Opinion
Docket Nos. 16105 16106 20069 20070.
1949-07-6
NELSON A. FARRY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.VELMA R. FARRY, WIFE OF NELSON A. FARRY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
S. L. Mayo, Esq., and J. L. McNees, Esq., for the petitioners. Stanley B. Anderson, Esq., for the respondent.
Petitioner Nelson A. Farry, who for a good many years has been in the insurance and real estate business, developed certain subdivisions in the city of Dallas, Texas, and constructed residences thereon, and in the taxable years he sold some of them at a profit. These profits he returned as ordinary income. Petitioner also during the course of the years acquired other properties, not located in these subdivisions, primarily for investment purposes and collected rentals thereon. During the taxable years he sold some of the rental properties and returned the profits therefrom as long term capital gains. The Commissioner has determined that such gains should be taxed as ordinary income. Held, that petitioner was not holding these rental properties primarily for sale to customers in the ordinary course of his trade or business, but was holding them primarily for investment purposes, and the gains from the sale thereof are taxable as capital gains under the provisions of section 117(j), Internal Revenue Code. S. L. Mayo, Esq., and J. L. McNees, Esq., for the petitioners. Stanley B. Anderson, Esq., for the respondent.
These consolidated proceedings involve deficiencies in income tax for the years 1944 and 1945, as follows:
+------------------------------------------+ ¦Petitioner ¦Docket No.¦Year¦Deficiency¦ +---------------+----------+----+----------¦ ¦Nelson A. Farry¦(¦16105 ¦1944¦$1,131.62 ¦ +---------------+-+--------+----+----------¦ ¦ ¦(¦20069 ¦1945¦2,092.51 ¦ +---------------+-+--------+----+----------¦ ¦Velma R. Farry ¦(¦16106 ¦1944¦1,131.62 ¦ +---------------+-+--------+----+----------¦ ¦ ¦(¦20070 ¦1945¦2,092.51 ¦ +------------------------------------------+
Petitioners filed separate returns for the years involved on the community property basis with the collector of internal revenue for the second district of Texas.
For the year 1944 the deficiency of each petitioner is due to one adjustment, ‘Additional income $6,466.18,‘ which is explained in the deficiency notices as follows:
It is held you are engaged in the business of buying and selling real estate and are not entitled to the benefits afforded by section 117(j) of the Internal Revenue Code in determination of taxable income for 1944 resulting from sales of real estate.
Therefore, the entire profit reported by you is held to be taxable in 1944, both on outright sales and the profit in installment payments received. * * *
For the year 1945 the deficiency of each petitioner is due to one adjustment, ‘(a) Gain from real estate sales increased $10,038.31.‘ This adjustment is explained in the deficiency notices as follows:
(a) It is held that the gains from sales of real estate which you reported on your 1945 return as capital gains represented ordinary income taxable 100% under section 22(a), Internal Revenue Code. Your income for that year has been increased in accordance with this determination.
Petitioners, by appropriate assignments of error, contest the foregoing determinations of the Commissioner as to both years.
FINDINGS OF FACT.
Petitioners Nelson A. Farry and Velma R. Farry, husband and wife, are residents of Dallas, Texas. Sometimes hereinafter Nelson A. Farry is referred to as the petitioner.
During 1944 and 1945 petitioner was engaged in the business of collecting rentals for a commission, insurance, investments, and dealing in real estate. Petitioner entered business in 1921 as a rent collector for a Dallas firm engaged in property management, real estate loans, and insurance. On January 1, 1927, the members of the firm having retired, petitioner succeeded to the business, and since then he has conducted it under his own name, considerably enlarging it as time has gone on.
In his investments in rental properties, from actual experience, petitioner considered negro rentals and duplex apartments more desirable as revenue producers than single family rent houses. For his own investment purposes, therefore, he acquired and retained more of the former type than the latter. Other than some stock in a small local company, petitioner had no other investments than those in his rental properties.
During the 1920's petitioner bought and built for his own account several negro rental houses, but was forced to sell them early in the depression. In 1934 he purchased 3 negro rental houses under a 10-year loan. These were bought from a bank which was liquidating its foreclosed properties. From time to time thereafter petitioner either made similar purchases or built for his own account duplexes and negro rental houses until at the end of 1939 he owned 29 such rental properties and at the end of 1940 he owned 38. These produced gross rents in excess of $10,000 in 1939 and $13,400 in 1940. All of these properties were located elsewhere than in two subdivisions known as Cedar Crest and Clarendon Heights, which petitioner developed and sales from which are not here involved.
