Opinion
Docket No. 83294.
1962-10-10
RANDOLPH D. ROUSE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Fred R. Tansill, Esq., and Louis Hoppe, Esq., for the petitioner. W. Ralph Musgrove, Esq., for the respondent.
Fred R. Tansill, Esq., and Louis Hoppe, Esq., for the petitioner. W. Ralph Musgrove, Esq., for the respondent.
1. Gains on the sale of houses which petitioner purchased for investment and held for rental purposes for periods of 6 months or longer held taxable as long-term capital gains and not as ordinary income. 2. Depreciation deductions on such houses disallowed for taxable years in which houses were sold at prices in excess of their undepreciated costs as of first of such taxable years. 3. Depreciation deductions on such houses allowed for taxable years in which they were not sold where houses had estimated useful lives extending into future years, and taxpayer's experience did not clearly indicate a utilization of the assets for a substantially shorter period than their full economic lives, even though the salvage values during the taxable years were in excess of depreciated cost.
This proceeding involves deficiencies in petitioner's income tax for 1953, 1954, and 1955 in the respective amounts of $58,721.95, $48,099.17, and $35,257.63. The questions in issue are: (1) Whether the gains from the sale of houses which petitioner purchased at cost from construction companies in which he owned a controlling interest and which he held for rent for periods of 6 months or longer are taxable as long-term capital gains or as ordinary income, and (2) whether petitioner is entitled to the depreciation deductions which he claimed on the houses during the periods of his ownership, where the prices which he actually received on the sale of the houses disclosed that the market value, or salvage value, as of the year of sale was in excess of his depreciated cost.
Other issues raised in the pleadings have been settled by stipulation. Some of the facts also have been stipulated.
FINDINGS OF FACT.
Petitioner is a former resident of Washington, D.C., and filed his income tax returns for the years 1953, 1954, and 1955 with the district director of internal revenue at Baltimore, Maryland. He now resides in Arlington, Virginia. In regard to his business, petitioner describes himself as ‘a builder, and a building consultant, a land developer, a motel and restaurant operator, and investor in different enterprises, a banker, in that I am a member of a bank board and on the Executive Committee of the Bank Board, a director of a national insurance company, a breeder of thoroughbred horses and a trainer of the same, and a farmer.’
Petitioner is a graduate of the Virginia public schools and of Washington and Lee University from which he received a B.S. degree in 1939. During World War II he served as an officer in the United States Navy.
Following his discharge from the Navy in 1946, petitioner formed a partnership with an architect to build houses. The partnership purchased 20 lots in a subdivision known as Hollinswood, near Tyson's Corner, Fairfax County, Virginia, on which it built 20 houses. All of these houses were sold through real estate brokers or agents. Petitioner purchased one of them as an intended residence but later rented it to a friend. He sold the house in 1949.
The partnership was dissolved in the late summer of 1948, and soon thereafter petitioner organized and became the principal owner of the Citadel Construction Corporation, hereinafter sometimes referred to as Citadel. Near the end of 1949 or early in 1950, petitioner organized and became the principal owner of another corporation, Constructors, Inc., hereinafter sometimes referred to as Constructors. Both of these corporations were organized to build and sell houses. Petitioner became president and a director of Citadel and was employed by the company as a builder. He also became an officer and director of Constructors.
After dissolution of the partnership in 1948, petitioner bought two lots in a subdivision known as Langley Forest on which he built two houses. He sold one of them immediately and rented the other for about a year. It was sold in September 1949.
Citadel began constructing and selling houses soon after its organization. It first built 3 houses in Langley Forest and later 10 houses in Hollinswood, all of which it sold.
