*145 Decisions will be entered for the respondent.
Held, that Kingsway Developments, Inc., was a collapsible corporation within the definition of section 117(m) of the 1939 Code, and therefore, that gains realized by petitioners upon a distribution from Kingsway and sale of their Kingsway stock were gains attributable to property which is not a capital asset.
*723 Respondent determined deficiencies in petitioners' income taxes for the taxable year ended December 31, 1950, as follows:
| Docket No. | Petitioners | Deficiency |
| 53982 | Max and Hilda Mintz | $ 24,201.54 |
| 53983 | Louis and Maybelle Mintz | 24,433.70 |
| 53984 | Morris and Evelyn Mintz | 5,122.26 |
The sole question is whether the gains realized*146 by petitioners upon a cash distribution from Kingsway Developments, Inc., and upon the sale of Kingsway stock are taxable to them as ordinary income under section 117(m) of the Internal Revenue Code of 1939.
FINDINGS OF FACT.
Certain facts and joint exhibits have been stipulated and are included herein by reference.
Petitioners Max and Hilda Mintz, Louis and Maybelle Mintz, and Morris and Evelyn Mintz, husbands and wives respectively, residing in Brooklyn, New York, filed joint income tax returns with the collector of internal revenue for the first district of New York. *724 Max, Louis, and Morris are brothers; they will hereinafter sometimes be referred to as petitioners.
For many years prior to 1948 Louis was engaged in the construction business, primarily as a builder of 1- and 2-family houses. Prior to 1946 he owned a 50 per cent interest in a construction firm; the other 50 per cent was owned by Monroe Markowitz, his brother-in-law. Markowitz was primarily engaged in the textile business and the active management of the construction business was left to Louis. Louis' business association with Markowitz began in 1943 or 1944. Except for a controversy in connection with*147 their first transaction, which arose when Markowitz sought to examine the books kept by Louis, their relationship ran smoothly until 1949. Markowitz had come to regard Louis as an expert in the acquisition, development, and management of real estate.
Max had been associated in the construction business with Louis since the late 1930's, and acquired a one-third interest therein upon his release from the Army in 1946 or 1947. Morris acquired a 10 per cent interest when he was taken into the business as a salesman in 1947 or 1948. Thereafter Louis, Max, and Markowitz each owned 30 per cent of the construction business and Morris owned 10 per cent.
In addition to building 1- and 2-family houses Louis held a real estate broker's license and had, over a period of years as far back as 1935, acquired numerous investment properties, mainly buildings and mortgages, which he continued to hold through the time of the trial of these cases. Louis usually acted as his own broker. One investment property was owned together with Max and numerous others were owned with Markowitz. Louis considered his investment activities to be separate and distinct from his 1- and 2-family building operations. *148 By 1948 a number of these investment properties had appreciated substantially in value. Rather than incur a capital gains tax upon their disposition, Louis preferred to continue holding the properties for income-producing purposes; as a general rule he sold only when he thought a property's income-producing ability to be in jeopardy.
Between March and September 1948, petitioners and Markowitz acquired 3 parcels of land, aggregating 43,207 square feet, identified respectively as Tax Lots Nos. 45 and 24, Block 4649, and Tax Lot No. 70, Block 4650, on the Tax Map of the Borough of Brooklyn, City of New York. The original purpose of acquiring these parcels (hereinafter sometimes referred to as the Kingsway tract) was to construct 1- and 2-family houses. At no time prior to September 2, 1948, did petitioners or Markowitz intend to build an apartment house on the acquired properties. Louis had never built an apartment house prior to those involved in the present cases.
*725 Tax Lots Nos. 45 and 24 were contiguous and comprised the block front on the north side of Kings Highway between East 94th and East 95th Streets, Brooklyn; Tax Lot No. 70 was separated from the other 2 lots*149 by East 95th Street and was located on the northeast corner of Kings Highway and East 95th Street.
On March 24, 1948, petitioners and Markowitz caused Marphil Realty Corporation (hereinafter referred to as Marphil) to enter into a contract to purchase Tax Lot No. 45; and on April 9, 1948, they similarly caused Marphil to enter into a contract to purchase Tax Lot No. 24. The lots were acquired from tax lien traders who bought the tax liens on the lots, made contracts to sell them, and then foreclosed the liens prior to transfer of title. On July 6, 1948, after foreclosure, the vendors deeded the lots to Marphil free and clear of all encumbrances at a cost of $ 13,800 for Tax Lot No. 45 and $ 14,250 for Tax Lot No. 24.
Louis Mintz, on behalf of petitioners and Markowitz, acquired the tax lien on Tax Lot No. 70 at a tax lien sale on September 2, 1948, and began suit to foreclose the lien. Although the separate cost of acquiring Tax Lot No. 70 has not been stipulated, the aggregate cost of the Kingsway tract was $ 44,567.96 and was apportioned among petitioners and Markowitz as follows: Louis -- 30 per cent; Max -- 30 per cent; Markowitz -- 30 per cent; Morris -- 10 per cent. Marphil*150 and Louis acted merely as nominees for petitioners and Markowitz in the acquisition of the Kingsway tract; the ownership of the land was in fact divided among petitioners and Markowitz according to the percentages noted above. The City of New York assessed each of the 3 lots at $ 20,000, or a total of $ 60,000, on the tax bills for the fiscal years ending June 30, 1949, and June 30, 1950.
Subsequent to September 2, 1948, petitioners and Markowitz abandoned their intention to build 1- and 2-family houses on the Kingsway tract and decided to apply to the Federal Housing Administration (FHA) for mortgage insurance with a view to construction of an apartment house project. Under section 608 of the National Housing Act, 12 U.S.C. section 1743, FHA was authorized to insure mortgages meeting certain statutory requirements and to promulgate rules and regulations to implement the mortgage insurance program. Petitioners and Markowitz had been aware of the existence of section 608 but decided to take advantage of it only after certain persons engaged in the construction of a "Section 608 project" in another neighborhood pointed out the suitability of the*151 Kingsway tract for a similar development. On the advice of these persons, Louis contacted Thomas C. Grady, a mortgage broker and specialist in FHA matters, with respect to securing the desired FHA mortgage approval. Grady *726 canvassed the proposed site and reported that because of its satisfactory location there would be no difficulty obtaining approval.
