Docket No. 42558-84.
Paul Frederic Marx, for the petitioner. Ross W. Paulson, for the respondent.
Petitioner sells land taking wrap-around installment obligations as at least a part of the sales price. For many years, the method of taxing gain in wrap-around installment sales in accordance with sec. 453, IRC 1954, has been judicially established in a line of cases headed by Stonecrest Corporation v. Commissioner, 24 T.C. 659 (1955), which interpreted the governing regulations. Congress made extensive changes to sec. 453 in the Installment Sales Revision Act of 1980, and although the congressional committees indicated pointedly their awareness of Stonecrest, no changes were made in the critical language of sec. 453 in respect of the method of computing the gain included in each installment as approved in Stonecrest. Highly complicated and confusing Temporary Regulations sharply at variance with Stonecrest were nevertheless promulgated in 1981, purportedly in reliance upon the 1980 amendments. HELD, sec. 15A.453-1(b)(3)(ii) of the Temporary Income Tax Regulations is invalid as inconsistent with sec. 453 of the Code, and the method of taxing wrap-around installment sales approved in the line of cases headed by Stonecrest is applicable to petitioner's wrap-around installment sales. Paul Frederic Marx, for the petitioner. Ross W. Paulson, for the respondent.
The Commissioner determined a deficiency in petitioner's fiscal 1981 income tax in the amount of $28,540. At issue is the proper amount of gain to be recognized in petitioner's 1981 tax year on its installment sales of land in which ‘wrap-around mortgages‘ are taken as part of the payment price.
The parties agree that the governing statutory provisions are in section 453(c) of the Code. That section provides that the income recognized in any taxable year is ‘that proportion of the payments received in that year which the gross profit (realized or to be realized when payment is completed) bears to the total contract price‘. In determining the proper proportion, there is no dispute between the parties as to the computation of the numerator of the relevant fraction, i.e., ‘gross profit‘, which is simply the sales price minus the seller's basis and costs of sale. In controversy, however, is the computation of the denominator, ‘the total contract price‘, in the circumstances of this case, involving the taxpayer's wrap-around sales. Petitioner argues that the total contract price here is simply the sales price or selling price used in computing the gross profit in the numerator. On the other hand, the Government contends that the total contract price is the sales price minus the amount of petitioner's outstanding mortgage liabilities. Petitioner's position is consistent with judicial decision and regulations of long standing, but the Government relies on Temporary Regulations promulgated after enactment of legislation in 1980 known as the Installment Sales Revision Act of 1980. Both parties agree that if these new regulations are valid the Government is entitled to prevail. The pivotal issue therefore is whether these new provisions in the Temporary Regulations are to be sustained.
Professional Equities, Inc. (petitioner or Professional Equities) is a corporation organized under the laws of California. Its principal office is located in Laguna Hills, California. It uses the accrual method of accounting, and keeps its books and records and files its Federal income tax returns on the basis of an August 31 fiscal year. Petitioner timely filed a U.S. Corporation Income Tax Return for its fiscal year ended August 31, 1981, with the office of the Internal Revenue Service at Fresno, California.
Professional Equities' business consists of buying undeveloped parcels of land and reselling such parcels to purchasers. A wrap- around mortgage, hereinafter explained, is created on the resale of the land.
When petitioner buys land, it either assumes an existing mortgage encumbering the land, or gives the seller a purchase money note and enters into a deed of trust agreement securing the note. In some instances, petitioner uses both of these methods to finance the purchase price. In the context of the later resale of the land, these obligations petitioner has placed on the land in purchasing it, are referred to as ‘underlying‘ or ‘wrapped‘ indebtedness.
Generally, petitioner resells the land using conditional sales contracts in which the buyer gives petitioner, as seller, a ‘wrap- around‘ mortgage in addition to a down payment of approximately 10 percent of the selling price. The wrap-around mortgage given petitioner by the purchaser is a new mortgage, the principal amount of which includes the unpaid balance of the wrapped or underlying indebtedness previously placed on the land at its purchase by petitioner. The buyer does not assume or take the property subject to the underlying indebtedness. Instead, petitioner is liable for and makes the payments on the wrapped indebtedness while the purchaser is liable for and makes payments to petitioner on the wrap-around indebtedness, i.e., the installment obligation. After petitioner has resold the land to a purchaser, it services the underlying mortgage on the parcel with the payments received from the purchaser. Petitioner's obligation to its creditors to make the payments on the underlying mortgage is not dependent, however, on whether petitioner receives timely payment from the purchaser. In addition, petitioner is not required to service the underlying obligation from the payments received from the purchaser.
In the sales at issue, the wrap-around indebtedness is payable to petitioner in monthly installments over a period of 10 to 15 years and bears a rate of interest which is higher than that on the underlying mortgage. At the time of resale by petitioner, the underlying mortgages on the land do not exceed petitioner's basis in the land.
