James W. and Laura L. Keith v. Commissioner

115 T.C. No. 42

UNITED STATES TAX COURT

JAMES W. AND LAURA L. KEITH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 11426-98. Filed December 28, 2000.

Prior to and during the years in issue, GIA, a
proprietorship owned by P wife, sold residential real
property by means of contracts for deed. Under these
agreements, the buyers obtained possession; assumed
responsibility for taxes, insurance, and maintenance;
and became obligated to make monthly payments, with
interest, of the purchase price. A warranty deed
would be delivered to the buyers by GIA only upon full
payment, and any default by the buyers prior thereto
would render the contracts null and void, with GIA
retaining all amounts paid as liquidated damages.

In accounting for these transactions, Ps reported
the gain attributable to the contracts for deed in the
year in which full payment was received and title
transferred. Only interest payments were included in
income for tax purposes until such time. GIA also
depreciated the subject properties during the term of
each contract.
 - 2 -

Held: Each contract for deed effected a completed
sale for tax purposes in the year of execution, and
income attributable to such disposition must be
recognized and reported for that taxable year.

Held, further, the net operating loss carryovers
claimed by Ps must be adjusted to take into account
income which should have been reported in years
preceding those at issue, for contracts entered during
such prior periods.

Held, further, Baertschi v. Commissioner, 49 T.C.
289 (1967), revd. 412 F.2d 494 (6th Cir. 1969), will no
longer be followed.

William J. White, for petitioners.

Nancy E. Hooten and Mark S. Mesler, for respondent.

OPINION

NIMS, Judge: Respondent determined the following

deficiencies and penalties with respect to petitioners’ Federal

income taxes for the taxable years 1993, 1994, and 1995:

Taxable Income Tax Penalty
Year Deficiency Sec. 6662(a)
1993 $74,925.00 $14,985
1994 127,304.00 25,461
1995 106,261.54 21,252

After concessions, the issues remaining for decision are:

(1) The proper method of accounting for, and timing of

recognition of gain attributable to, sales of property by means

of contracts for deed; and
 - 3 -

(2) the reduction of net operating loss carryovers from

years preceding the years in issue to reflect income attributable

to contracts for deed executed in those prior years.

Additionally, the parties have agreed that a third issue,

the availability of depreciation deductions for properties

subject to such contracts for deed, is dependent upon and will be

resolved by our decision regarding petitioners’ accounting

method. The parties have stipulated the amounts to be allowed as

depreciation deductions in the event of a ruling either for

petitioners or for respondent.

Unless otherwise indicated, all section references are to

sections of 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.

Background

This case was submitted fully stipulated pursuant to Rule

122, and the facts are so found. The stipulations of the

parties, with accompanying exhibits, are incorporated herein by

this reference. Petitioners resided in Moultrie, Georgia, during

each of the years in issue and at the time their petition was

filed in this case.

Formation of Greenville Insurance Agency (GIA)

Petitioner James W. Keith is a radiologist, and petitioner

Laura L. Keith is a dentist. Mrs. Keith is also the owner of a
 - 4 -

proprietorship known as Greenville Insurance Agency (GIA). Mrs.

Keith established the business in 1983 on the advice of her

father, J.D. Latzak, as a vehicle to create potential tax

savings. GIA was formed primarily to sell insurance, to purchase

real estate for resale or rent, and to broker mortgages. Since

its genesis, GIA has been run by Mr. Latzak who, because of large

judgment creditors, could not conduct business or hold assets in

his name. Although neither of the Keiths possesses an insurance

license or has experience in real estate transactions, Mr. Latzak

is a licensed insurance agent and an experienced broker. We

previously addressed the treatment of insurance commissions and

mortgage placement fees earned incident to GIA’s operations for

years 1984 through 1988 in Latzak v. Commissioner, T.C. Memo.

1994-416. We now focus on the reporting of income attributable

to the company’s sales of real property.

GIA’s Real Estate Transactions

During the years at issue, GIA was in the business of

selling, financing, and renting residential real property. The

sales were effected by means of contracts for deed. The record

reflects 18 such contracts entered into between 1989 and 1995, 12

of which were executed in the 1993 to 1995 period presently

before the Court. The following is representative of these

agreements:
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CONTRACT FOR DEED

GEORGIA, MERIWETHER COUNTY

This agreement entered into by the seller and the
buyer(s). The seller hereby agrees to convey to the
buyer(s) fee simple title to a certain property
described on Exhibit “A” to this contract, at which
time all of the conditions of the sale described below
are met by the buyer.

