Hernandez v. Commissioner

T.C. Memo. 1998-329

UNITED STATES TAX COURT

JOHN R. HERNANDEZ, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent*

Docket No. 17244-96. Filed September 21, 1998.

The Court granted P's Motion for Reconsideration
of Hernandez v. Commissioner, T.C. Memo. 1998-46, which
held that interest received on redemption of tax
certificates sold at public auction by Pasco County,
Florida, for nonpayment of property taxes was not
excluded from P's gross income under I.R.C. sec. 103(a)
as interest earned on State or local obligations. The
ground of decision was that tax certificates are not
issued by a State or political subdivision in exercise
of its sovereign borrowing power and therefore are not
obligations of a State or political subdivision for
purposes of I.R.C. sec. 103.

On reconsideration, P asserts that the portion of
the interest paid on redemption of tax certificates
that is attributable to special assessments (in
contrast to ad valorem taxes) is excluded from his
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*
This opinion supplements our previously filed Memorandum
Findings of Fact and Opinion in Hernandez v. Commissioner, T.C.
Memo. 1998-46, filed Feb. 5, 1998.
gross income under sec. 1.103-1(b), Income Tax Regs.,
which states: "Certificates issued by a political
subdivision for public improvements * * * which are
evidence of special assessments * * * and which the
political subdivision is required to enforce, are, for
purposes of this section, obligations of the political
subdivision".

Held: The language at issue in sec. 1.103-1(b),
Income Tax Regs., is restricted to special assessment
obligations that are issued by a State or political
subdivision in exercise of its sovereign borrowing
power to finance public improvements. The tax
certificates in this case are issued by a State or
political subdivision as a means of collecting
delinquent taxes in the exercise and enforcement of its
taxing power, not as a means of raising capital to
finance public improvements. Accordingly, sec. 1.103-
1(b), Income Tax Regs., does not apply.

John R. Hernandez, pro se.

Charles Baer, for respondent.

SUPPLEMENTAL MEMORANDUM OPINION

BEGHE, Judge: This matter is before us on petitioner's

motion under Rule 1611 for reconsideration of our opinion in

Hernandez v. Commissioner, T.C. Memo. 1998-46 (Hernandez I).

Hernandez I held that tax certificates sold by the Pasco County,

1
All section references are to 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, unless otherwise
indicated.
 - 3 -

Florida, tax collector for delinquent taxes owed on real property

are not obligations of a State or political subdivision, so that

interest paid on the certificates is not excluded from gross

income under section 103 for the taxable years 1990, 1991, and

1992. On May 28, 1998, we granted petitioner's motion for

reconsideration.

Introduction

On reconsideration, petitioner contends:2 (1) That tax

certificates issued by the Pasco County, Florida, tax collector

include both ad valorem real property taxes and special

assessments; (2) that section 1.103-1, Income Tax Regs., clearly

provides that certificates issued to enforce special assessments

against specific property, are, for the purposes of section 103,

obligations of the political subdivision; and (3) respondent’s

computation under Rule 155 has failed to deduct interest relating

to special assessments, from the composite interest payments,

which include interest on both special assessments and ad valorem

taxes, derived by the county as a single computation on the gross

charge against each parcel of land for which a tax certificate

was issued.

In his new arguments, petitioner relies on the following

language of section 1.103-1(b), Income Tax Regs.:

2
Petitioner makes other claims that lack even facial merit
and do not warrant reconsideration. Accordingly, they are
denied.
 - 4 -

Certificates issued by a political subdivision for
public improvements (such as sewers, sidewalks,
streets, etc.) which are evidence of special
assessments against specific property, which
assessments become a lien against such property and
which the political subdivision is required to enforce,
are, for purposes of this section, obligations of the
political subdivision even though the obligations are
to be satisfied out of special funds and not out of
general funds or taxes. * * *

We have considered petitioner's new arguments and find them

to be without merit. We remain convinced that our prior findings

and opinion in Hernandez I are correct; we decline to alter them

in any respect.

