115 T.C. No. 34
UNITED STATES TAX COURT
DONALD DECLEENE AND DORIS DECLEENE, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 24459-97. Filed November 17, 2000.
P had operated his business on the M Street property since 1977. In 1992, P purchased the unimproved L Drive property as replacement property. In September 1993, P and WLC, who wished to acquire M Street, agreed that M Street and unimproved L Drive were of equal value, $142,400; P quitclaimed title to L Drive to WLC for a deferred cash consideration of $142,400, to be paid at a second closing; WLC agreed to build a building on L Drive to P’s specifications and in December 1993 to reconvey L Drive to P, with the substantially completed building on it, in exchange for M Street. These transactions closed as agreed. While WLC held title to L Drive, P retained beneficial ownership thereof and was responsible for all transaction costs and carrying charges. Construction was financed by a note and mortgage guaranteed by P that were nonrecourse as to WLC, and P assumed personal - 2 -
liability for them at the second closing, when WLC paid P the cash consideration of $142,400.
Held: The subject transactions were a sale of M Street to WLC for $142,400, as determined by R, rather than a sale of unimproved L Street, followed by a reverse like-kind exchange of M Street for improved L Street under sec. 1031(a), I.R.C., as reported by P. Because P never divested himself of beneficial ownership of L Street, P could not acquire improved L Street as replacement property in exchange for his relinquishment of M Street to WLC. Held, further, P is not liable for the accuracy-related penalty under sec. 6662(a), I.R.C.
Brian R. Mudd, for petitioners.
Michael J. Calabrese, for respondent.
BEGHE, Judge: Respondent determined for the taxable year
1993 that petitioners had a Federal income tax deficiency of
$23,796 and were liable for a section 6662(a)1 accuracy-related
penalty of $4,759.
The sole substantive issue for decision is whether the
subject transactions qualified as a taxable sale of the Lawrence
Drive property and a like-kind section 1031(a)(1) exchange of the
McDonald Street property, as petitioners reported them, or was a
taxable sale of the McDonald Street property, as respondent
1 Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. - 3 -
determined. We uphold respondent’s determination that the
transactions resulted in a sale of the McDonald Street property,
but we hold for petitioners on the penalty issue.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulations of fact and the accompanying exhibits are
incorporated herein by this reference. Petitioners are husband
and wife who resided in Green Bay, Wisconsin, at the time they
filed their petition.
Since 1969, petitioner Donald DeCleene (petitioner) has
owned and operated a trucking/truck repair business. In 1976 and
1977, petitioner purchased improved real property located on
McDonald Street, Green Bay (the McDonald Street property). He
used the McDonald Street property for his business operations.
In 1993, petitioners owned and worked as employees of
DeCleene Truck Repair and Refrigeration, Inc. (Refrigeration).
Petitioner served as president. Refrigeration installs and
repairs truck refrigeration units and performs general truck
repairs. Through December 29, 1993, Refrigeration rented the
McDonald Street property from petitioner as its business
premises. Petitioner computed his adjusted basis for the
McDonald Street property, including the depreciated cost of
improvements, as being $59,831 at the time he disposed of that
property on December 29, 1993. - 4 -
In 1992, petitioner was looking for land to which he could
move his business.
On September 30, 1992, petitioner purchased 8.47 acres of
unimproved real property on Lawrence Drive in De Pere, Wisconsin
(the Lawrence Drive property), a suburb of Green Bay. Petitioner
described the Lawrence Drive property as a “very good spot” that
he “took advantage of”. Petitioner promptly sold 2.09 acres of
the Lawrence Drive property to an unrelated corporation.
Petitioner’s adjusted basis of the Lawrence Drive property that
he purchased and retained, with allocated fees and other closing
costs, was $137,027.
Petitioner partially financed the purchase of the Lawrence
Drive property with a $100,000 loan from Bank One, Green Bay.
Bank One, Green Bay received petitioner’s note and a mortgage on
the Lawrence Drive property as security for its loan.
By 1993, petitioner was ready to move his business to a new
building to be constructed on the Lawrence Drive property.
After petitioner acquired the Lawrence Drive property, The
Western Lime and Cement Co. (WLC) expressed interest in acquiring
petitioner's McDonald Street property.