SELLER: Greenville Insurance Agency, a
proprietorship, which is registered and
domiciled in Meriwether County, Ga.,
maintaining an office open to the public at
109 Court Square, Greenville, Georgia 30222.

BUYER(S): _____________________________________________
_____________________________________________
_____________________________________________

SELLING PRICE: ____________ DOWN PAYMENT _____________

BALANCE of $__________ to be evidenced by a promissory
note plus interest at ____% interest payable in ___
monthly installments of $______ per month, starting
_________ and ending ________.

SPECIAL STIPULATIONS TO THE CONDITIONAL SALE:

(1) The buyer(s) shall pay the prorated [year of
execution] property taxes, and all future property
taxes promptly when due.

(2) The buyer(s) shall not permit the general
condition of the property to deteriorate in value
any futher [sic] than its delivered condition.

(3) The buyer(s) shall perform any and all required
maintenance on the property.

(4) The buyer(s) shall assume all liabilities as if
they had fee simple title.

(5) The property is to be used as a primary single
family residence for the buyer(s), and for no
other purpose.
 - 6 -

(6) The buyer may not transfer or assign their [sic]
rights or interest in this contract.

(6a) Fire Insurance in the amount of $__________ from a
company approved by the Seller must be kept in
force at all times, seller named as loss payee,
until all terms are met by buyer.

(7) Payment of the monthly installments of $_______
are required to be tendered to the seller at its
offices stated above or other place so designated
by the seller or its assigns, and payable in
United States Currency, on or before the due date.
Any payment accepted more than ten (10) days
beyond the due date will require an additional
charge of 10% of the amount payable, and the
acceptance of same will not modify or novate any
other terms and conditions and will not act as a
waiver of the sellers [sic] right to declare the
contract in default and null and void and of no
effect.

The seller agrees to convey to the buyer(s), a Warranty
Deed, free of any leins [sic] and encumbrances within
ten (10) days after all of the terms and conditions of
this agreement are met by the buyer(s).

Should the buyer(s) elect to acelerate [sic] this
agreement, then the terms and conditions of the
promissory note executed contemporaneously with this
agreement by the buyer(s) would determine the amount to
be tendered by the buyer(s) for the acceleration in
order to prematurely obtain a warranty deed.

Should the buyer(s) default or breach or not meet any
of the conditions of the terms herein specified, then
this contract and the note attached evidenced by this
contract will be immediately declared NULL & VOID, and
no futher [sic] benefits or equities would be accrued
to the buyer(s), except that the buyer(s) would be
liable for any monies unpaid under the terms and
conditions of the contract to the date that the
contract was declared null and void.

It is understood and agreed by the Buyer(s) and the
Seller that the $________ ernest [sic] money down
payment, and the monthly installments and other charges
tendered by the buyer(s) from inception, and any
 - 7 -

improvements to the property made by or on the behalf
of the buyer(s) during the life of this contract, if
forfeited by the buyer(s) as a result of default or
breach of the contract, is a fair value for the
liquidated damages incurred by the seller as a result
of said breach or default.

No warranties as to the condition or usability of the
property are either expressed or implied by the seller.

It is herein disclosed to the buyer(s) that the subject
property may presently have existing debt being
serviced by the seller, and that future debt (not to
exceed the amount payable under this contract) may be
incepted by the seller.[1]

The conditions of sale, as well as the provisions related to

default, voidability, and liquidated damages, were substantially

identical in all material respects in each of the contracts.

Printed descriptions or handwritten notations indicate that the

subject property of most of the agreements was a residence. A

small percentage of the contracts may have been for land alone.

The majority of the contracts were for terms of between 240 and

300 months and specified interest at a rate of 11 to 18 percent.

The sales prices ranged from a low of less than $3,000 to a high

of $40,000. The total gain represented by the contracts,

1
With respect to this final paragraph, we note that neither
party has referenced its existence or discussed its intended
operation. Our own research has similarly yielded no insight
into the precise meaning of such a provision or its potential
impact on the buyer-seller relationship. Hence, since the
parties apparently regard it as insignificant boilerplate, we
shall do likewise and shall give it no further consideration.
 - 8 -

calculated as the difference between the sales price and GIA’s

basis, was $58,373, $62,517, and $11,500 for agreements executed

in 1993, 1994, and 1995, respectively.