I. Taxation of Real Property in the State of Florida

A brief preliminary discussion of the Florida local property

tax system may be helpful. Taxes are generally imposed on real

property in the form of ad valorem property taxes or special

assessments. Ad valorem taxes are levied uniformly throughout a

taxing district for the general benefit of residents and

property. Sarasota County v. Sarasota Church of Christ, Inc.,

667 So. 2d 180, 183 (Fla. 1995); City of Boca Raton v. State, 595

So. 2d 25, 29 (Fla. 1992). In contrast, special assessments are

usually imposed for a specific purpose to benefit a specific area

or class of property and are imposed only on those properties

that will derive a benefit from the services or improvements made

possible by the special assessment. Sarasota County v. Sarasota

Church of Christ, Inc., supra at 183; City of Boca Raton v.

State, supra at 29.
 - 5 -

Although Florida ad valorem taxes and special assessments

are conceptually distinct, the Florida legislature contemplates

their joint collection.3 Florida statutory law, which governs

the collection of ad valorem taxes and the sale of tax

certificates, provides that special assessments may be collected

in the same manner as ad valorem property taxes. Fla. Stat. Ann.

sec. 197.363 (West 1989 & Supp. 1998). In order to be validly

collected in the same manner as ad valorem property taxes,

special assessments must be subjected to all collection

provisions of chapter 197, including, among others, the issuance

of tax certificates and tax deeds for nonpayment. Consequently,

an unpaid tax bill subject to sale of a tax certificate may

include both ad valorem taxes and special assessments.

II. Tax Certificates Not Issued by Florida or Political
Subdivision in the Exercise of Sovereign Borrowing Power

In Hernandez I, we held that interest earned on a Florida

tax certificate is not excluded from petitioner's gross income

under section 103. We held that a Florida tax certificate is

not an obligation of the State of Florida or a political

subdivision for purposes of section 103(c), because it is not

issued by a municipality as an exercise of its sovereign

borrowing power. Whether the interest earned on a Florida tax

3
See City of Boca Raton v. State, 595 So. 2d 25, 29 (Fla.
1992) (a legally imposed special assessment is not a tax and may
be imposed by a municipality without violating the Florida
Constitution's reservation of all taxation powers, other than ad
valorem taxes, to the State).
 - 6 -

certificate is attributable to ad valorem property taxes or

special assessments has no bearing. Our holding was based upon

an analysis of the nature and substance of the tax certificate

itself. Thus, the fact that part of the interest earned on

petitioner's tax certificates may be attributable to special

assessments would not alter our decision.

The sale of Florida tax certificates is properly

characterized not as an exercise of municipal borrowing power,

but as an exercise of municipal taxing power. In contrast to a

bond offering, or the issuance of special assessment obligations4

to contractors to finance municipal improvements, the sale of tax

certificates is not an activity designed to raise new capital.

Instead, the sale of tax certificates is an effort to collect

outstanding taxes, which are part of the municipality's existing

capital.5 See Consolidated Edison Co. v. United States, 10 F.3d

68, 72 (2d Cir. 1993) ("we think it clear that the City [New

York] was not exercising its borrowing power in accepting Con

4
In this opinion, the terms "special assessment
obligations" and "special assessment indebtedness" are used
interchangeably to refer generally to nonrecourse securities
issued by a municipality to finance public improvements, with the
obligation for repayment limited to funds available from special
assessments on the properties benefited by the improvements.
5
See Barrow v. Commissioner, T.C. Memo. 1983-123, in which
"We cited Florida court opinions that characterize tax
certificates as nothing more than evidence of a lien created
solely to facilitate expedient enforcement of the obligation of a
landowner to pay taxes lawfully assessed." Hernandez v.
Commissioner, T.C. Memo. 1998-46 (citing Beebe v. State Supreme
Court, 151, So. 298, 299 (Fla. 1933)).
 - 7 -

Edison's tax prepayments, but instead was exercising its power to

tax").

As discussed in Hernandez I, Florida tax certificates are

sold at auction to the bidder who will pay the outstanding taxes,

interest, costs, and other charges and is willing to accept the

lowest rate of interest. The issuer, Pasco County in the case at

hand, has no stake in the outcome of such an auction, other than

seeing to it that all tax certificates are sold, as in every case

in which a certificate is sold the issuer will receive payment in

full up front at the time of sale. The auction process

determines the rate of interest to be paid by the delinquent

property owner to redeem the certificate. The system so

described above is consistent with our characterization of the

sale of a Florida tax certificate as a collection activity in

exercise of the issuer's sovereign taxing power.