Petitioner discussed WLC's interest in the McDonald Street
property with his accountant. The accountant suggested that
petitioner could structure a like-kind exchange in which he would
quitclaim the Lawrence Drive property to WLC, after which WLC - 5 -
would convey back to petitioner the Lawrence Drive property with
a new building built thereon to petitioner's specifications, in
exchange for the McDonald Street property.
On September 24, 1993, WLC made an offer–-prepared by
petitioner’s attorney–-which petitioner accepted, to purchase the
Lawrence Drive property for $142,400; petitioner’s acceptance
contained an undertaking to “transfer building permit to Buyer on
or before September 27, 1993”.2 On September 24, 1993,
petitioner quitclaimed title to the Lawrence Drive property to
WLC, and WLC gave petitioner a fully nonrecourse noninterest
bearing one payment note and mortgage on the Lawrence Drive
2 The copy of the building permit included as Exhibit 39-J in paragraph 67 of the Supplemental Stipulation of Facts replaces paragraph 30 of the Stipulation of Facts, which stated as follows: “Prior to his September 24, 1993 quit claim of title to the Lawrence Drive property to the Western Lime & Cement Co., a permit was obtained in Donald DeCleene’s name for construction of a building on the Lawrence Drive property”.
Exhibit 39-J is a photocopy that bears a variety of dates: it was originally submitted to and preliminarily approved by the City of DePere Building Inspector on July 29, 1993; it bears the signature of the “Owner/Agent Michael DeCleene V.P. Date 1/12/94"; it was recorded “10/22/93" and bears the notation, “Site Plan approved by Plan Commission on 4-27-93". The name of petitioner as Owner, his mailing address, and telephone number appear on the line of the permit form provided for that information. However, the name, mailing address, and telephone number of WLC have been written in above those of petitioner.
On July 29, 1993, Green Bay Abstract & Title Company, Inc. (the title company), had issued a title commitment with WLC as the proposed insured on the owner’s policy in the insured amount of $142,400 and Bank One, Green Bay as the proposed insured on the loan policy in the insured amount of $522,400. - 6 -
property in the amount of $142,400. On that same day, petitioner
assigned to Bank One, Green Bay, the WLC $142,400 note and
mortgage. The WLC $142,400 note was due by its terms “upon the
closing of an exchange transaction between” WLC and petitioner,
or 6 months from the date of the note, “whichever is earlier”.
On September 24, 1993, WLC and petitioner also executed the
Exchange Agreement regarding the McDonald Street property and the
Lawrence Drive property. The Exchange Agreement was drafted by
petitioner’s attorney with input from WLC’s attorney.
Paragraph 1 of the Exchange Agreement required petitioner to
convey by warranty deed the McDonald Street property to WLC,
“free and clear of all liens and encumbrances”, in exchange for
WLC’s paying its $142,400 note to petitioner and conveying the
Lawrence Drive Property back to petitioner by quitclaim deed.
Paragraph 2 of the Exchange Agreement provided that
petitioner would pay all costs relating to the transfers of the
McDonald Street and Lawrence Drive properties.
In Paragraph 4 of the Exchange Agreement, petitioner made
comprehensive warranties to WLC with respect to the McDonald
Street property, but WLC expressly disavowed making any
warranties to petitioner with respect to the Lawrence Drive
property. - 7 -
The Exchange Agreement provided that WLC would construct a
building on the Lawrence Drive property to petitioner's
specifications.
The Exchange Agreement provided that petitioner at the
closing of the exchange would pay an amount representing the
costs of the building on the Lawrence Drive property, as well as
insurance premiums, real estate taxes, interest, and all other
“soft” costs WLC might incur incident to the construction of the
building.
Petitioner in the Exchange Agreement agreed to indemnify and
hold WLC harmless against any damages sustained or incurred in
connection with the construction and financing of the Lawrence
Drive property.
Petitioner and WLC intended to close on the Exchange
Agreement upon completion of construction of the building on the
Lawrence Drive property "but not later than December 31, 1993".
Bank One, Green Bay provided financing for the construction
of the building on the Lawrence Drive property. On September 24,
1993, Bank One, Green Bay agreed to a construction loan of
$380,000, naming WLC as borrower and petitioner as guarantor.