Constructors began building houses in a subdivision known as Great Forest, located within the city limits of Falls Church, Virginia. Altogether there were 62 houses built in this subdivision. The first 42 houses built were bungalow type, brick and frame construction, containing two bedrooms, living room, dining room, kitchen, and bath. They were sold to the public by Constructors. A friend of petitioner, Captain Ware, a retired Navy officer, handled the sales for Constructors. The houses were sold for from $11,500 to $12,000 each and were financed largely through FHA. The remaining 20 houses were built with the understanding that they would be purchased by petitioner for rental purposes. They were of the rambler type, consisting usually of three bedrooms, one and one-half baths, combination dining room and living room, kitchen, and an attached garage. The baths were finished in ceramic tile. These houses were sold to petitioner, individually, at cost to Constructors as fast as they were completed, 7 on May 1, 1950, and 13 on July 1, 1951. Their cost and price to petitioner ranged from about $7,700 to $11,000. If they had been sold to the public at that time the sale price would have been about 25 percent more.
In purchasing the houses petitioner obtained a first trust loan on each house and paid Constructors the entire purchase price in cash. Thereafter petitioner made the payments on the trust notes as they became due. All of these 20 houses were immediately offered for rent by petitioner and were promptly rented at satisfactory rentals. The leases were all written on standard commercial lease forms and when rented to members of the armed services contained the usual military clause. Most of the leases were for a minimum term of 1 year. None of them contained any option to purchase. Petitioner set up an office and employed an assistant to handle the rentals and keep appropriate records. He did not devote much of his time to these matters.
Petitioner sold one of the Great Forest houses in June 1951, and in August of that year sold two others, all on adjacent lots. These houses had developed moisture and other structural problems causing numerous tenant complaints. They were located below street level and had not been given adequate drainage. A fourth house in this group was sold by petitioner in April 1952. Of the remaining 16 Great Forest houses, petitioner sold 5 in 1953, 6 in 1954, 1 in 1955, 1 in 1956, and 3 in 1957.
In the meantime Citadel and another corporation controlled by petitioner, Seventh Citadel Construction Corporation, hereinafter sometimes referred to as Seventh Citadel, had been building houses in another subdivision known as Bel Air, located near Seven Corners, Fairfax County, Virginia. This is a large subdivision containing over 400 houses. They are low-cost, mass-produced houses, designed to sell for between $10,000 and $11,500. They were sold largely to veterans under GI and FHA financing.
Petitioner began purchasing houses in the Bel Air subdivision early in 1951. He purchased six of them in April 1951, nine in 1952, and five in 1953. These houses also were purchased by petitioner for investment and rental purposes. In each instance petitioner paid Citadel or Seventh Citadel the cost of construction plus a ‘builder's fee’ of $300, which petitioner had previously been paid by the builders. The total purchase price to petitioner varied from approximately $7,000 to $10,000. The rental of the Bel Air houses was handled in the same manner as those in the Great Forest subdivision.
During 1950, 1951, and 1952 rental houses were in great demand, and petitioner had little difficulty in renting his properties. However, these conditions began to change in 1953 and it became more and more difficult to obtain desirable tenants. Low-cost houses were being made available to purchasers with small downpayments and low-interest-rate financing. Some of petitioner's rental houses stood vacant for several months at a time and in some instances the rent had to be reduced. Whenever petitioner was unable to rent a house within a reasonable time he would offer it for sale. Prospective purchasers were often referred to him by real estate agents who had seen his ‘for rent’ sign on vacant houses. Petitioner never advertised his houses for sale in the newspapers and never listed them with outside real estate salesmen. Sometimes a house would be sold to an occupying tenant, but desirable tenants were never dispossessed to make a sale.