On October 22, 1948, petitioners and Markowitz commenced negotiations with FHA by causing their architects, Proskauer & Lama, to file an application with FHA for approval of the Kingsway tract as a site for a federally insured housing project. FHA issued a site approval on November 12, 1948. At that time petitioners hoped that they would "mortgage out," that is, that mortgage loan proceeds might exceed the cost of constructing the project.
Title to the parcel known as Tax Lot No. 70 was acquired in the name of Louis Mintz under judgment of foreclosure on November 29, 1948.
On or about January 4, 1949, Louis and Markowitz, as cosponsors on behalf of Kingsway Developments, Inc. (hereinafter referred to as Kingsway), a corporation which they contemplated forming to construct the project, applied to the Federal Housing Commissioner*152 for mortgage insurance in the amount of $ 1,125,000 in connection with the proposed construction of a 6-story, 126-family, 456-room apartment house project on the Kingsway tract at an average monthly rental of $ 29.21 per room. The loan of $ 1,125,000 was to be made by the Lincoln Savings Bank of Brooklyn (hereinafter referred to as Lincoln). It was estimated in the application that Kingsway's "total estimated requirements" for putting up the project would be $ 1,250,000. Included in the estimates were a 5 per cent "builder's fee" of $ 49,386 and a 5 per cent "architect's fee" of $ 51,855. Petitioners did not intend to pay these fees in full; instead, it was anticipated that Proskauer & Lama would receive a substantially smaller fee and that petitioners would supervise the building themselves, thereby saving the cost of independent foreman and dispensing with the supervision of an architect. Grady had informed petitioners that architect's and builder's fees could be included in estimated construction cost even though such fees were never in fact to be paid, or not to be paid in the amount estimated. Petitioners estimated that Kingsway would supply $ 125,000 of estimated costs*153 in the form of land (the Kingsway tract) valued at $ 86,414 (43,207 square feet at $ 2 per square foot) and "other equity" of $ 38,586 which in fact represented that portion of estimated fees which Kingsway did not intend to pay.
On February 8, 1949, Lincoln issued a letter of commitment in which it tentatively authorized a fully insured FHA building and permanent loan of $ 1,125,000 to Kingsway.
Kingsway was organized as a New York corporation on February 14, 1949. On February 21, 1949, it issued 10 shares of common stock for $ 1,000 cash paid in; Louis Mintz, Max Mintz, and Monroe *727 Markowitz each paid in $ 300 and each received 3 shares; Morris Mintz paid in $ 100 and received 1 share. The Kingsway tract was conveyed to Kingsway by deeds dated February 25, 1949, for 60 additional shares of Kingsway common stock, 18 shares each to Louis Mintz, Max Mintz, and Monroe Markowitz, and 6 shares to Morris Mintz. Thereafter, and until September 28, 1950, there were 70 shares of Kingsway common stock outstanding; Max Mintz, Louis Mintz, and Monroe Markowitz each owned 21 shares and Morris Mintz owned 7 shares. The Kingsway tract was carried on the books of the corporation at *154 its cost to petitioners and Markowitz of $ 44,567.96.
In addition to the issuance of common stock, Kingsway issued 100 shares of preferred stock (par $ 1) to FHA as a prerequisite to the securing of mortgage insurance; FHA, however, did not pay for the stock until August 11, 1949.
Further analysis of anticipated construction costs by Louis indicated to him that a loan of $ 1,125,000 might not be sufficient. Markowitz objected to the possibility of his having to advance additional funds and indicated he wanted to withdraw from the deal. As a result of his analysis, Louis decided to submit revised plans to FHA as a basis for securing increased mortgage insurance; Markowitz refused to cosponsor the revised application.
On April 4, 1949, Louis, on behalf of Kingsway, submitted a revised application to the Federal Housing Commissioner for mortgage insurance in the amount of $ 1,283,000 in connection with the proposed construction of a 6-story, 144-family, 519-room apartment house project (consisting of 3 separate buildings) on the Kingsway tract at an average monthly rental of $ 29.07 per room. As compared with the original application of January 4, 1949, the revised application indicated*155 an increase in the number of family units, from 126 to 144, and an increase in the number of rooms, from 456 to 519. On the basis of the original application Kingsway would have been able to build rooms larger than FHA minimum requirements. On the basis of the revised application, the increase in the number of rooms required a decrease in the size of the rooms from that originally proposed; however, even as decreased, the size of each room was in excess of FHA minimum requirements. Kingsway also volunteered to install terrazzo flooring instead of Kentile in the first floor hallways.
The application stated that Kingsway's "total estimated requirements" for construction of the project amounted to $ 1,425,555, computed as follows: *728
| Land: | |
| 43,207 square feet at $ 2 per square foot | $ 86,414 |
| Land improvement | 15,000 |
| Construction: | |
| Dwellings | 1,008,980 |
| Garages | 128,300 |
| Fees: | |
| Builder | 57,613 |
| Architect | 60,494 |
| Carrying charges and financing | 66,254 |
| Legal and organization expense | 2,500 |
| Total estimated requirements | 1,425,555 |
Kingsway estimated its own resources at $ 142,555 leaving the net amount of $ 1,283,000 to be provided by mortgage loan proceeds. *156 The amount of $ 142,555 represented the Kingsway tract valued in the application at $ 86,414 plus "other equity" of $ 56,141 consisting of that part of the estimated fees which Kingsway did not intend to pay.
