*1433 1. Where petitioner receives under contracts for sales of lots, nonvoidable by vendee, cash and unconditional obligations applicable to the selling price, such cash and obligations constitute, at receipt, income derived from dealings in property.
2. Since petitioner acquired absolute ownership and control over such cash and obligations, it realized income irrespective of whether the transactions were sales.
3. Cost of a tract of land subdivided and sold in lots includes amounts spent on improvements subsequent to the taxable period.
4. Expenditures prior to the beginning of operation of a trade or business do not constitute a net loss within section 206(a)(b) of the 1926 Act.
*1084 Respondent determined a deficiency of $730.91 in petitioner's income tax for the fiscal period January 1 to August 31, 1926. Petitioner contends the determination is in error because there have been included in income alleged gains from transactions which were not present sales of certain lots, and such gains have been determined upon a cost basis which does*1434 not include the cost of improvements made in later years. Respondent claims an increased deficiency on the grounds that he erred in allowing a deduction for a 1925 net loss of $2,992.57, that he understated the gains from lot sales by using a cost basis which is excessive by $57,179.17, and, alternatively, if the Board decides that certain transactions were not present sales, that he erred in allowing a deduction of $30,971.67 for commissions on such transactions.
FINDINGS OF FACT.
Petitioner, a Virginia corporation with its principal office at Norfolk, was organized in 1925, for the purpose of buying and subdividing a tract of land in Princess Anne County, near Virginia Beach. The tract was acquired in 1925, and after selling a portion thereof to the Bay Shore Improvement Company in 1926, the petitioner *1085 subdivided the remainder into lots and offered the lots for sale. By agreement of May 15, 1926, the Atlantic Coast Realty Corporation was made exclusive selling agent of the petitioner, for the subdivision.
The petitioner's books of account were on an accrual basis.
1. The lots were disposed of under contracts entitled "contract for deed," reciting that*1435 petitioner "hereby sells" and the purchaser "hereby buys" a certain described lot, the petitioner agreeing to deliver a general warranty deed conveying a fee simple estate in said property when the purchase price was paid in full. A down payment was made by the purchaser upon signing the contract, and the remainder, payable in installments, was represented by his notes. The contract contains the following provisions:
* * * Upon default in payment of any one of said installments when the same shall become due, the party of the first part [the seller], may, at its option, (1) cancel this contract, in which event all rights of the party of the second part [the buyer] hereunder shall cease and determine and all amounts theretofore paid hereunder shall be retained by the party of the first part as liquidated damages for the breach thereof; or (2) at such option of the party of the first part all unpaid installments of such purchase price, with interest thereon, shall forthwith become due and payable, anything in the note by which the same is evidenced to the contrary notwithstanding. It is understood that the party of the second part acquires neither a legal or equitable title*1436 to the property herein mentioned until the same shall have been paid in full.
* * *
If it so desires, the party of the first part may, at any time before the purchase price herein provided has been paid in full in accordance with the terms hereof, deliver to the party of the second part a deed of bargain and sale conveying said property as herein provided and the party of the second part will execute a first lien deed of trust conveying said property to a trustee selected by the party of the first part to secure the part of the purchase price therefor then unpaid and will execute new notes for such unpaid purchase price, with interest, bearing even date with said deed of trust and secured thereunder.
* * * the party of the second part agrees to pay to the party of the first part, for a period of three (3) years, the sum of Fifteen Dollars ($15.00) per year, evidenced by three (3) non-interest bearing notes * * * which said sum * * * is to be expended * * * toward keeping the property above described cleared of weeds and undergrowth; * * *. In the event the party of the second part shall construct a residence on said property before the expiration of said period of three (3) *1437 years, the obligation to pay the said sum of Fifteen Dollars ($15.00) per annum shall cease and determine upon the commencement of said construction * * *.
The petitioner paid all taxes assessed against the lots until delivery of the deeds. During the period in question no purchaser took or claimed actual possession of a lot.
During the period in question the petitioner disposed of fifty-six lots on which the purchaser made down payments and gave negotiable interest-bearing promissory notes for the remainder of the *1086 contract price. The notes were included in the assets on the balance sheet of August 31, 1926, attached to the return, and the cost of lots covered by contracts of the period was excluded. About 30 per cent of the notes were eventually paid. The transactions involving these contracts were reported in the return either as completed sales or installment sales.
2. The contracts contained the following provisions relating to improvements to be made in the subdivision by the petitioner:
The first party [the seller] further agrees:
1. To lay water mains to serve the lots or sites shown on said plat, the cost of connecting with the said mains and*1438 consumption charges to be borne by the owners of the respective lots or sites.
2. To provide an opportunity for the owners of said property to contract for electric lights for private use.
3. To construct improved roadways to serve said property; the same to be of cinder, sand-clay, gravel or concrete construction, as the party of the first part may determine.
4. And also to pay State and County taxes on siad property until deed for the same is delivered to the party of the second part.