This loan was nonrecourse as to WLC. On the same day WLC
executed a note and mortgage to Bank One, Green Bay, which
provided that WLC had no personal liability on the note secured
by the mortgage and that the lender would look solely to the - 8 -
Lawrence Drive property securing the mortgage; petitioner
guaranteed the $380,000 construction loan.
Bank One, Green Bay considered petitioner the source of
repayment of the September 24, 1993, $380,000 construction loan.
In connection with that loan, Bank One, Green Bay never obtained
any financial statements from WLC. The check of the
creditworthiness of WLC by the Bank One, Green Bay loan officer
consisted of calling a branch bank to discuss WLC’s business
reputation.
The $380,000 note for the September 24, 1993 Bank One, Green
Bay construction loan required no interest or principal payments
during the time that WLC was expected to be the named borrower on
the note; the note did not require payment of interest until
March 23, 1994.
On September 24, 1993, the following other events occurred:
Petitioner gave Bank One, Green Bay a new mortgage on the
McDonald Street property securing a total obligation of $480,000,
consisting of both his September 30, 1992, $100,000 note and the
WLC nonrecourse note of $380,000 that he had guaranteed; WLC
accepted the commitment of Bank One, Green Bay to provide a
$380,000 loan for financing construction of the building on the
Lawrence Drive property; WLC executed a corporate borrowing
resolution authorizing it to borrow from Bank One, Green Bay; WLC
executed an application to Bank One, Green Bay for a standby - 9 -
letter of credit in the amount of $380,000 in favor of the title
company, which was delegated the task of making progress payments
to the contractor under the construction contract; the bank
issued its irrevocable standby credit in favor of the title
company in that amount.
On September 24, 1993, Landmark Building Systems Ltd.
(Landmark) entered into a lump sum construction contract in the
amount of $375,688 (subject to certain adjustments) with WLC to
construct the building on the Lawrence Drive property. The
contract named petitioner, Mike DeCleene (petitioners’ son, who
works in the family business), and/or a representative of Excel
Engineering, as owner's representative. As owner’s
representative, petitioner and Mike DeCleene had general
authority, including the right to approve changes in design or
construction, to inspect and approve workmanship and materials,
to visit the construction site, and to determine compliance with
the contract.
Although the standby letter of credit and the construction
contract do not expressly so state, progress payments to the
contractor were to be made only with the approval of petitioner
or Michael DeCleene as owner’s representative. Excel Engineering
played a role in the design of the building, but lacked actual
authority to sign off as owner’s representative. - 10 -
The construction contract called for substantial completion
by December 15, 1993. Between September 24 and December 29,
1993, Landmark worked on the construction of the building on the
Lawrence Drive property and substantially completed the building
to petitioner's specifications.
On December 28, 1993, 1 day prior to execution and closing
of the Assumption, Release and Escrow Agreement described below,
Bank One, Green Bay executed a Satisfaction of Mortgage for the
mortgage given by WLC to petitioner that petitioner had assigned
to the bank in connection with petitioner’s quitclaim of the
Lawrence Drive property to WLC on September 24, 1993.
On December 29, 1993, Bank One, Green Bay, WLC, and
petitioner executed the Assumption, Release and Escrow Agreement,
which provided that petitioner assumed and became personally
obligated to the bank for all obligations of WLC arising out of
the construction note and mortgage, notwithstanding their
nonrecourse language; petitioner agreed to be responsible for
completion of the construction project; and WLC agreed to pay
petitioner $142,400 for the McDonald Street property. Petitioner
undertook to use $100,000 of the $142,400 received from WLC “to
pay a Note due the Bank in the amount of * * * $100,000" (which
had been secured by mortgages on both the Lawrence Drive property
and the McDonald Street property) and to escrow the remainder
with the bank to pay real estate taxes and any special - 11 -
assessments on the McDonald Street property and to reduce the
balance of the construction loan note and mortgage to $360,000,
with any surplus of the escrowed funds to be delivered to
petitioner. Bank One, Green Bay agreed “to release any liens
that it may have on the property located on McDonald Street”.
On December 29, 1993, petitioner formally assumed as
borrower what had been WLC’s nonrecourse $380,000 Bank One, Green
Bay note of September 24, 1993; petitioner conveyed the McDonald
Street property to WLC by warranty deed. WLC quitclaimed to
petitioner its interest in the Lawrence Drive property. WLC
directly paid petitioner $142,400 by check to petitioner’s order
drawn on M&I First National Bank of West Bend, Wisconsin.