The FHA chief mortgage credit examiner prepared a "Project Analysis" dated April 26, 1949, and approved May 6, 1949, which determined that the "maximum insurable mortgage" available to Kingsway was $ 1,253,800, approximately $ 30,000 less than the amount Kingsway had requested. In arriving at this amount, the FHA examiner employed several alternative methods of computation pursuant to the provisions of section 608. Each method produced a different figure for "maximum insurable mortgage," the lowest of which controlled the amount which FHA was authorized to insure. The method which ultimately determined the "maximum insurable mortgage" to be $ 1,253,800 was based on a limitation of $ 8,100 per family unit, adjusted to allow for the cost of garage space. Alternative methods, based on 90 per cent of the total estimated replacement costs of the property as of December 31, 1947, or as of the "present," whichever was lower, resulted in larger "maximum insurable mortgages" and, *157 therefore, were not controlling. For purposes of computing replacement cost under the alternative methods, the credit examiner estimated builder's and architect's fees at more than $ 120,000 and estimated the fair market value of the Kingsway tract at $ 65,000 (43,207 square feet at $ 1.50 per square foot).
Based on an average rent per room per month of $ 29.83 and an estimated occupancy rate of 93 per cent, the FHA examiner estimated Kingsway's annual "net income" at $ 95,977 before deduction of "debt service requirements," income taxes, franchise taxes, or capital stock taxes. "Debt service requirements," undefined in the project analysis, were estimated at $ 75,228 per year.
On May 6, 1949, the Federal Housing Commissioner issued an amended commitment insuring a first mortgage loan to Kingsway*729 in an amount not to exceed $ 1,253,800. The loan was to bear interest at 4 per cent per annum and was payable on a level annuity basis by 391 equal monthly installments of principal and interest commencing not later than December 1, 1950.
On June 22, 1949, the Department of Housing and Building for the Borough of Brooklyn issued a building permit on the locations at 9407 and *158 9427 Kings Highway (Tax Lots 24 and 45) and, on June 30, 1949, FHA granted Kingsway's request to commence construction of the project prior to the closing of the building loan agreement with Lincoln.
The loan agreement, secured by a first mortgage on the land and project, was closed on August 11, 1949. It was agreed that Lincoln would lend $ 1,253,800 to Kingsway at 4 per cent per annum, the loan to be evidenced by Kingsway's note dated August 1949, due and payable June 1, 1983, in the aforesaid principal amount. Kingsway obligated itself to complete construction by November 1, 1950, in accordance with drawings and specifications dated July 28, 1949. Applications for advances under the agreement were to be made by Kingsway "on or about the first day of each month after the commencement of work hereunder, for work done during the preceding month or part thereof" except with respect to certain specified items. The amount of each monthly advance was limited to the total of the purchase price of uninstalled materials stored on the premises plus the cost of the portions of the work acceptably completed, computed in accordance with the amounts assigned to the several items in the "Trade*159 Payment Breakdown" annexed to the agreement, less a 10 per cent "holdback" and prior advances. The final advance, plus the 10 per cent "holdback," was payable 30 days after completion of construction, including all landscape requirements and off-site utilities and streets, and acceptance of the project by Lincoln with the approval of FHA --
provided, however, that this contract shall not be considered complete for purposes of final payment unless and until all the work requiring inspection by municipal or other governmental authorities having jurisdiction has been duly inspected and approved by such authorities and by the applicable Board of Fire Underwriters, if any, and all requisite certificates of occupancy and other approvals have been duly issued; and provided further, that the Lender may withhold approval of final payment until after the expiration of any period which laborers, subcontractors, and materialmen may have for filing notice of mechanics liens and until after satisfactory completion of all off-site utilities and streets as required by the Lender and Federal Housing Commissioner.
A "Trade Payment Breakdown" submitted by Kingsway on August 10, 1949, and approved*160 by FHA on August 11, 1949, was attached to the building loan agreement and listed in detail estimated costs of on-site construction, exclusive of fees and carrying charges, in the amount of $ 1,224,745. In addition to that amount the breakdown noted a 5 *730 per cent "contractor's fee" of $ 61,237 "to be paid by means other than cash."
On the same date, August 11, 1949, Kingsway entered into a "Lump Sum Construction Contract" with Marmintz Homes, Inc. (hereinafter referred to as Marmintz), pursuant to which Marmintz agreed to erect the project for the amount of $ 1,182,001 cash. At all times herein material, the common stock of Marmintz was owned by petitioners and Markowitz; Louis, Max, and Markowitz each owned 30 per cent and Morris owned 10 per cent. Marmintz agreed to complete construction by November 1, 1950. It was provided that "in no event * * * shall the work to be performed under this contract be considered to be completed until all the construction items called for in the drawings and specifications have been fully completed and the contract price paid in full." Applications for payments under the contract were to be made to Kingsway on or about the first day of*161 each month after commencement of construction, for payment for work done during the preceding month or part thereof. Payments were limited to the total of the purchase price of uninstalled materials stored on the premises plus the cost of the portions of the work acceptably completed, less 10 per cent and prior advances, computed in accordance with the amounts assigned to the several items in the "Trade Payment Breakdown" attached to the contract. The "Trade Payment Breakdown" was identical in every respect to that annexed to the building loan agreement.
On August 30, 1949, FHA transmitted to Kingsway a statement of "Hazard Insurance Requirements" under section 608 containing a "Hazard Insurance Schedule" which estimated the initial insurable value of the project upon completion of construction to be $ 1,340,676. FHA required that during construction the mortgagee have in its possession and control and in full force and effect a standard form of builders risk insurance policy or policies (showing the mortgagor to be the insured) for an aggregate amount not less than 100 per cent of the insurable value of the entire project as shown on the attached hazard insurance schedule. Upon*162 occupancy of any structure within the project the policy or policies were to be endorsed for occupancy in order to continue the insurance in force as to such occupied portions; and upon completion of any structure within the project the policy or policies were similarly to be endorsed for completion in order to continue the insurance in force as to such completed structures. Upon completion of the entire project for occupancy, the builders risk insurance was to be replaced by permanent insurance.
Petitioners supervised the construction themselves rather than employ an independent foreman and they did not employ any office help.
*731 The item of "builder's fee" was a source of friction between petitioners and Markowitz. At the outset of construction petitioners and Markowitz had an oral understanding that the former would receive $ 30,000 for supervising construction rather than the $ 60,000 estimated in the project analysis; the fee was to be paid to Marmintz and withdrawn by petitioners from Marmintz in the form of salaries. In November or December 1949, petitioners' accountant prepared a report showing clearly that mortgage loan proceeds would exceed construction costs. *163 At this time Louis approached Markowitz and suggested that petitioners receive a builder's fee of $ 45,000 rather than $ 30,000 as originally agreed. Markowitz objected but the matter was not settled at that time.
