conditions of the contract to the date that the contract was declared null
and void.

It is understood and agreed by the Buyer(s) and the Seller that the $ ______
ernest [sic] money down payment, and the monthly installments and other
charges tendered by the buyer(s) from inception, and any improvements to the
property made by or on the behalf of the buyer(s) during the life of this
contract, if forfeited by the buyer(s) as a result of default or breach of
the contract, is a fair value for the liquidated damages incurred by the
seller as a result of said breach or default.

No warranties as to the condition or usability of the property are either
expressed or implied by the seller.

It is herein disclosed to the buyer(s) that the subject property may
presently have existing debt being serviced by the seller, and that future
debt (not to exceed the amount payable under this contract) may be incepted
by the seller. 1

The conditions of sale, as well as the provisions related to default, voidability, and liquidated damages, were substantially identical in all material respects in each of the contracts.
Printed descriptions or handwritten notations indicate that the subject property of most of the agreements was a residence. A small percentage of the contracts may have been for land
alone. The majority of the contracts were for terms of between 240 and 300 months and specified interest at a rate of 11 to 18 percent. The sales prices ranged from a low of less than
$3,000 to a high of $40,000. The total gain represented by the contracts, calculated as the difference between the sales price and GIA?s basis, was $58,373, $62,517, and $11,500 for
agreements executed in 1993, 1994, and 1995, respectively.

GIA?s Accounting and Reporting

With their 1993, 1994, and 1995 Federal income tax returns, petitioners included Schedules C, Profit or Loss From Business, with respect to GIA. On each such Schedule C, petitioners
indicated GIA?s accounting method by checking the box labeled ?Accrual?. A like designation was made on Schedules C filed with returns for the preceding years 1984 through 1992.

As regards accounting for the above-described real estate transactions in particular, the methodology generally utilized by petitioners has been stipulated by the parties. During the
term of a contract for deed, petitioners would report as income the interest received on the promissory note entered into in conjunction with the contract. The portion of any payment
allocable to principal would be treated as a deposit on the purchase and would be recorded as a liability on the books of the company. If a property were repossessed prior to completion
of the contract, this deposit would be applied first to repairs and maintenance, and any remaining amount would be reported as miscellaneous income. The properties would also be
depreciated by GIA during the payment period.

Upon full payment of the contract price, petitioners would recognize income on the disposition of the property. Gain on the sale would be computed by reducing the total sale price by
petitioners? adjusted basis in the property.

Discussion

I. Contentions of the Parties

Petitioners contend that their method of accounting for and recognizing gain attributable to the contracts for deed is appropriate and clearly reflects income. According to petitioners,
the contracts are mere voidable, executory agreements and as such do not effect a closed and completed sale in the year signed. Hence, in petitioners? view, there is no disposition of the
properties for tax purposes and no consequent realization of gain until final payment is received and title transferred.

Conversely, respondent asserts that petitioners? method of accounting for sales under the subject contracts for deed is improper and fails to clearly reflect income. Respondent avers
that each instrument produced a completed sale in the year of execution, as the benefits and burdens of ownership were transferred from petitioners to the buyer at that time. Respondent,
characterizing petitioners as accrual method taxpayers, therefore concludes that no grounds exist for deferring recognition of gain on these completed transactions. In addition,
respondent argues that petitioners? incorrect method of accounting resulted in inflated losses in prior years such that the net operating loss carryovers to the years at issue should be
reduced accordingly.

II. Method of Accounting and Recognition of Gain

A. Existence of Gain–Completed Sale

As a general rule, the Internal Revenue Code imposes a Federal tax on the taxable income of every individual. See sec. 1 . Section 61(a) specifies that gross income for purposes of
calculating such taxable income means ?all income from whatever source derived?. Expressly encompassed within this broad pronouncement are ?Gains derived from dealings in
property?. Sec. 61(a)(3) . Section 1001(a) then defines such gains as the amount realized ?from the sale or other disposition of property?, less the adjusted basis. Accordingly, section
1001(a) indicates that gross income within the meaning of section 61(a) does not arise until property is considered sold or otherwise disposed of for Federal tax purposes.

Case law then sets forth the standard for determining when a sale is complete for tax purposes. With respect to real property, a sale and transfer of ownership is complete upon the
earlier of the passage of legal title or the practical assumption of the benefits and burdens of ownership. See Major Realty Corp. & Subs. v. Commissioner [85-1 USTC ¶9124 ], 749 F.2d
1483, 1486 (11th Cir. 1985), affg. in part and revg. in part [Dec. 38,056(M) ] T.C. Memo. 1981-361; Dettmers v. Commissioner [70-2 USTC ¶9534 ], 430 F.2d 1019, 1023 (6th Cir. 1970), affg.
Estate of Johnston v. Commissioner [Dec. 29,244 ], 51 T.C. 290 (1968); Baird v. Commissioner [Dec. 34,374 ], 68 T.C. 115, 124 (1977). This test reaffirms the longstanding principle,
evidenced by the following early statement, that transfer of legal title is not a prerequisite for a completed sale: ?A closed transaction for tax purposes results from a contract of sale
which is absolute and unconditional on the part of the seller to deliver to the buyer a deed upon payment of the consideration and by which the purchaser secures immediate possession
and exercises all the rights of ownership.? Commissioner v. Union Pac. R.R. Co. [36-2 USTC ¶9525 ], 86 F.2d 637, 639 (2d Cir. 1936), affg. [Dec. 8932 ] 32 B.T.A. 383 (1935).

In determining whether passage either of title or of benefits and burdens has occurred, we look to State law. It is State law that creates, and governs the nature of, interests in property,
with Federal law then controlling the manner in which such interests are taxed. See United States v. National Bank of Commerce [85-2 USTC ¶9482 ], 472 U.S. 713, 722 (1985). Here,
execution of the contracts for deed was not accompanied by a transfer of legal title, so we must decide whether these instruments were sufficient under State law to confer upon the
purchaser the benefits and burdens of ownership. This inquiry is a practical one to be resolved by examining all of the surrounding facts and circumstances. See Clodfelter v.
Commissioner [70-1 USTC ¶9413 ], 426 F.2d 1391, 1393 (9th Cir. 1970), affg. [Dec. 28,573 ] 48 T.C. 694 (1967); Baird v. Commissioner, supra at 124. As all contracts at issue appear to
involve Georgia properties and to have been executed in Georgia, the relevant State law is supplied by the statutes and courts of that jurisdiction.