GIA’s Accounting and Reporting

With their 1993, 1994, and 1995 Federal income tax returns,

petitioners included Schedules C, Profit or Loss From Business,

with respect to GIA. On each such Schedule C, petitioners

indicated GIA’s accounting method by checking the box labeled

“Accrual”. A like designation was made on Schedules C filed with

returns for the preceding years 1984 through 1992.

As regards accounting for the above-described real estate

transactions in particular, the methodology generally utilized by

petitioners has been stipulated by the parties. During the term

of a contract for deed, petitioners would report as income the

interest received on the promissory note entered into in

conjunction with the contract. The portion of any payment

allocable to principal would be treated as a deposit on the

purchase and would be recorded as a liability on the books of the

company. If a property were repossessed prior to completion of

the contract, this deposit would be applied first to repairs and

maintenance, and any remaining amount would be reported as

miscellaneous income. The properties would also be depreciated

by GIA during the payment period.
 - 9 -

Upon full payment of the contract price, petitioners would

recognize income on the disposition of the property. Gain on the

sale would be computed by reducing the total sale price by

petitioners’ adjusted basis in the property.

Discussion

I. Contentions of the Parties

Petitioners contend that their method of accounting for and

recognizing gain attributable to the contracts for deed is

appropriate and clearly reflects income. According to

petitioners, the contracts are mere voidable, executory

agreements and as such do not effect a closed and completed sale

in the year signed. Hence, in petitioners’ view, there is no

disposition of the properties for tax purposes and no consequent

realization of gain until final payment is received and title

transferred.

Conversely, respondent asserts that petitioners’ method of

accounting for sales under the subject contracts for deed is

improper and fails to clearly reflect income. Respondent avers

that each instrument produced a completed sale in the year of

execution, as the benefits and burdens of ownership were

transferred from petitioners to the buyer at that time.

Respondent, characterizing petitioners as accrual method

taxpayers, therefore concludes that no grounds exist for

deferring recognition of gain on these completed transactions.
 - 10 -

In addition, respondent argues that petitioners’ incorrect method

of accounting resulted in inflated losses in prior years such

that the net operating loss carryovers to the years at issue

should be reduced accordingly.

II. Method of Accounting and Recognition of Gain

A. Existence of Gain--Completed Sale

As a general rule, the Internal Revenue Code imposes a

Federal tax on the taxable income of every individual. See sec.

1. Section 61(a) specifies that gross income for purposes of

calculating such taxable income means “all income from whatever

source derived”. Expressly encompassed within this broad

pronouncement are “Gains derived from dealings in property”.

Sec. 61(a)(3). Section 1001(a) then defines such gains as the

amount realized “from the sale or other disposition of property”,

less the adjusted basis. Accordingly, section 1001(a) indicates

that gross income within the meaning of section 61(a) does not

arise until property is considered sold or otherwise disposed of

for Federal tax purposes.

Case law then sets forth the standard for determining when a

sale is complete for tax purposes. With respect to real

property, a sale and transfer of ownership is complete upon the

earlier of the passage of legal title or the practical assumption

of the benefits and burdens of ownership. See Major Realty Corp.

& Subs. v. Commissioner, 749 F.2d 1483, 1486 (11th Cir. 1985),
 - 11 -

affg. in part and revg. in part T.C. Memo. 1981-361; Dettmers v.

Commissioner, 430 F.2d 1019, 1023 (6th Cir. 1970), affg. Estate

of Johnston v. Commissioner, 51 T.C. 290 (1968); Baird v.

Commissioner, 68 T.C. 115, 124 (1977). This test reaffirms the

longstanding principle, evidenced by the following early

statement, that transfer of legal title is not a prerequisite for

a completed sale: “A closed transaction for tax purposes results

from a contract of sale which is absolute and unconditional on

the part of the seller to deliver to the buyer a deed upon

payment of the consideration and by which the purchaser secures

immediate possession and exercises all the rights of ownership.”

Commissioner v. Union Pac. R.R. Co., 86 F.2d 637, 639 (2d Cir.

1936), affg. 32 B.T.A. 383 (1935).

