Willow Terrace Dev. Co. v. CIR, 345 F.2d 933 (5th Cir. 1965)
United States Court of Appeals Fifth Circuit.
WILLOW TERRACE DEVELOPMENT CO., Inc. and Post
Oak Manor Building Co., Inc.,
COMMISSIONER OF INTERNAL REVENUE, Respondent.
COMMISSIONER OF INTERNAL REVENUE, Petitioner,
WILLOW TERRACE DEVELOPMENT CO., Inc. and Post
Oak Manor Building Co., Inc.,
June 1, 1965.
Rehearing Denied July 1, 1965.
Proceeding on petition of taxpayers to review
a decision of the Tax Court of the United States, 40 T.C. 689. The Court
of Appeals, Griffin B. Bell, Circuit Judge, held that taxpayers were required
to include in their gross income full amount of trade-in allowances given to
new house purchasers on their old houses, but taxpayer was allowed to add to
costs of house and lot the cost of construction of water and sewage plant.
Affirmed on petition and cross petition.
Before GEWIN and BELL, Circuit Judges, and
McRAE, District Judge.
GRIFFIN B. BELL, Circuit Judge.
Taxpayers are the Willow Terrace Development
Co., Inc., and its wholly-owned subsidiary, Post Oak Manor Building Co.,
Inc. Both corporation engaged in developing real estate subdivisions in
the Houston area, and filed consolidated corporate income tax returns for the
tax years here involved, 1955-1958. They petition to review a decision of
the Tax Court requiring the Building Company to include in gross income the
full amount of 'trade-in-allowances' given to purchasers of new homes in return
for equities in their old homes. The Commissioner cross-petitions from
the Tax Court's decision allowing the Building Company to add the cost of
constructing water and sewage facilities to the cost basis of the houses it
built and sold. The opinion of the Tax Court is reported at 40 T.C.,
689. We affirm on both questions.
I. The Taxpayers' Appeal
Building Company built and sold new houses in
the Post Oak Manor Subdivision in Harris County, Texas. In making sales
of new houses, the building company often accepted the purchaser's interest or
equity in his old house as part of the sales price for the new house in Post
Oak Manor. The credit received by the purchaser, or 'trade-in allowance,'
was treated as part of the down payment on the new house. The trade-in houses
all had outstanding mortgages on them, and Building Company acquired them
subject to the prior encumbrances. During the tax years here involved,
Building Company made trade-in allowances on the equities in 151 houses in the
total amount of $348,609.73. [FN1]
Rather than taking title to the trade-in
houses directly, Building Company had the new house purchasers deed them to
Terwil Corporation, a corporation owned in the same proportions by the same
three men who owned Development Company which in turn owned Building Company.
[FN2] Terwil attempted to resell the houses as soon as possible to avoid
making mortgage payments, and all 151 were sold under contracts for a deed,
with a small down payment, usually $200, and with the balance of the purchase
price to be paid after the existing mortgage was satisfied. Interest on
the contract price was to be paid in the interim. The total face amount of the
151 contracts was approximately $392,600, but when sales expenses were deducted
from the initial payments totaling $34,200, the net amount of cash received was
only $9,345.13. The balance due on the contracts was $358,600.
There was no established market in the Houston area for the contracts received
by Terwil Corporation for the trade-in houses.
The Commissioner determined that the entire
amount of the trade-in allowances ($348,609.73) should be included in Building
Company's gross income as part of the amount realized from the sale of new
houses under § 1001(a), (b) of the Internal Revenue Code of 1954. That section
provides that the 'amount realized from the sale * * * of property shall be the
sum of any money received plus the fair market value of the property (other
than money) received.' In the Tax Court, Building Company contended that
the fair market value of the trade-in houses was not equal to the trade-in
allowances, but was zero, or in any event, not more than from $8,000 to
$12,000. The Tax Court held that Building Company failed to sustain its
burden of showing that the fair market value of the trade-in houses was less
than $348,609.73. We agree.
standard for determining fair market value under 1001 is well
established. It is the price at which property will change hands between
a willing buyer and a willing seller, neither being under any compulsion to buy
or sell and both having reasonable knowledge of the facts. French Dry Cleaning Co. v. Commissioner of Internal Revenue, 5 Cir.,
1934, 72 F.2d 167. The Tax Court applied this standard. Stiles v.
