Daugherty v. Comm'r of Internal Revenue
| Decision Date | 15 April 1982 |
| Docket Number | Docket No. 21161-80. |
| Citation | 78 T.C. 623 |
| Parties | WILLIAM B. DAUGHERTY and CHARLOTTE G. DAUGHERTY, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Ps, who operated a proprietorship engaged in the sale of real estate to customers in the ordinary course of their business, purchased in 1968 for $11,000 certain acres of unimproved waterfront land adjacent to Janes Island State Park in Maryland. From 1968 through 1972 they platted, subdivided, and preliminarily developed the property. In 1973, Ps received notice from the State of Maryland that it was interested in acquiring the property by condemnation. In 1974, condemnation proceedings were begun, which culminated in April 1975 in a settlement whereby Ps received $165,000. On their 1976 Federal income tax return, Ps reported half of the condemnation gain as ordinary income, but subsequently filed an amended return in an attempt to take advantage of the rollover provisions of sec. 1033, I.R.C. 1954. R determined that the entire amount was taxable to Ps as ordinary income in 1975. Held, Ps held the Janes Island property for sale to customers in the ordinary course of their business immediately prior to receiving notice by Maryland of its intent to condemn it. Held, further: Receipt of notice of intent to condemn did not, ipso facto, negate the intent of Ps to hold such property for sale in the ordinary course of their real estate business for Federal income tax purposes. Juleo, Inc. v. Commissioner, 483 F.2d 47 (3d Cir. 1973), revg. T.C. Memo. 1971-68, followed. Tri-S Corp. v. Commissioner, 48 T.C. 316 (1967), affd. on other grounds400 F.2d 862 (10th Cir. 1968), and Ridgewood Land Co. v. Commissioner, 477 F.2d 135 (5th Cir. 1973), affg. T.C. Memo. 1972-16, not followed. The gain realized by Ps is taxable as ordinary income in 1975. Held, further, Ps are liable for the additions to tax under sec. 6653(a) for 1976 and 1977. Joshua W. Miles, for the petitioners.
John F. Dean, for the respondent.
Respondent determined the following deficiency in and additions to petitioners' Federal income taxes:
+-------------------------------------+
¦ ¦ ¦Addition to tax ¦
+------+------------+-----------------¦
¦Year ¦Deficiency ¦sec. 6653(a)1 ¦
+------+------------+-----------------¦
¦ ¦ ¦ ¦
+------+------------+-----------------¦
¦1975 ¦$42,940.64 ¦None ¦
+------+------------+-----------------¦
¦1976 ¦None ¦$147.64 ¦
+------+------------+-----------------¦
¦1977 ¦None ¦109.86 ¦
+-------------------------------------+
The principal issue is whether the gain received by petitioners in 1975 from the State of Maryland incident to the condemnation of land owned by them adjacent to Janes Island State Park is taxable as ordinary income or as capital gain. The resolution of this issue depends upon whether the petitioners were holding the property for sale to customers in the ordinary course of their business immediately prior to receiving the notice of condemnation and, if so, whether the condemnation notice, ipso facto, negated their intent to hold it for sale in the ordinary course of their real estate business and changed their intent into an investment purpose. A secondary issue is whether the petitioners' underpayments of tax for 1976 and 1977 were due to negligence or intentional disregard of rules and regulations.
Some of the facts have been stipulated and are found accordingly.
William B. Daugherty and Charlotte G. Daugherty (petitioners) are husband and wife who resided in Crisfield, Md., when they filed their petition in this case. They filed their joint Federal income tax returns for the years 1975, 1976, and 1977 with the Internal Revenue Service Center at Philadelphia, Pa.
William B. Daugherty (herein referred to individually as petitioner) has been in the real estate business (sales and rentals) since 1964 when he purchased a tract of land consisting of about 52 acres known as Heart's Ease. That property was subdivided with the intent to sell individual lots to customers in the ordinary course of business. About 30 lots of the Heart's Ease property have been sold.
Petitioner reported on Schedule C of his joint Federal income tax returns, as ordinary income from the sale of property to customers in the ordinary course of his business, the proceeds from the sale of lots making up the property known as Heart's Ease. In addition, petitioner has sold other miscellaneous properties to customers in the ordinary course of his business, the proceeds from which he reported on Schedule C of his Federal income tax returns.