In determining whether passage either of title or of

benefits and burdens has occurred, we look to State law. It is

State law that creates, and governs the nature of, interests in

property, with Federal law then controlling the manner in which

such interests are taxed. See United States v. National Bank of

Commerce, 472 U.S. 713, 722 (1985). Here, execution of the

contracts for deed was not accompanied by a transfer of legal

title, so we must decide whether these instruments were

sufficient under State law to confer upon the purchaser the

benefits and burdens of ownership. This inquiry is a practical

one to be resolved by examining all of the surrounding facts and
 - 12 -

circumstances. See Clodfelter v. Commissioner, 426 F.2d 1391,

1393 (9th Cir. 1970), affg. 48 T.C. 694 (1967); Baird v.

Commissioner, supra at 124. As all contracts at issue appear to

involve Georgia properties and to have been executed in Georgia,

the relevant State law is supplied by the statutes and courts of

that jurisdiction.

Among the factors which this and other courts have cited as

indicative of the benefits and burdens of ownership are: A right

to possession; an obligation to pay taxes, assessments, and

charges against the property; a responsibility for insuring the

property; a duty to maintain the property; a right to improve the

property without the seller’s consent; a bearing of the risk of

loss; and a right to obtain legal title at any time by paying the

balance of the full purchase price. See Goldberg v.

Commissioner, T.C. Memo. 1997-74; see also Major Realty Corp. v.

Commissioner, supra at 1487; Grodt & McKay Realty, Inc. v.

Commissioner, 77 T.C. 1221, 1237-1238 (1981); Musgrave v.

Commissioner, T.C. Memo. 2000-285; Berger v. Commissioner, T.C.

Memo. 1996-76; Spyglass Partners v. Commissioner, T.C. Memo.

1995-452. When a buyer, by virtue of such incidents, would be

considered to have obtained equitable ownership under State law,

a sale will generally be deemed completed for Federal tax

purposes. See Baird v. Commissioner, supra at 126; Berger v.

Commissioner, supra; Spyglass Partners v. Commissioner, supra.
 - 13 -

In the case at bar, we observe that the contracts for deed

gave the buyers possession of the property during the agreement

term (evidenced by the mandate to use the property as a

residence). The contracts also required purchasers to pay

property taxes from the date of execution, to keep fire insurance

in force during the payment term, to perform maintenance and

prevent deterioration, and to assume all liabilities as if they

held fee simple title. Moreover, the instruments allowed buyers

to accelerate the agreement and “prematurely obtain a warranty

deed” by tendering the full amount owing under the related

promissory note. Therefore, given these significant

accoutrements of ownership, we turn to whether Georgia courts

would construe an instrument so designating rights and

obligations as a transfer of equitable ownership to the buyer.

In Chilivis v. Tumlin Woods Realty Associates, Inc., 297

S.E.2d 4 (Ga. 1982), the Supreme Court of Georgia interpreted a

contract analogous to those at issue here. In that case, an

“Agreement for Deed” was executed by the parties. Id. at 5-6.

According to its terms, a deed was placed in escrow to be

delivered to the buyer upon completion of all payments called for

in the accompanying promissory note. See id. at 6. The

instrument specifically recited:

“Seller and Buyer acknowledge and agree that this
Agreement is not a mortgage or security deed to secure
a loan made to Buyer by Seller, that this is an
agreement to convey the Property to Buyer upon the
 - 14 -

completion of the terms and provisions of this
Agreement * * * , that this is not a loan secured by
the Property and that no title in and to the Property
has passed to Buyer or will pass to Buyer until Buyer
fulfills and complies with each and every term and
provision hereof.” [Id.]

The buyer was given immediate possession of the property and was

responsible for taxes, maintenance, and insurance thereon. See

id. Upon a default by the buyer, the seller’s remedy was either

to rescind the transaction or to exercise a power of sale over

the property. See id. The buyer would not be liable for any

deficiency in the event of such a sale. See id.

Faced with these facts, the court decided that the

“Agreement for Deed” was “for all practical purposes no different

from a bond for title”, an instrument formerly used in Georgia

real estate law in connection with sales of land. Id. at 7-8.

The court further noted that prior case law had said of a bond

for title:

“In the sale of land on credit where the vendor retains
title, he has not the absolute estate, but is a trustee
holding the title only as security. For many purposes
the transaction may be treated in equity as though the
vendor had made a deed to the vendee and the latter had
thereupon given a common-law mortgage to secure the
purchase-money.” [Id. (quoting Lytle v. Scottish Am.
Mortgage Co., 50 S.E. 402, 406 (Ga. 1905)).]

