*1749 1. Under the facts in this case, petitioner having elected to report the sale of real estate according to the installment method, may not change to the deferred payment plan not on the installment basis.
2. Claimed deductions for accrued expenses disallowed because of failure to establish that books of account were kept on the accrual basis.
*1013 The respondent determined deficiencies in income taxes for the years 1925 and 1926 in the respective amounts of $3,539.74 and $624.91. For the year 1925 petitioner alleges that respondent erred in (a) refusing to accept an amended return reporting profits from the sales of real estate, on the deferred payment plan, (b) in determining the amount of taxable profit on sales of real estate, and (c) in disallowing a claimed reserve for operating expenses. For the *1014 year 1926 the errors alleged are (a) the disallowance of a claimed deduction for State and county taxes, (b) disallowance of a claimed net loss for 1925, (c) disallowance of legal expenses and costs*1750 incurred in reacquiring property, and (d) reduction of profit realized on sales of real estate.
The cases were consolidated for hearing and decision.
FINDINGS OF FACT.
Petitioner was incorporated under the laws of Florida on February 24, 1925. It acquired a tract of land containing 73 acres in the northeast part of Miami, Fla., between 71st and 79th streets on Biscayne Boulevard. The corporation was organized for the purpose of acquiring, developing, and selling the tract. It laid out streets and subdivided the property into 361 building lots of various sizes ranging from approximately 40 by 60 feet to 50 by 150 feet.
All of the 361 lots were sold in 1925 in the period from March to June. Of these, 26 were sold for cash. Of the remaining 335, deeds were given to the purchasers of about 25 or 30 and mortgages taken back by petitioner for the balance of the purchase price. The remaining lots were sold under contracts whereby the purchaser, after making an initial payment agreed to pay the balance in installments, which were evidenced by promissory notes, and the petitioner agreed upon completion of the payments to deliver a deed to the purchaser. The contracts provided*1751 that all taxes and assessments thereafter imposed were to be paid by the purchaser. In the majority of sales made by petitioner in 1925 the initial payment received did not exceed one-fourth of the sales price.
By August of 1925 land prices in the vicinity of petitioner's subdivision began to drop. By September some of the purchasers of its lots had defaulted in interest payments and some of them failed to pay taxes which became payable in November. There were defaults on 62 contracts up to December 31, 1925, and on 205 contracts up to December 31, 1926. Of the 335 lots sold on contract or mortgage, only 44, or slightly over 13 per cent, have been paid out.
The contracts for deferred payments had no fair market value at the close of the years 1925 and 1926.
In petitioner's original return for 1925, filed March 15, 1926, all sales of real estate, whether the initial payment was more or less than one-fourth of the sales price, were reported on the installment basis. The computation of petitioner was as follows:
| Gross sales | $2,202,341.90 | ||
| Less allowances | 183,740.77 | ||
| Net sales | 2,018.601.13 | ||
| Cash received | $517,616.96 | ||
| Contract notes due 1-2- | |||
| 3-4 yrs | 1,500,984.17 | ||
| Costs: | |||
| Purchase price | $500,000.00 | ||
| Improvements | 180,389.55 | ||
| 680,389.55 | 33.76% | ||
| Gross profit on real estate | |||
| sales | $1,338,211.58 | 66.24% | |
| Percentage of profit real | |||
| estate sales | 66.24% | ||
| Percentage of cost | 33.76% | ||
| Collections on sales | $517,616.96 | ||
| Costs collected (33.76%) | 174,747.79 | ||
| Returnable profit | 342,869.17 |
*1752 *1015 In auditing the return the respondent segregated the sales, treating those in which the initial payments did not exceed one-fourth of the sale price as installment sales, and the balance as deferred payment sales. In the latter group the respondent treated the obligations of the purchasers as equal to the cost of the land to the petitioner. This resulted in increasing income from the sale of real estate by $16,333.77.
Among the deductions claimed by petitioner was an amount of $10,000 designated as a "reserve for operating subdivision." This sum was set up by petitioner as the estimated cost of maintaining water supply and lighting systems in the subdivision until such time as those systems should be taken over by the city of Miami. A water system was installed by petitioner and water supplied to the purchasers of lots. A lighting plant was also installed but light was not furnished to lot purchasers in the taxable year, owing to destruction of the system by storm before entire completion. The respondent disallowed the deduction of $10,000 claimed.
In December, 1926, petitioner filed an amended return for the year 1925 in which it computed its profit on sales*1753 of lots by the deferred payment method as follows:
| Total Sales of Real Estate | $2,046,414.38 | |
| Less Discounts and Allowances | 27,813.25 | |
| NET SALES | 2,018,601.13 | |
| Collections | $517,616.96 | |
| a1 Contract Mortgage Notes | ||
| receivable - 1-2-3 years | 1,500,984.17 |
| Collections | $517,616.96 | ||
| Costs collected | 464,955.97 | ||
| Realized Profit | $52,660.99 | ||
| Net Sales | $2,018,601.13 | ||
| Cost of Sales | 630,389.55x | ||
| Gross Profit to be realized | 1,388,211.58 | ||
| Unrealized Profit | 1,335.550.59 | ||
| REALIZED PROFIT | 52,660.99 | ||
| Cost of Sales | 630,389.55 | ||
| Costs Collected | 464,955.97 | ||
| Uncollected Costs | 165,433.58 |
(x In the original return this figure was given as $680,389.55. The difference of $50,000 is not explained.)
*1016 The result of petitioner's change of method*1754 of computing profit on sales of lots was that on the face of its amended return it showed a net loss of $20,874.07.