Among the factors which this and other courts have cited as indicative of the benefits and burdens of ownership are: A right to possession; an obligation to pay taxes, assessments,
and charges against the property; a responsibility for insuring the property; a duty to maintain the property; a right to improve the property without the seller?s consent; a bearing of the
risk of loss; and a right to obtain legal title at any time by paying the balance of the full purchase price. See Goldberg v. Commissioner [Dec. 51,878(M) ], T.C. Memo. 1997-74; see also
Major Realty Corp. v. Commissioner, supra at 1487; Grodt & McKay Realty, Inc. v. Commissioner [Dec. 38,472 ], 77 T.C. 1221, 1237-1238 (1981); Musgrave v. Commissioner [Dec. 54,037
], T.C. Memo. 2000-285; Berger v. Commissioner [Dec. 51,179(M) ], T.C. Memo. 1996-76; Spyglass Partners v. Commissioner [Dec. 50,915(M) ], T.C. Memo. 1995-452. When a buyer, by
virtue of such incidents, would be considered to have obtained equitable ownership under State law, a sale will generally be deemed completed for Federal tax purposes. See Baird v.
Commissioner, supra at 126; Berger v. Commissioner, supra; Spyglass Partners v. Commissioner, supra.

In the case at bar, we observe that the contracts for deed gave the buyers possession of the property during the agreement term (evidenced by the mandate to use the property as a
residence). The contracts also required purchasers to pay property taxes from the date of execution, to keep fire insurance in force during the payment term, to perform maintenance and
prevent deterioration, and to assume all liabilities as if they held fee simple title. Moreover, the instruments allowed buyers to accelerate the agreement and ?prematurely obtain a warranty
deed? by tendering the full amount owing under the related promissory note. Therefore, given these significant accoutrements of ownership, we turn to whether Georgia courts would
construe an instrument so designating rights and obligations as a transfer of equitable ownership to the buyer.

In Chilivis v. Tumlin Woods Realty Associates, Inc., 297 S.E.2d 4 (Ga. 1982), the Supreme Court of Georgia interpreted a contract analogous to those at issue here. In that case, an
?Agreement for Deed? was executed by the parties. Id. at 5-6. According to its terms, a deed was placed in escrow to be delivered to the buyer upon completion of all payments called for
in the accompanying promissory note. See id. at 6. The instrument specifically recited:

?Seller and Buyer acknowledge and agree that this Agreement is not a mortgage or security deed to secure a loan made to Buyer by Seller, that this is an agreement to convey the
Property to Buyer upon the completion of the terms and provisions of this Agreement * * * , that this is not a loan secured by the Property and that no title in and to the Property
has passed to Buyer or will pass to Buyer until Buyer fulfills and complies with each and every term and provision hereof.? [Id.]

The buyer was given immediate possession of the property and was responsible for taxes, maintenance, and insurance thereon. See id. Upon a default by the buyer, the seller?s remedy
was either to rescind the transaction or to exercise a power of sale over the property. See id. The buyer would not be liable for any deficiency in the event of such a sale. See id.

Faced with these facts, the court decided that the ?Agreement for Deed? was ?for all practical purposes no different from a bond for title?, an instrument formerly used in Georgia real
estate law in connection with sales of land. Id. at 78. The court further noted that prior case law had said of a bond for title:

?In the sale of land on credit where the vendor retains title, he has not the absolute estate, but is a trustee holding the title only as security. For many purposes the transaction may
be treated in equity as though the vendor had made a deed to the vendee and the latter had thereupon given a common-law mortgage to secure the purchase-money.? [Id. (quoting
Lytle v. Scottish Am. Mortgage Co., 50 S.E. 402, 406 (Ga. 1905)).]

Accordingly, the court then concluded with respect to the instrument before it as follows: ?In practicality, it is no different than if * * * [the seller] had delivered a warranty deed to * * *
[the buyer] and accepted a deed to secure debt in return. The agreement created an equitable interest in * * * [the buyer] and a security interest in * * * [the seller].? Id. at 8.

The Court of Appeals of Georgia subsequently relied on Chilivis v. Tumlin Woods Realty Associates, Inc., supra, in interpreting a similar agreement in Tucker Fed. Sav. & Loan
Association v. Alford, 311 S.E.2d 229 (Ga. Ct. App. 1983). The appellate case likewise involved a land sale contract under which the seller agreed to deliver a warranty deed upon full
payment (or the assumption by the buyers of two outstanding mortgages on the property). See id. at 230. Again the instrument recited that no title passed upon execution of the
agreement, but the buyers took possession and control of the premises. See id. The court first opined that ?The transaction clearly granted * * * [the buyers] all the benefits and
responsibilities of ownership.? Id. On that basis, the conclusion ultimately reached was that ?The contract of sale, of course, did not vest legal title in * * * [the buyers], but it did give
them an equitable interest and rights of ownership.? Id. at 231.

Given the foregoing, we conclude that Georgia courts would similarly construe the contracts for deed at issue here to pass equitable ownership to the purchasers and to leave GIA
essentially with a security interest. In addition, we note that certain statements made by petitioners on brief are not inconsistent with the notion that security concerns may in fact have
motivated the transactional form chosen: ?GIA sells real property to low-income families in Western Georgia near Columbus. Because these families are poor and have little or no credit
history the properties are sold using a ?Contract for Deed? ?. Hence, we hold that these instruments upon their execution effected a completed sale for Federal tax purposes. Petitioners?
reliance on Hambrick v. Bedsole, 91 S.E.2d 205 (Ga. Ct. App. 1956), and on the voidability of their agreements, in support of a contrary conclusion, is misplaced.

Hambrick v. Bedsole, supra at 208-209, involved a contract under which title to property was not to pass and possession was not to be delivered until the full, lump-sum purchase
price was paid. The agreement did not provide for either a downpayment or installment payments. See id. The court decided that the contract ?was a mere executory agreement to sell and
did not constitute a sale?, on the grounds that the buyer ?gained by the contract neither title to, nor the right of possession of? the subject property. Id. at 209. The situation in Hambrick
v. Bedsole, supra, thus bears almost no resemblance to that in the instant case and cannot inform our analysis.