In the agency agreement with the Atlantic Coast Realty Corporation the petitioner agreed "to develop and improve said property by the laying out and construction of sand and clay, cinder, concrete or gravel roadways * * * and the establishment of water and electric light lines to serve the said property and also by a reasonable beautifying program, and to expend for such development the sum of * * * $75,000." The agreement further provided that "It is estimated that the cost of such development and improvement will not be in excess of $75,000" and that "The 'cost of development' shall also include cost of all surveys and plats of said property to be made, accounting, bookkeeping and City, *1439 County and State taxes on the land."
On May 31, 1926, the petitioner, by journal entry properly posted to the general ledger, charged the land account and credited reserve for improvements account with the sum of $75,000, to record the additional cost of the subdivided land involved in the contemplated improvements, and its liability, under the several contracts, to make such improvements. Construction of improvements was begun but not completed within the period under consideration. At August 31, 1926, there was an unexpended balance in the reserve of $57,179.17. The petitioner has expended $171,000 in the "development" of and for "improvements" to the subdivision.
In the return the petitioner reported gross sales, completed and installment, of $240,370.07, and a correlative cost of $133,492.80. These figures included the selling price and the cost of that portion of the tract not subdivided but sold to the Bay Shore Development *1087 Company. The selling price in the last mentioned transaction was $50,000, and the respondent determined, in the deficiency notice, that the cost of the land involved was $41,054. The cost of sales reported in the return included some*1440 portion of the $75,000 added to the land account, but did not include any part of the additional $96,000 expended in later years for "development" and "improvements." The return shows net gains on completed sales of $60,906.10, which include a gain of $8,946 for the Bay Shore Development Company transaction; and shows profits realized on installment sales of $10,632.96. In the deficiency notice the respondent redetermined the taxable gain on the Bay Shore Development Company transaction, on the installment basis, to be $3,338, and accordingly reduced the net income reported by $5,608. The respondent did not make any other change in the reported gains from sales.
For the 56 transactions of the period under consideration, evidenced by contracts for deeds, the petitioner's books show a total selling price of $168,370.07 and a total cost of $81,214.38. "Cost of unsold land" is included among the assets in the balance sheet of August 31, 1926, attached to the return, in the amount of $268,128.30. The cost of the lots involved in the 56 transactions, as reflected by the books of account, and the cost of unsold land shown by the balance sheet include some portion of the $75,000 added*1441 to the land account, but it is not clear from the record whether they include any part of the additional $96,000 expended in later years for "development" and "improvements." Also the petitioner's books of account show in respect of the said 56 transactions that the total payments received during the period under consideration amounted to $54,205.77, and that as to all but two of such transactions the payments received within the period, in each case, were less, in the total amount, than the cost of the lots involved as reflected by the books. As to the excepted two, the payments received within the period exceeded the book costs of the lots involved by $5,468.57.
3. From the date of its organization to the close of 1925, the petitioner's activities were confined to the perfection of its organization, the acquisition of land, and preparations incident to subdividing and marketing the land. No sales of land were made before the close of the year. In connection with these activities the petitioner incurred expenses for stationery, taxes, legal services, surveying, traveling and miscellaneous items, totaling $2,992.57. It claimed this amount as a deduction from income in the return*1442 of the period under consideration, as a net loss sustained during the preceding taxable year. The deduction has been allowed by the respondent.
*1088 4. The agency contract with the Atlantic Coast Realty Corporation provides, with respect to the payments of commissioner on lot sales, as follows:
For its services in selling said property as herein provided the party of the second part [agent] shall receive a commission of 25% on the selling price of each lot or subdivision sold. Such commission shall be payable as follows:
Where the property is sold on a basis of 20% cash, balance in 36 monthly installments, the party of the second part shall receive two-fifths of its commission out of the cash payment and the balance of said commission, namely, three-fifths, shall be payable out of the first maturing notes to the extent of one-half of the cash collected on each note. Where the sales are made on the terms of one-fourth of the purchase price in cash, under the provision of "B" of paragraph two above, the party of the second part shall receive one-half of its commission out of the cash payment and the balance thereof out of the first maturing notes to the extent of*1443 fifty per cent of the cash collected. Where the sales are made on the terms of one-third cash under the provisions of Article "C," paragraph two above, the party of the second part shall receive four-fifths of its commission from the cash payment and the balance will be paid out of the first maturing notes to the extent of fifty per cent of the cash collected.
The commissions were paid in accordance with the contract provisions. In the return the petitioner claimed an expense deduction of $41,993.75, representing the commissions due to agents on lot sales of the period. Only a portion of the whole amount claimed had been paid within the period. Of the whole amount claimed, the respondent allowed $30,971.67 and disallowed $11,022.08.
OPINION.
STERNHAGEN: 1. The single error assigned in the petition is respondent's failure to compute petitioner's taxable gain from contracts for the sale of lots in accordance with Solicitor's Law Opinion 988, C.B. II, page 84, which is as follows:
No realization of gain or loss arises from a mere contract to sell real estate in the future. The sale is held to occur at the time a deed passes or at the time possession and the burdens and*1444 benefits of ownership are from a practical standpoint transferred to the buyer whichever occurs first. Payments made prior to the sale are to be applied in reduction of cost so far as they do not exceed cost; being treated as income to the extent, if any, to which cost is exceeded.
