*1854 Fair market value of certain mortgage notes determined.
*579 This proceeding is for the redetermination of a deficiency in income tax for the year 1925 in the amount of $2,998.93, of which $2,464.24 is in controversy.
As presented by an amended petition, the sole error alleged is that the respondent determined that the petitioner realized " a taxable net profit of $44,503.01 in the year 1925" from the sale of certain lands.
The adjustment upon which the respondent computed the deficiency was the disallowance as a deduction of a commission paid for sale of the lands, upon the theory that petitioner was not regularly engaged in the real estate business, and therefore, is not entitled to such a deduction as an expense in the taxable year.
FINDINGS OF FACT.
Petitioner is a domestic corporation with its principal place of business at Ojus, Fla.
In 1925 petitioner sold to Lorrain G. Smith, Inc., a certain tract of land comprising from 480 to 485 acres and situated about three and one-half*1855 miles northwest of Ojus, which is a small village fourteen miles north of Miami. This land was at a distance of approximately three miles west of the nearest paved highway. The *580 property was connected with Ojus by a road which was partially rough-rock paved and partially dirt road.
The property is located on the neck of the Everglades, being partially within that section. It consists of pine, prairie, and muck lands in the approximate proportions of 40, 20, and 40 per cent of each class, respectively. The pine land had been cut over, and in 1925 was covered with a growth of palmetto and other scrub growths indigenous to that section. All of the prairie and muck lands were subject to periodic overflows due to rainfalls and water backing up from the Everglades, with the result that about 60 per cent of it was under a considerable depth of water for several months each year. The overflowed land had no agricultural value, because crops would be destroyed by the overflow. About 10 or 15 acres of the land had been cleared. Some of it was partly barren. The muck land furnished good pasturage during certain seasons.
In 1925 there were no improved lands closer to those*1856 herein involved than Ojus, with the exception of a small dairy farm about one and one-half miles to the northeast and a few small farms about two miles west on the other side of the Glade neck.
Prior to the petitioner's sale of the property, it had been used as a dairy farm. Improvements on it at the time of sale consisted of a two-story, five-room dwelling, built of pine and occupied by the farm manager, four or five two-room pine tenant houses, a cow barn, a milk house and two or three small implement sheds. The cow barn had a concrete or rock floor and a composition roof. It was open on all sides and had a capacity of about 20 cows. The milk house was constructed of concrete blocks. All of these improvements were in fairly good condition.
The property described above was carried on petitioner's books in 1925 at a cost of $41,713.52. The respondent has determined the depreciated cost of the property at the date of sale in 1925 as $40,866.71, made up of land at $27,600, and improvements at $13,266.71. Petitioner accepts these adjustments which represent depreciation.
The property was sold by petitioner through R. V. Waters, of the Waters Realty Company, who was a brother-in-law*1857 of F. W. Cason, president and principal stockholder of petitioner. Extended negotiations were required to effectuate the deal because petitioner would pay only a 5 per cent broker's commission instead of the 10 per cent commission usually paid for sales of such property. When it appeared that the deal must be closed or the price of the property would be increased, the prospective purchaser, Lorrain G. Smith, Inc., agreed to pay $12,250 of the broker's commission rather than lose the purchase. A sale was then made at a price of $237,500, of *581 which $60,000 was paid in cash on or about June 5, 1925. In addition the petitioner received in cash at that time about $400 as an adjustment of taxes paid on the property. Petitioner received five notes for the balance of the purchase price. Each of these notes was dated June 5, 1925, and they were payable as follows:
$35,143.95 on February 15, 1926
$35,545.31 on February 15, 1927
$35,545.31 on February 15, 1928
$35,545.31 on February 15, 1929
$35,545.31 on February 15, 1930
In addition to the notes described above, the purchaser executed a note for $12,250, dated June 5, 1925, and payable to petitioner February 15, 1926. *1858 This note represented the portion of the broker's commission which the purchaser had agreed to pay. It was made payable to petitioner with the understanding that payments upon it would be the property of the broker, Waters. Each of the abovedescribed notes bore interest at the rate of 8 per cent from February 24, 1925.