In 1941 petitioner constructed 5 duplexes for rental purposes. He still owned these in 1949 at the time of the hearing. He also constructed for rental purposes 8 single family negro houses in that year from secondhand materials and scraps from other construction projects. Those houses were rented for $12 to $15 per month. Petitioner's gross rental income in 1941 was in excess of $15,000. At the end of 1941 petitioner owned approximately 45 different parcels of rental properties, comprising about 100 rental units.
In 1940 and 1941 there was an abnormal vacancy ratio in the city of Dallas and rents were unusually low. These low rents were eventually frozen by rent controls, effective in late 1942. During that period and into 1943, rental properties of the kind petitioner owned could be purchased at a relatively small investment by arranging proper financing. In 1942 petitioner purchased 11 rental properties. In 1943 petitioner acquired 18 rental properties, including 10 duplex apartments. In 1943, in connection with the great expansion of the Municipal Airport, Love Field, for use by plane manufacturers and the Army Air Forces, petitioner purchased 15 buildings from the Government— 5 single family houses and 10 duplexes. These had to be purchased as one transaction and removed from the area in a hurry. Nine duplexes and 2 single family houses were moved to Danford Street and 1 duplex and 3 single family houses were moved to Bomar Street. The 5 single family houses were sold forthwith without being rented or registered for rent control, since petitioner did not favor that type o of rental property. Gains on their sale were reported as fully taxable. The projects at Danford and Bomar Streets were completed in August 1943, and the 10 duplexes were rented immediately under 2-year written leases.
While petitioner paid cash for some of the above rental properties and constructed others from left-over materials, most of his rental properties were acquired under long term loans (10 years or longer). Many of these were blanket loans, covering several rent properties. The blanket loans usually contained no ‘release clauses‘ and were payable in installments on specified dates, without ‘on or before‘ privileges. Petitioner made these long term financing arrangements on his rental properties (as distinguished from short term construction loans) in expectation that the rentals would liquidate the loans so as to increase his estate and ultimate revenue.
In additional to acquiring rental properties as aforesaid and managing them and collecting rent from them, petitioner acquired lands in the city of Dallas and developed subdivisions by constructing single family residences for sale. These subdivisions were known as Cedar Crest and Clarendon Heights. Petitioner never rented the residences which he constructed in these two subdivisions, but generally sold them soon after they were completed. The gain from the sales of these houses and lots which petitioner made in the taxable years was reported as ordinary income and is not here in controversy.
By mid-1943 the housing situation, especially rentals, in Dallas had changed materially. The removal of the Eighth Service Army Command from San Antonio to Dallas, which began in late 1942, was accomplished, bringing in thousands of service personnel. Other war agencies and plants were in operation. The heavy influx of new Dallas residents had absorbed rental vacancies and people were seeking almost any place to live; if not to rent, then by buy. The scramble to rent or to buy housing, not investment property, was well under way in late 1943. It was yet to become acute in 1944 and 1945, when housing demands forced prices to new peaks. Under these conditions and in view of rent control, when petitioner counseled with his banker the advisability of liquidating some of his rental properties was suggested. It was pointed out to petitioner by his banker that interest on the notes which he could take in the sale of these rental properties would yield more than rents from the property. Petitioner concurred in this view.
In 1944 petitioner sold 19 of his rental properties and reported the gains as capital gains. Of the 19 rental parcels sold in 1944, 2 were held and rented between 6 months and 1 year; 11 from 1 to 2 years; and others up to 8 years.
In 1945 petitioner sold 27 of these rental properties and reported the gains therefrom as capital gains. Of the 27 rental or investment parcels sold in 1945, 12 were held from 1 year 4 months to 5 years, and 15 were held from 5 years or longer, up to 11 1/2 years.
Petitioner accounted for rental income, both his own and that of clients, in a manner quite distinct from his gains on sales of houses constructed for sale. A separate ledger was maintained for rents and a separate one kept for houses built for sale. A separate account was set up for each rental property petitioner owned and rents were collected or credited thereto just as for property managed for clients. Separate ledger sheets for rental properties carried all expenses, including depreciation. Separate ledger sheets were maintained in a separate ledger on each house constructed for sale, reflecting all costs, selling prices, and profits.
The gains reported by petitioner for 1944 and 1945 as long term capital gains (both installment and cash basis) were gains from properties acquired and held by him for more than six months, primarily for investment and the production of income.
Petitioner is the holder of a real estate dealer's license. In petitioner's income tax return for 1944 the business of petitioner is stated to be ‘Rentals, Insurance, Investments, Real Estate.‘ In petitioner's income tax return for 1945 the business of petitioner is stated to be ‘Rentals, Insurance, Investments, Real Estate Developer.‘
OPINION.
