Harris Trust & Sav. Bank v. Commissioner , 24 B.T.A. 498 ( 1931 )

HARRIS TRUST AND SAVINGS BANK, EXECUTOR OF THE ESTATE OF ALEXANDER FRIEND, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Harris Trust & Sav. Bank v. Commissioner

Docket No. 33885.

United States Board of Tax Appeals

24 B.T.A. 498; 1931 BTA LEXIS 1633;

October 27, 1931, Promulgated

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">*1633 Under the terms of a contract of sale of real estate made subject to a mortgage given to secure initial bonds, the purchasing corporation agreed to make 180 specified monthly payments without interest until after maturity. In accordance with the terms of the contract, upon making the initial monthly payment, the purchaser was put in possession of the property sold and a deed conveying the premises in fee simple was placed in escrow for delivery to the purchasing corporation upon its compliance with the terms of the contract of sale. Held, that the contract was a completed contract of sale when the initial payments had been made, the purchaser had been put in possession and the deed had been delivered to the escrow agent. Held, further, that the petitioner, who acquired by purchase the seller's rights under the contract of sale, would derive no taxable income from the monthly payments until he recovered therefrom the costs to him of his interest in the contract.

Benjamin E. Jaffe, Esq., for the petitioner.

P. M. Clark, Esq., and C. C. Holmes, Esq., for the respondent.

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VAN FOSSAN

">*498 This proceeding is for the redetermination">*1634 of deficiencies in income taxes for the years 1924 and 1925 and for the period from January 1 to September 2, 1926, inclusive, amounting, respectively, to $2,017.89, $1,795.92 and $1,087.75.

The question at issue is the taxable status of certain payments made on a contract for the sale of real property, the rights under the contract having been purchased by the testator, Alexander Friend. Another issue was raised by the pleadings, but has been abandoned.

The parties entered into a written stipulation of facts, reserving the right to introduce further evidence at the hearing of this proceeding. From the stipulation and the testimony we find the facts as follows:

FINDINGS OF FACT.

The petitioner is the duly qualified and acting executor of the last will and testament of Alexander Friend, deceased.

During his lifetime and on February 5, 1924, Alexander Friend entered into an agreement with one George H. Shank and Allie C. Shank, his wife, which is as follows:

THIS MEMORANDUM WITNESSETH, That ALEX FRIEND, hereinafter called the "Purchaser", hereby agrees to purchase, at a price of Thirty-nine Thousand ">*499 Dollars ($39,000.00), the following described real estate, ">*1635 situated in the County of Cook and State of Illinois, to-wit:

Lots one (1) to eight (8) inclusive in Block three (3) in Rawson and Akerly's Subdivision of the north seventy-four (74) road of the North East quarter (N.E. 1/4) of Section four (4), Township thirty-eight (38) North, Range fourteen (14), East of the Third Principal Meridian, lying East of the Chicago, Rock Island and Pacific Railroad, excepting from said Lot four (4) that part, if any, taken or used for railroad right of way, and excepting from said Lots one (1), two (2), three (3), five (5), six (6), seven (7) and eight (8) that part conveyed to the Lake Shore and Michigan Southern Railway Company and the Chicago, Rock Island and Pacific Railway Company, together with all buildings, improvements and all other appurtenances belonging thereunto, located at the southwest corner of Pershing Road (39th Street) and Federal Street, Chicago, otherwise known as "C" of the Shank Buildings.

and GEORGE H. SHANK and ALLIE C. SHANK, his wife, hereinafter called the "Sellers", agree to sell said premises at said price, and to convey to said purchaser a good title in fee simple thereto by special warranty deed with release of dower">*1636 and homestead rights and estates, subject to:

(1) Trust deed dated February 15, 1918, recorded March 1, 1915, as Document number 6283040, made by george H. Shank and Allie C. Shank to Samuel J. T. Straus, as Trustee, originally securing a bond issue in the sum of One Hundred Eighty Thousand Dollars ($180,000.00), of which Fifty-five Thousand Dollars ($55,000.00) has been paid, leaving a balance secured by said trust deed of One Hundred Twenty-five Thousand Dollars ($125,000.00), payable as follows: Ten Thousand Dollars ($10,000.00) February 15, 1925, Ten Thousand Dollars ($10,000.00) February 15, 1926, Ten Thousand Dollars ($10,000.00) February 15, 1927, Ten Thousand Dollars ($10,000.00) February 15, 1928 and Eighty-Five thousand Dollars ($85,000.00) February 15, 1928, said bonds carrying interest at the rate of six per cent. (6%) per annum, both principal and interest being payable in equal monthly installments on the 15th day of each month in advance.