Petitioners and Markowitz were uncertain whether they had any right to distribute the excess mortgage funds to themselves. Although they recognized the possibility of distributing these funds, there was a question in their minds as to whether FHA would "permit" such distribution. This question was not resolved until July 1950, when petitioners and Markowitz decided to sell their Kingsway stock.
Prior to February 15, 1950, petitioners began planning for rental of the building at 9507 Kings Highway (on Tax Lot No. 70). They set up a rental office, advertised in the newspapers, and procured brochures showing the various layouts of the apartments. Morris was placed in charge of rental operations with instructions "to do nothing else but to concentrate on filling up those apartments."
A temporary certificate of occupancy for 9507 was issued by the Department of Housing and Buildings on February 15, 1950, and some tenants took possession of apartments at that time. In general, *164 however, rental progress was slow. As a result, prior to March 1, 1950, petitioners felt compelled to reduce rents at 9507 approximately 10 per cent on the 3 1/2-room and 4 1/2-room units. Rents on 1-room units were not reduced. Garage rents were reduced as much as one-third.
Markowitz would visit the property periodically and was "very much perturbed" about the renting situation. He was openly critical of Morris and felt that Morris was not experienced enough to be trusted with the management of rental operations. He would also discuss the matter at length with Louis on the telephone.
After the reduction of rates, rentals at 9507 improved to the point that vacancies as of the end of March 1950, were $ 445.50 out of a total monthly rental value of $ 4,768.
Completion and rental occupancy of the building at 9407 and 9427 Kings Highway (on Tax Lots Nos. 24 and 45, respectively) were delayed deliberately past April 14, 1950, so as to cause their assessed valuation to revert to land value, thereby effecting a substantial savings in real estate taxes for the fiscal year July 1, 1950, to June 30, 1951.
*732 Poor rentals at 9407 and 9427 again caused Markowitz to criticize petitioners, *165 particularly Morris, for their management of rental operations. Louis thought that Markowitz's criticism was unjustified. It was in "May or June" 1950, that Louis realized that Markowitz would be difficult to handle. The tone of Markowitz's earlier criticism had not been such as to cause Louis to anticipate serious friction with him.
The realization of rental income at 9407 and 9427 (at the same reduced rates prevailing at 9507) began June 1, 1950. At the end of June, 9507 was almost fully occupied but vacancies at the two newer buildings were substantial. Vacancies at 9407 were $ 1,696 out of a total monthly rental value of $ 4,733; vacancies at 9427 were $ 3,724 out of a total monthly rental value of $ 4,627. The variation in rentals between 9507, on the one hand, and 9407 and 9427, on the other, was in part attributable to petitioner's efforts to rent the units at 9507 before those in the other two buildings.
Permanent certificates of occupancy for all three buildings were issued by the Department of Housing and Buildings on July 27, 1950, and bear notations showing that plumbing had been completed and inspected by May 19, 1950, that construction had been completed and inspected*166 by June 9, 1950, and that the department had approved the completion of construction as of June 29, 1950.
"Contractor's Requisition" No. 12, submitted by Marmintz to Kingsway on June 16, 1950, showed construction of the project, to be 98.4 per cent complete. The trade payment items noted as 100 per cent complete included excavation, dampproofing and waterproofing, rough carpentry, windows, frames and glazing, doors and frames, stairs, lathing and plastering, insulation, weatherstripping and caulking, kitchen ranges, electric fixtures, screens, elevators, terrazzo, sprinkler system, and on-site utilities. The items listed as incomplete were as follows:
| Item | |
| Per cent complete | |
| Concrete walls and footing | 98 |
| Masonry | 99 |
| Concrete floors and cement work | 99 |
| Finished wood flooring | 98 |
| Miscellaneous millwork and carpentry | 99 |
| Miscellaneous iron and structural steel | 99 |
| Roofing | 99 |
| Sheet metal | 99 |
| Painting | 90 |
| Finish hardware | 95 |
| Tile and bathroom accessories | 98 |
| Linoleum | 99 |
| Refrigerators | 85 |
| Kitchen cabinets and hampers | 99 |
| Medicine cabinets | 95 |
| Plumbing and hot water supply | 99.5 |
| Heating, including garage | 99 |
| Electric wiring and exhaust fans | 99 |
| Shades | 70 |
| Washing machines and dryers | 70 |
| Landscape work | 80 |
*167 *733 Of the incomplete items the finished hardware, mirrors for medicine chests, and shades were stored in a warehouse in a cellar of the project, primarily to prevent vandalism and theft in vacant apartments. The uninstalled refrigerators had been purchased by Kingsway but were stored in the warehouse of General Electric and could be delivered on a few days' notice. Landscaping had been completed except for reseeding to repair damage caused by school children attending neighboring schools. Incomplete painting represented final coats of paint to be selected by tenants upon rental of then vacant apartments; the necessary paint was stored in the project's painting storehouse. A substantial portion of the unfinished work on the remaining items was in the nature of cleanup and patching.
During July 1950, the relationship between Markowitz and petitioners grew increasingly strained. Rentals at 9407 and 9427 had improved slightly but were still poor; vacancies during July amounted to $ 1,292 at 9407 out of a total monthly rental value of $ 4,768 and to $ 2,981 at 9427 out of a total rental value of $ 4,627. Markowitz became anxious about when he was going to realize a return *168 on his investment. When Louis suggested that Morris, who had devoted his entire time to management of the project be allowed a management fee of $ 3,500 or $ 4,000, Markowitz asserted that he should be allowed a management fee also, even though his participation in the management was minimal. Markowitz also found fault with Louis for not spending more time on the premises during July; Louis, on the other hand, regarded the construction as substantially complete and saw no need to continue spending a large portion of his time on the site. Sometime in July Markowitz called for a meeting to reach a definite understanding as to the future of Kingsway. Louis decided to avoid further conflict by effecting a separation between Markowitz, on the one hand, and himself and his brothers, on the other, not only with respect to the Kingsway stock but also with respect to all properties which they owned together. The next day Louis telephoned a person named Pierce, a real estate broker who had theretofore expressed interest in purchasing the Kingsway stock. Louis told Pierce that the stock could be purchased for $ 100,000 if Pierce could obtain a buyer immediately. Although Louis usually *169 acted as his own broker in real estate transactions, on this occasion he operated through Pierce *734 because he was interested in selling the stock as quickly as possible and did not have time to find a buyer himself.