In petitioner's return for the year 1926 it reported collections of $247,858.96 on sales in 1925 and, applying the deferred payment method of computation to this figure, it arrived at a profit from collections of $182,947.40. Petitioner also reported contract cancellations amounting to $217,960, on which it computed a profit of $50,110, representing the difference between the amount paid by purchasers on their contracts and the cost of the land to petitioner. The respondent in auditing the return segregated the collections, and, as in the prior year, treated as deferred payment items the collections made in those cases where the initial payment exceeded one-fourth of the sale price. The balance of the collections were treated by the respondent as installments sales collections. This action of the respondent resulted in decreasing the net income from collections by $67,522.52.
In its return for 1926 petitioner claimed a deduction for a net loss of $20,874.07 for the year 1925, which deduction was disallowed by the respondent.
In its return for 1926 petitioner*1755 claimed a deduction of $15,000 for State and county taxes on repossessed property. This amount was not paid by petitioner in 1926. As stated above, the majority of petitioner's sales were on contracts whereby the land was not to be deeded to the purchaser until payment was completed. In view of this fact the State and county taxes were assessed in the name of the petitioner. In 1927 petitioner paid $11,063.34 representing taxes for 1926 and advertising costs on property which it had contracted to sell in 1925 and on which the purchasers had defaulted. The respondent disallowed the $15,000 deduction claimed.
Petitioner claimed a deduction in its 1926 return of $36,277.43 representing an amount set up to cover estimated legal expenses and *1017 court costs in repossessing property in those cases in which purchasers had defaulted on their contracts. Petitioner in 1926 turned over to its attorneys the defaulted contracts for the purpose of securing repossession of the lots. In those cases where it was necessary to foreclose the attorneys were to receive 10 per cent of the amount of the mortgage and in those cases where the purchasers voluntarily surrendered their deeds*1756 or contracts the attorneys were to receive a fee of from $35 to $75 in each case. In all cases petitioner was to pay the costs. The respondent disallowed the deduction claimed.
OPINION.
ARUNDELL: The petitioner was organized in the year 1925, and thereafter within that year acquired 73 acres of land in Miami, Fla., subdivided it into 361 lots, all of which were sold within the year. A few of the lots were sold for cash and in a few instances more than 25 per cent of the purchase price was paid within the year 1925, but as to these sales we are not particularly concerned. The petitioner made its return on the installment basis and now seeks to change that basis to one wherein it may first recover its capital outlay before being called upon to pay a tax on a possible profit.
The respondent objects to any change of basis on the ground that, petitioner having elected in the first instance to file on the installment basis, such election is binding and irrevocable, citing as authority ; *1757 ; aff'd., ; . We have held in , decided this day, that where the facts clearly establish that the installment method does not reflect a taxpayer's true income, an election once exercised to so report is not in all circumstances irrevocable. However, the facts in that case were entirely different from those in this proceeding. In the Key Largo case the taxpayer had parted with title to its land and the second mortgage taken back, which included the greater part of the amount returned as profit, was shown to have had no value before the close of the year, and the purchaser was entirely irresponsible. In the instant case the petitioner had actually conveyed title to but a comparatively small number of lots, the majority of the contracts entered into being contracts to sell as distinguished from contracts of sale. Consequently, when at the end of the year it was evident that many of the contracts would not be paid out, the petitioner still had its capital in the form of land and also the*1758 cash installments that had been paid under the contracts. Moreover, during the following year collections were made on the contracts to the amount of $247,858.96. Under the installment method only a portion of the cash so received by petitioner was returned as income, the balance being treated as a return of *1018 capital. Certainly it may not be said under the circumstances that petitioner's income was distorted to its disadvantage, and we are of the opinion that the method adopted of reporting on the installment basis should not be changed except as changed by the respondent in respect of sales where the initial payment was in excess of one-fourth of the sale price.
The respondent, in our opinion, correctly disallowed the claimed deduction of $10,000 set up as a reserve for operating water and lighting systems on the subdivision. This amount was at best a mere estimate of what the petitioner might possibly spend in the future in the maintenance of the systems. While one witness testified that petitioner promised purchasers of lots that these facilities would be furnished, it is not shown that petitioner was under any obligation to do so. In fact, light was not furnished*1759 in the taxable year and there is no evidence to show that it was ever furnished to purchasers. An examination of a sample copy of a lot sales agreement placed in evidence by petitioner does not disclose any agreement on the part of the petitioner to furnish light and water. Moreover, it has not been established to our satisfaction that petitioner's books were kept on other than the cash receipts and disbursements basis. Petitioner's returns contain the statement that they are made on the basis of the "books of account," but no disclosure is made as to what that basis is. Petitioner's secretary testified that "the books are kept on the cash receipts and disbursements basis."
The respondent's disallowance of claimed deductions from 1926 income of $15,000 for accrued taxes and $36,277.43 for costs and legal expenses in connection with the repossession of property must be affirmed, because of the failure of petitioner to establish that its accounts were kept in such manner as to permit the deduction of any items not actually paid in the taxable year. In other words, as stated above with respect to the claimed deduction for operation of light and water systems, the only evidence*1760 on this point indicates that the books were kept on the cash basis, and if the books were so kept, it is clear that accruals can not be deducted.
The respondent's reduction of profit from sales of real estate by $67,522.53 results from his placing on the installment basis collections made in 1926 on contracts of sale where the initial payment did not exceed one-fourth of the sale price. As we have held that the use of the installment method approaches more nearly the reflection of income than the method sought to be used by petitioner, the change made by the respondent is approved.
Reviewed by the Board.
Decision will be entered for the respondent.
MURDOCK concurs in the result only.
Footnotes
a1. The above contract Mortgage Notes Receivable had no fair market value at the time they were accepted. Collections have been applied against basis in each transaction and the excess only reported as profit. Subsequent profits, if any, will be reported if and when they are realized. The details of each transaction are in our files and will be furnished upon request. ↩