*3355 1. INSTALLMENT SALE. - Where the petitioner leased property to another and the lease contained an option to purchase, which was exercised by acceptance by the optionee, and it was provided that deed was not to be delivered until payment was completed, and the initial payments being less than one-fourth of the purchase price, held, an installment sale and proportionate part of profit should be reported each year in accordance with section 212(d), Act of 1926, and article 44(2), Regulations 69.
2. MORTGAGE - DEDUCTION. - In the case of an installment sale of mortgaged realty the amount of the mortgage must be deducted from the original agreed consideration to arrive at the total contract price in order to fix the basis for computation of the percentage of profit. Article 44(2), Regulations 69.
*1359 This proceeding is to obtain a redetermination of deficiencies in income and profits taxes for the years 1920 and 1921, in the respective sums of $2,787.39 and $6,202.03. Petitioner avers that the respondent erred in holding a certain real estate*3356 transaction an installment sale and in including $5,965 a proportionate part of the profits in taxable income for the year 1920, and a similar error for the year 1921, by including $11,930 in petitioner's taxable income. Respondent in his answer admits the facts above stated, but denies error, and alleges that upon a recomputation he finds that $9,050 of the profits should be included in income for 1920, and $18,100 for 1921, resulting in deficiencies of $3,651.19 for 1920 and $9,207.61 for 1921, instead of the amounts heretofore found by the respondent.
FINDINGS OF FACT.
The petitioner and its subsidiary Pass Orchard Co. are California corporations with their principal office at Gilroy, Calif. On September 1, 1917, they were the owners of 551.422 acres of land in Santa Clara County, Calif., and on that day entered into a contract with C. C. Lester, the material parts of which are as follows: By a writing of that date the first parties leased to C. C. Lester the 551.422 acres above mentioned during all of the time the title to said land remained in the lessors, but not to exceed 10 years, for which Lester agreed to pay as rental the sum of $12,648.50 per annum, payable quarterly. *3357 Various clauses follow requiring the lessee, Lester, to plant and maintain certain portions of the land in orchard, requiring him to pay all State, County and School taxes, keep up insurance and care for said property in a proper and farmer-like manner.
It was provided that at the termination of the lease the lessee should surrender the property in good order, that he should not assign or transfer the lease without the consent of the lessors, and that upon default by the lessee of any of his obligations, lessors had the right to terminate the lease, evict lessee, reenter and take possession of the property.
It was further provided in the contract that the lessee was to collect all outstanding rentals of the lessors for 1917, was to harvest and sell all crops then on the premises, pay all current indebtedness of *1360 lessors and pay over to them any balance, which was to be credited to him.
An option to purchase the property was contained in the lease at the price of $210,808.88, according to the terms of a proposed contract for deed attached to the lease and made part thereof. It was also agreed that 6 per cent on all payments made on the purchase price of the property*3358 should be credited on the rent. Other clauses in the lease reserved the right in lessors to sell the property to some other person, but as that was not done they are immaterial. The First National Bank of San Jose held a mortgage on the property for $73,000.
The essential parts of the contract for deed attached to and made part of the lease are as follows:
THIS AGREEMENT, made and entered into this 1st day of September, A.D., 1917, by and between PACHECO CREEK ORCHARD COMPANY and PASS ORCHARD COMPANY, corporations duly organized and existing under and by virtue of the laws of the State of California, the parties of the first part, and C. C. LESTER of the County of Santa Clara, State of California, the party of the second part.
WITNESSETH: That the said parties of the first part hereby agree to sell to the said party of the second part, and the said party of the second part hereby agrees to buy, all those certain lots, pieces or parcels of land, situate, lying and being in the County of Santa Clara, State of California, and more particularly described as follows:
(Here follows description.) Said parties of the first part hereby agree to accept for said property the sum of*3359 Two Hundred and Ten Thousand and Eight Hundred and Eight and 88/100 ($210,808.88) Dollars, and said party of the second part hereby agrees to pay said sum in the manner following, to-wit:
The sum of Twenty-five hundred ($2,500.00) Dollars upon the execution and delivery of this agreement.
The sum of Twenty-five thousand ($25,000.00) Dollars on January 1, 1918.
The sum of Twenty-five thousand ($25,000.00) Dollars on January 1, 1919.
The sum of Twenty-five thousand ($25,000.00) Dollars on January 1, 1920.
The sum of Twenty-five thousand ($25,000.00) Dollars on January 1, 1921.
The sum of One Hundred and Eight Thousand and Three Hundred and Eight and 88/100 ($108,308.88) Dollars on December 9, 1921.
Said payments to be cumulative up to the time of the execution of this option.
Said deferred payments are to bear interest from September 1, 1917 at the rate of six (6) per cent per annum payable quarterly, and said principal sums and interest are payable in United States gold coin.
Said party of the second part further agrees to pay all outstanding current bills owing by said parties of the first part on or before December 1, 1917.