As security for the notes, petitioner took a purchase-money mortgage reading in part as follows:
It is understood and agreed between the parties hereto that the mortgagor herein shall have the right to subdivide the above described property and to require from the mortgagees partial releases, which partial releases shall release the property described therein from the effect and lien of this mortgage deed. Upon said mortgagor adopting a plat showing subdivision of said property and filing the same for record in the public records of Dade County, Florida, the said mortgagees agree to thereupon fix an amount to be paid for the release of each lot shown on such plat, the total of such release values, however, not to exceed the total principal amount of the mortgage indebtedness then due plus thirty-five per centum. Provided, however, that said mortgagees shall*1859 not be obligated to give such releases in the event this mortgage and notes hereby secured be in default, and provided further that said mortgagor shall pay any and all expenses incident to the release of said lots, including recording charges. All amounts paid for the release of lots hereunder shall be credited by said mortgagees on the principal of the note then next to become due.
R. W. Cason, president of petitioner and brother-in-law of Waters, was a practicing attorney of Miami, and he was attorney for Waters. Cason and Waters agreed that the note of the Smith Company representing a portion of Water's commission should be made payable to petitioner and held by it as a trust for Waters in order that it might be secured by the purchase-money mortgage and to avoid the possibility of its being outstanding in the hands of strangers in the event the maker defaulted. When this note was received by petitioner, Cason wrote across the face of it the following: "This note goes to Waters as bal. of his commission." It was further understood between Cason and Waters that payments by the purchaser on account *582 of the notes described above should not be considered as applicable*1860 to the "commission note" until the first purchase-money note in the amount of $35,143.95, due February 15, 1926, had been paid in full and that thereafter payments by the maker would be turned over to Waters to the extent of $12,250 if and as received by petitioner.
Petitioner paid Waters a broker's commission of $12,500 when the sale was made. It also paid $250 for revenue stamps affixed to the deed.
No payments were ever made on the principal of any of the six notes herein involved. The first semiannual interest payment on all of the notes was paid in cash. After approximately one year's default in interest payments, petitioner accepted a reconveyance of 25 acres of the land in payment of one year's interest on the notes. All of the improvements above described were situated on the reconveyed land. Petitioner had never surrendered possession of any of the lands involved, since by agreement with the purchaser it was not required to do so until the mortgage notes had been paid or portions of the lands released in accordance with the terms of the mortgage. Petitioner continued to use the lands for dairying purposes.
In 1928 petitioner assigned the mortgage to Cason as*1861 security for certain loans and to facilitate the clearing of title in the event foreclosure should become necessary and land contracts appeared of record.
In January, 1928, the persons holding title to the lands, as purchasers from Lorrain G. Smith, Inc., were in default in certain payments on the principal of the notes, and in interest payments from August 24, 1926, and they admitted their inability to make the payments due. After investigation Cason concluded that none of the persons liable on the notes were financially responsible. He, therefore, accepted a reconveyance of the remainder of the lands involved and discharged all parties involved from further liability on the mortgage notes. A reconveyance was accepted in order to save the cost of foreclosure. The mortgage is still outstanding of record.
Petitioner made no effort to sell the mortgage notes herein involved during 1925. It did, however, endeavor to secure a $15,000 loan from a Miami bank, offering the notes as security and the loan was refused. Petitioner was advised, however, that the loan would be made if Cason would endorse the notes personally.
In 1925 the section of Florida in which the lands herein*1862 involved are situated was experiencing a "land boom." In the years immediately preceding 1925 there was no active market for lands in the vicinity of petitioner's property. Land in that locality could then be secured at a price not in excess of $60 per acre. During the land boom of 1925 people bought such land at any price, regardless *583 of its intrinsic value, if they believed they could resell it at a profit. Lorrain G. Smith, Inc., did, in fact, resell the lands herein involved at a profit.
At the end of the year 1925 the assets of Lorrain G. Smith, Inc., consisted of $400 or $500 in cash, and various equities in real property which had been purchased in 1924 and during the boom of 1925.
The average value of the lands involved for dairying or farming purposes was, during 1925, not in excess of $60 per acre. The total value of the tract of about 485 acres was, therefore, approximately $29,100. In the latter part of 1925, the inordinately inflated values in land slumped, due to collapse of the "land boom."