Petitioner contends that its contract for deed not constitute a sale, but an executory agreement for sale, and denies the realization of any taxable gain from transactions based on its contracts signed during the taxable period. It relies primarily on ; , as establishing that the contracts passed no property right in the lots under Virginia law.
*1089 Even if the petitioner's taxable income depended upon the passing of title (but see , the cited case is inapplicable. The contract in that case provided that default in payment of any installment would render it void; default had occurred, not even the full initial payment having been made, and the court held that the prospective purchaser was without property rights in the premises to support a mechanic's*1445 lien. But here petitioner's contracts are not voided or voidable by the vendee upon default. Clearly, a definition of a contractee's right under a voided contract is not determinative of the petitioner's rights under the present instruments.
But we are of opinion that the question whether the transactions were sales is not determinative of income under these contracts. During the taxable period petitioner received under its contracts cash sums over which it acquired absolute ownership and control. While its obligation to transfer title in the lot was dependent upon payment of all installments of the purchase price, its right to the cash installments as paid was absolute and unconditional. They were not held in trust nor subject to any obligation to return in case the contractual obligations were not fulfilled. Under the statutory definition of gross income in section 213(a), they clearly constituted income derived from dealings in property. Cf. ; .
This proceeding is readily distinguishable from *1446 , wherein petitioner contended that the obligations received by it were of little or no value. After so finding as a fact, the Board noted that in any event the transactions there considered were not present sales and that no part of the future payments could be said to have accrued in the first year. Petitioner insists that the same reasoning is applicable here. The agreements construed in the cited case provided that any default in subsequent installments rendered the contract void; after such event, which rested in the prospective purchaser's control, no liability for the unpaid portion of the purchase price remained. In this proceeding, however, a default gave petitioner the option to declare the unpaid remainder due and payable. The liability for the full price, therefore, became absolute at the signing of the instrument.
The view that petitioner's cash received constitutes income is strengthened by an examination of the consequences of the contrary view. In respect of the installment sales as defined in the statute (section 212(d)), petitioner is taxed only on that proportion of the installment payment which the*1447 total anticipated profit bears *1090 to the purchase price. Since practically the entire payment would constitute gain if the contract were not carried out, it is taxed, therefore, only on the minimum possible profit realized.
But in respect of those transactions not taxable on the installment basis, it may happen that the total anticipated profit, on which petitioner is here taxed, exceeds the amount of the cash payment received. In such a situation it can not be said, as above, that petitioner is taxed only on cash paid, which upon receipt became its absolute property. But together with the cash, petitioner likewise received the unconditional obligation of the vendee to pay the remaining amount of the purchase price. In absence of evidence to the contrary, the respondent's determination that such obligations were worth no less than par at the time of receipt is sustained.
2. At the hearing petitioner amended its petition to allege that respondent should add to the cost of the subdivided tract from which its lots were sold $96,000, expended in addition to a $75,000 reserve therefor. This addition results in a total cost of $171,000 for development and improvement*1448 of the tract. Respondent contests the propriety of allowing this addition in cost, and further pleads affirmatively that the $75,000 cost, already allowed, should be reduced by $57,179.17, representing that part of the original reserve unexpended during the taxable period.
Petitioner's witnesses testified that the expenditures made were for roads, water mains and other improvements of a capital nature, and its contract with the Atlantic Coast Realty Corporation indicates that the cost of its surveys, accounting, taxes and other noncapital items were likewise to be drawn from this reserve. Respondent bases his plea for reduction of the cost determination on the ground that $57,179.17 was not actually spent until after the taxable period.
The inclusion in cost of an estimated future expenditure on the development of tracts of land from which lots are sold has been recognized by the Board as proper. ; ; cf. O.D. 226 (1919), C.B. I, page 26; O.D. 567 (1920), C.B. II-2 page 108. The amount of $171,000 should be treated as cost of the land and development.
*1449 3. In his amended answer respondent pleads that he erroneously allowed the deduction in 1926 of the amount of $2,992.57 claimed as a net loss sustained in 1925. During 1925 petitioner expended this amount for stationery, taxes, legal services, etc., in perfecting its organization and securing title to its land. No lots were sold and no normal business was conducted in 1925. The alleged loss, *1091 therefore, did not result from the operation of a trade or business and is not a net loss within section 206(a)(b) of the 1926 Act. ; 379 .
4. The respondent also pleads affirmatively that in the event it be held, as petitioner contends, that the transactions were not present sales, and, therefore, involved no gain, there can be no room for the allowance of any commissions whatever in respect of such transactions. Since, however, it has been held above that income was realized upon the transactions of the taxable period, the commissions of $30,971.67 paid in respect of such income transactions were properly determined by respondent to be deductible. The petitioner*1450 is entitled to the deduction of no more.
Judgment will be entered under Rule 50.