As regards the voidability of the contracts for deed, we see no material difference between the provisions on default here and those contained in the agreement in Chilivis v. Tumlin
Woods Realty Associates, Inc., supra. In either case, if the buyer were to default and refuse to complete the transaction, the seller would have no further recourse against the buyer
personally. The seller could look only to the property itself as a means to recover the full value of the aborted deal and would be unable to enforce remaining payments or deficiencies
against the buyer as a personal liability. Yet, the court still characterized the Chilivis instrument as creating an equitable interest in the buyer and leaving the seller with a mere security
interest. Hence, we do not believe that Georgia courts would hold a lack of recourse against the purchaser, following default of an otherwise binding agreement, to prevent a finding that
the benefits and burdens of ownership, i.e., an equitable interest, were nonetheless transferred when the contract was signed. Accordingly, the sale should be considered complete for tax
purposes, regardless of the possibility of future voidance.

The foregoing conclusion is further buttressed by the weight, or lack thereof, that other courts have given to various types of nonrecourse clauses in evaluating the completeness of a
sale. For instance, the sales agreement at issue in Commissioner v. Baertschi [69-2 USTC ¶9461 ], 412 F.2d 494, 497 (6th Cir. 1969), revg. [Dec. 28,718 ] 49 T.C. 289 (1967), contained the
following language:

The remedy or recourse of said parties of the first part for the non-performance of any obligation of the parties of the second part hereunder shall be limited solely to the moneys
paid hereunder, and to the herein described property, and said parties of the second part shall not be liable for any deficiency arising from the sale of said property in any way,
capacity or manner whatsoever, nor shall said parties of the first part have the right to, nor seek, a deficiency or other money judgment against said parties of the second part.

The court, however, noted such factors as the buyers? absolute right to title on full payment; the sellers? lack of any right to cancel except upon the purchasers? default; and the buyers?
possession of, and responsibility for taxes and insurance on, the property. See id. at 498. Given these elements, the court declared: ?we do not feel that the single fact of a ?no recourse?
clause served to delay the finality of this sale until final payment of the total purchase price had been made.? Id. An identical result was reached on similar facts in Clodfelter v.
Commissioner [70-1 USTC ¶9413 ], 426 F.2d 1391, 1395 (9th Cir. 1970).

While we acknowledge that our opinion in Baertschi reached a contrary conclusion on this issue, we have now reconsidered our holding in light of reversal by the Court of Appeals
for the Sixth Circuit. We are persuaded that the position of the Court of Appeals on the effect of a non-recourse provision rests on sound legal principles. Accordingly, Baertschi v.
Commissioner [Dec. 28,718 ], 49 T.C. 289 (1967), will no longer be followed. We further note that this approach better harmonizes with our earlier ruling that contracts with provisions
closely analogous to those here and which by their terms became ?utterly null and void? on the buyer?s default, with the seller retaining all moneys paid, represented closed sales in the
year entered. See Arnold v. Commissioner, a Memorandum Opinion of this Court dated Mar. 17, 1953. We see no reason to infer differently here.

B. Reporting of Gain–Timing of Inclusion

Thus, having decided that petitioners? contracts for deed effected a completed sale when executed, we proceed to the question of when gain from such sales must be included in gross
income. The general rule for the taxable year of inclusion is set forth in section 451(a) : ?The amount of any item of gross income shall be included in the gross income for the taxable year
in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period.?
Regulations then specify as follows:

Under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof
can be determined with reasonable accuracy. * * * Under the cash receipts and disbursements method of accounting, such an amount is includible in gross income when actually
or constructively received. * * * [Sec. 1.451-1(a) , Income Tax Regs.]

Taxable income, in turn, generally ?shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books?, with the
exception that ?if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly
reflect income.? Sec. 446(a) and (b) .

As used in section 446 , the term ?method of accounting? encompasses ?not only the over-all method of accounting of the taxpayer but also the accounting treatment of any item?.
Sec. 1.446-1(a)(1) , Income Tax Regs. Furthermore, it has been recognized repeatedly that this section grants the Commissioner broad discretion, such that to defeat a proposed change
thereunder, the taxpayer must establish that the Commissioner?s determination is ? ?clearly unlawful? ? or ? ?plainly arbitrary? ?. Thor Power Tool Co. v. Commissioner [79-1 USTC ¶9139 ],
439 U.S. 522, 532-533 (1979) (quoting Lucas v. American Code Co. [2 USTC ¶520 ], 280 U.S. 445, 449 (1930), and Lucas v. Kansas City Structural Steel Co. [2 USTC ¶520 ], 281 U.S. 264,
271 (1930)). However, if the taxpayer?s method does clearly reflect income, the Commissioner cannot require the taxpayer to change to a different method even if the Commissioner?s
method more clearly reflects income. See Ford Motor Co. v. Commissioner [95-2 USTC ¶50,643 ], 71 F.3d 209, 213 (6th Cir. 1995), affg. [Dec. 49,642 ] 102 T.C. 87 (1994).

In the case at bar, the only evidence in the record which speaks to GIA?s overall method of accounting is the Schedules C filed with petitioners? tax returns. On each such Schedule C,
the box indicating ?Accrual? was checked. We therefore have no basis on which to conclude that GIA was other than an accrual method business and must proceed on the assumption
that, excepting the contract for deed transactions, its items of income and expense were reported using this method.

Under the accrual method, gain arising from the contracts for deed would be reportable in the year when the right to receive the income became fixed and the amount of the income
became reasonably determinable. Since the instruments at issue expressly dictated price, the latter requirement regarding amount of income is not in question here. Concerning the former
element of a fixed right to the income, we reiterate the well-established principle that ?In applying the all events test, this and other courts have distinguished between conditions
precedent, which must occur before the right to income arises, and conditions subsequent, the occurrence of which will terminate an existing right to income, but the presence of which
does not preclude accrual of income.? Charles Schwab Corp. & Subs. v. Commissioner [Dec. 51,651 ], 107 T.C. 282, 293 (1996), affd. [99-1 USTC ¶50,109 ] 161 F.3d 1231 (9th Cir. 1998).