At the time petitioners were uncertain whether FHA would "permit" withdrawal of the excess mortgage proceeds for their personal use. Matthew Tosti, an attorney recommended by Grady, advised petitioners that as far as FHA was concerned the excess proceeds could be withdrawn from Kingsway and the stock sold; he also advised them that the gains on distribution and sale would be taxed at capital gains rates. With these doubts assauged, petitioners and Markowitz entered into a contract on July 31, 1950, to sell their Kingsway stock to a purchaser obtained by Pierce. Petitioners thereupon instructed their attorneys and accountant to prepare a separation agreement with respect to all properties owned together with Markowitz.
On September 1, 1950, an FHA inspector conducted a "final inspection" and, on September 7, 1950, submitted his final "Project Inspection Report" showing construction of the project to be complete. The report was approved by the FHA deputy chief*170 construction examiner on September 15, 1950, but the following notation appeared over his signature:
Construction acceptably completed, subject to the escrowing of sufficient funds to assure acceptable completion of items listed as items of delayed completion. All offsite sewer, water, electrical and gas utilities are completely installed and connected and safe, adequate facilities for ingress and egress are provided.
The "items of delayed completion" to which the above notation referred amounted to $ 3,400 and included: Cleaning of brickwork, pointing up and whitewash of cellar walls and ceiling, sidewalk repair -- $ 100; repair of garage door and replacement of missing shelves in closets -- $ 50; repair of leak in garage roof and straightening of flashing -- $ 100; installation of missing shower heads, handles on faucets, toilet seats, and missing parts of gas ranges -- $ 100; repair of a heater, repair of asbestos and installation of a ceiling radiator in the porter's apartment -- $ 100; installation of electric switches in cellar rooms -- $ 50; installation of 3 additional washing machines -- $ 450; completion of the painting of 20 apartments -- $ 1,800; touching up exterior*171 painting, painting pipes and ironwork in cellar -- $ 200; completion of landscaping -- $ 300. The deputy chief underwriter of FHA gave final approval to the report on September 20, 1950.
As of September 1, 1950, Kingsway submitted to Lincoln a request for approval of "construction change," stating:
It is proposed to install terrazzo floors with 6" terrazzo base in all public halls, 2nd to 6th floors inclusive, and terrazzo treads on all public stairs, 2nd floor to roof, instead of cement floors and cement treads as previously specified.
*735 In the original trade payment breakdown petitioners proposed to install terrazzo only in the first floor hallways at a cost of $ 2,082. Although the language of the request speaks of "proposed" installation, Kingsway had in fact installed terrazzo on all floors and stairs "at the beginning of construction * * * immediately after the roof was enclosed." The request stated that construction costs would be increased by $ 3,500 over the amount estimated in the trade payment breakdown. The purpose of the request was merely to secure approval of past expenditures in excess of the amount allocated to terrazzo in the trade payment breakdown. *172 Lincoln approved the request on September 6, 1950, and, in turn, submitted it for FHA approval. FHA approved the request on September 8, 1950.
Kingsway also installed promenade tile over the garage area at a cost in excess of $ 30,000 in comparison with $ 23,422 called for in the trade payment breakdown. For an unexplained reason, Kingsway did not request approval of this increase in construction costs.
Marmintz submitted "Contractor's Requisition" No. 13 to Kingsway on September 5, 1950. All items listed in the payment breakdown were shown to be 100 per cent complete. Payment in the amount of $ 17,555 was requested "for work performed up to the first day of September, 1950."
On September 6, 1950, Kingsway, in turn, applied to FHA for insurance of advance No. 13 from Lincoln in the amount of $ 27,478.98 to cover the payment requested by Marmintz, interest on the building loan for the period to July 1, 1950, and other carrying charges. On the same day Kingsway applied for insurance of the final advance from Lincoln, No. 14, in the amount of $ 122,474, representing the 10 per cent "holdback" theretofore withheld by Lincoln. FHA approved both requests on September 20, 1950.
On*173 September 22, 1950, FHA issued a copy of its requirements for permanent hazard insurance to Lincoln to replace the building risk insurance which had been in effect during construction. For purposes of permanent insurance the insurable value of the project was determined by FHA to be $ 1,304,486 as of September 8, 1950.
"Finaling out" of the insured mortgage loan took place on September 25, 1950. Kingsway deposited $ 300 in escrow to be held by the depository until Kingsway completed certain onsite landscaping work and convenanted to complete such work by October 25, 1950; it was agreed that "no part of this sum will be advanced until the work under this agreement is 100 per cent complete." On the same day FHA endorsed Kingsway's note to Lincoln in the amount of $ 1,253,800. In its request for final endorsement Kingsway stated that "construction of this project is complete." The following schedule of advances received from Lincoln was incorporated in the request: *736
| Date | Amount |
| Aug. 29, 1949 | $ 55,126.00 |
| Sept. 20, 1949 | 92,409.00 |
| Oct. 25, 1949 | 132,755.00 |
| Nov. 18, 1949 | 243,865.00 |
| Dec. 22, 1949 | 117,849.00 |
| Jan. 23, 1950 | 108,751.64 |
| Feb. 24, 1950 | 85,632.00 |
| Mar. 23, 1950 | 105,641.92 |
| Apr. 24, 1950 | 62,251.00 |
| May 24, 1950 | 65,059.46 |
| June 29, 1950 | 34,507.00 |
| Sept. 15, 1950 | 27,478.98 |
| Sept. 25, 1950 | 122,474.00 |
| Total | 1,253,800.00 |
*174 Upon securing FHA's final endorsement, Kingsway received a mortgage premium from Lincoln in the amount of $ 47,017.50.