BLACK, Judge:
In these proceedings we have no issue as to the amounts of petitioners' income, which, as shown in our findings of fact, was from several sources. The only question is whether petitioners are entitled to report the profits from the sales of certain rental properties as long term capital gains and taxable on only 50 per cent thereof, as petitioners contend, or whether they are taxable on 100 per cent thereof as the Commissioner has determined. In addition to the income which petitioners reported from the sale of these rental properties, they also reported gross income on the community property basis from rentals received, commissions on insurance written, commissions on the sale of real estate, and profits from the sale of houses and lots in subdivisions which petitioner had developed. All of these latter were reported as ordinary income and taxable on 100 per cent thereof. The only income which petitioners reported as long term capital gains was the profits from the sale of the rental properties described in our findings of fact. Petitioners claim the right to do this under the provisions of section 117(j), added to the Internal Revenue Code by section 151 of the Revenue Act of 1942. Respondent concedes that is the applicable section, but denies that petitioner is entitled to the benefit thereof under the facts. It is printed in the margin.
For a discussion of the 1942 amendments containing section 117(j) as applied to losses on the sale of such assets, see Leland Hazard, 7 T.C. 372; William H. Jamison, 8 T.C. 173; and Solomon Wright, Jr., 9 T.C. 173. In the Leland Hazard case, we said:
SEC. 117. CAPITAL GAINS AND LOSSES.(j) GAINS AND LOSSES FROM INVOLUNTARY CONVERSION AND FROM THE SALE OR EXCHANGE OF CERTAIN PROPERTY USED IN THE TRADE OR BUSINESS.—(1) DEFINITION OF PROPERTY USED IN THE TRADE OR BUSINESS.— For the purposes of this subsection, the term ‘property used in the trade or business‘ means property used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 23(i), held for more than 6 months, and real property used in the trade or business, held for more than 6 months, which is not (A) 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 (B) property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. * * *(2) GENERAL RULE.— If, during the taxable year, the recognized gains upon sales or exchanges of property used in the trade or business * * * exceed the recognized losses from such sales, exchanges, and conversions, such gains and losses shall be considered as gains and losses from sales or exchanges of capital assets held for more than 6 months. If such gains do not exceed such losses, such gains and losses shall not be considered as gains and losses from sales or exchanges of capital assets. * * *
* * * Section 151(b) of the 1942 Act added the new subsection (j), covering, as its title indicates, ‘Gains and Losses From Involuntary Conversions and From the Sale or Exchange of Certain Property Used in the Trade or Business.‘ This section provides for special treatment where gains exceed losses from involuntary conversions and from the sale of certain property used in a trade or business. Such gains are treated as capital gains. This is a relief provisions for the benefit of such taxpayers as come within its provisions. Losses in excess of gains in respect to such property are still treated as ordinary losses allowable in full. * * *
In the above cited cases we held that under the provisions of section 117(j) of the code the losses incurred from the sale of rental property should be allowed as ordinary losses and deductible in full. However, as pointed out in the Hazard case, supra, the situation is different when the sale of such property results in a gain. In such a case the gain, under the provisions of section 117(j), is taxable as capital gain and not as ordinary income. In other words, under the provisions of section 117(j) the taxpayer is given the benefit of full deduction of any loss on a sale of rental property used in his trade or business, but the Government does not receive a corresponding advantage in the case of gain.
We do not understand from respondent's brief that he disputes the foregoing interpretation of the meaning of section 117(j) However, he does contend that in the instant case the petitioner was holding the rental properties ‘primarily for sale to customers in the ordinary course of his trade or business.‘ Of course, if that were true, petitioner could not prevail even under the provisions of section 117(j). Section 117(j) does not change the rule of law that property held by a taxpayer ‘primarily for sale to customers in the ordinary course of his trade or business‘ is not a capital asset. However, it seems to us that petitioner has proved by overwhelming evidence that he purchased and held these rental properties primarily for investment purposes. The fact that in the taxable years he received satisfactory offers for some of them and sold them does not establish that he was holding them ‘primarily for sale to customers in the ordinary course of his trade or business.‘ The evidence shows that he was holding them for investment purposes and not for sale as a dealer in real estate.
It is true, of course, that petitioner was in the business of developing two subdivisions in the city of Dallas, namely, Cedar Crest and Clarendon Heights. He constructed houses on these properties and sold them as a profit. To this extent he was a dealer in real estate. That he does not deny and he has returned all of his gains from the sale of these Cedar Crest and Clarendon Heights properties as ordinary income. But a dealer can also be an investor, and, where the facts show clearly that the investment property is owned and held primarily as an investment for revenue and speculation, it is classed as a capital asset and not property held ‘primarily for sale to customers in the ordinary course of trade or business.‘ See E. Everett Van Tuyl, 12 T.C. 900, and Carl Marks & Co., 12 T.C. 1196. On the facts, we sustain the petitioner on the issue presented for our decision.
Decisions will be entered under Rule 50.