Frazee v. Comm'r of Internal Revenue, Tax Ct. Dkt. No. 27995-89

CourtUnited States Tax Court
Citation98 T.C. 554,98 T.C. No. 37
Docket NumberTax Ct. Dkt. No. 27995-89,27996-89.
Decision Date04 May 1992

98 T.C. 554
98 T.C. No. 37


Tax Ct. Dkt. No. 27995-89


United States Tax Court

Filed May 4, 1992.

Ps transferred improved real property to their children on Oct. 7, 1985, receiving in exchange a promissory note in the principal sum of $380,000, bearing interest at 7 percent, and secured by a first deed of trust on the improved real property.

1. HELD: The highest and best use of the improved real property was industrial use. HELD, FURTHER, the value of the property was $1 million, allocating $950,000 to the land and $50,000 to the improvements.

2. HELD, FURTHER, sec. 7872, I.R.C. provides the proper interest rate to discount the promissory note for gift tax purposes. Ballard v. Commissioner, 854 F.2d 185 (7th Cir. 1988), not followed on this issue. Likewise, sec. 1274, I.R.C. is not applicable for gift tax valuation purposes.

[98 T.C. 554]

David R. Clark, for petitioners.

Thomas A. Dombrowski, for respondent.


Respondent determined deficiencies in Edwin H. and Mabel G. Frazee's (petitioners) Federal gift tax and additions to tax for the taxable years as follows:

                ¦ ¦ ¦ ¦ ¦Addition to tax ¦
                ¦Petitioner ¦Docket No. ¦Year ¦Deficiency ¦sec. 6660 ¦
                ¦Edwin H. Frazee¦27995-89 ¦1985 ¦$171,555 ¦$51,466.50 ¦
                ¦ ¦ ¦1986 ¦59,472 ¦ ¦
                ¦Mabel G. Frazee¦27996-89 ¦1985 ¦171,555 ¦51,466.50 ¦
                ¦ ¦ ¦1986 ¦59,472 ¦ ¦
Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the taxable years at issue and Rule references are to the Tax Court Rules of Practice and Procedure.

After concessions by respondent, 1 the issues remaining for decision are: (1) The fair market value of improved real

[98 T.C. 555]

property which petitioners transferred to their children for purposes of computing gift tax under section 2501; and (2) whether petitioners must use the interest rate provided in section 7872 to value the promissory note received in exchange for the transfer of improved real property to their children for gift tax purposes or whether they may instead rely on the interest rate provided in section 483(e).


Some of the facts have been stipulated and are found accordingly. The stipulation of facts, the supplemental stipulation of facts, the second supplemental stipulation of facts, and exhibits are incorporated herein by this reference.

Petitioners, husband and wife, resided in San Diego County, California, at the time they filed their petitions in these cases. Petitioners each timely filed Federal gift tax returns for the calendar years 1985 and 1986.


For more than 50 years petitioners were growers and worldwide distributors of flower bulbs. As of 1984, petitioners wished to retire from the flower farming business. Petitioners consulted with their attorneys and accountants and decided upon an estate plan to transfer their business to their children. In 1985 petitioners disposed of a portion of their flower business, by transferring 12.2 acres of improved real property located in Carlsbad, California (Carlsbad property), to their four children, James D. Frasee, John C. Frasee, Dorislee Frasee, and Harley D. Frasee.

Petitioners transferred the Carlsbad property to their children receiving in exchange a promissory note in the principal sum of $380,000, bearing interest at 7 percent per annum, and secured by a first deed of trust on the Carlsbad property. The note, dated October 1, 1985, provides a 20-year graduated repayment schedule with quarterly payments. The final principal payment is due in October 2005. Petitioners did not receive a cash payment when they transferred the property to their children.

On October 7, 1985, petitioners executed two grant deeds relating to the Carlsbad property. One deed conveyed the

[98 T.C. 556]

interest in the land and the other conveyed the interest in the improvements. Petitioners reported the transfer of the land portion as an installment sale on their 1985 income tax return. The deeds were held by petitioners' attorney, Charles Marvin, until November 21, 1985, when they were recorded. There were no negotiations between petitioners and their children as to the terms of the transfer of the Carlsbad property and no formal sales documents were prepared.