In its return for the taxable year ended January 31, 1951, and on the corporate books, Kingsway recorded its aggregate cost basis in the buildings and equipment comprising the project at $ 1,037,698.14. Mortgage loan proceeds ($ 1,253,800) exceeded this cost basis by the amount of $ 216,101.86. As a result of an adjustment proposed by a revenue agent and agreed to by Kingsway, the cost basis in the buildings and equipment was increased to $ 1,045,845.24. This amount included a builder's fee of $ 30,000 which Kingsway paid to Marmintz and which petitioners withdrew from Marmintz in the form of salaries, and a fee of approximately $ 25,000 which Kingsway paid to its architects, Proskauer & Lama. Except for its fee of $ 30,000 Marmintz built the project at cost.
In addition to building and equipment costs, Kingsway incurred legal and organization expenses of $ 2,800 and carrying and finance charges of $ 52,566.72, computed as follows:
| Interest | $ 28,984.33 |
| Real estate taxes | 3,410.00 |
| Hazard insurance | 1,660.73 |
| Mortgage insurance | 7,122.26 |
| FHA examination fee | 3,761.40 |
| FHA inspection fee | 6,269.00 |
| Title and recording expense | 1,339.00 |
| Total carrying and finance charges | 52,566.72 |
*175 The "mortgage insurance" charge of $ 7,122.26 represents the first premium of $ 6,269 covering the period August 11, 1949, to August 11, 1950, plus that portion of the second premium allocable to the period August 11, 1950, to September 30, 1950.
A meeting of the board of directors of Kingsway, composed of petitioners and Markowitz, was held on September 25, 1950, for the purpose of considering the financial condition of the corporation. On the basis of an appraisal made by James Muldoon, a recognized appraiser, it was resolved that the buildings and equipment appurtenant thereto be valued at $ 1,300,000. Kingsway continued to carry its land at cost. *737 The values attributed to the land and buildings in the Muldoon appraisal were as follows:
| Land | $ 150,000 |
| Buildings | 1,325,000 |
| Total | 1,475,000 |
The aforementioned revaluation of buildings and equipment resulted in a revaluation surplus of $ 262,301.86. 1 On September 28, 1950, the board of directors authorized a distribution from surplus of 5 cents per share on the outstanding preferred stock and $ 3,090 per share on the outstanding common. The total distribution on the 70 shares of common held by petitioners*176 and Markowitz was $ 216,300. On their returns for 1950 petitioners reported capital gain on their respective shares of the distribution, as follows:
| Max | Louis | Morris | |
| Proceeds from Kingsway | $ 64,890.00 | $ 64,890.00 | $ 21,630.00 |
| Cost of stock | 13,670.39 | 13,670.39 | 4,556.80 |
| Capital gain | 51,219.61 | 51,219.61 | 17,073.20 |
On the same day petitioners and Markowitz sold their respective shares of Kingsway common stock for $ 102,905 pursuant to the contract of July 31, 1950. Petitioners reported their respective shares of the proceeds of sale as capital gain, as follows:
| Number of | Cost | Amount | Capital | |
| shares | received | gain | ||
| Max | 21 | 0 | $ 30,871.50 | $ 30,871.50 |
| Louis | 21 | 0 | 30,871.50 | 30,871.50 |
| Morris | 7 | 0 | 10,290.50 | 10,290.50 |
*177 Total gain realized by petitioners and Markowitz on the distribution and sale amounted to $ 273,637.04.
On October 16, 1950, petitioners and Markowitz effected a complete separation of their interests in all properties which they owned together, except one. In one instance Markowitz agreed to assign his stock in Marmintz and Marphil to Louis in return for Louis' agreement to transfer his interests in certain properties to Markowitz and to execute a note to Markowitz for $ 6,100 payable 1 year from date. In another instance Markowitz bought out Louis' interest for cash. In still another instance a third party with whom Louis and Markowitz were engaged in a business venture bought out Markowitz's interest. *738 The single exception to the separation arrangements was a property held jointly by Louis and Markowitz the disposition of which was held in abeyance because of a condemnation proceeding against it. Louis and Markowitz received their respective shares of the condemnation award on March 11, 1958.
Prior to the drafting of the separation agreement Markowitz, without Louis' knowledge, had withdrawn approximately $ 100,000 from the bank account of Marphil. By the terms *178 of the separation agreement Markowitz agreed to "refund to Marphil Realty Corporation $ 54,000 recently withdrawn by him."
As of September 30, 1950, there were still substantial vacancies at 9407 and 9427 although the amount of vacancies had decreased steadily since June. The following table shows the monthly relationship between vacancies and rental value for each of the three buildings. Income from apartment rentals as of September 30, 1950, is equal to the difference between the rental value of all buildings ($ 70,813) and total vacancies ($ 16,788), or $ 54,025.
| 9507 | 9407 | |||
| 1950 | ||||
| Vacancies | Rental | Vacancies | Rental | |
| value | value | |||
| March | $ 445.50 | $ 4,768 | ||
| April | 49.00 | 4,768 | ||
| May | 4,768 | |||
| June | 107.00 | 4,768 | $ 1,696.50 | $ 4,733 |
| July | 53.50 | 4,768 | 1,292.00 | 4,733 |
| August | 4,768 | 983.00 | 4,733 | |
| September | 98.00 | 4,775 | 892.00 | 4,733 |
| Total | 753.00 | 33,383 | 4,863.50 | 18,932 |
| 9427 | Totals | |||
| 1950 | ||||
| Vacancies | Rental | Vacancies | Rental value | |
| value | all buildings | |||
| March | $ 445.50 | $ 4,768 | ||
| April | 49.00 | 4,768 | ||
| May | 4,768 | |||
| June | $ 3,724.00 | $ 4,627 | 5,527.50 | 14,128 |
| July | 2,981.00 | 4,627 | 4,326.50 | 14,128 |
| August | 2,577.00 | 4,626 | 3,560.00 | 14,127 |
| September | 1,889.50 | 4,618 | 2,879.50 | 14,126 |
| Total | 11,171.50 | 18,498 | 16,788.00 | 70,813 |
*179 In addition, Kingsway received income from advance apartment rentals in the amount of $ 1,469.50, garage rental of $ 3,196.92, and sundry income of $ 1,204.50.