(2) Contract dated September 26, 1922, between George H. Shank and Allie C. Shank, as parties of the first part, and Brunswick-Balke-Collender Co., as party of the second part, under the terms of which contract said George H. Shank">*1637 and Allie C. Shank have agreed to sell to the Brunswick-Balke-Collender Co., and the Brunswick-Balke-Collender Co. has agreed to purchase said premises for the sum of Three Hundred Forty-five Thousand Dollars ($345,000.) payable in installments as in said contract set forth, of which sum there has been paid to the date hereof the exact sum of Seventy-one Thousand six hundred sixty-seven and 85/100 Dollars ($71,667.85), and which contract and all of sellers' rights thereunder, sellers agreed to assign to purchaser by instrument containing apt language acceptable to purchaser's attorneys.

(3) Warranty deed from George H. Shank and Allie C. Shank to Brunswick-Balke-Collender Co., deposited in escrow with S. W. Straus & Company, as provided in said contract, and subject also to all of the rights, interest and title of said Brunswick-Balke-Collender Co. in and to said premises under the terms of said contract and the escrow deposit of said warranty deed; subject also to party wall rights or agreements of record, zoning and building laws and ordinances.

Interest accrued on the said encumbrance shall be adjusted as of the date of the delivery of the deed, and all payments made by Brunswick-Balke-Collender">*1638 Co. subsequent to the date hereof shall be credited to the said purchaser.

">*500 Said purchaser has deposited with CHICAGO TITLE AND TRUST COMPANY the sum of Thirty-nine Thousand Dollars ($39,000.00), and said sellers have deposited with CHICAGO TITLE AND TRUST COMPANY a warranty deed to said premises as above provided, and the original or duplicate original of said contract between George H. Shank and Allie C. Shank and brunswick-Balke-Collender Co. and an assignment to the purchaser of the rights of said George H. Shank and Allie C. Shank, with irrevocable instructions to said Chicago Title and Trust Company as follows:

To immediately record said warranty deed, and if and when said Chicago Title and Trust Company is willing to issue its guaranty policy in its usual form, guaranteeing title in the purchaser at the date of record of said deed, subject only to the matters and things to which said warranty deed is to be made subject, and in addtion acts done or suffered by or judgments against the purchaser, and that there has been no default in the performance of said trust deed, then the deed of the sellers shall take effect and be deemed delivered as of the date when deposited">*1639 in escrow with said Trust Company, shall pay to the purchaser the sum of Four Thousand Dollars ($4000.00), being an amount due the purchaser from the sellers, and shall pay to the sellers the net purchase price after deducting said Four Thousand Dollars ($4000.00) and making the net adjustments of interest and payments made by said Brunswick-Balke-Collender Co. as herein provided have been made.

The reasonable escrow fee of the Chicago Title and Trust Company shall be paid one-half by the sellers and one-half by the purchaser.

The fee for recording said deed shall be paid by the sellers.

In the event that the Chicago Title and Trust Company shall, within thirty (30) days of the date of said deposit, fail to issue its guaranty policy in its usual form, as above provided, then and in such event the purchaser shall, at his option, reconvey to the sellers said premises and shall be entitled to the return of the cash deposited with the Chicago Title and Trust Company, as above provided, and said sellers shall be entitled to the return of all papers deposited with said Chicago Title and Trust Company. If said purchaser shall not, within ten (10) days after the expiration of said">*1640 thirty (30) days, reconvey to said sellers said premises, then said Chicago Title and Trust Company shall pay out said sums and deliver said papers as hereinabove provided.

