Liftin v. Commissioner , 36 T.C. 909 ( 1961 )

Morton Liftin and Sylvia Liftin, Petitioners, v. Commissioner of Internal Revenue, Respondent

Liftin v. Commissioner

Docket No. 82630

United States Tax Court

36 T.C. 909; 1961 U.S. Tax Ct. LEXIS 87;

August 30, 1961, Filed

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Decision will be entered under Rule 50.

Petitioner purchased monthly payment notes, secured by second deeds of trust, at substantial discounts. His investments therein were speculative and the amount of realizable discount income therefrom was uncertain. He treated all of the monthly payments on principal as recovery of cost. Held, petitioner was not required to report a pro rata portion of each payment of principal, measured by the percentage of discount, as ordinary income prior to the recovery of his cost of such notes.

Morton Liftin, pro se.

Hubert E. Kelly, Esq., for the respondent.

Kern, Judge.

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KERN

The respondent determined deficiencies in petitioners' income taxes as follows:

1954	$ 383.97
1955	1,006.72
1956	897.18

The only question for our decision is whether petitioner is entitled to recover his cost of monthly payment notes, purchased by him at discounts, before reporting as discount or ordinary income any portion of the payments of principal received thereon.

FINDINGS OF FACT.

Some of the facts in this case have been stipulated. The stipulation and the exhibits attached thereto are incorporated herein and made a part of our findings of fact by this reference.

Petitioners are husband and wife residing in Arlington, Virginia. For the years 1954, 1955, and 1956 they filed joint income tax returns on the cash basis of accounting with the district director of internal revenue for the district of Virginia.

Since about the middle of 1956 Morton Liftin (hereinafter referred to as petitioner) has been regularly engaged in the general practice of law in the Washington, D.C., area. Prior to such engagement he was an attorney in the Department of Justice, working full time.

Over a period of years, beginning in 1953 and extending through 1956, petitioner purchased 84 interest-bearing second deed of trust notes. These notes were secured by second deeds of trust on residential property in the Washington area, and they provide for repayment on the basis of monthly installments (ranging from 5 to 15 years) which "shall be first applied to the payment of interest and the balance credited to the principal." These notes were purchased by petitioner at discounts from their face value, ranging up to 45 percent. Each note is in reality a second mortgage given by a purchaser of a home to make up the difference between the downpayment plus the first deed of trust and the selling price of the property. Petitioner's investments in such notes were speculative and the amount of his income or profit realizable by reason of payments to him in excess of the discounts was uncertain.

The notes were purchased by petitioner from various real estate dealers, note brokers, and builders in the Washington area. Such notes are frequently advertised for sale in a special section of newspapers. Petitioner frequently answered such advertisements and, after he became known as a person interested in acquiring such notes, he sometimes received listings of notes offered for sale.

Petitioner kept a complete set of books and records with respect to his note activities. The bookkeeping method he used, and according to which he reported income during the years in question, treated all payments of interest as ordinary income and all payments of principal as return of cost or investment until his full purchase price was recovered, and all payments on account of principal in excess of cost were treated as ordinary income when received.

The deficiency in issue results from respondent's determination that a proportionate part of each principal payment received by petitioner on each note, measured by the percentage of discount at which the note was purchased, constitutes ordinary income to petitioner in the year of payment.

OPINION.

The parties agree that where note obligations are purchased at a discount the receipt of the discount is ordinary income. The question here relates to the time when such discount income is realized and should be reported. Respondent contends that each payment on the principal should be allocated, part to a return of cost and part to discount income. Thus, if a note was purchased at a discount of 25 percent of face, 75 percent of each monthly payment on principal would, under respondent's method, represent return of cost, and 25 percent discount or ordinary income. Petitioner contends that he is entitled to apply all of the payments on principal to his costs until the full amount of his purchase money has been recovered and only thereafter should the principal payments be reported as ordinary income.

Petitioner cites as persuasive authority for his position the following cases: ; ;; , affirming ; , affirming a Memorandum Opinion of this Court; and , affirming a Memorandum Opinion of this Court.

Respondent, while conceding on brief that "There does not appear to be any decided cases factually on all fours with this case," cites as persuasive authority for his position the following cases: ; ; ; and , reversing in part .

After a consideration of the cited cases and also of the general statutory provisions (see ), we conclude that a rule of law applicable to the instant case may be stated as follows: Where a taxpayer acquires at a discount contractual obligations calling for periodic payments of parts of the face amount of principal due, where the taxpayer's cost of such obligations is definitely ascertainable, and where there is no "doubt whether the [contracts] [will] be completely carried out" ( ), it is proper to allocate such payments, part to be considered as a return of cost and part to be considered as the receipt of discount income; but, conversely, where it is shown that the amount of realizable discount gain is uncertain or that there is "doubt whether the contract [will] be completely carried out," the payments should be considered as a return of cost until the full amount thereof has been recovered, and no allocation should be made as between such cost and discount income.

In the instant case the petitioner, who of course has the burden of proof, has shown to our satisfaction that the amount of realizable discount income to be derived from the contractual obligations here in question was uncertain. That the notes were highly speculative is evidenced by the substantial discounts (up to 45 percent) at which they were purchased, and the quality of the security which was junior to a first deed of trust (up to 60 to 80 percent of the selling price of the property). The evidence is that makers of the notes had but small equities in the properties covered by the deeds of trust because of their small cash payments to the sellers. When purchasing notes petitioner gave consideration to the length of time the loan was to run, to the holder's equity in the property, sometimes to his credit standing, and generally to the location and condition of the property covered by the trust deed after what he called "an outside inspection." During the few years in question about 19 of the 84 notes were disposed of, about half of them were disposed of by payment in full while the other half were disposed of by foreclosure, the acceptance by the petitioner of a deed, or the acceptance by the petitioner of less than face for an early payoff. It was petitioner's experience that the latter half of the notes so disposed of resulted in his receiving less than the face value of the notes.

We therefore decide the issue presented herein in favor of petitioner.

For the purpose of giving effect to other adjustments which have been conceded or were not placed in issue,

Decision will be entered under Rule 50.