Said party of the second part*3360 shall pay all taxes levied against the property for State, County or School purposes.
Said party of the second part will keep in force the insurance now placed upon the buildings on said premises.
Said party of the second part agrees not to sell or transfer this agreement, without the written consent of the parties of the first part, until at least $75,000 of the purchase price has been paid.
*1361 Said party of the second part agrees to accept the title to said property as shown by the abstract of title which he has examined and approved.
Said party of the second part agrees to care for said property in a proper and farmer-like manner. In case of dispute between said parties regarding the care given, the matter shall be submitted to arbitration in the usual and customary manner.
It is further stipulated and agreed that the said party of the second part shall have the right to make all the payments due upon this contract at any time. If said payments are made within six months from the date hereof a discount of five per cent upon the sum paid (less $100,000) will be allowed by said parties of the first part to said party of the second part. A discount of three*3361 per cent will be allowed if all of said payments (less $73,000) are made within two years from the date hereof. No discount to be allowed on matured payments.
It is further agreed that all the accounts receivable and rentals due to the parties of the first part shall be transferred to the party of the second part.
Said parties of the first part agree that when all of the payments have been made and other conditions performed as herein provided for, they will make, execute and deliver to said party of the second part a good and sufficient conveyance of said party free and clear of any encumbrance made or done by the said parties of the first part.
The lease was signed by all the parties, but the contract for deed was signed by the petitioner only.
Possession of the property was at once taken by Lester under the so-called lease contract and his rental account as shown by petitioner's books, is as follows:
| 1917 | ||
| Dec. 1, 1917 | To Rent Due | $3,162.12 |
| 4 | By check | 3,162.12 |
| Mar. 1, 1918 | To Rent Due | 3,097.62 |
| By check | 3,097.62 | |
| June 1 | To Rent Due | 3,031.62 |
| To Interest on Same | 113.68 | |
| Sept. 1 | To Rent Due | 3,031.62 |
| To Interest on Same | 68.21 | |
| Dec. 1 | To Rent Due | 3,031.62 |
| To Interest on Same | 22.73 | |
| Jan. 20, 1919 | By Check, Interest on Mortgage | 2,190.00 |
| By Check, Interest on Int. on Mortgage | 21.87 | |
| Jan. 28, 1919 | By Check | 7,087.61 |
| 1920 | ||
| Jan. 28 | To Rent Due, March, 1919 | $1,666.63 |
| June | 1,666.63 | |
| Sept | 1,666.63 | |
| Dec | 1,666.63 | |
| To Interest, Mar. 1919 | 90.55 | |
| June | 65.55 | |
| Sept | 40.55 | |
| Dec | 15.55 | |
| 28 | By check | 6,878.72 |
| 1921 | ||
| Dec. 6 | To Rent Due Dec. 1, 1919 to Jan. 27, 1920 | $1,074.05 |
| To rent due Jan. 27, 1920 to Mar. 1, 1920 | 459.25 | |
| June 1, 1920 | 1,291.63 | |
| Sept. 1 | 1,291.63 | |
| Dec. 1 | 1,291.63 | |
| Mar. 1, 1921 | 1,291.63 | |
| June 1 | 1,291.63 | |
| Sept. 1 | 1,291.63 | |
| Dec. 1 | 1,291.63 | |
| To Interest on Rent Due: | ||
| June 1, 1920 | 22.99 | |
| Sept. 1 | 42.71 | |
| Dec. 1 | 62.73 | |
| Mar. 1, 1921 | 83.05 | |
| June 1 | 103.67 | |
| Sept. 1 | 124.60 | |
| Dec. 1 | 145.84 | |
| Dec. 6 | 11.16 | |
| By check | 11,171.46 |
*3362 *1362 Lester exercised his option to purchase, but the exact date thereof is not shown by the evidence unless it be by his purchasing account on petitioner's books, which shows the following payments, viz: January 1, 1918, $1,200; January 18, 1918, $7,500; January 20, 1919, $18,000; January 28, 1920, $25,000; December 6, 1921, $50,000; February 1, 1922, $73,000, paid to First National Bank of San Jose on mortgage, and $36,108.88 paid petitioner, making in all $210,808.88 paid by Lester, exclusive of interest and rental, and being the total purchase price agreed upon.
The total selling price was $210,808.88. By deducting the mortgage of $73,000, the net selling price or total contract price was $137,808.88. The total cost of the property to petitioner was $160,808.88, less the mortgage of $73,000, making $87,808.88.
The profit was $50,000 and the percentage of profit to the total contract price of $137,808.88 is 36.2 per cent. This percentage of the payments of $25,000 and $50,000 made in 1920 and 1921, respectively, amount to $9,050 and $18,100.
In his determination as shown in his 60-day letter, respondent failed to deduct the mortgage of $73,000 from the total*3363 contract price and determined the deficiencies on a basis of 23.86 per cent profit, and by his answer seeks to correct this omission.