Accordingly, the court then concluded with respect to the

instrument before it as follows: “In practicality, it is no

different than if * * * [the seller] had delivered a warranty

deed to * * * [the buyer] and accepted a deed to secure debt in
 - 15 -

return. The agreement created an equitable interest in * * *

[the buyer] and a security interest in * * * [the seller].” Id.

at 8.

The Court of Appeals of Georgia subsequently relied on

Chilivis v. Tumlin Woods Realty Associates, Inc., supra, in

interpreting a similar agreement in Tucker Fed. Sav. & Loan

Association v. Alford, 311 S.E.2d 229 (Ga. Ct. App. 1983). The

appellate case likewise involved a land sale contract under which

the seller agreed to deliver a warranty deed upon full payment

(or the assumption by the buyers of two outstanding mortgages on

the property). See id. at 230. Again the instrument recited

that no title passed upon execution of the agreement, but the

buyers took possession and control of the premises. See id. The

court first opined that “The transaction clearly granted * * *

[the buyers] all the benefits and responsibilities of ownership.”

Id. On that basis, the conclusion ultimately reached was that

“The contract of sale, of course, did not vest legal title in * *

* [the buyers], but it did give them an equitable interest and

rights of ownership.” Id. at 231.

Given the foregoing, we conclude that Georgia courts would

similarly construe the contracts for deed at issue here to pass

equitable ownership to the purchasers and to leave GIA

essentially with a security interest. In addition, we note that

certain statements made by petitioners on brief are not
 - 16 -

inconsistent with the notion that security concerns may in fact

have motivated the transactional form chosen: “GIA sells real

property to low-income families in Western Georgia near Columbus.

Because these families are poor and have little or no credit

history the properties are sold using a ‘Contract for Deed’”.

Hence, we hold that these instruments upon their execution

effected a completed sale for Federal tax purposes. Petitioners’

reliance on Hambrick v. Bedsole, 91 S.E.2d 205 (Ga. Ct. App.

1956), and on the voidability of their agreements, in support of

a contrary conclusion, is misplaced.

Hambrick v. Bedsole, supra at 208-209, involved a contract

under which title to property was not to pass and possession was

not to be delivered until the full, lump-sum purchase price was

paid. The agreement did not provide for either a downpayment or

installment payments. See id. The court decided that the

contract “was a mere executory agreement to sell and did not

constitute a sale”, on the grounds that the buyer “gained by the

contract neither title to, nor the right of possession of” the

subject property. Id. at 209. The situation in Hambrick v.

Bedsole, supra, thus bears almost no resemblance to that in the

instant case and cannot inform our analysis.

As regards the voidability of the contracts for deed, we see

no material difference between the provisions on default here and

those contained in the agreement in Chilivis v. Tumlin Woods
 - 17 -

Realty Associates, Inc., supra. In either case, if the buyer

were to default and refuse to complete the transaction, the

seller would have no further recourse against the buyer

personally. The seller could look only to the property itself as

a means to recover the full value of the aborted deal and would

be unable to enforce remaining payments or deficiencies against

the buyer as a personal liability. Yet, the court still

characterized the Chilivis instrument as creating an equitable

interest in the buyer and leaving the seller with a mere security

interest. Hence, we do not believe that Georgia courts would

hold a lack of recourse against the purchaser, following default

of an otherwise binding agreement, to prevent a finding that the

benefits and burdens of ownership, i.e., an equitable interest,

were nonetheless transferred when the contract was signed.

Accordingly, the sale should be considered complete for tax

purposes, regardless of the possibility of future voidance.

The foregoing conclusion is further buttressed by the

weight, or lack thereof, that other courts have given to various

types of nonrecourse clauses in evaluating the completeness of a

sale. For instance, the sales agreement at issue in Commissioner

v. Baertschi, 412 F.2d 494, 497 (6th Cir. 1969), revg. 49 T.C.

289 (1967), contained the following language:

The remedy or recourse of said parties of the first
part for the non-performance of any obligation of the
parties of the second part hereunder shall be limited
solely to the moneys paid hereunder, and to the herein
 - 18 -

described property, and said parties of the second part
shall not be liable for any deficiency arising from the
sale of said property in any way, capacity or manner
whatsoever, nor shall said parties of the first part
have the right to, nor seek, a deficiency or other
money judgment against said parties of the second part.