Here, the only circumstance in which GIA could fail to receive the full amount of the purchase price would be a default by the buyer. A default, however, is a condition subsequent. As
we stated regarding the similar sales contract in Clodfelter v. Commissioner [Dec. 28,573 ], 48 T.C. 694, 701 (1967):

the purchaser was given immediate possession; it thereupon assumed the rights and obligations of beneficial ownership; and thereafter such property interest and beneficial
ownership would not be subject to termination or forfeiture, except on the happening of a condition subsequent–i.e., a default.

Thus, because the buyer?s obligation to pay the full price under the agreements in the instant case was otherwise unconditional, execution of the contracts fixed petitioners? right to
these sums. Our declaration that ?the amount of and right to the purchase price were fixed and unqualified?, in the context of another sales agreement which provided for forfeiture of the
contract and retention of all moneys paid in liquidation of damages, is equally applicable here. Elsinore Cattle Co. v. Commissioner, a Memorandum Opinion of this Court dated Feb. 21,
1950. Accordingly, both elements for inclusion were met in the year of signing, the year the transaction was completed for tax purposes.

This is consistent with the longstanding position of this Court that the factual predicate requiring income inclusion in a given year by an accrual method taxpayer is completion of a
sale in that year. For instance, it was held as early as 1925, with respect to a contract entered in 1918 with all payments to be made in subsequent years: ?The transaction was a completed
sale in the year 1918, and, as the taxpayer kept its books of account on the accrual basis, the sale price was properly accruable in that year. We hold, therefore, that the profits arising from
the sale in question were income to the taxpayer in the year 1918.? Parish-Watson & Co. v. Commissioner [Dec. 831 ], 2 B.T.A. 851, 860 (1925); see also sec. 15A.453-1(d)(2) , Temporary
Income Tax Regs., 46 Fed. Reg. 10717 (Feb. 4, 1981). But see sec. 1.1001-1(g) , Income Tax Regs., for sales or exchanges occurring on or after August 13, 1996.

We additionally point out that, to the extent petitioners argue no income is required to be recognized because the voidable notes evidencing the debt have no fair market value and
thus are not the equivalent of cash, this consideration has no place in the analysis of an accrual method entity. The following explanation clearly distinguishes between accrual and cash
accounting in this regard:

An agreement, oral or written, of some kind is essential to a sale. If payment is made at the same time that the obligation to pay arises under the agreement, then the profit would be
reported at that time no matter which method was being used. However, the situation is different when the contract merely requires future payments and no notes, mortgages, or
other evidence of indebtedness such as commonly change hands in commerce, which could be recognized as the equivalent of cash to some extent, are given and accepted as a
part of the purchase price. That kind of a simple contract creates accounts payable by the purchasers and accounts receivable by the sellers which those two taxpayers would
accrue if they were using an accrual method of accounting in reporting their income. But such an agreement to pay the balance of the purchase price in the future has no tax
significance to either purchaser or seller if he is using a cash system. [Johnston v. Commissioner [Dec. 17,578 ], 14 T.C. 560, 565 (1950).]

Consequently, unless a specific exception to the above general rules will permit deferral, we are satisfied that GIA, as an accrual method business, must recognize and report income
attributable to the contracts for deed in the years of their respective executions.

The primary exception for income deferral is section 453 , which provides for the ?installment method? to be used in reporting an ?installment sale?. Petitioners do not, however, appear
to argue that this statute is applicable. We also note that a ?dealer disposition?, including ?Any disposition of real property which is held by the taxpayer for sale to customers in the
ordinary course of the taxpayer?s trade or business?, is excluded from the definition of an installment sale. Sec. 453(b)(2)(A) , (l)(1)(B) . The parties here have stipulated that ?GIA was in
the business of selling, financing, and renting residential real property.? Additionally, although a further exception can permit use of the installment method for sales of residential lots,
see sec. 453(l)(2)(B) , the record before us fails to establish that petitioners could qualify under this provision. The contracts indicate that the majority of the properties were houses, not
lots. Also, as to the contracts which may have been for land alone, no evidence shows that the remaining requirements for this election have been met. See sec. 453(l)(2)(B)(ii) , (l)(3) ;
Wang v. Commissioner [Dec. 52,645(M) ], T.C. Memo. 1998127. In any event, petitioners have nowhere contended that the various transactions should be treated differently.

A second basis for potential income deferral, to which petitioners do make reference on brief as an apparent alternative argument, is the recovery of cost approach. However,
substantive requirements for use of this method aside, we have refused to allow taxpayers to switch to cost recovery accounting without following the established procedures under
section 446(e) for requesting such a change from the Commissioner. See Wang v. Commissioner, supra; see also Witte v. Commissioner [75-1 USTC ¶9477 ], 513 F.2d 391 (D.C. Cir.
1975)(holding that section 446(e) requires that consent be sought even for a change from an improper to a proper accounting method), revg. in part and remanding [Dec. 31,609(M) ] T.C.
Memo. 1972-232. It is undisputed that petitioners have never filed the requisite Form 3115. See sec. 1.446-1(e)(3)(i) , Income Tax Regs. The Commissioner thus was not obligated to
consider this approach in analyzing whether petitioners? accounting clearly reflected income or in determining a method which did so.

To summarize, respondent determined that gain of an accrual method business must be reported consistently with that method in order to clearly reflect income. Given the above, we
now conclude that such determination accords with settled law and precedent. Hence, petitioners have not shown that the proposed change is either clearly unlawful or plainly arbitrary.
We hold that petitioners must include the gain attributable to GIA?s contracts for deed, the excess of sales price over basis, in their gross income for the respective years of the
agreements? execution.

III. Reduction of Net Operating Loss Carryovers

Section 172(a) authorizes a net operating loss deduction. Essentially, a net operating loss is the excess of deductions over gross income, with enumerated modifications. See sec.
172© and (d) . The net operating loss so determined may be carried back to the 3 preceding taxable years and carried forward to the 15 succeeding years, until absorbed by taxable
income. See sec. 172(b) .