In its income tax return for the year ended January 31, 1951, filed on an accrual basis, Kingsway reported income from rents (including apartments, garages, and sundry income) in the amount of $ 114,061.57 and deductions of $ 116,355.94, resulting in a net loss of $ 2,294.37. The following adjustments proposed by a revenue agent and agreed to by Kingsway changed the net loss into net income of $ 15,912.11:
| Net income (loss) as reported | ($ 2,294.37) | |
| Increases: | ||
| Mortgage premium deemed to be ordinary income | $ 47,017.50 | |
| Advance rent collected deemed to be income when | ||
| collected | 1,325.50 | |
| Total increases | 48,343.00 | |
| 46,048.63 | ||
| Decreases: | ||
| Mortgage expenses allowed as ordinary deductions: | ||
| Mortgage tax | 6,269.00 | |
| Mortgage insurance | 6,269.00 | |
| Commission to Grady | 12,538.00 | |
| Mortgage expense amortized | 418.01 | |
| 25,494.01 | ||
| Additional depreciation | 4,642.51 | |
| Total decreases | 30,136.52 | |
| Adjusted taxable net income | 15,912.11 |
*739 The item denoted "mortgage*180 expense amortized" resulted from the agent's determination that amounts totaling $ 13,794.40 expended for legal fees, FHA examination fee, FHA inspection fee, and title and recording expense were to be lumped together as "amortizable mortgage expense," deductible ratably over the 391-month life of the mortgage. The other items (mortgage tax, mortgage insurance premium paid to FHA, and the commission paid to Grady) were allowed as deductible in full.
Petitioner has submitted a profit and loss statement for Kingsway, prepared by a certified public accountant, showing Kingsway's "net profit" as of September 30, 1950, to be $ 12,868.39 after taking the foregoing adjustment into account.
Accountants' reports are in evidence covering the operations of Kingsway for fiscal years ended January 31, 1952, through January 31, 1956, and showing net losses as follows:
| Year ending Jan. 31 -- | Net loss |
| 1952 | ($ 7,072.36) |
| 1953 | ( 5,628.75) |
| 1954 | (11,013.76) |
| 1955 | (14,602.04) |
| 1956 | ( 9,983.75) |
| Total | (48,300.66) |
Petitioners' shares of stock in Kingsway have been successively sold in a series of transactions. Kingsway is still in existence and its principal asset remains the apartment*181 house which is still operated pursuant to FHA regulations and the terms of mortgage between Kingsway and Lincoln.
OPINION.
This case presents the question whether gains realized by petitioners upon receipt of cash distributions from Kingsway Developments, Inc., and upon the sale of their stock in that corporation, are taxable pursuant to section 117(m) of the Internal Revenue Code of 1939 as though the gains were attributable to property which *740 is not a capital asset. Kingsway was incorporated to construct and own an apartment house development, consisting of three buildings, under section 608 of the National Housing Act. The fact that the proceeds of the FHA-insured mortgage were in excess of the cost of the property was responsible in substantial measure for the availability of the cash funds that were distributed to petitioners. Moreover, such excess was anticipated at least as far back as "November or December" 1949. And although petitioners may not have felt sure that such excess could be distributed to them, we are satisfied that they definitely recognized the possibility of such distribution long before the project was completed.
The basic problems involved herein*182 have been extensively litigated in a number of recent cases, and although there may be factual differences to a greater or lesser degree as to each of the issues, each issue presented herein has been disposed of adversely to the petitioners' position in at least one or more of the following cases: Raymond G. Burge, 28 T.C. 246">28 T.C. 246, affirmed 253 F. 2d 765 (C.A. 4); Edward Weil, 28 T.C. 809">28 T.C. 809, affirmed per curiam 252 F. 2d 805 (C.A. 2); Arthur Sorin, 29 T.C. 959">29 T.C. 959, on appeal (C.A. 2); Carl B. Rechner, 30 T.C. 186">30 T.C. 186; Glickman v. Commissioner, 256 F. 2d 108 (C.A. 2), affirming a Memorandum Opinion of this Court; Elizabeth M. August, 30 T.C. 969">30 T.C. 969, on appeal (C.A. 3); Leland D. Payne, 30 T.C. 1044">30 T.C. 1044, on appeal (C.A. 5); Rose Sidney, 30 T.C. 1155">30 T.C. 1155.
1. Petitioners contend earnestly that the withdrawal of the cash from Kingsway and the sale of the Kingsway stock were prompted by their disagreement with *183 Markowitz and that they thus had a "post-construction motive" which rendered section 117(m) inapplicable. 2 There are at least several short answers to this contention. In the first place, friction with Markowitz arose before completion of the project, even if completion be assumed to have occurred near the end of June, as urged by petitioners. But the project was not completed at that time, for it has been held that "under the correct interpretation of the statute 'construction' should be defined technically to mean all construction required to perform the contract completely." (Emphasis added.) Glickman v. Commissioner, 256 F. 2d 108, 111 (C.A. 2); Weil v. Commissioner, 28 T.C. 809">28 T.C. 809, 815, affirmed 252 F. 2d 805 (C.A. 2). We are satisfied from the final FHA inspection report, the final requisition and advances, and all activities in connection with *741 "finaling out" of the mortgage that construction was not fully completed until after July, subsequent to the decision to withdraw cash from Kingsway and sell the stock. Moreover, apart from the Markowitz conflict, it is*184 clear on this record that the availability of excess cash was recognized many months before the Markowitz dispute came to a head. Regulations 111, section 29.117-11(b) states that the requisite "view" exists if the sale of stock or the distribution to shareholders is contemplated "unconditionally, conditionally, or as a recognized possibility" and, further, that the view exists during construction if the sale or distribution is attributable to "circumstances which reasonably could be anticipated at the time of such * * * construction." Cf. Elizabeth M. August, 30 T.C. 969">30 T.C. 969, 979, 980. Certainly, petitioners, upon whom the burden rests, have not convincingly shown that that distribution was not a "recognized possibility." To be sure, they may have had some doubts, but they unquestionably recognized that such doubts could be resolved in their favor.