In 1966 or 1967, the petitioners purchased 12 acres or less of waterfront property on which four log cabins were built for rental primarily during the summer season. One of these lots was sold at a profit to petitioners' former accountant, Richard Jones.
In June 1968, the petitioners purchased property consisting of 22.78 acres of land on the north side of Janes Island State Park (hereinafter referred to as the Janes Island property). This was unimproved waterfront land adjacent to Janes Island State Park. They paid $11,000 for it.
Petitioners have not substantiated the manner of purchase of the Janes Island property, i.e., whether by cash, check, or whether it was financed in whole or in part.
Within the 12 months following the purchase of the Janes Island property, the petitioners began development activities. On or about May 30, 1973, they recorded a subdivision plat with the Board of County Commissioners of Somerset County, Md., and the Somerset County Planning and Zoning Commission.
On or about March 11, 1974, the State of Maryland, Department of Natural Resources, filed a petition for condemnation against petitioners to acquire the Janes Island property, although petitioners had received official notice that the State of Maryland wanted the property at least 1 year prior to the initiation of the condemnation suit.
During the course of the condemnation proceedings, the State of Maryland propounded interrogatories which were answered by the defendants (petitioners here) in the condemnation suit.
The highest, best, and most profitable use of the Janes Island property at and just before its condemnation was for subdivision and lot sales.
During the condemnation proceedings, the petitioners valued the Janes Island property on the basis of the total proceeds they would receive by selling it on a per lot basis.
In April 1975, the parties in the condemnation suit reached a basis for settlement pursuant to which, in the year 1975, petitioners received $165,000 from the State of Maryland as proceeds for the sale of their Janes Island property.
Petitioner felt he had no recourse but to accept the State's settlement offer because the bank was “breathing down [his] neck” for some money, and he had to pay the bank.
Petitioners' 1977 Federal income tax return was prepared by Brooks L. Sterling, Sr., an accountant. During the audit of petitioners' taxable years 1975, 1976, and 1977, Mr. Sterling was employed as their accountant. He also represented them during the examination of their 1978 Federal income tax return.
Under the method of accounting used by petitioners, no balance sheet was maintained showing the purpose for which a piece of property was purchased or was being held.
Petitioners accounted on the cash method for property other than property carried as “inventory,” and property accounted for on the cash method was expensed by them in the current year.
The Janes Island property was not expensed by petitioners in the year 1968 when purchased. Instead, it was treated as inventory.
The examining agent for the Internal Revenue Service was not advised that the Janes Island property was to be used as rental property until after petitioners had retained legal counsel.
During the examination of petitioners' returns for the years 1975, 1976, and 1977, petitioner told the examining agent that when the State of Maryland contacted him about condemning the property, the community knew about it right away, it clouded his title, and he was not able to make any sales after that time.
During the audit examination, while on a physical tour of the Janes Island property, petitioner advised Revenue Agent Daniel Duffy that he could have sold the property 30 times over. He also advised the agent that in his type of business in a small community, it is not necessary to advertise.
Petitioners deducted as a cost of sales in their real estate business the principal payments on loans made to purchase real estate. The deduction of principal payments as a cost of sales was not determinable from the petitioners' books alone but required, in addition, the examination of bank statements or loan schedules.
In a letter dated November 23, 1977, to respondent, the petitioners admitted that they were dealers in real estate and that they had reported half the proceeds of the condemnation on their 1976 Federal income tax return as real estate business income. In 1978, the petitioners filed an amended Federal income tax return for the year 1976 claiming a refund based upon the alleged erroneous inclusion, as ordinary income, of half the condemnation proceeds from the sale of the Janes Island property.
Petitioners did not maintain records segregating property by category of investment, use in business, or property held for sale to customers in the ordinary course of business. Nor did they maintain books or records indicating that the Janes Island property was being held for investment purposes or for use in their business.
Of eight miscellaneous parcels of property purchased, petitioner stated that all which remain unsold are being held for investment. However, the actual sales of portions of the eight miscellaneous properties were treated by petitioners as having been held in the ordinary course of business,...
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