The CHICAGO TITLE AND TRUST COMPANY is hereby expressly authorized and directed to disregard in its sole discretion any and all notices or warnings given by any of the parties hereto, or by any other person or corporation, excepting only orders or process of court entered or issued with or without jurisdiction, and the said Company is hereby expressly authorized to comply with and obey any and all orders, judgments or decrees of any court entered or issued with or without jurisdiction, and in case the said Company obeys or complies with any such order, judgment or decree of any court it shall not be liable to any of the parties hereto or to any other person, firm or corporation by reason of such compliance, notwithstanding any such order, judgment or decree be subsequently reversed, modified, annulled, set aside or vacated. In case of any suit or proceeding regarding this escrow, to which said Company is or may be at any time a party, it shall have a lien on any and all deposits hereunder for any and all costs, ">*1641 attorneys' and solicitors' fees, and other expenses which it may have incurred or become liable for on account thereof and it shall be entitled to reimburse itself therefor out of said deposits, and the undersigned jointly and severally agree to pay to said Company upon demand all said costs, fees and expenses so incurred. [Duly signed by the parties.]

">*501 The contract, dated the 26th day of September, 1922, between George H. Shank and Allie C. Shank, his wife, as parties of the first part, and the Brunswick-Balke-Collender Company, party of the second part, which is referred to in the above quoted memorandum, was a contract whereby Shank and his wife agreed to convey to the Brunswick-Balke-Collender Company the same premises described in the memorandum of agreement between Shank and wife and Alexander Friend. Under this contract the Brunswick-Balke-Collender Company agreed to pay $345,000 for the real estate therein described, of which amount there was paid $45,000 on the execution of the contract, and the balance of $300,000 was to be paid as follows: One monthly payment of $1,670.86 on the date of the execution of the contract and the balance in 179 equal monthly amounts">*1642 of $1,666.66 each until the sum of $300,000 was paid in full, with interest on the deferred payments at the rate of 6 per cent per annum after maturity. The purchasing corporation was to pay all taxes and assessments and to keep the property insured. The sellers agreed to pay off and discharge the unpaid balance of the mortgage for $180,000, referred to and described in the memorandum agreement entered into by Shank and wife and Friend, which was a lien on the property at the date of the execution of the Brunswick-Balke-Collender contract. All of the monthly payments under the contract with the Brunswick-Balke-Collender Company were payable at the office of S. W. Straus & Company, Chicago, Ill., and were to be applied by that firm first to the payment of the principal and interest and other monthly charges under the mortgage for $180,000 referred to in the memorandum agreement entered into by Shank and wife and Friend. The balance of the payments to be made monthly by the Brunswick-Balke-Collender Company, if any, was to be paid to Shank. The Brunswick-Balke-Collender contract provided further that when and if 60 per cent of the purchase price of $345,000 was paid by the said">*1643 corporation, then at its election, upon 30 days notice, the corporation should receive a warranty deed to said property from S. W. Straus & Company, with whom such warranty deed was deposited in escrow by Shank, simultaneously with the execution of the contract. It was provided, however, that prior to the delivery of such warranty deed to the corporation the latter should execute and deliver to Shank a second mortgage for the amount of the purchase price of the property still remaining unpaid, which second mortgage should be subject to the first mortgage and the unpaid balance thereon. It was also provided that the Brunswick-Balke-Collender Company should have possession of the property immediately upon the execution of its contract and should pay all ">*502 taxes thereon and keep the buildings insured. The sellers reserved the right to reenter and repossess the premises on the default of the purchasing corporation.

The agreement between Friend and Shank and wife was fully consummated in accordance with its terms. The Brunswick-Balke-Collender contract was assigned to Friend by Shank and wife. Friend had a twelve-Thirteenths interest in the property and contract acquired">*1644 by him from Shank and wife. The cost of the property and contract acquired by Friend was $164,000 and the cost of his twelve-thirteenths interest therein was $151,384.61. At the date of the assignment of the said contract there was still due under its terms the sum of $273,332.16, payable in 164 monthly payments of $1,666.66 each, without interest until after maturity. Friend received payments upon his twelve-thirteenths interest in the sum of $16,923.06 for the year 1924, in the sum of $18,461.55 for the year 1925, and in the sum of $13,846.17 for the period from January 1, 1926, to September 2, 1926, inclusive. No part of the sums so received by Friend were reported as income in the returns for the periods respectively in question. The respondent, however, held "that the purchase of certain real estate from George H. Shank, subject to the contract of sale to the Brunswick-Balke-Collender Company partakes of the nature of a deferred payment sale on the installment basis and that profits should be reported yearly upon payments received." The respondent also held that since Alexander Friend paid $164,000 for the property and at the date of such purchase there was due, under the">*1645 Brunswick-Balke-Collander Company contract, balance of $273,332.15, a profit of $109,332.15 was "to be reported as income over the period covered by the original sale agreement." The respondent further held that 60 per cent of the payments received during the year 1924 and the year 1925 and the period from January 1, 1926, to September 2, 1926, inclusive, was a return of capital and 40 per cent was profit. The respondent, therefore, increased the income of Friend during the years 1924 and 1925 and the period from January 1 to September 2, 1926, inclusive, by the amount of profit so calculated.