*185 2. As a second argument petitioners maintain that Kingsway was not a "collapsible corporation" because the distribution and sale did not take place "prior to the realization of a substantial part of the net income to be derived from such property." They point out that Kingsway had net income of $ 12,868.39 as of September 30, 1950, when the distribution and sale took place, and that, except for the fiscal year ending January 31, 1951, Kingsway had net losses in each fiscal year up to and including the fiscal year ending January 31, 1956. Therefore, it is urged, Kingsway's net income as of September 30, 1950, represented a substantial part of the net income to be derived from the property. In the light of previously decided cases, we see no merit in this argument. In determining net income from the property as of September 30, 1950, petitioners included the mortgage premium of $ 47,017.50 received from Lincoln upon "finaling out." Although this premium was properly included in Kingsway "net income" for ordinary tax reporting purposes, we have previously held that "such receipts did not constitute 'net income to be derived from such property' within the meaning of section 117(m)(2)(A)(i)*186 when the property constructed by the corporations consisted of apartment buildings." Rose Sidney, supra at 1163. When the mortgage premium is eliminated, net income from the property as of September 30, 1950, becomes a net loss. Furthermore, our statement in Leland D. Payne, supra at 1057, is equally applicable here:
the net income expectations of such heavily indebted corporations will necessarily be nonexistent or small during the first years of operation and * * * a normal return of profit to the stockholders can be anticipated only upon a decrease in outstanding corporate indebtedness and, as an incident thereto, reduced interest payments. Inasmuch as the F.H.A.-insured mortgages require *742 the repayment of mortgage loans through equal payments over a period of 391 months, it seems reasonable to conclude that the first 7 years of operation do not provide a fair sampling of corporate net income expectations.
The project analysis estimate with respect to Kingsway supports this conclusion here.
3. Finally, petitioners argue that section 117(m) is inapplicable because not more than 70 per cent of the gain was*187 attributable to the property constructed. Sec. 117(m)(3)(B). Despite an elaborate analysis of the "sources to which gain is attributable," submitted by petitioners, it is our opinion that their position is unsound. At the formation of Kingsway, its only asset was land carried at a cost of $ 44,567.96. The only activities in which Kingsway engaged were negotiations to secure adequate financing for the construction of a housing project, actual construction of the project, and subsequent rentals of apartments therein for a period of several months. After these activities, petitioners and Markowitz were able to distribute corporate funds and sell their stock at a gain to themselves of $ 273,637.04 The only possible sources of this gain were the aforementioned corporate activities and their effect on corporate net income and the value of corporate assets. Petitioners have certainly not demonstrated otherwise. They argue that the Kingsway tract had a value of $ 150,000 at the time it was transferred to the corporation in exchange for stock, that this transfer occurred prior to any construction, and that, therefore, the difference between land value of $ 150,000 and land cost of $ *188 44,567.96 was not attributable to the property constructed. We disagree. The figure of $ 150,000, even if otherwise sound -- and we do not accept it as such -- does not represent land value apart from subsequent construction of the project. The increase in value of the land that is attributable to its use in a section 608 project has been viewed as part of the profit relating to the property constructed for purposes of the 70 per cent rule. See Glickman v. Commissioner, supra at 111; Elizabeth M. August, supra at 987; Leland D. Payne, supra at 1058.
It should be noted in this connection that the amount of $ 216,300 distributed to petitioners and Markowitz virtually equaled the amount of $ 216,101.86 by which mortgage loan proceeds exceeded the cost basis in buildings and equipment recorded on Kingsway's books and reported in its tax return. This fact alone provides a clear basis for the inference that petitioners themselves regarded the entire corporate distribution as attributable to the excess mortgage loan proceeds rather than to any increase in value of the land. Furthermore, *189 the gain of $ 273,637.04 realized by petitioners and Markowitz on the distribution and sale was only slightly in excess of the $ 262,301.86 revaluation surplus, which surplus arose entirely from revaluation of the buildings and equipment. The fact that a portion of this *743 increase in value might have been attributable to petitioners' activities prior to the formation of Kingsway does not affect our conclusion. In J. D. Abbot, 28 T.C. 795">28 T.C. 795, affirmed 258 F. 2d 537 (C.A. 3), we held that such preliminary steps as the securing of FHA commitments, whether carried out by taxpayers individually or by a corporation subsequently formed to construct and operate the property, were encompassed within the term "construction."
Petitioners advance numerous other arguments in an effort to show that more than 30 per cent of the gain was attributable to sources other than the property constructed. For example, they contend that both the mortgage premium and the excess mortgage proceeds were so attributable. These contentions, and others put forward by petitioners, have all been disposed of adversely to their position in the cases *190 cited at the outset of this Opinion and do not require further discussion at this time.
Decisions will be entered for the respondent.
Footnotes
1. Building and equipment were carried on Kingsway's books at $ 1,037,698.14 representing cost of construction; revaluation to $ 1,300,000 therefore created a revaluation surplus of $ 262,301.86. Cost of construction was later revised to $ 1,045,845 pursuant to an adjustment made by a revenue agent and agreed to by Kingsway.↩
2. The inapplicability of section 117(m) where the "view" or motive arises after construction is not spelled out in section 117(m). That result rests merely upon Regulations 111, section 29.117-11(b), which may be unduly favorable to petitioners, as noted by the Court of Appeals in Glickman v. Commissioner, 256 F. 2d 108, 111. However, this Court has previously accepted the regulations as valid. See Carl B. Rechner, 30 T.C. 186">30 T.C. 186. But cf. Leland D. Payne, 30 T.C. 1044">30 T.C. 1044; Rose Sidney, 30 T.C. 1155">30 T.C. 1155. It is not necessary here to reexamine the validity of these regulations, because, as in the Payne and Sidney↩ cases, petitioners fail to bring themselves within such regulations.