The following table shows, with respect to each of the rental properties acquired by petitioner, referred to above, the location, date purchased, cost, the date sold, sales price, depreciation claimed, and the net profit realized by petitioner on such sales:
+-----------------------------------------------------+ ¦ ¦ ¦ ¦ ¦Depreciation¦Net profit¦ +--------+----+----+----------+------------+----------¦ ¦Date ¦Cost¦Date¦Sale price¦claimed ¦after ¦ +--------+----+----+----------+------------+----------¦ ¦acquired¦ ¦sold¦ ¦ ¦selling ¦ +--------+----+----+----------+------------+----------¦ ¦ ¦ ¦ ¦ ¦ ¦expenses ¦ +--------+----+----+----------+------------+----------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------+
Hollinswood July 1948 $12,238.26 Apr. 1949 $13,850.00 $346.78 $1,908.50
Langley Forest Oct. 1948 13,157.27 Sept. 1949 16,000.00 482.43 2,481.06
Great Forest May 1950 7,765.85 July 1953 19,500.00 918.54 12,732.19 May 1950 7,765.84 July 1953 19,500.00 930.30 11,660.76 May 1950 7,765.84 Jan. 1954 19,750.00 1,083.42 12,151.93 May 1950 7,765.84 Aug. 1951 19,500.00 400.39 11,615.60 May 1950 7,765.84 Apr. 1952 22,500.00 577.03 14,118.04 May 1950 7,765.84 Aug. 1951 21,750.00 400.39 13,812.30 May 1950 7,765.84 June 1951 21,500.00 353.29 12,941.30 July 1951 9,082.94 July 1954 22,000.00 1,033.88 12,821.14 July 1951 9,082.93 July 1953 21,308.58 684.59 11,816.14 July 1951 11,082.93 1,601.86 July 1951 9,082.93 Nov. 1954 21,950.00 1,117.70 12,857.47 July 1951 11,082.93 Jan. 1955 22,750.00 1,173.58 11,671.25 July 1951 11,082.93 1,601.86 July 1951 11,082.93 1,601.86 July 1951 9,082.94 Aug. 1953 21,793.50 726.50 12,416.26 July 1951 9,082.94 July 1954 19,750.00 1,005.94 10,656.80 July 1951 9,082.94 July 1954 20,000.00 1,033.88 11,922.24 July 1951 9,082.94 June 1953 21,000.00 642.68 11,479.94 July 1951 11,082.94 1,601.86 July 1951 9,082.94 July 1954 20,500.00 1,005.94 11,363.65
Bel Air Apr. 1951 7,006.53 Sept. 13,500.00 570.60 6,361.47 1953 Apr. 1951 7,006.54 Sept. 11,650.00 1,041.09 5,016.35 1955 Apr. 1951 7,006.53 Aug. 11,650.00 1,041.09 5,136.04 1955 Apr. 1951 7,003.34 240.00 Apr. 1951 9,376.76 Feb. 12,750.00 935.04 3,643.73 1954 Apr. 1951 9,376.76 Oct. 11,800.00 1,507.20 3,226.78 1955 Jan. 1952 9,376.76 Nov. 14,500.00 1,283.90 5,516.14 1955 Jan. 1952 8,980.18 Aug. 11,500.00 1,228.08 3,091.08 1955 Feb. 1952 9,100.00 Nov. 11,950.00 1,065.11 3,207.43 1955 Feb. 1952 9,100.00 Aug. 11,950.00 994.10 3,758.41 1955 Feb. 1952 9,100.00 Nov. 11,500.00 1,065.11 2,863.93 1955 July 1952 7,931.59 958.07 July 1952 7,931.59 Oct. 11,950.00 912.45 4,832.41 1955 July 1952 7,931.59 Apr. 12,750.00 752.78 4,897.81 1955 July 1952 7,931.59 Nov. 11,950.00 912.45 4,220.66 1955 Mar. 1953 10,240.94 June 14,950.00 93.69 4,098.15 1953 Mar. 1953 10,240.94 1,061.82 Mar. 1953 8,240.94 Apr. 12,950.00 614.25 4,613.77 1955 Mar. 1953 8,240.94 835.38 Mar. 1953 9,240.94 Feb. 14,500.00 669.60 5,186.11 1955 Telegraph Road Commercial, 1950—52 13,678.38 1,861.91
The number of houses held for rent by petitioner, the gross rentals received, and the net rentals after deduction of the cost of maintenance, insurance, interest, taxes, depreciation, and other miscellaneous expenses, for the period from 1948 to 1955, inclusive, were as follows:
+------------------------------------------------+ ¦ ¦Number of¦Gross rents¦Net rentals ¦ +------+---------+-----------+-------------------¦ ¦Year ¦houses ¦received ¦after depreciation,¦ +------+---------+-----------+-------------------¦ ¦ ¦ ¦ ¦etc. ¦ +------+---------+-----------+-------------------¦ ¦ ¦ ¦ ¦ ¦ +------+---------+-----------+-------------------¦ ¦1948 ¦1 ¦$769.50 ¦$37.77 ¦ +------+---------+-----------+-------------------¦ ¦1949 ¦2 ¦428.25 ¦254.42 ¦ +------+---------+-----------+-------------------¦ ¦1950 ¦7 ¦7,860.00 ¦3,950.57 ¦ +------+---------+-----------+-------------------¦ ¦1951 ¦27 ¦23,890.84 ¦13,071.56 ¦ +------+---------+-----------+-------------------¦ ¦1952 ¦32 ¦50,786.23 ¦25,494.95 ¦ +------+---------+-----------+-------------------¦ ¦1953 ¦36 ¦52,313.67 ¦(1,100.08) ¦ +------+---------+-----------+-------------------¦ ¦1954 ¦29 ¦35,643.46 ¦4,871.81 ¦ +------+---------+-----------+-------------------¦ ¦1955 ¦22 ¦20,756.78 ¦212.95 ¦ +------+---------+-----------+-------------------¦ ¦Totals¦ ¦192,448.73 ¦46,793.95 ¦ +------+---------+-----------+-------------------¦ ¦ ¦ ¦ ¦ ¦ +------------------------------------------------+