Commissioner of Internal Revenue, 5 Cir., 1934, 69 F.2d 951, relied on by
taxpayers for their contention that the proper standard is the amount presently
realizable in cash, is not to the contrary. Indeed, the court in the
French Dry Cleaning Co. case so stated.
Given that the Tax Court applied the proper
legal standard in determining fair market value, there was ample evidence to
support its conclusion that the fair market value of the equities in the
trade-in houses was at least equal to $348,609.73, the amount of the trade-in
allowances. One factor considered by the Tax Court was what they were
actually sold for in the open market, $392,600. The receipt of only
slightly more than $9,000 net in cash after sales expenses does not alter the
fact that the price at which Terwil sold the houses were substantially above
the trade-in allowances. Moreover, and this is the long and short of the
matter, the Commissioner introduced the testimony of two real estate appraisers
which established a value for the trade-in houses in excess of the trade-in allowances.
Taxpayers' appraisers testified that the value of the houses was only $12,000,
and there was other evidence to support the taxpayer' contention.
However, the testimony of the Commissioner's witnesses was adequate, if
credited as it was by the Tax Court, to carry the day for the Commissioner, and
the finding by the Tax Court was in no event clearly erroneous. See Greer
v. Commissioner of Internal Revenue, 5 Cir., 1964, 334 F.2d 20.
Taxpayers argue alternatively that even if
the trade-in houses were worth the trade-in allowances, Building Company sold
the houses to Terwil Corporation at a corresponding loss. In this regard,
the Tax Court was correct in holding that there was no sale by Building Company
to Terwil. Form must give way to substance in the tax law. Commissioner
of Internal Revenue v. Court Holding Co., 1945, 324 U.S. 331, 65 S.Ct. 707, 89
L.Ed. 981; Hindes v. United States, 5 Cir., 1964, 326 F.2d 150. [FN3]
It follows that the decision of the Tax Court
requiring Building Company to include the full amount of the trade-in
allowances in gross income must be and it is affirmed.
II. The Commissioner's Appeal
Building Company constructed all houses in
Post Oak Manor Subdivision in accordance with Federal Housing Administration
specifications and requirements in order to secure FHA or Veteran's
Administration loan insurance guarantees on the mortgages to be utilized in the
purchase of the new business. As a condition to issuing loan commitments
on the subdivision, the FHA required that a satisfactory water system and
sewerage disposal system be made available to the new houses. Building
Company first attempted to secure these facilities from the City of
Houston. Post Oak Manor was at that time beyond the city limits, and Houston
declined to construct the facilities. After determining that it would be
more economical to construct and operate its own systems rather than obtain
them from a neighboring subdivider, Building Company constructed a water plant,
sewerage disposal plant, and the necessary connecting systems. The total
cost of these facilities to Building Company was $157,187.49.
By an instrument dated July 30, 1954,
Building Company transferred the water and sewerage facilities to Post Oak
Manor Water Company, Inc., a separate corporation owned in identical
proportions by the same three men who owned Development Company and Building
Company. The only consideration furnished by the Water Company was its
agreement to operate the systems. The transfer agreement set the rates
which Water Company would charge, and provided that the rates could be
increased only if they proved insufficient to cover operating costs, provide
sufficient reserves for replacement, obsolescence and depreciation, and a
reasonable rate of return on the basis of capital investment.
Pursuant to FHA requirements, Water Company
executed a trust deed transferring title to the facilities to an approved
trustee for the benefit of the property owners. Water Company retained
the active control and management of the systems, but the trust deed provided
that if the Water Company abandoned the plant, changed the rate structure
materially, or failed to provide satisfactory service, the trustee could take
over the operation of the system for the benefit of the property owners.