The court, however, noted such factors as the buyers’ absolute

right to title on full payment; the sellers’ lack of any right to

cancel except upon the purchasers’ default; and the buyers’

possession of, and responsibility for taxes and insurance on, the

property. See id. at 498. Given these elements, the court

declared: “we do not feel that the single fact of a ‘no

recourse’ clause served to delay the finality of this sale until

final payment of the total purchase price had been made.” Id.

An identical result was reached on similar facts in Clodfelter v.

Commissioner, 426 F.2d 1391, 1395 (9th Cir. 1970).

While we acknowledge that our opinion in Baertschi reached a

contrary conclusion on this issue, we have now reconsidered our

holding in light of reversal by the Court of Appeals for the

Sixth Circuit. We are persuaded that the position of the Court

of Appeals on the effect of a non-recourse provision rests on

sound legal principles. Accordingly, Baertschi v. Commissioner,

49 T.C. 289 (1967), will no longer be followed. We further note

that this approach better harmonizes with our earlier ruling that

contracts with provisions closely analogous to those here and

which by their terms became “utterly null and void” on the

buyer’s default, with the seller retaining all moneys paid,
 - 19 -

represented closed sales in the year entered. See Arnold v.

Commissioner, a Memorandum Opinion of this Court dated Mar. 17,

1953. We see no reason to infer differently here.

B. Reporting of Gain--Timing of Inclusion

Thus, having decided that petitioners’ contracts for deed

effected a completed sale when executed, we proceed to the

question of when gain from such sales must be included in gross

income. The general rule for the taxable year of inclusion is

set forth in section 451(a): “The amount of any item of gross

income shall be included in the gross income for the taxable year

in which received by the taxpayer, unless, under the method of

accounting used in computing taxable income, such amount is to be

properly accounted for as of a different period.” Regulations

then specify as follows:

Under an accrual method of accounting, income is
includible in gross income when all the events have
occurred which fix the right to receive such income and
the amount thereof can be determined with reasonable
accuracy. * * * Under the cash receipts and
disbursements method of accounting, such an amount is
includible in gross income when actually or
constructively received. * * * [Sec. 1.451-1(a), Income
Tax Regs.]

Taxable income, in turn, generally “shall be computed under the

method of accounting on the basis of which the taxpayer regularly

computes his income in keeping his books”, with the exception

that “if the method used does not clearly reflect income, the
 - 20 -

computation of taxable income shall be made under such method as,

in the opinion of the Secretary, does clearly reflect income.”

Sec. 446(a) and (b).

As used in section 446, the term “method of accounting”

encompasses “not only the over-all method of accounting of the

taxpayer but also the accounting treatment of any item”. Sec.

1.446-1(a)(1), Income Tax Regs. Furthermore, it has been

recognized repeatedly that this section grants the Commissioner

broad discretion, such that to defeat a proposed change

thereunder, the taxpayer must establish that the Commissioner’s

determination is “‘clearly unlawful’” or “‘plainly arbitrary’”.

Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533 (1979)

(quoting Lucas v. American Code Co., 280 U.S. 445, 449 (1930),

and Lucas v. Kansas City Structural Steel Co., 281 U.S. 264, 271

(1930)). However, if the taxpayer’s method does clearly reflect

income, the Commissioner cannot require the taxpayer to change to

a different method even if the Commissioner’s method more clearly

reflects income. See Ford Motor Co. v. Commissioner, 71 F.3d

209, 213 (6th Cir. 1995), affg. 102 T.C. 87 (1994).

In the case at bar, the only evidence in the record which

speaks to GIA’s overall method of accounting is the Schedules C

filed with petitioners’ tax returns. On each such Schedule C,

the box indicating “Accrual” was checked. We therefore have no

basis on which to conclude that GIA was other than an accrual
 - 21 -

method business and must proceed on the assumption that,

excepting the contract for deed transactions, its items of income

and expense were reported using this method.

Under the accrual method, gain arising from the contracts

for deed would be reportable in the year when the right to

receive the income became fixed and the amount of the income

became reasonably determinable. Since the instruments at issue

expressly dictated price, the latter requirement regarding amount

of income is not in question here. Concerning the former element

of a fixed right to the income, we reiterate the well-established

principle that “In applying the all events test, this and other

courts have distinguished between conditions precedent, which

must occur before the right to income arises, and conditions

subsequent, the occurrence of which will terminate an existing

right to income, but the presence of which does not preclude

accrual of income.” Charles Schwab Corp. & Subs. v.