The real estate referred to in the agreements hereinbefore set forth is located on the southwest corner of 39th Street (otherwise known as Pershing Road) and Federal Street in the city of Chicago. The building thereon had five stories, with no basement, and was of milltype construction, with its interior unfinished. The building was cheaply constructed, having paving-brick facing on the outside. It was about 60 feet high, with a hip roof, and was suitable only for light manufacturing. The neighborhood in which the premises were located had become much deteriorated in 1924 and in that">*1646 year the ">*503 market value of the lot and building was $175,000. In 1924 the present worth of the deferred payments provided for in the agreement between Shank and wife and the Brunswick-Balke-Collender Company, computed by discounting at 6 per cent per annum, was $186,221.75 and the fair market value of the contract between Shank and Friend as of February 5, 1924, was $150,000.

At the time of the execution of the agreement herein described Shank was engaged in the business of building large factory buildings and selling them on contract, and Friend was engaged in dealing in real estate and in the real estate brokerage business.

OPINION.

VAN FOSSAN: The problem for solution in this proceeding is whether or not any part of the payments received by the decedent, Alexander Friend, from the Brunswick-Balke-Collender Company during the period between January 1, 1924, and September 2, 1926, constituted taxable income. To solve this problem we must determine what it was that Friend acquired by reason of his agreement with Shank and wife. Such a determination involves consideration of the contract by which in the year 1922 Shank and his wife agreed to convey to the Brunswick-Balke-Collender">*1647 Company the premises described in the agreement between Shank and Friend.

By the contract with the Brunswick-Balke-Collender Company Shank and his wife covenanted to convey to the corporation the real property referred to if the corporation made the payments specified and performed the covenants on its part to be performed. The contract price was $345,000. The corporation paid $45,000 in cash and agreed to pay the balance of the purchase price, namely, $300,000, in 180 monthly payments. These monthly payments did not bear interest until after maturity and no notes were given for the unpaid balance of the purchase price. By the provisions of the contract immediate possession of the premises was vested in the purchasing corporation, which agreed to pay all taxes and to keep the property insured. A warranty deed conveying title in fee simple to the corporation was placed in escrow, by Shank, for delivery to the purchasing corporation upon its compliance with the terms of the agreement. The sellers, however, reserved the right to reenter and repossess the premises in the event that the purchaser defaulted in any of the covenants on its part to be performed. It was also provided">*1648 that whenever 60 per cent of the purchase price had been paid the Brunswick-Balke-Collender Company should be entitled at its election, upon 30 days notice, to receive the warranty deed, provided it executed and delivered a purchase-money second mortgage for the amount of the unpaid balance of the purchase ">*504 price. It was also stipulated that the contract and the premises described therein were subject to the terms and conditions of a certain deed of trust conveying the premises as security for an issue of bonds totaling $180,000, of which the sum of $142,000 was still unpaid at the date of the execution of the contract. Shank and wife, as sellers, agreed to pay the unpaid balance of the mortgage and it was further agreed that the monthly amounts to be paid by the purchasing corporation should be applied first to the payment of principal, interest and other charges due monthly under the terms of the trust deed referred to. The balance of these monthly payments, if any, were payable to Shank.