Water Company carried the facilities on its
books at a zero basis and no depreciation was ever claimed on them. The
president of the company received no salary. Without allowance for
depreciation, the operations of the company from 1955 through 1959 produced net
income for the five year period of $12,934.02. [FN4] Assuming a five per
cent replacement factor per year on cost, the operation resulted in a net loss
of $17,702.80. [FN5]
By an ordinance enacted on December 31, 1956,
the city of Houston annexed an area which included the Post Oak Manor
Subdivision. Action by the city to annex this area had been begun by at least
the preceding February. By ordinance of May 1, 1957, the city prohibited
private water companies in the annexed area from increasing their rates until
future rate hearings. Water Company sought permission to increase its
rates but was refused. Negotiations for the sale of the facilities to the city
were begun, and in September, 1959, the city of Houston purchased all of Water
Company's water and sewerage facilities for $221,200. There were about 60
private water and sewerage systems in the area annexed in December, 1956, but
by November 1962, the city had acquired only 40 of them. From 1950 to
1955, the city acquired 47 private systems that were located in an area annexed
to the city in 1950.
Building Company sought to deduct the full
$157,000 cost of the water and sewer systems as part of the cost basis of the
lots it had developed. This was accomplished by allocating a pro rata
portion of the $157,000 to the cost of each of the 432 lots in the
subdivision. Under §§ 1012 and 1016 of the Internal Revenue Code, the
proper basis for the lots is 'cost' plus 'adjustment * * * for expenditures * *
* properly chargeable to capital account.' The Commissioner disallowed
the deductions in full, taking the position that the cost of the water and
sewerage systems was not part of the cost of the lots, but was an independent
investment in separate valuable property, cost of which should be recovered
through capitalization or subsequent sale. The Tax Court, relying on its
prior decision in Estate of Collins v. Commissioner of Internal Revenue, 1958,
31 T.C. 238, sided with the taxpayers, and the Commissioner appeals.
The Commissioner's position is that the
facilities may be allocated to the cost of the lots only if they are
constructed in order to sell the lots and are permanently and irrevocably
dedicated to the lot owners so that the cost of the facilities is recoverable
in no other manner. Thus, streets, sidewalks, public parks and recreation
areas in which the developer retains no interest are properly considered part
of the cost of the lots sold. See Country Club Estates, Inc. v. Commissioner
of Internal Revenue, 22 T.C. 1283 (1954). However, the Commissioner contends
that the water and sewerage systems here involved were a separate investment in
valuable and potentially income producing property by the developer, which
property was retained by the developer rather than dedicated to the homeowners.
The cost of such an independent investment, according to the Commission, should
be recovered through depreciation of the facilities or subsequent sale.
Here the taxpayer did in fact recover the cost by selling the facilities to the
City of Houston.
Estate of Collins v. Commissioner, supra,
involved a sewerage disposal system. There the Tax Court stated the rule
'* * * if a person engaged in the business of exploiting a real estate subdivision constructs a facility thereon for the basic purpose of inducing people to buy lots therein, the cost of such construction is properly a part of the cost basis of the lots, even though the subdivider retains tenuous rights without practical value to the facility constructed (such as a contingent reversion), but if the subdivider retains 'full ownership and control' of the facility and does 'not part with the property * * * for the benefit of the subdivision lots,' then the cost of such facility is not properly a part of the cost basis for the lots.'
The opinions of the Tax Court in Collins and in this case are buttressed by the recent decision of the Fourth Circuit in Commissioner of Internal Revenue v. Offutt, 4 Cir., 1964, 336 F.2d 483. Taxpayer in that case was allowed to deduct the cost of water and sewerage systems on facts very similar to those presented here. We agree with the Tax Court and with the Fourth Circuit.