Commissioner, 107 T.C. 282, 293 (1996), affd. 161 F.3d 1231 (9th

Cir. 1998).

Here, the only circumstance in which GIA could fail to

receive the full amount of the purchase price would be a default

by the buyer. A default, however, is a condition subsequent. As

we stated regarding the similar sales contract in Clodfelter v.

Commissioner, 48 T.C. 694, 701 (1967):

the purchaser was given immediate possession; it
thereupon assumed the rights and obligations of
 - 22 -

beneficial ownership; and thereafter such property
interest and beneficial ownership would not be subject
to termination or forfeiture, except on the happening
of a condition subsequent--i.e., a default.

Thus, because the buyer’s obligation to pay the full price under

the agreements in the instant case was otherwise unconditional,

execution of the contracts fixed petitioners’ right to these

sums. Our declaration that “the amount of and right to the

purchase price were fixed and unqualified”, in the context of

another sales agreement which provided for forfeiture of the

contract and retention of all moneys paid in liquidation of

damages, is equally applicable here. Elsinore Cattle Co. v.

Commissioner, a Memorandum Opinion of this Court dated Feb. 21,

1950. Accordingly, both elements for inclusion were met in the

year of signing, the year the transaction was completed for tax

purposes.

This is consistent with the longstanding position of this

Court that the factual predicate requiring income inclusion in a

given year by an accrual method taxpayer is completion of a sale

in that year. For instance, it was held as early as 1925, with

respect to a contract entered in 1918 with all payments to be

made in subsequent years: “The transaction was a completed sale

in the year 1918, and, as the taxpayer kept its books of account

on the accrual basis, the sale price was properly accruable in

that year. We hold, therefore, that the profits arising from the
 - 23 -

sale in question were income to the taxpayer in the year 1918.”

Parish-Watson & Co. v. Commissioner, 2 B.T.A. 851, 860 (1925);

see also sec. 15A.453-1(d)(2), Temporary Income Tax Regs., 46

Fed. Reg. 10717 (Feb. 4, 1981). But see sec. 1.1001-1(g), Income

Tax Regs., for sales or exchanges occurring on or after August

13, 1996.

We additionally point out that, to the extent petitioners

argue no income is required to be recognized because the voidable

notes evidencing the debt have no fair market value and thus are

not the equivalent of cash, this consideration has no place in

the analysis of an accrual method entity. The following

explanation clearly distinguishes between accrual and cash

accounting in this regard:

An agreement, oral or written, of some kind is
essential to a sale. If payment is made at the same
time that the obligation to pay arises under the
agreement, then the profit would be reported at that
time no matter which method was being used. However,
the situation is different when the contract merely
requires future payments and no notes, mortgages, or
other evidence of indebtedness such as commonly change
hands in commerce, which could be recognized as the
equivalent of cash to some extent, are given and
accepted as a part of the purchase price. That kind of
a simple contract creates accounts payable by the
purchasers and accounts receivable by the sellers which
those two taxpayers would accrue if they were using an
accrual method of accounting in reporting their income.
But such an agreement to pay the balance of the
purchase price in the future has no tax significance to
either purchaser or seller if he is using a cash
system. [Johnston v. Commissioner, 14 T.C. 560, 565
(1950).]
 - 24 -

Consequently, unless a specific exception to the above general

rules will permit deferral, we are satisfied that GIA, as an

accrual method business, must recognize and report income

attributable to the contracts for deed in the years of their

respective executions.

The primary exception for income deferral is section 453,

which provides for the “installment method” to be used in

reporting an “installment sale”. Petitioners do not, however,

appear to argue that this statute is applicable. We also note

that a “dealer disposition”, including “Any disposition of real

property which is held by the taxpayer for sale to customers in

the ordinary course of the taxpayer’s trade or business”, is

excluded from the definition of an installment sale. Sec.

453(b)(2)(A), (l)(1)(B). The parties here have stipulated that

“GIA was in the business of selling, financing, and renting

residential real property.” Additionally, although a further

exception can permit use of the installment method for sales of

residential lots, see sec. 453(l)(2)(B), the record before us

fails to establish that petitioners could qualify under this

provision. The contracts indicate that the majority of the

properties were houses, not lots. Also, as to the contracts

which may have been for land alone, no evidence shows that the

remaining requirements for this election have been met. See sec.

453(l)(2)(B)(ii), (l)(3); Wang v. Commissioner, T.C. Memo. 1998-
 - 25 -

127. In any event, petitioners have nowhere contended that the

various transactions should be treated differently.