On their returns for 1993 through 1995, petitioners claimed deductions for net operating loss carryovers from prior years. In the notice of deficiency, respondent disallowed a portion of
the amount claimed for 1993 and the full amount for years 1994 and 1995. Respondent argues that the net operating loss carryovers were overstated and should be allowed only to the
extent the underlying losses were incurred and remain unabsorbed after taking into account certain adjustments.

Two primary adjustments are referenced in the parties? stipulations and briefs. First, both parties are apparently in agreement that the net operating loss carryovers should be
increased to reflect the insurance commissions and mortgage placement fees which we previously held should have been reported by Mr. Latzak. See Latzak v. Commissioner [Dec.
50,070(M) ], T.C. Memo. 1994-416. Second, however, respondent also contends that the carryovers should be reduced to reflect the income attributable to contracts for deed entered in
years 1989 through 1992, as such gain was properly reportable in those years.

In general, the taxpayer bears the burden of establishing both the actual existence of net operating losses in the prior years and the amount of such losses that may be carried to the
years at issue. See Rule 142(a); Jones v. Commissioner [Dec. 21,590 ], 25 T.C. 1100, 1104 (1956), revd. and remanded on other grounds [58-2 USTC ¶9832 ] 259 F.2d 300 (5th Cir. 1958);
Ocean Sands Holding Corp. v. Commissioner [Dec. 37,289(M) ], T.C. Memo. 1980-423, affd. without published opinion 701 F.2d 167 (4th Cir. 1983); Moyer v. Commissioner [Dec.
33,701(M) ], T.C. Memo. 1976-69, affd. without published opinion 565 F.2d 152 (3d Cir. 1977). We have jurisdiction to consider such facts related to years not in issue as may be necessary
for redetermination of tax liability for the period before the Court. See sec. 6214(b) .

Here, petitioners have not and could not, given our conclusions above, establish their incurrence of and entitlement to deduct losses premised in part on a failure to report income
attributable to the contracts for deed entered in the loss years. We agree with respondent that these adjustments should be taken into account along with those based on the income
properly reportable by Mr. Latzak. Thus, we hold that to the extent recomputation applying these adjustments shows that GIA?s net operating loss carryovers do not exceed the amount
allowed by respondent for 1993, petitioners are not entitled to deduct such further amounts.

To reflect the foregoing and the parties? concessions,

Decision will be entered under Rule 155.

Reviewed by the Court.

WELLS, CHABOT, WHALEN, COLVIN, HALPERN, CHIECHI, LARO, FOLEY, VASQUEZ, GALE, THORNTON, and MARVEL, JJ., agree with this majority opinion.

SWIFT and RUWE, JJ., concur.

1 With respect to this final paragraph, we note that neither party has referenced its existence or discussed its intended operation. Our own research has similarly yielded no insight into
the precise meaning of such a provision or its potential impact on the buyer-seller relationship. Hence, since the parties apparently regard it as insignificant boilerplate, we shall do
likewise and shall give it no further consideration.

Baertschi - Posted by JHyre in Ohio

Posted by JHyre in Ohio on January 12, 2001 at 06:25:35:

TC, [CCH Dec. 28,718] , E. F. Baertschi and Alma M. Baertschi v. Commissioner, [Nonrecognition of gain: Sale of old residence: Newly constructed residence: Date of sale.]–, (Dec. 29,
1967)
E. F. Baertschi and Alma M. Baertschi v. Commissioner

Docket No. 2186-66, 49 TC --, No. 29, 49 TC 289, Filed December 29, 1967

[1954 Code Sec. 1034 ]

[Nonrecognition of gain: Sale of old residence: Newly constructed residence: Date of sale.]–Held, on the facts disclosed by the record, that petitioners had commenced construction of a
new residence prior to the expiration of one year after the date of sale of the old residence and had used the newly constructed residence as their principal residence within 18 months of
said sale date and that, therefore, they are entitled to utilize the non-recognition provisions of sec. 1034 , I. R. C. 1954, with respect to the sale of their old residence.

James F. Kennedy, Jr., for the petitioners. Robert T. Hollohan, for the respondent.

Fay, Judge:

Respondent determined deficiencies in petitioners? Federal income taxes for the calendar years 1962 and 1963 in the amounts of $4,736.68 and $13,046.88, respectively.

The sole issue for determination is whether petitioners are entitled to utilize the non-recognition provisions of section 1034 of the Internal Revenue Code of 1954 with respect to the
sale of their old residence.

Findings of Fact

Some of the facts have been stipulated, and the stipulation of facts, together with the exhibits attached thereto, is incorporated herein by this reference.

E. F. Baertschi and Alma M. Baertschi, husband and wife, had their legal residence in Toledo, Ohio, at the time the petition herein was filed. They filed joint Federal income tax returns
for the years 1962 and 1963 with the district director of internal revenue at Cleveland, Ohio.

On October 15, 1962, petitioners entered into an agreement which was captioned as a ?LAND CONTRACT? with Irving Stollman (hereinafter referred to as Stollman) and Herman Ross
(hereinafter referred to as Ross), two real estate promoters who were contemplating the construction of a shopping center. The agreement provided, in pertinent part, as follows:

FIRST. The said parties of the second part, for themselves and their heirs, assigns, executors and administrators, promise, convenant and agree to purchase from the parties of
the first part, 1 the following described property, * * * [the property described will hereinafter be referred to as the old residence] and to pay therefor to the said parties of the first
part their heirs, and assigns, at such place as may be designated by said parties of the first part the sum of One Hundred Ninety Two Thousand Dollars ($192,000.00), 2 in the
manner following, to-wit: Eleven Thousand Dollars ($11,000.00) cahs, the receipt whereof is hereby acknowledged, and Forty Six Thousand Dollars ($46,000.00), on or before the
30th day of November, A. D. 1962, and One Hundred Thirty-Five Thousand Dollars ($135,000.00) on or before the 31st day of May, A. D. 1963, said balance of $135,000.00 shall bear
interest from the date hereof at the rate of six per cent per annum.