As pointed out in Hernandez I, the requirement that an

obligation be issued in exercise of sovereign borrowing power in

order to qualify as a section 103(c)(1) obligation "derives from

the notion that the purpose of the section 103 exclusion is to

enable States and localities to obtain capital at lower than

market rates of interest". In the municipal bond market, "the

exclusion causes purchasers of tax-exempt bonds to accept

interest at lower rates equal to the lower after-tax rates of

interest earned by holders of taxable bonds of equivalent risk."

Hernandez v. Commissioner, T.C. Memo. 1998-46. But the market
 - 8 -

for Florida tax certificates does not serve the purposes of

section 103, inasmuch as that market is not a source of borrowing

for municipalities, which bear no interest costs in the issuance

of tax certificates. Interest on tax certificates is paid only

by the delinquent property owner upon redemption of the

certificate; the municipality incurs no obligation to pay any

amount to the holder of tax certificates. In selling a tax

certificate, the municipality always receives up front the full

amount of outstanding taxes, interest, costs, and other charges

on the respective property.

III. Section 1.103-1(b), Income Tax Regs., and Its Predecessors

Commencing with the first Federal income tax statute

following the 16th Amendment to the Constitution, the regulations

under the statutory predecessors of section 103 had a tortuous

history, as numerous issues bearing on the exclusion for

municipal bond interest were teased out and dealt with by the

Bureau of Internal Revenue (Bureau) and the Board of Tax Appeals.

One area of contention was whether various forms of instruments

issued by municipalities to finance public improvements that

limited the issuer's repayment obligation to the levying and

collection of special assessments were municipal obligations.

Initially, the Bureau treated such instruments as municipal

obligations. See, e.g., O.D. 447, 2 C.B. 93; O.D. 491, 2 C.B.

93; O.D. 999, 5 C.B. 102, 102-103; I.T. 1606, II-1 C.B. 69,

69-70.
 - 9 -

In 1934 the Bureau began to distinguish among special

assessment obligations primarily on the basis of what they were

called. See G.C.M. 13469, XIII-2 C.B. 125, 125-126.

Accordingly, in 1935, the following language was added to Article

22(b)(4)(1), "Interest upon State obligations", Regulations 86:

"Special tax bills issued for special benefits to property, if

such tax bills are legally collectible only from owners of the

property benefited, are not the obligations of a State,

Territory, or political subdivision." This language reflected

the Bureau's position in G.C.M. 13469, supra, that special

assessment bonds otherwise satisfying the requirements of the

exclusion were exempt, see, e.g., Estate of Shamberg v.

Commissioner, 3 T.C. 131 (1944), affd. 144 F.2d 998 (2d Cir.

1944); Garland v. Commissioner, 42 B.T.A. 324 (1940); Carey-Reed

Co. v. Commissioner, 36 B.T.A. 36 (1937), affd. 101 F.2d 602, 603

(6th Cir. 1939); Pontarelli v. Commissioner, 35 B.T.A. 872

(1937), affd. 97 F.2d 793 (7th Cir. 1938), while special

assessment bills, certificates, and warrants were not, see, e.g.,

District Bond Co. v. Commissioner, 113 F.2d 347 (9th Cir. 1940)

(following Bryant v. Commissioner, 111 F.2d 9 (9th Cir. 1940),

revg. 38 B.T.A. 618 (1938)), revg. 39 B.T.A. 739 (1939); Avery v.

Commissioner, 111 F.2d 19 (9th Cir. 1940); Morrison Bond Co. v.

Commissioner, 42 B.T.A. 720 (1940) (modification of opinion in

response to Bryant v. Commissioner, supra); Estate of Bekins v.

Commissioner, 38 B.T.A. 604 (1938); T.I. Stoner v. Commissioner,
 - 10 -

37 B.T.A. 249 (1938); Standard Inv. Co. v. Commissioner, 36

B.T.A. 156 (1937).

In Riverview State Bank v. Commissioner, 1 T.C. 1147 (1943),

following the rationale of the decision of the U.S. Court of

Appeals for the Ninth Circuit in Bryant v. Commissioner, supra,

we ended much of the controversy surrounding special assessment

obligations by holding that the distinction in name only between

special assessment bills and special assessment bonds had no

bearing on the exclusion. Riverview State Bank v. Commissioner,

supra at 1150.