OPINION.
MILLIKEN: The questions for decision here are (1) Was the sale of the property an installment sale? and, if so, (2) Should the mortgage of $73,000 be deducted from the selling price for the purpose of calculating the percentage of profit to contract price?
*1363 It is suggested in brief of counsel for petitioner that as Lester did not sign the contract for deed that the contract was not enforcible and that the purchaser, Lester, did not have any interest in the property until the final payments were made in 1922 and he received his deed. We understand petitioner's position to be that no part of the gain realized by this transaction should be included in income or taxed until 1922, when final payment was made.
It is not for us to say whether the contract was enforcible or not. That would have been a question for the parties to it if there had been a breach thereof, but such was not the case, for it was performed and carried out according to its terms. From such performance petitioner admits a gain of $50,000.
Reading*3364 the lease and contract for deed together, it is perfectly plain that this was a sale of real estate if Lester exercised his option to purchase, otherwise, a lease, and merely one of the various forms or methods of making an installment sale and securing the vendor by retention of the title until payment was completed and clothing the vendor with power to repossess without resort to legal action. The contract for deed provides for 6 per cent interest on deferred payments, but the lease provides that 6 per cent on all payments made on the purchase price of the property should be credited on rentals. Stating it differently, all payments of rent were credited on the interest on the purchase price. The original amount of the rent was exactly 6 per cent of the purchase price, but as payments on the purchase price were made the rent was correspondingly reduced. No interest other than the rent was paid on the purchase price.
A California contract practically in haec verba with this was before the Board in , and was held to be an installment sale. The Board said:
With respect to the contract to sell the real property, the*3365 buyer agreed to pay $2,500,000 to the taxpayer. Six hundred thousand dollars was paid on the execution of the contract and the balance was to be paid in installments within a period of three years. The contract had the usual provisions reserving the title in the seller until all payments were made, gave the seller the right of repossession in case of failure to make payments, and provided for forfeiture of all rights and all money paid as liquidated damages in case of default. The buyer had the right of possession and the right to remove timber. He could not assign the contract without the written consent of the seller. There were no notes, mortgages, or other securities given by the buyer other than the provisions of the contract. Payments subsequent to the initial payment of $600,000 were made as set out in the findings of fact.
Section 212(d) of the Revenue Act of 1926 is as follows:
"(d) Under regulations prescribed by the Commissioner with the approval of the Secretary, a person who regularly sells or otherwise disposes of personal property on the installment plan may return as income therefrom in any taxable year that proportion of the installment payment actually*3366 received in that year which the total profit realized or to be realized when the payment is completed, *1364 bears to the total contract price. In the case (1) of a casual sale or other casual disposition of personal property for a price exceeding $1,000, or (2) of a sale or other disposition of real property, if in either case the initial payments do not exceed one-fourth of the purchase price, the income may, under regulations prescribed by the Commissioner with the approval of the Secretary, be returned on the basis and in the manner above prescribed in this subdivision. As used in this subdivision the term 'initial payments' means the payments received in cash or property other than evidences of indebtedness of the purchaser during the taxable period in which the sale or other disposition is made."
Section 1208 of the Revenue Act of 1926 makes the above section retroactive to the Revenue Act of 1918, under the provisions of which the tax liability of the taxpayer must be determined.
The initial payment is less than one-fourth of the purchase price and the balance of the purchase price was to be paid in installments. The transaction, therefore, comes within the purview*3367 of the above-quoted section of the statute. * * *
Compare , Regulations 69, article 44.
The remaining question relates to the deduction of the $73,000 mortgage from the purchase or selling price in order to arrive at the total contract price, the basis upon which to compute yearly percentage of profit. Regulations 69, article 44(2), provides in part:
In the sale of mortgaged property the amount of the mortgage, whether the property is merely taken subject to the mortgage or whether the mortgage is assumed by the purchaser, shall not be considered as a part of the "initial payments" or of the "total contract price," but shall be included as part of the "purchase price," as those terms are used in section 212(d), in articles 42 and 45, and in this article. * * *
In the instant case, there was no assumption of the mortgage in express terms, but the property was purchased subject to the mortgage and the purchaser paid it together with the interest thereon.
This question was considered by the Board in the case of *3368 , and it was there held that the total contract price is the consideration named in the original agreement less the mortgage on the property, and that the sum thus found is to be used as the basis for the computation of percentage of profit.
The initial payments made by the purchaser in this case during the first taxable year were $8,700, which was less than 25 per cent of the purchase price and constitutes the transaction an installment sale. In order to compute the percentage of profit, the mortgage of $73,000 should be deducted from the original consideration of $210,808.88, which results in a percentage of .362. Applying this to the payment of $25,000 made in 1920, and to that of $50,000 in 1921, it results that $9,050 should be included in petitioner's 1920 income and $18,100 in 1921 income, but this includes the amounts heretofore found by respondent.
Judgment will be entered under Rule 50.