Petitioner never engaged in the business of selling real estate except in disposing of the rental properties described above. He was not licensed as a real estate salesman in Virginia. He was listed in the telephone directory as a builder but not as a real estate salesman.
In respect to the houses which petitioner held for rent in 1953, 1954, and 1955 he was engaged in the business of owning and renting residential properties but was not engaged in the business of selling real estate.
The salvage value during each of the taxable years of each of the houses which petitioner held for rent and sold in the respective taxable years was in excess of its depreciated cost to petitioner as disclosed by its sale at a price in excess of such cost.
The stipulated facts are hereby incorporated in these findings.
OPINION.
Kern, Judge:
The principal question in issue is whether petitioner's profits on the sale of the residential properties which he had purchased and held for rent for more than 6 months are taxable as long-term capital gains, as reported by petitioner in his returns, or as ordinary income as determined by respondent.
As an alternative issue, respondent contends that if the profits from the sale of the houses in question constituted long-term capital gains, no depreciation deductions on the houses are allowable because in each instance the resale or salvage value of the house exceeded its depreciated cost to petitioner.
Two minor issues involving depreciation on automobiles and dividend income have been settled by agreement between the parties, which will be given effect under Rule 50 settlement.
Under section 117(j) of the Internal Revenue Code of 1939 (applicable in 1953) and section 1231 of the 1954 Code (applicable in 1954 and 1955), gains from the sale of capital assets used in trade or business and held for 6 months or longer are treated as long-term capital gains, excluding, however, gains from the sale of assets held primarily for sale to customers in the ordinary course of the taxpayer's trade or business. The question presented, therefore, is whether the properties in question were held by petitioner primarily for sale to customers in the regular course of business.
This question in similar form has been before the courts in a large number of cases from which no rule of law of general application has evolved. We have said that each case must turn on its own particular facts. See Nelson A. Farry, 13 T.C. 8; Walter R. Crabtree, 20 T.C. 841; D. G. Bradley, 26 T.C. 970.
On the facts here there can be little question but that petitioner purchased and held the 40-odd houses in the Great Forest and Bel Air subdivisions for investment and rental purposes, as we have found above. The fact that he rented most of them for periods of 2 years or more; that he decided to go out of the rental business only after changes in real estate conditions made it unprofitable; that he purchased no more houses for rent after that time; that he offered none of his houses for sale as long as he could rent them satisfactorily; and that the sale of the rental houses extended over a period of several years, as tenant occupancies failed, all tend to support petitioner's contentions that he acquired and held the houses for rental purposes and not for resale. The record contains little evidence in support of the contrary view. The gains on the sales of the properties that were held for 6 months or more were properly reported, we think, as long-term capital gains.
It is true, as respondent contends, that petitioner's corporations were also in the business of building and selling houses. But even disregarding these corporate entities would not change the result. This Court has repeatedly recognized the dual roles of taxpayers in comparable situations. In Nelson A. Farry, supra, we held that the taxpayer was engaged both in the business of buying and selling houses and in the business of investing in houses for rent. See also Walter R. Crabtree, supra; D. L. Phillips, 24 T.C. 435.