On September 19, 1986, petitioners each timely filed a gift tax return, reporting $605,000 in total gifts made during 1985. Petitioners reported that the value of the Carlsbad property was $985,000, $380,000 of which they assigned to the land and for which they received a 7-percent promissory note and $605,000 which was assigned to the improvements. Petitioners reported the transfer of the improvements to their children as a gift. The reported value of $985,000 was based on a report prepared for petitioners by William C. Markley, Jr., dated May 23, 1985. On their 1985 gift tax returns, petitioners consented to have gifts made by either of them considered as made one-half by each spouse and reported no tax due after application of the unified credit.



In 1968 petitioners purchased the Carlsbad property, a 10-acre parcel located at 6145 Laurel Tree Road in Carlsbad, California, for use as a flower distribution center. The purchase price was $50,000. Petitioners shortly thereafter acquired approximately 2 adjoining acres. As of 1985, petitioners claimed an $81,770 basis in the land. Subsequently, petitioners constructed a warehouse building (warehouse) on the property at a cost of approximately $180,000. The warehouse contains office space, loading docks, and five large special-purpose coolers. The building is used to process and store flowers and flower bulbs. On October 7, 1985, the Carlsbad property consisted of a 12.2-acre tract of real property, a warehouse, and approximately 50,000 square feet of partially paved roads and parking areas. Petitioners made approximately $73,000 in additional improvements to the property prior to transferring it to their children. Petitioners

[98 T.C. 557]

total investment in the Carlsbad property as of the date of transfer was approximately $335,000 ($81,770 plus $180,000 plus $73,000).

The property, which has an irregular shape, is located approximately 1 mile east from the Palomar Airport. It has frontage on Laurel Tree Road and extends to the west approximately 1,165 feet. An asphalt road provides access from the property to Laurel Tree Road which provides direct access to the four-lane Palomar Airport Road. The western two-thirds has a depth of 484.7 feet. The property is almost level near grade; however, the western rear perimeter of the site has a steep upward slope. Utilities, including public water, sewer, gas, and electric, are easily accessible to the property and drainage is adequate. A small stream or drainage area runs along the northerly border of the property.

The warehouse, a 17-year-old, 38,400-square-foot metal Butler building, was in average condition at the date of gift. However, the warehouse was below industrial standards. The interior has a special- purpose design for the storage and packaging of flowers. Approximately 50 percent of the interior consists of large coolers and heating rooms.

The properties immediately surrounding the Carlsbad property were vacant in 1985. However, to the south, the Carlsbad property was surrounded by a group of retirement homes for the Sudean Mission.

During 1985 the area surrounding the Palomar Airport was one of the fastest developing areas in north San Diego County. The Carlsbad property is located on the south side of Palomar Airport Road. There was an extensive increase in the development of both industrial and commercial properties, and land values were on an upward trend at this time. One mile east of the subject site, the Palomar Airport area was emerging as a major office and development center. Additionally, there were a number of planned industrial projects located in the vicinity of Palomar Airport Road.

Compared to commercial and industrial activity in the Carlsbad area, residential land values were level or in decline during the relevant period. There were no sales of agricultural land in Carlsbad, nor were there any rezonings of agricultural land in Carlsbad in the years immediately before and after the gift in these cases.

[98 T.C. 558]


In October 1985, the Carlsbad property was zoned as limited control (L-C) and exclusive agriculture (E-A). Under the city of Carlsbad zoning ordinance, the purpose of the L-C zone is to provide an interim zone for areas where planning for future uses have not been completed or plans of future development have not been formalized. After proper planning or plan approval, property zoned L- C may be rezoned.

The E-A zone provides for agricultural uses in areas not suited for urban development. The E-A zoning permits crop production, floriculture, greenhouses less than 2,000 square feet, sheep and cattle production (maximum 1 per half acre), poultry, rabbits and chinchillas (maximum 25), roadside stands, and tree farms. Petitioners and their children never attempted to, nor did they want to, rezone their property. The Carlsbad property, therefore, retained this E-A zoning classification as of the date of trial.

During 1985 the general plan designation of the Carlsbad property was nonresidential reserve (NRR). The general plan designation of the area surrounding the Carlsbad property was changed from NRR to planned...

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