SECOND. In consideration of the above and the fulfillment of all and singular the covenants contained in this agreement to be performed and kept, and upon the fulfillment of
each and every one of them by the said parties of the second part, in the manner and at the time herein specified, the said parties of the first part agree to sell and convey the above
described premises by good and sufficient deed of general warranty unto the said parties of the second part, their heirs and assigns, and free and clear from all encumbrances,
whatsoever except as stated herein and existing easements and restrictions of record, ordinances and zoning. Said parties of the first part further agree to give immediate
possession of said premises to the parties of the second part, except that said parties of the first part shall have the right to remain in occupancy of and living at their residence on
said premises until December 15, 1962 without interference from parties of the second part and the building located on said premises shall not be razed or removed at any time prior
to December 15, 1962 without written consent of parties of the first part, and excavations, footings parties of the second part until the payment parties of the second part untilthe
payment of the $46,000.00 as required aforesaid has been made.

THIRD. It is understood and agreed by the parties hereto that the said parties of the second part shall pay all taxes and assessments on said described real estate, which may be
assessed or become payable on same from and after this date and shall not fail to discharge the same before the accruing of any penalty incurred by delay in the payment thereof,
and shall keep said premises fully insured in favor of the said parties of the first part, their heirs or assigns in companies to be approved by the parties of the first part. If the parties
of the second part shall fail to make payments of said taxes, assessments or insurance premiums within twenty (20) days after said payments fall due, the same may be paid by the
parties of the first part, and thereupon be charged against and become immediately due from the parties of the second part, and any amount paid by the parties of the second part
may be applied or reapplied in satisfaction of the claim of the parties of the first part against the parties of the second part for taxes, assessments, or insurance premium paid by the
parties of the first part. All payments to be made by the parties of the second part to the parties of the first part if not paid when due shall bear interest at the rate of eight per cent
per annum, payable semi-annually.

FOURTH. If the parties of the second part, their heirs, executors, administrators or assigns, shall fail to make any of the payments pursuant to this agreement, either of principal
or interest, or in payment of taxes or insurance premiums, and be so in default for 20 days after registered mail notice of said default has been given by parties of the second part as
hereinafter provided or in any other manner break the conditions of this contract, then and in that event, parties of the first part are hereby given an option either to declare the
entire balance of the purchase price due and payable, and enforce their vendor?s lien for payment thereof, or to rescind this contract to sell and convey said property, and take
possession thereof; and in event of the exercise of the option to rescind this contract, any and all payments theretofore made by parties of the second part, and all improvements
made on said premises shall be taken and retained by parties of the first part as and for liquidated damages for the non-performance of this contract, and parties of the first part,
their heirs, executors, administrators or assigns, shall be entitled to the possession of the premises aforesaid, and of all the improvements thereon, and parties of the second part
covenant and agree that they and all persons holding under them shall and will surrender possession thereof, with the improvements, to parties of the first part, their heirs,
executors, administrators or assigns. Failure or delay to exercise said option at the time of any default shall not be, or operate as, a waiver of the right to exercise such option at any
time thereafter. * * * The remedy or recourse of said parties of the first part for the non-preformance of any obligation of the parties of the second part hereunder shall be limited
solely to the moneys paid hereunder, and to the herein described property, and said parties of the second part shall not be liable for any deficiency arising from the sale of said
property in any way, capacity or manner whatsoever, nor shall said parties of the first part have the right to, nor seek, a deficiency or other money judgment against said parties of
the second part. 3

AND IT IS FURTHER AGREED, that no sale, transfer, assignment or pledge of this contract shall be in any manner binding upon the said parties of the first part, unless the
parties of the first part first consent in writing hereon to such sale, transfer, assignment or pledge.

On October 15, 1962, upon the signing of the agreement, petitioners received the sum of $11,000 from Stollman and Ross. The payment due on November 30, 1962, was not timely
received. On December 12, 1962, petitioners? attorney gave written notice of default to Stollman and Ross. On December 14, 1962, petitioners received the overdue payment in the
amount of $46,000, plus interest.

Also in December 1962, petitioners vacated their old residence, after which they lived temporarily in a house located on Bancroft Street, Toledo, Ohio, while looking for a satisfactory
permanent residence.

On May 31, 1963, petitioners timely received the final payment of $135,000, plus interest as specified in the agreement and at that time they executed and delivered the required deed to
Stollman and Ross. At the date of this final payment, the old residence was still intact.

On November 20, 1963, petitioners purchased a lot on Farmington Road, Toledo, Ohio, and later, on December 9, 1963, commenced construction of a new residence. The construction
was completed at a total cost of $103,860.72 and on September 16, 1964, petitioners took up residence therein.

On their joint Federal income tax returns for the years 1962 and 1963, petitioners reported the sale of their residence as being subject to the nonrecognition provisions of section 1034 .

Respondent, in his statutory notice of deficiency, determined that the transaction did not qualify for the relief provisions of section 1034 and that, therefore, the entire gain on the sale
was taxable to the petitioners in 1962 and 1963.

Opinion

The issue for determination is whether petitioners are entitled to utilize the nonrecognition provisions of section 1034 , with respect to the sale of their old residence. Section 1034
provides, in part, as follows:

SEC. 1034 . SALE OR EXCHANGE OF RESIDENCE.

(a) Nonrecognition of Gain–If property (in this section called ?old residence?) used by the taxpayer as his principal residence is sold by him after Deceber 31, 1953, and, within a
period beginning 1 year before the date of such sale and ending 1 year after such date, property (in this section called ?new residence?) is purchased and used by the taxpayer as
his principal residence, gain (if any) from such sale shall be recognized only to the extent that the taxpayer?s adjusted sales price (as defined in subsection (b)) of the old residence
exceeds the taxpayer?s cost of purchasing the new residence.


© Rules for Application of Section.–For purposes of this section:


(5) In the case of a new residence the construction of which was commenced by the taxpayer before the expiration of one year after the date of the sale of the old residence, the
period specified in subsection (a), and the 1 year referred to in paragraph (4) of this subsection, shall be treated as including a period of 18 months beginning with the date of the
sale of the old residence.

In order to qualify for nonrecognition treatment, therefore, petitioners must show (1) that construction of the new residence was commenced before the expiration of one year after the
date of sale of the old residence and (2) that the newly constructed residence was used by them as their principal residence within 18 months after the date of sale.