Petitioner endorsed this check “Pay only to the order of Bank
One-Green Bay”.
Petitioner and WLC had agreed in the Exchange Agreement that
the McDonald Street property, including improvements, and the
unimproved Lawrence Drive property each had a value of $142,400.
The quitclaim deed of the Lawrence Drive property from petitioner
to WLC and the warranty deed of the McDonald Street property from
petitioner to WLC each showed that real estate transfer tax of
$427.20 had been paid, based on a value of $142,400; the
quitclaim deed from WLC to petitioner of the title to the - 12 -
improved Lawrence Drive property showed that real estate transfer
tax of $1,140 had been paid, based on a value of $380,000.3
Although petitioner had a general desire to complete his
acquisition of the improved Lawrence Drive property as soon as
possible, he didn’t particularly care whether the closing
occurred before or after December 31, 1993. WLC wished to have
the closing occur before December 31, 1993, because it wanted the
Lawrence Drive property removed from its books for insurance
valuation purposes before the end of the year.
On their 1993 return, petitioners treated the subject
transactions between petitioner and WLC as a sale of the
unimproved Lawrence Drive property and a like-kind exchange of
the McDonald Street property for the improved Lawrence Drive
property. Petitioners reported no gain or loss on the
disposition of the McDonald Street property. They reported a
$5,373 short-term capital gain ($142,400 gross "sales price" less
$137,027 basis) on their quitclaim transfer of the Lawrence Drive
property to WLC, which is described in Schedule D of their return
as a sale of “investment land”.
3 Although these amounts do not computationally coincide in all respects with the transfer tax figures shown on the buyer’s and seller’s closing statements, those statements confirm that the transfer taxes on the subject transactions were paid by petitioner. - 13 -
Petitioners' 1993 return includes a Form 8824, Like-Kind
Exchanges, which states that petitioners exchanged “land and
building” for “land and building”. The return discloses no other
facts regarding the transactions between petitioner and WLC.
Respondent used petitioner’s $59,831 adjusted basis figure
for the McDonald Street property in computing the long-term
capital gain on the sale of the McDonald Street property
determined in the deficiency notice. However, on audit of
petitioners’ return, an adjusted basis of $61,331 had been
established. Respondent’s deficiency notice did not back out the
gain petitioners had reported on petitioner’s quitclaim transfer
of the unimproved Lawrence Drive property to WLC, notwithstanding
that, under respondent’s theory of the case, the Lawrence Drive
property has never been disposed of by petitioner.
On April 29, 1998, Bank One, Green Bay, WLC, and petitioner
executed an amendment to the Assumption, Release and Escrow
Agreement. The amendment recites that the original of that
agreement contained a scrivener’s error, and recites that WLC
would pay petitioner $142,400 “in satisfaction of the Note and
Mortgage” on the Lawrence Drive property, that the Lawrence Drive
Property “is exchanged per the Exchange Agreement” for the
McDonald Street property, that petitioner will use $100,000 of
the $142,400 received from WLC to pay petitioner’s $100,000 note - 14 -
to the bank, and that the balance of $42,400 will be escrowed
with the bank to pay real estate taxes and any special
assessments on the Lawrence Drive property (emphases supplied)
and to reduce the balance of the construction loan and mortgage
to $360,000.
The amendment also sets forth a revision of the provision
regarding release of liens by Bank One, Green Bay, reading as
follows:
The Bank agrees to release any liens that it may have on the property located at 625 Lawrence Drive, De Pere, Wisconsin, that are the obligation of the Company [WLC] and against 917 MacDonald [sic] Street, Green Bay, Wisconsin that are the obligation of DeCleene.
The terms of the foregoing transactions among WLC and
petitioner and Bank One, Green Bay assured that WLC would pay no
amounts thereunder until it received the McDonald Street
property, that WLC would have no personal liability with respect
to the Lawrence Drive property or financing while the Lawrence
Drive property was titled in its name or at any time thereafter,
and that all transaction and other costs with respect to the
McDonald Street and Lawrence Drive properties would be paid by
petitioner.