We have found as a fact on the evidence before us that petitioner as an individual was engaged in the business of buying, owning and renting residential houses during the years under review, and was not engaged in the business of selling those houses. It follows that the houses which petitioner sold during the taxable years were not held primarily for sale to customers in the regular course of business.
This disposition of the capital gains issue brings into controversy respondent's alternative contention that the depreciation deductions taken on the rental houses, while held for rent by petitioner, are unallowable.
In computing the depreciation deductions in question, petitioner used a straight line method based on an estimated useful life of 25 years. This estimate is not challenged by respondent. No consideration was given to the salvage value of the houses. Respondent determined in his notice of deficiency that since the salvage values were in excess of petitioner's depreciated costs,
no depreciation is allowed. The Code sections involved are section 23(1) of the 1939 Code and section 167 of the 1954 Code. These sections provide for depreciation deductions of a reasonable amount for the exhaustion and wear and tear of property used in trade or business. Section 167(b) of the 1954 Code provides that for the taxable years beginning after December 31, 1953, ‘the term ‘reasonable allowance’ * * * shall include (but shall not be limited to) an allowance computed in accordance with regulations prescribed by the Secretary of his delegate * * * .' The pertinent sections of the Commissioner's regulations are quoted in the margin.
We interpret this to mean the salvage value at the end of each of the taxable years and not the salvage value as of the end of the useful life of the houses.
Income Tax Regs.Sec. 1.167(a)-1 DEPRECIATION IN GENERAL.— (A) Reasonable allowance. Section 167(a) provides that a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property used in the trade or business or of property held by the taxpayer for the production of income shall be allowed as a depreciation deduction. The allowance is that amount which should be set aside for the taxable year in accordance with a reasonably consistent plan (not necessarily at a uniform rate), so that the aggregate of the amounts set aside, plus the salvage value, will, at the end of the estimated useful life of the depreciable property, equal the cost or other basis of the property as provided in section 167(f) and Secs. 1.167(f)-1. An asset shall not be depreciated below a reasonable salvage value under any method of computing depreciation. See paragraph (c) of this section for definition of salvage. * * *Sec. 1.167(b)-0 Methods OF COMPUTING DEPRECIATION.— (A) In general. Any reasonable and consistently applied method of computing depreciation may be used or continued in use under section 167. Regardless of the method used in computing depreciation, deductions for depreciation shall not exceed such amounts as may be necessary to recover the unrecovered cost or other basis less salvage during the remaining useful life of the property. The reasonableness of any claim for depreciation shall be determined upon the basis of conditions known to exist at the end of the period for which the return is made. * * *
During each of the taxable years petitioner sold houses theretofore held by him for rent at prices in excess of their undepreciated costs as of the first of such years. Thus it was apparent with regard to each house thus sold and a condition ‘known to exist at the end of the period for which the return is made’ that its salvage value during the year of sale was in excess of its undepreciated cost as of that year. Accordingly, no depreciation deduction is allowable on account of a home thus sold for the taxable year during which it was sold. Cohn v. United States, 259 F.2d 371.
However, the situation with regard to other years is different. Petitioner's rental houses did not constitute a ‘type of asset, where the experience of the taxpayers clearly indicates a utilization of the asset for a substantially shorter period than its full economic life,‘ such as involved in the cases of Massey Motors v. United States and Commissioner v. Evans, 364 U.S. 92, 96, 97. We construe the facts as indicating that petitioner did not know how long his rental houses would be of profitable use to him or how long they might be utilized until no longer capable of functioning,‘ and therefore the depreciation base should be ‘recognized as to the number of years the asset is expected to function profitably in use.’ See Massey Motors v. United States, supra at 96.
Accordingly, we decide that the respondent erred in disallowing the depreciation deductions here involved with the exception of the depreciation for each of the taxable years upon houses actually sold within such year at a price in excess of petitioner's depreciated cost as of the first of such year.
Decision will be entered under Rule 50.