The facts of this case are (1) that construction of the new residence began on December 9, 1963, and (2) that use of the new residence began on September 16, 1964. The parties are in
dispute as to the date on which the sale took place. Petitioners contend that the sale occurred on May 31, 1963, the date of the final payment and the execution and transfer of legal title.
Respondent contends that the date of sale is either the date of the agreement, October 15, 1962, or sometime during December of 1962 when Stollman and Ross, having made the second
payment called for by the agreement, had the right to begin operations on the land.

When the sale took place is a question to be determined from a consideration of all the relevant circumstances. The material facts, however, are not in dispute and the crux of the
problem presented is the effect of the agreement of the parties dated October 15, 1962.

The agreement, set forth in detail in our findings, provided in general that petitioners were bound to sell to Stollman and Ross on full payment of the purchase price. Petitioners,
however, did not have the enforceable right to receive the full purchase price. In the event of nonpayment, petitioners had the option either to declare the entire balance due and payable
and enforce their vendor?s lien for payment thereof or to rescind the contract and retain all payments and improvements made on the land as liquidated damages. Both alternatives,
however, were subject to the condition that any recovery was limited solely to the moneys paid and the value of the property and that petitioners possessed no right against Stollman
and Ross in excess of that limit.

We are of the opinion that this agreement did not constitute a sale of the property on October 15, 1962.

The words ?sale? or ?exchange? as used in the Internal Revenue Code must be given their ordinary meanings. * * * `A sale, in the ordinary sense of the word is a transfer of
property for a fixed price in money or its equivalent.? * * *? [Ralph A. Boatman [Dec. 23,750 ], 32 T. C. 1188, 1191-1192 (1959)].

In Commissioner v. Union Pac. R. Co. [36-2 ustc ¶9525 ], 86 F. 2d 637, 639 (C. A. 2, 1936), affirming [Dec. 8932 ] 32 B. T. A. 383 (1935), the Court of Appeals summarized the applicable rule
as follows:

A closed transaction for tax purposes results from a contract of sale which is absolute and unconditional on the part of the seller to deliver to the buyer a deed upon payment
of the consideration and by which the purchaser secures immediate possession and exercises all the rights of ownership. Teh delivery of the deed may be postponed and payment
of part of the purchase price may be deferred by installment payments; but for taxing purposes it is enough if the vendor obtains under the contract the unqualified right to
recover the consideration. * * * [Emphasis supplied]

In the case at bar, the vendors did not receive an unqualified right to recover the consideration. The contract in the Fourth paragraph specifically provided that in the event of the
buyers? default the sellers? recourse was limited solely to the moneys paid and the property itself. Applying the facts of this case to the rule set forth above, we are convinced that no
sale took place at the date the agreement was signed. 4

On brief, respondent argues that the limitation on the sellers? rights in the event of a breach by the buyers is contradictory to the contract provision which entitled the sellers to
declare the balance of the purchase price due and payable and enforce their vendor?s lien for the payment thereof and, therefore, the limitation should be ignored. We cannot agree. This
right and the limitation thereon are both contained in the Fourth paragraph of the contract and the latter in our opinion is merely explanatory of the former. They are not provisions which
require the acceptance of the one and the rejection of the other as suggested by the respondent. We also disagree with respondent?s further argument which relies on this premise,
namely, that under Ohio law the seller would be entitled to specific performance as against the buyer and that, therefore, we should treat the transaction as closed. Cf. Commissioner v.
Stuart [62-1 ustc ¶9381 ], 300 F. 2d 872 (C. A. 3, 1962). We note that the contract herein was made at arm?s length and the limitation provision was a matter of specific negotiation
between the parties. In fact, the provision was included at the insistence of the buyers and over the objection of the sellers. To state that such a provision is null and void and to allow
the seller to succeed in an action for the full purchase price is to do violence to the intent of the parties and in effect to rewrite their agreement. This we cannot do and we are not
persuaded that under state law such a specific intention, manifested by the parties, would be ignored. In short, we are of the opinion that the parties intended that no sale would occur
until full payment was made by the buyer. See Smith v. Loewenstein, 50 Ohio St. 346, 34 N. E. 159, 161 (1923), in which the court stated that–

To what extent a conversion takes place * * * must be determined by looking to the contract or instrument as indicating the intention of parties. * * *

Respondent next argues that the sale occurred no later than December 31, 1962, since by that date the purchasers had the right to begin excavating and to begin construction of the
shopping center. They also had the right to raze the house though they did not, in fact, do so prior to the date of final payment. They also had the duty to insure the property and to pay
the realty taxes. He concludes that they therefore had assumed the benefits and burdens of ownership of the property at least by that date. He concludes that the sale therefore occurred
at that time, relying on Commissioner v. Union Pac. R. Co., supra, Elsinore Cattle Company [Dec. 17,516(M) ], 1950 TCM, and Ted F. Merrill [Dec. 26,076 ] 40 T. C. 66 (1963), affd. per
curiam [64-2 ustc ¶9771 ] 336 F. 2d 771 (C. A. 9, 1964), Respondent in so arguing misinterprets the benefits and burdens test. In each of the above cases the respective courts dealt with
a ?closed transaction,? that is, one in which, inter alia, the seller?s right to the purchase price is unconditional. We do not believe that these cases are applicable to a situation like the
one before us in which the seller has no such unconditional right.

We therefore hold that the sale occurred on May 31, 1963, the date of the final payment and that, therefore, on the facts of this case petitioners are entitled to utilize the nonrecognition
provisions of section 1034 with respect to the sale.

Reviewed by the Court.

Decision will be entered under Rule 50.

Withey, Judge, concurs in the result.

1 Stollman and Ross are the ?parties of the second part? and petitioners are the ?parties of the first part.?

2 The cost basis to petitioners of the old residence was $25,000.

3 This last sentence was included in the contract at the insistence of Stollman and Ross.

4 This case is distinguishable from the situation in William B. Cusack [Dec. 28,463 ], 48 T. C. 156 (1967), wherein we held that an option granted to the buyer to reconvey the property
in exchange for a return of all consideration paid in the event the seller failed to supply either water service or a right-of-way did not prevent the sale from being a completed transaction.