In our opinion the Brunswick-Balke-Collender contract was a completed contract of sale in 1922. ">*1649 ; ; ; affd., . After the execution of the contract, the making of the initial payment, the placing of the purchaser in possession and the delivery of the deed to the escrow agent, the sellers retained only the bare legal title to the premises described in the contract and the right to reenter and repossess them in the event of the default or defaults of the purchasing corporation. If the purchasing corporation fulfilled its covenants the deed would be delivered to it and the bare title to the land reserved by the sellers would be extinguished. This bare legal title and the right to reenter and repossess the premises constituted the security held by the sellers for the payment of the balance of the purchase price. Practically, therefore, the sellers were in the same situation as if they had actually conveyed the title to the premises to the purchasing corporation and had accepted a purchase-money second mortgage for the unpaid balance of the purchase price. As a matter of fact the contract provided that the sellers">*1650 were to receive such a second mortgage if the purchasing corporation elected to exercise its option and demand the deed to the premises after 60 per cent of the purchase price was paid.

It follows from the foregoing that after the agreement between Shank and wife and Friend had been fully consummated, as set out in the findings of fact, Friend acquired under that agreement only what Shank and his wife had to sell, namely, the right to receive monthly payments as specified in the Brunswick-Balke-Collender contract, the unpaid total of which might be converted into a purchase-money second mortgage under specified conditions, together with the right as owner of the bare legal title to repossess the premises in the event of the default of the Brunswick-Balke-Collender Company. Friend, therefore, purchased something akin to a purchase-money second mortgage, the balance unpaid thereon at date of purchase being payable in 164 stipulated monthly amounts, ">*505 without interest until after maturity. In the deficiency notice, copy of which is attached to the petitioner herein, respondent held that the transaction entered into by Friend with Shank and wife "partakes of the nature of">*1651 a deferred payment sale on the installment basis, and that profits should be reported yearly upon payments received." The respondent thereupon stated in the deficiency notice that since "the purchase price was $164,000 and since the amount to be received was $273,332.15 there was a profit of $109,332.15 to be reported over the period covered by the original sale agreement." Such a computation of profit is based on the primary assumptions that the Brunswick-Balke-Collender Company would not default in any of the monthly payments to be made by it during a period of 164 months, or approximately 14 years, and that the total sum payable in monthly amounts without interest over a period of 14 years was worth its face at the time the Brunswick-Balke-Collender contract was purchased by Friend. We are of the opinion that these assumptions are not well founded and would not furnish a proper basis for computing profits in such a case as this. It is a matter of common knowledge that the financial character and solvency of any corporation may change in a few years, that real estate may depreciate in value and that obligations that are only a second lien on real estate rarely sell for their face">*1652 value. Cf. , affirming .

It appears from the evidence that contracts such as the Brunswick-Balke-Collender Company contract were bought and sold in the Chicago real estate market just as second mortgages are bought in that same market, namely, at their fair market value. The testimony discloses that the realty which was the security for the payment of the monthly amounts to be paid to Friend was depreciating in value, that the building on the premises was not well constructed and was built for factory purposes only, and that the neighborhood of the premises was undesirable. A witness, who was admittedly qualified, testified that in the Chicago real estate market the customary and usual method of determining the fair market value of such a contract as the Brunswick-Balke-Collender contract was to discount the present worth of the deferred payments by at least 20 per cent. This percentage of discount was arrived at by consideration of the value of the land and buildings covered by the contract and the financial character of the person or corporation obligated to pay the deferred amounts. This">*1653 witness also testified to the effect that at the date the right to receive the monthly payments was acquired by Friend their present worth was $186,221.75. This testimony stands uncontradicted and undisputed in the record and no reason is shown why it should be disregarded by us. We have, therefore, found that the fair market value of the Brunswick-Balke-Collender contract, at the ">*506 date of its acquisition by Friend, was $150,000. Since this amount is less than the cost of the contract of Friend, we are of the opinion that the cost should be recovered from the monthly payments before any taxable income will be derived. It therefore follows that during the period in question in this proceeding Alexander Friend was not required to report any taxable gain on the transaction herein considered until he had received payments in his own right in the aggregate sum of $151,384.64, the cost to him of his interest in the Brunswick-Balke-Collender contract. See ; .

In accordance with the stipulation entered into between the parties, we find for the purpose of the recomputation of deficiencies">*1654 in income tax that the adjusted net income of Alexander Friend for the year 1924 was $56,928.97; for the year 1925 his adjusted net income was $62,291.83; and for the period from January 1, 1926, to September 2, 1926, his adjusted net income was $45,587.86. The deficiencies should be recomputed accordingly.

Judgment will be entered under rule 50.