Under the contracts of sale, legal title to the land is not deeded to the purchaser until the purchaser has paid petitioner the entire balance of the selling price together with interest. Petitioner's ‘Standard Agreement of Sale‘ describes this condition on the transfer of title as follows: ‘When Buyer has fully performed this Agreement in accordance with its terms * * * Seller will then execute and deliver to Buyer a deed which will convey good and sufficient title to said realty‘.
The parties have submitted to the Court documents used by petitioner in a ‘typical‘ land purchase and sale transaction. These exhibits support the foregoing stipulated description of the transactions entered into by petitioner. They show first that in the contract of sale, petitioner agreed to ‘keep encumbrances of record current, so long as Buyer »of the particular parcels involved† is not in default‘. They further reveal that petitioner received, on the sale of land, installment obligations from which its obligation on the underlying mortgage could readily be discharged. On the sale of the ‘typical‘ parcels, petitioner received a right to monthly payments of $320, $300, $209.89, and $209.89, totaling $1,039.78 a month, or $12,477.36 a year. Petitioner's continuing obligation on the underlying mortgages amounted to only approximately $3,500 a year for the first six years after it purchased the land and approximately $4,200 a year thereafter. The payments received on the installment sales were greater than the payments petitioner owed on the underlying mortgages both because the principal amount of the $104,000 obligation due petitioner (the so-called wrap-around mortgage) was larger than that of the $44,080 underlying mortgages, and because the interest rate on the obligation due petitioner (8- 3/4 percent) was higher than that on the underlying mortgages (7 and 8 percent).
The deficiency in income tax stems from the Commissioner's determination that petitioner has, on its 1981 return, incorrectly computed the proportion of the payments received on installment sales in that year to be recognized as gain. All such payments were made in 1981 on sales that occurred in 1981.
It is stipulated that petitioner was entitled to report its income under section 453 in the year before us. Section 453 allows gain on an installment sale to be reported on a deferred basis. It permits ‘the spreading of the income tax over the period during which payments of the sales price are received‘ and thus ‘alleviates possible liquidity problems which might arise from the bunching of gain in the year of sale when a portion of the selling price has not actually been received‘. H. Rept. No. 96-1042 at 5 (1980); S. Rept. No. 96-1000 at 7 (1980), 1980-2 C.B. 494, 497. See Commissioner v. South Texas Lumber Co., 333 U.S. 496, 503 (1948). This spreading of gain is achieved by dividing each installment payment and applying ‘part »to† return of capital and part to profit‘. Burnet v. S. & L. Bldg. Corp., 288 U.S. 406, 413 (1933).
Section 453 provides in relevant part as follows:
(c) Installment Method Defined. — For purposes of this section, the term ‘installment method‘ means a method under which the income recognized for any taxable year from a disposition IS THAT PROPORTION OF THE PAYMENTS RECEIVED IN THAT YEAR WHICH THE GROSS PROFIT (REALIZED OR TO BE REALIZED WHEN PAYMENT IS COMPLETED) BEARS TO THE TOTAL CONTRACT PRICE. »Emphasis supplied.† In essence, section 453(c) requires the taxpayer to recognize as gain a percentage of the payments received from an installment sale in any year. The amount required to be recognized is determined by multiplying the payments received by a fraction, the numerator of which is the gross profit to be realized on the sale and the denominator of which is the total contract price.
The parties' disagreement centers on the proper calculation of the total contract price or the denominator in this fraction. Respondent argues that petitioner must reduce the total contract price by the underlying mortgage in accordance with newly issued Temporary Regulations. Petitioner argues that the contract price is simply the same sales price used to determine the gross profit in the numerator. It contends that it need not, as respondent asserts it must, ‘deduct the amount of the underlying mortgage (deed of trust) * * * in computing the contract price of each sale‘. In so arguing, petitioner maintains that the Temporary Regulations that support the Commissioner's position are invalid both because unsupported by the statute and because they are in conflict with an opinion of this Court, Stonecrest Corporation v. Commissioner, 24 T.C. 659 (1955), and the regulations that opinion interprets. Because it claims that the Temporary Regulations are invalid, petitioner relies instead on the well-established judicial interpretation in Stonecrest of those regulations that the Temporary Regulations were meant to supplant.
The interpretation upon which petitioner relies to support its calculation of gain to be recognized was first set out in Stonecrest Corporation v. Commissioner, 24 T.C. 659 (1955). In that case, the Court was called upon to interpret the regulations that governed the reporting of installment sales. At that time those regulations provided as follows (section 29.44-2, Regs. 111):
In the sale of mortgaged property the amount of the mortgage, WHETHER THE PROPERTY IS MERELY TAKEN SUBJECT TO THE MORTGAGE OR WHETHER THE MORTGAGE IS ASSUMED BY THE PURCHASER, shall be included as a part of the ‘selling price,‘ but THE AMOUNT OF THE MORTGAGE, TO THE EXTENT IT DOES NOT EXCEED THE BASIS TO THE VENDOR OF THE PROPERTY SOLD, SHALL NOT BE CONSIDERED AS A PART OF THE ‘INITIAL PAYMENTS‘ OR OF THE ‘TOTAL CONTRACT PRICE,‘ as those terms are used in »the predecessors to section 453 and accompanying regulations†>>. Essentially the same regulations applied to ‘subject to‘ and ‘assumed‘ sales just before the Temporary Regulations were filed; they too required the contract price to be reduced by the underlying mortgages.