[Dissenting Opinion]

Drennen, Judge dissenting:

I cannot agree that solely because petitioner may not have had the unqualified right to recover the entire balance of the cash consideration to be paid for the property that this
transaction did not become a sale of the old residence for purposes of section 1034 until the balance of the cash consideration was actually paid. Section 1034 is a relief provision which
permits a taxpayer to postpone recognition of gain on the sale of property used by him as his principal residence if he reinvests the proceeds from the sale of the old residence in a new
residence within the time specified. It should be applied with the congressional purpose in mind.

It seems clear to me that not later than December 31, 1962, petitioners had given up the use and possession of their old residence, the purchasers had acquired possession of the
property with the right to raze or remove the house and had assumed all of the benefits and burdens of ownership, and that the parties intended ownership of the property to pass prior
to that date. See Ted F. Merrill [Dec. 26,076 ], 40 T. C.66. Petitioners were by that time unconditionally bound to deliver a deed to the purchasers upon payment of the purchase price.
Delivery of the deed and payment of all installments of the purchase price did not defer consummation of the transaction. I disagree with the majority?s emphasis on the absence of
personal liability on the part of the purchaser. Sales often occur where, in the event of default, the seller?s recourse is limited to the property itself. I think that for purposes of section
1034 the sale of the old residence occurred not later than December 31, 1962, and consequently petitioners are not entitled to the nonrecognition benefits provided in that section.

If the rationale of the majority opinion is to be applied in all instances, a taxpayer, by selling his residence under a contract of sale containing the same recourse provision as the
contract here involved, but with the consideration to be paid in installments over an extended period of time, could extend the period within which he could reinvest the proceeds of sale
and defer recognition of gain on the sale far beyond the period contemplated in the statute and make the statute meaningless.

Tietjens, Raum, Tannenwald, and Simpson, Judges, agree with this dissent.

P.S. - Posted by JPiper

Posted by JPiper on January 12, 2001 at 22:18:51:

Assuming you called a lease/option a “sale” and then treated it as an installment sale…do enough of these and you become a dealer. Dealers are specifically excluded from installment sales.

Without additional explanation I would say your guy is shooting himself in the foot.

JPiper

Re: Prefferential Installment Sales Treatment - Posted by JPiper

Posted by JPiper on January 12, 2001 at 22:16:16:

In terms of the above IRS ruling, the investor had claimed it was NOT a sale, and therefore he was taking the principal part of his payment in as a “deposit” and showing it as a liability on his balance sheet. Further, since it was not a “sale” in this investors estimation, the property was then eligible for depreciation…and expense on your income statement.

Note that this ruling hinges on whether the IRS is correct…and the transaction is a “sale”…or the investor is correct…and the transaction is NOT a sale.

If it is a sale, then the tax treatment is clear. You pay tax as an installment sale, UNLESS you are a dealer, in which case you would pay tax on the entire profit in the year of sale.

In my case my corporation is a dealer. I pay tax on the entire profit when I sell. Then as I collect the contract or note, I collect interest on which I pay tax. The principal portion of the note repayment is not taxed…it simply reduces the balance of the note in the assets of my balance sheet.

I don’t have a clue what it means to “exempt 60-80% of the principal from taxes”. As a dealer 100% of the principal repayment is exempt from taxes. The hooker is that you already paid tax on the entire profit upfront.

I might add, most people would prefer to characterize a transaction as something OTHER than a “sale”. Hence the actions of the investor in the above ruling. Why someone would purposely want to characterize a lease/option as a “sale” is beyond me. They must have attended the Rodney Dangerfield School of Taxation.

JPiper

Re: English - Posted by JPiper

Posted by JPiper on January 12, 2001 at 12:44:04:

In this case the investor was a “dealer” and therefore would normally pay tax on the entire profit in the year of sale. However, he reported the income in a different way…the result of which was to defer tax until the end…which of course would be a number of years down the road. His claim was that his contract for deeds were not “sales”. The IRS ruled against him based on the particular facts and circumstances involved. (As Dave points out below, a non-dealer would pay tax based on an installment sale…essentially as the principal is received).

What I thought was of particular interest was the criteria used by the court for establishing whether it was in fact a “sale”…the so-called “burdens and benefits” of ownership. My CPA and I discussed this criteria in terms of the lease/options that I do.

One reason for the post is that I have been told by some other investors over the last few years that they are treating their contracts for deed as something other than “sales” for tax purposes. As you will note in John Hyre’s post, the penalties for this decision in this case were substantial. Imagine if the investor had been doing even more business.

JPiper

Re: English - Posted by Dave T

Posted by Dave T on January 12, 2001 at 11:33:52:

This simply reinforces the long-standing IRS position that a contract for deed is an installment sale for tax purposes.

The details of the transaction determine whether the taxpayer has to recognize the entire profit on the sale in the year the property is sold. If the property was used as an investment rental for some time, then the installment sale tax treatment will allow the taxpayer to spread out the capital gains taxes – paying taxes only on the payments actually received each year.

On the other hand, if the property is “quick turn real estate”, a “flip”, or real estate purchased to resell for quick profit, then the entire profit is treated as ordinary income and taxed in the year of sale. For these transactions, even though the taxpayer might not receive his entire profit until later (e.g., an installment sale), the taxes on the entire profit are due and payable in the year of sale.

Re: Keith/GIA - Posted by BillW.

Posted by BillW. on January 12, 2001 at 19:35:17:

So, what you’re saying here is that for taxes on about 62,000 or roughly 25K, that these people now will pay almost $310,000 in penalities. Not to mention which, it should be fair warning to us all to watch the way we conduct our business. In trying to outmaneuver the IRS, they stuck themselves.
Bottom line–pay what you owe and get on to the next deal. Do you think that they were just dishonest (you did mention some apparant possible problems with the wife’s dad, who apparantly ran this company)or that they were simply trying to be too clever?
BillW.

Re: Keith/GIA - Posted by JPiper

Posted by JPiper on January 12, 2001 at 07:08:21:

Good thing the Keith’s are a doctor and dentist…they can probably pay those penalties!

Thanks for posting the two cases in their entirety.

JPiper