OPINION
Section 1001(c) provides that the entire gain or loss on the
sale or exchange of property shall be recognized. Section - 15 -
1031(a)(1) provides for nonrecognition of gain or loss on the
exchange of certain types of like-kind property, including real
property, held for productive use in trade or business or for
investment.4 Section 1031(b) in effect provides that if the
property received in an exchange otherwise qualifying for
nonrecognition of gain under section 1031(a) includes money or
other property (“boot”), then any gain to the recipient shall be
recognized, but not in excess of the boot.
Was McDonald Street Sold or Exchanged?
The question posed by respondent’s determination is whether
the subject transactions were a taxable sale to WLC of the
McDonald Street property, as respondent determined, or instead
were a taxable sale of the unimproved Lawrence Drive property to
WLC, followed 3 months later by petitioner’s transfer of the
McDonald Street property to WLC in a like-kind exchange for WLC’s
4 Clearly, the Lawrence Drive property, in both its unimproved and improved states, and the McDonald street property were like-kind properties within the meaning of sec. 1031(a). Sec. 1.1031(a)-1(b), Income Tax Regs., states:
Definition of “like kind.” As used in section 1031(a), the words “like kind” have reference to the nature or character of property and not to its grade or quality. * * * The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. * * * - 16 -
reconveyance to petitioner of the Lawrence Drive property--now
substantially improved--as petitioners reported.
The tax significance of the answer to the question stems
from the disparity in the adjusted bases of the McDonald Street
and Lawrence Drive properties in petitioner’s hands. McDonald
Street, which petitioner purchased in 1976-77, had an adjusted
basis in his hands substantially lower than his cost of Lawrence
Drive, which he purchased in 1992. Petitioner therefore reported
as the taxable sale not his permanent relinquishment to WLC of
the low-basis McDonald Street property, but rather the first leg
of the “repo” transaction that temporarily parked the high-basis
Lawrence Drive property with WLC.
Legal and Administrative Background
The primary reason that has been given for deferring
recognition of gain under section 1031(a) on exchanges of like-
kind property is that the exchange does not materially alter the
taxpayer’s economic position; the property received in the
exchange is considered a continuation of the old property still
unliquidated. See, e.g., Koch v. Commissioner, 71 T.C. 54, 63-64
(1978). However, section 1031(a) does not go so far in
implementing this notion as to be a reinvestment rollover
provision, like section 1033 or section 1034. A sale of
qualified property for cash requires that gain or loss be - 17 -
recognized under the general rule of section 1001(c); such a sale
does not become part of a qualifying exchange under section
1031(a) even though the cash received on the sale is immediately
invested in like property. Compare Coastal Terminals, Inc. v.
United States, 320 F. 2d 333, 337 (4th Cir. 1963), with Rogers v.
Commissioner, 44 T.C. 126, 136 (1965), affd. per curiam 377 F.2d
534 (9th Cir. 1967).
Petitioners remind us, and we are well aware--as we stated
in another section 1031 exchange case in which we held against
the taxpayer--that “Notwithstanding the familiar and long-
standing rule that exemptions are to be narrowly or strictly
construed, * * * section 1031 has been given a liberal
interpretation.” Estate of Bowers v. Commissioner, 94 T.C. 582,
590 (1990) (citing Biggs v. Commissioner, 69 T.C. 905, 913-914
(1978), affd. 632 F.2d 1171 (5th Cir. 1980)). The courts have
exhibited a lenient attitude toward taxpayers in like-kind
exchange cases, particularly toward deferred exchanges. See,
e.g., Starker v. United States, 602 F.2d 1341 (9th Cir. 1979).
The Commissioner has also played a facilitating role by issuing
regulations that provide safe harbors for deferred exchanges, see
sec. 1.1031(k)-1, Income Tax Regs., under the statutory
limitations imposed on such exchanges by section 1031(a)(3), as
enacted by Deficit Reduction Act of 1984, Pub. L. 98-369, sec. - 18 -
77(b), 98 Stat. 596. These regulations, with their provisions
for use of third-party “qualified intermediaries” as
accommodation titleholders, who will not be considered the
taxpayer’s agent in doing the multiparty deferred exchanges
permitted by the regulations, have encouraged the growth of a new
industry of third-party exchange facilitators.