In 1952, the Secretary deleted from the regulations the

above-quoted language that had been added in Regulations 86 in

1935. See T.D. 5875, 1952-1 C.B. 15. The Treasury Decision

noted that it was relieving taxpayers from a limitation in the

prior regulations. This deletion was consistent with our

decision in Riverview State Bank v. Commissioner, supra, in which

we had rejected the drawing of a distinction between special

assessment bonds and bills for purposes of the exclusion.

In Rev. Rul. 56-159, 1956-1 C.B. 609, the Commissioner,

following our decision in Riverview State Bank, took the position

that nonrecourse special assessment assignable certificates

issued to contractors by a municipality in consideration of

paving improvements were the obligations of a political

subdivision, and thus exempt from income taxation. The

certificates differed in name only from special assessment bills
 - 11 -

and bonds. Shortly thereafter, the language in question in

section 1.103-1, Income Tax Regs., quoted supra p. 3, was added

to the regulations when they were republished under the 1954

Code. See T.D. 6220, 1957-1 C.B. 34, 38.

Our review of the judicial and administrative history of

section 1.103-1(b), Income Tax Regs., impels us to conclude that

the addition of the language at issue was intended to conform

administrative interpretation of section 103 with our holding in

Riverview State Bank v. Commissioner, supra, by recognizing that

special assessment indebtedness, whether labeled bonds, bills, or

otherwise, can be an obligation of a State or a political

subdivision for purposes of section 103. See Independent Gravel

Co. v. Commissioner, 56 T.C. 698 (1971). In Riverview State

Bank, we declined to make any differentiation based upon the form

in which a special assessment obligation was denominated in

determining whether the interest on the obligation was excluded

from gross income. Riverview State Bank v. Commissioner, supra

at 1150. Following Riverview State Bank, we decline to hold that

section 1.103-1(b), Income Tax Regs., applies in this case,

merely because the Pasco County obligations in issue are called

"tax certificates". (Emphasis added.)

Petitioner's effort to apply section 1.103-1(b), Income Tax

Regs., to the case at hand is misconceived and fundamentally

flawed. That regulation requires that special assessment

indebtedness be issued “for public improvements (such as sewers,
 - 12 -

sidewalks, streets, etc.).” Sec. 1.103-1(b), Income Tax Regs.

But, as we noted in Hernandez I, the Pasco County tax

certificates in issue in the case at hand “`are only a means

of evidencing unpaid taxes and to enable the sale thereof for

the purpose of realizing funds or current governmental

expenditures’”. Hernandez v. Commissioner, T.C. Memo. 1998-46

(quoting Smith v. City of Arcadia, 185 So. 2d 762, 767 (Fla.

Dist. Ct. App. 1966)). In short, the tax certificates in issue

are not issued to finance public improvements. In each of the

above-cited special assessment cases, municipal obligations were

issued to finance particular public improvement projects. See,

e.g., Independent Gravel Co. v. Commissioner, supra at 705 ("We

have on many occasions in the past dealt with the exemption of

interest paid on instruments issued by a governmental unit in

consideration for municipal improvements") (street and sewer

improvements); Estate of Shamberg v. Commissioner, supra (bridges

and tunnels); Riverview State Bank v. Commissioner, supra (street

improvements); Carey-Reed Co. v. Commissioner, supra (street,

paving, and sewer improvements); Pontarelli v. Commissioner, 35

B.T.A. 872 (1937)(sewer improvements). In Florida, however, tax

certificates are sold solely as a means of collecting delinquent

real property taxes. Fla. Stat. Ann. sec. 197.432 (West 1989 &

Supp. 1997).

Conclusion
 - 13 -

We hold that the tax certificates issued by Pasco County to

petitioner are not covered by section 1.103-1(b), Income Tax

Regs., to any extent. We reaffirm that they are not obligations

of a political subdivision for purposes of section 103.

Accordingly, none of the interest earned on the Pasco County tax

certificates, whether attributable to special assessments or to

ad valorem property taxes, is exempt from Federal income tax

under section 103.

For the reasons stated, we decline to alter the result

reached in our opinion reported at Hernandez v. Commissioner,

T.C. Memo. 1998-46.

To reflect the foregoing,

An appropriate order

will be issued.