In 1925 there was practically no market for mortgage notes of the character of those herein involved. In some instances such notes, and their mortgage security, *1863 when bearing the endorsement of persons known to be reliable, might be accepted as collateral security for bank loans. The notes in this proceeding had a fair market value of $20,000 during the year 1925.
OPINION.
LOVE: As presented by the amended petition, the sole issue in this proceeding is the fair market value of certain notes, secured by a purchase money mortgage, received by petitioner upon the sale of certain lands during the year 1925.
The selling price of this land we have found to be $237,500, of which $60,000 was paid in cash at the time of the sale, petitioner accepting five notes totaling $177,325 for the balance. In addition, petitioner received for the benefit of the broker effecting the sale, a note in the amount of $12,250, representing a portion of the broker's commission which the purchaser had agreed to bear in order to facilitate its acquisition of the property. The respondent has treated all of the notes involved, including that representing the broker's commission, as income of petitioner, and he has approved the installment method of reporting a profit upon the transaction. At the same time the respondent has denied the deduction of the amount*1864 of $12,500 paid by petitioner as a broker's commission, upon the theory that petitioner was not regularly engaged in the real estate business, and, therefore, is not entitled to deduct the entire commission as an ordinary and necessary expense in the year of the sale. The respondent has, however, offset the commission against the total selling price determined by him for the purpose of computing the profit derived by petitioner in the taxable year, upon the theory that the transaction was an installment sale. This is in accordance with the provisions of article 1562 of Regulations 65, and I.T. 2305, interpreting section 202 of the Revenue Act of 1924.
*584 We are satisfied that the note for $12,250, representing the portion of the broker's commission which the purchaser had agreed to pay, was received by petitioner solely as an agent of the broker and was never petitioner's property.
The question to be determined, therefore, is the fair market value of the five notes totaling $177,325 received by petitioner for its own benefit.
The testimony has been presented entirely by deposition. It consists of opinion evidence offered by six witnesses for the petitioner and*1865 of evidence of such other facts as are set out in our findings. While the opinion evidence tends strongly to establish that the notes had no fair market value, upon consideration of the whole record we find ourselves unable to adopt this view. We are of the opinion that the notes involved had a vair market value of not less than $20,000 during the year 1925, and that they should be included in petitioner's income to that extent in the said year.
Petitioner's return for the year 1925 reported the sale herein involved on the installment basis. It now seeks to change to what is generally called the deferred payment basis. Under ordinary circumstances, such a change is not permitted. We believe, however, that the principle announced in Key Largo Shores Properties, Inc.,21 B.T.A. 1008">21 B.T.A. 1008, is applicable in the instant case. We there held that a taxpayer reporting an installment sale of real property might later change to the deferred payment basis when it had become apparent during the taxable year that notes received in the transaction were worthless. We said, inter alia:
Under the Revenue Acts various methods of reporting income may be adopted by taxpayers, *1866 but all are designed to correctly reflect the true income in order that a just tax may be levied and collected. If a method used by a taxpayer does not clearly reflect income, the respondent may determine the income according to a method which in his opinion does clearly reflect it. Section 212, Revenue Act of 1926. This in itself is sufficient to demonstrate that it was not intended that taxpayers should be irrevocably bound by the election of a method of reporting when that method is erroneous. * * *
We, therefore, believe and so hold that the circumstances of the instant case justify a change as now contended by the petitioner. It follows that petitioner's profit upon the sale should not be computed upon the installment sale basis, but rather upon the basis of a completed transaction in the taxable year. The expense of the sale should, therefore, be offset against the gross profit in determining net profit in the taxable year. The parties agree that the depreciated cost of the property in 1925 was $40,866.71. The net profit may, therefore, be computed as follows:
| Cash payment received in 1925 | $60,000.00 | |
| Fair market value of notes received in 1925 | 20,000.00 | |
| Gross amount received | 80,000.00 | |
| Depreciated cost of property | 40,866.71 | |
| Gross profit | 39,133.29 | |
| Selling expense: | ||
| Commission | $12,500.00 | |
| Revenue stamps | 250.00 | |
| 12,750.00 | ||
| Net profit | 26,383.29 |
*1867 *585 Reviewed by the Board.
Judgment will be entered under Rule 50.