In Stonecrest, the Court determined that the regulations quoted above did not apply to the installment sales involved there. The sales before the Court in the Stonecrest case were essentially like those before us now, i.e., the various sales prices were financed at least in part by wrap-around obligations. In Stonecrest, the Court's conclusion that the regulations did not apply to the wrap-around sales therein was based upon its interpretation of the predecessor to section 453 and application of its understanding of the installment method required by that section in the context of the wrap-around sales before it. Under the Court's interpretation in Stonecrest, there was no justification for reducing the sales price by the amount of any underlying mortgage in determining the ‘contract price‘ in the denominator, since the buyer neither ‘assumed‘ the underlying mortgage nor took ‘subject‘ to it — the only circumstances set forth in the regulations for any such extraordinary reduction.
The Stonecrest holding that the regulations therein did not apply to wrap-around sales was thus based primarily on the ground that those regulations were, by their very own terms, limited in application to sales in which ‘the property is merely taken subject to the mortgage or * * * the mortgage is assumed by the purchaser‘. Section 1.453-4(c), Income Tax Regs. By excluding wrap-around sales from the province of the regulations governing ‘subject to‘ and ‘assumed‘ sales, the Court in effect recognized that the wrap-around mortgage, in the context of installment sales, was sufficiently different from the other two categories of mortgages as to require different tax treatment.
In holding that the regulations did not apply and in formulating its own interpretation of the proper application of the section to wrap-around mortgages, the Court recognized that the regulations applying to ‘subject to‘ and ‘assumed‘ sales were carefully tailored to the specific circumstances presented in the ‘subject to‘ and ‘assumed‘ situations. Those specific circumstances were that, in those types of sales, the entire sales price would not be paid directly to the seller of the property but instead would be paid in part to the seller's mortgagee in satisfaction of the underlying mortgage. The regulations increased the proportion to be used to tax gain by reducing the contract price by the underlying mortgages because, in the context of ‘subject to‘ and ‘assumed‘ sales, if they did not, they would tax too small a proportion of each payment. Cf. Burnet v. S. & L. Bldg. Corp., 288 U.S. 406 (1933). However, if that adjusted proportion were applied to wrap-around sales in which the full price was paid directly to the seller, too much gain would be recognized too soon. Consequently, this Court in Stonecrest found that the regulations mandating use of the larger fraction or proportion were ‘not intended to apply to every sale of mortgaged property but only to those situations where only part of the total selling price would be paid directly to the seller by the purchaser, the remaining part being paid by the buyer directly to the mortgagee.‘ Estate of Lamberth v. Commissioner, 31 T.C. 302, 315 (1958).
To adjust for the diversion of a portion of the sales price from the seller to his mortgagee, and the resulting receipt by the seller of smaller payments, the regulations reduced the contract price in the denominator of the proportion and thereby increased that proportion used to tax a portion of each payment as gain. The denominator, or contract price, was reduced by the underlying mortgage to the extent that such mortgage did not exceed the seller's basis in the property sold. Only by so adjusting the proportion used to tax each installment payment as gain by that much of the sales price that would not be paid to the seller would the regulations reach ‘the entire profit on the sale ‘. Stonecrest Corporation v. Commissioner, 24 T.C. at 665. See Estate of Lamberth v. Commissioner, 31 T.C. at 315. A proportion that was not so adjusted would have an overly large denominator and would accordingly result in taxing too small a proportion of each payment.
In Stonecrest and the many cases that followed, the Court recognized that this proportion used to tax payments made in the ‘subject to‘ and ‘assumed‘ situations was not the correct proportion to be used in an installment sale involving a wrap-around obligation because in such a wrap-around sale the purchase price would be paid in full directly to the seller. Estate of Lamberth v. Commissioner, 31 T.C. 302, 215 (1958). If that larger adjusted proportion were applied to tax as gain a portion of each payment in a wrap-around sale, the gain on the sale would be recognized in an accelerated manner that was not contemplated by the statute. See Hunt v. Commissioner, 80 T.C. 1126, 1144 (1983); Estate of Lamberth v. Commissioner, 31 T.C. at 318. In the case of a wrap-around sale, ‘the entire profit on the sale‘ would be reached without any adjustment of the proportion through reduction of the contract price in the denominator. Consequently, the proportion applied in Stonecrest to wrap-around sales was the smaller or unadjusted proportion in which the denominator was not reduced by the underlying mortgages.