The problem presented by these cases is
whether deduction or capitalization of such costs will more accurately reflect
the economic realities of the situation from the standpoint of the
subdivider. We cannot accept the rule advocated by the Commissioner,
which in effect allows deduction only when the costs can be recovered in no
other manner. Some relevant factors to be considered in determining the
proper tax treatment of the costs of such facilities are whether they were
essential to the sale of the lots or houses, whether the purpose or intent of
the subdivider in constructing them was to sell lots or to make an independent
investment in activity ancillary to the sale of lots or houses, whether and the
extent to which the facilities are dedicated to the homeowners, what rights and
of what value are retained by the subdivider, and the likelihood of recovery of
the costs through subsequent sale. These factors were considered in
Collins, and the holding centered on the basic purpose test as modified by
ownership. The Tax Court said:
'* * * We have concluded that petitioners constructed the sewerage system not only for the basic purpose but for the sole purpose of inducing and making possible the sale of lots * * *, that they did not retain full ownership and control of the sewerage system, and that they parted with material property rights therein for the benefit of the subdivision lots.'
In the present case the facts meet this test and support the conclusion of the Tax Court. The basic purpose of Building Company in constructing the facilities was to sell lots and houses, not to invest in the water and sewerage business. It was essential that the lots in the subdivision be supplied with water and sewerage, both in order to sell the lots and in order to secure FHA financing. Building Company constructed the facilities itself only after the City of Houston refused and after it was determined that to secure them from a neighboring subdivider would be more expensive.
The water and sewerage systems were, under
the FHA trust deed, dedicated to the benefit of the lot owners. Legal
title was held by the trustee for their benefit. Abandonment, impairment
of service or any material increase in rates would give the trustee the right
to take over the facilities. Water Company retained only the right and
duty to operate the systems. There is no indication that the developers
of Post Oak Manor anticipated any independent profit from the operations of
Water Company, and, allowing for replacement costs, no profit was in fact
made. At the time of the trust deed, the assets in the hands of Water
Company had little if any saleable value. Sale to the City of Houston
became possible only after the Post Oak Manor area was annexed to the
city. The possibility of future sale to the city must be considered
remote at that time, depending as it did on the vagaries of future annexation.
In sum, construction of the water and
sewerage systems was necessary, if not essential, to the sale of homes in Post
Oak Manor, and the systems were in fact constructed for that purpose, as
distinguished from the purpose of independent investment. The facilities
were dedicated to the benefit of the homeowners under the FHA trust deed, the
rights retained by Water Company having at that time little if any saleable
value, and the possibility of recovering the costs through future sale to the
city was remote. The conclusion of the Tax Court that the cost of these
facilities were properly allocated to the cost of the houses sold by Building
Company rested on these conclusions of fact which find support in the record.
Its decision was correct, and it is thus affirmed.
Affirmed on the petition and cross-petition.
Tax Court stated:
'A typical transaction would be somewhat as
follows: Building Co. would offer a new house in Post Oak Manor for sale for
$16,000. Mortgage arrangements on this new house could be made for $13,000. A
prospective purchaser had a house that cost him $10,000 but was subject to an
encumbrance of $8,000. He could buy Building Co.'s $16,000 home by paying
$1,000 cash, deeding his old home to Terwil (subject to the $8,000 encumbrance)
for which Building Co. would give him a $2,000 trade-in allowance, and making
arrangements for a $13,000 mortgage on the new home to pay the balance of the
$16,000 purchase price.'
method was followed to avoid showing any contingent liability of Building
Company for the outstanding indebtedness against the trade-in houses on its
statement, and to prevent it from becoming involved in foreclosures to the
displeasure of the Federal Housing Administration.
FN3. Building Company followed the
bookkeeping practice with respect to the trade-in allowances of debiting an
account called trade-in allowances for the amounts allowed, and then writing
off these amounts at the end of the year as worthless. On its tax returns
for the years in question it reported the allowances as sales receipts but
deducted the amount thereof as expense. In the Tax Court they contended
simply that they had overstated their new house sales to the extent of the allowances
since the equities in the trade-in houses were without value.
figures for each of the five years are as follows:
1955 -- $
1959 -- 1,044.47
1957 -- 12,697.20
1958 -- 2,286.40
corresponding annual figures are:
1955 -- $(2,146.43) loss
1956 -- (8,371.29) loss
1957 -- 5,202.79
1958 -- (5,572.97) loss
1959 -- (6,814.90) loss