A second basis for potential income deferral, to which

petitioners do make reference on brief as an apparent alternative

argument, is the recovery of cost approach. However, substantive

requirements for use of this method aside, we have refused to

allow taxpayers to switch to cost recovery accounting without

following the established procedures under section 446(e) for

requesting such a change from the Commissioner. See Wang v.

Commissioner, supra; see also Witte v. Commissioner, 513 F.2d 391

(D.C. Cir. 1975) (holding that section 446(e) requires that

consent be sought even for a change from an improper to a proper

accounting method), revg. in part and remanding T.C. Memo. 1972-

232. It is undisputed that petitioners have never filed the

requisite Form 3115. See sec. 1.446-1(e)(3)(i), Income Tax Regs.

The Commissioner thus was not obligated to consider this approach

in analyzing whether petitioners’ accounting clearly reflected

income or in determining a method which did so.

To summarize, respondent determined that gain of an accrual

method business must be reported consistently with that method in

order to clearly reflect income. Given the above, we now

conclude that such determination accords with settled law and

precedent. Hence, petitioners have not shown that the proposed

change is either clearly unlawful or plainly arbitrary. We hold
 - 26 -

that petitioners must include the gain attributable to GIA’s

contracts for deed, the excess of sales price over basis, in

their gross income for the respective years of the agreements’

execution.

III. Reduction of Net Operating Loss Carryovers

Section 172(a) authorizes a net operating loss deduction.

Essentially, a net operating loss is the excess of deductions

over gross income, with enumerated modifications. See sec.

172(c) and (d). The net operating loss so determined may be

carried back to the 3 preceding taxable years and carried forward

to the 15 succeeding years, until absorbed by taxable income.

See sec. 172(b).

On their returns for 1993 through 1995, petitioners claimed

deductions for net operating loss carryovers from prior years.

In the notice of deficiency, respondent disallowed a portion of

the amount claimed for 1993 and the full amount for years 1994

and 1995. Respondent argues that the net operating loss

carryovers were overstated and should be allowed only to the

extent the underlying losses were incurred and remain unabsorbed

after taking into account certain adjustments.

Two primary adjustments are referenced in the parties’

stipulations and briefs. First, both parties are apparently in

agreement that the net operating loss carryovers should be

increased to reflect the insurance commissions and mortgage
 - 27 -

placement fees which we previously held should have been reported

by Mr. Latzak. See Latzak v. Commissioner, T.C. Memo. 1994-416.

Second, however, respondent also contends that the carryovers

should be reduced to reflect the income attributable to contracts

for deed entered in years 1989 through 1992, as such gain was

properly reportable in those years.

In general, the taxpayer bears the burden of establishing

both the actual existence of net operating losses in the prior

years and the amount of such losses that may be carried to the

years at issue. See Rule 142(a); Jones v. Commissioner, 25 T.C.

1100, 1104 (1956), revd. and remanded on other grounds 259 F.2d

300 (5th Cir. 1958); Ocean Sands Holding Corp. v. Commissioner,

T.C. Memo. 1980-423, affd. without published opinion 701 F.2d 167

(4th Cir. 1983); Moyer v. Commissioner, T.C. Memo. 1976-69, affd.

without published opinion 565 F.2d 152 (3d Cir. 1977). We have

jurisdiction to consider such facts related to years not in issue

as may be necessary for redetermination of tax liability for the

period before the Court. See sec. 6214(b).

Here, petitioners have not and could not, given our

conclusions above, establish their incurrence of and entitlement

to deduct losses premised in part on a failure to report income

attributable to the contracts for deed entered in the loss years.

We agree with respondent that these adjustments should be taken

into account along with those based on the income properly
 - 28 -

reportable by Mr. Latzak. Thus, we hold that to the extent

recomputation applying these adjustments shows that GIA’s net

operating loss carryovers do not exceed the amount allowed by

respondent for 1993, petitioners are not entitled to deduct such

further amounts.

To reflect the foregoing and the parties’ concessions,

Decision will be entered

under Rule 155.

Reviewed by the Court.

WELLS, CHABOT, WHALEN, COLVIN, HALPERN, CHIECHI, LARO,
FOLEY, VASQUEZ, GALE, THORNTON, and MARVEL, JJ., agree with this
majority opinion.

SWIFT and RUWE, JJ., concur.