The subject transactions present a case of first impression
in this Court. They reflect the effort of petitioner and his
advisers to implement a so-called reverse exchange directly with
WLC, without the participation of a third-party exchange
facilitator. Reverse exchanges have been described as
transactions in which the taxpayer locates and identifies the
replacement property (and acquires it or causes it to be acquired
on his behalf by an exchange facilitator) before he is ready to
transfer the property to be relinquished in exchange. The
preamble to the deferred exchange regulations, sec. 1.1031(k)-1,
Income Tax Regs., made clear the Commissioner’s view that section
1031(a)(3) and the deferred-exchange regulations do not apply to
reverse exchanges. See T.D. 8346, 1991-1 C.B. 150, 151.
The Commissioner has recently responded to industry and
practitioner requests for guidance5 by publishing a revenue
5 See, e.g., American Bar Association Section on Taxation, Committee on Sales, Exchanges and Basis, Report on the (continued...) - 19 -
procedure describing the Commissioner’s conditions for qualifying
reverse exchanges for nonrecognition of gain under section
1031(a)(1). See Rev. Proc. 2000-37, 2000-40 I.R.B. 308. Like
the deferred exchange regulations that implement section
1031(a)(3), the revenue procedure provides for third-party
qualified intermediaries as exchange accommodation titleholders
in carrying out the “qualified exchange accommodation
arrangements” whose use will qualify reverse exchanges for
nonrecognition of gain or loss under section 1031(a)(1). Like
the deferred exchange regulations, the revenue procedure provides
a safe harbor; it states that “the Service recognizes that
‘parking’ transactions can be accomplished outside of the safe
harbor provided this revenue procedure”, but that “no inference
is intended with respect to the federal income tax treatment of
‘parking’ transactions that do not satisfy the terms of the safe
harbor”. Rev. Proc. 2000-37, 2000-40 I.R.B. 308.
Because the revenue procedure is prospectively effective, it
does not apply to the case at hand. See id. We therefore have
5 (...continued) Application of Section 1031 to Reverse Exchanges, 21 J. Real Est. Tax. 44 (1993); Handler, Pricewaterhouse Coopers Forwards Proposed Guidance on Reverse Exchanges, 2000 TNT 16-27, Doc. 2000-2588 (Jan. 25, 2000); Safe Harbor Guidance for Reverse Like- kind Exchanges To Come Soon, IRS Official Promises, Highlights and Documents 1157 (Jan. 25, 2000). - 20 -
recourse to general principles of tax law to answer the question
posed by repondent’s determination.
Analysis and Conclusion
In the case at hand, petitioner did not just locate and
identify the Lawrence Drive property in anticipation of acquiring
it as replacement property in exchange for the McDonald Street
property that he intended to relinquish. He purchased the
Lawrence Drive property without the participation of an exchange
facilitator a year or more before he was ready to relinquish the
McDonald Street property and relocate his business to the
Lawrence Drive property. In the following year, petitioner
transferred title to the Lawrence Drive property, subject to a
reacquisition agreement--the Exchange Agreement--not to a third-
party exchange facilitator, but to WLC, the party to which he
simultaneously obligated himself to relinquish the McDonald
Street property.
In forgoing the use of a third party and doing all the
transfers with WLC, petitioner and his advisers created an
inherently ambiguous situation. The ambiguity is exacerbated by
the fact that petitioner and WLC agreed in the Exchange Agreement
that the McDonald Street property and the unimproved Lawrence
Drive property were of equal value, $142,400. So when WLC paid
petitioner $142,400--at the same time that he permanently - 21 -
relinquished the McDonald Street property to WLC--was the payment
received by petitioner from WLC the sale price of the McDonald
Street property at the December 29 closing, as respondent
determined? Or was it the deferred purchase price on
petitioner’s September 24 quitclaim transfer of title to the
unimproved Lawrence Drive property (which petitioner received
back on December 29 from WLC with the substantially completed
building that had been erected on it in the intervening 3
months), as petitioner reported?
Our approach to answering these questions is to determine
for tax purposes whether WLC became the owner of the Lawrence
Drive property during the 3-month period it held title to the
property while the building was being built on it to petitioner’s
specifications. If petitioner remained the owner of the Lawrence
Drive property during this period, petitioner could not engage in
a qualified like-kind exchange of the McDonald Street property
for the Lawrence Drive property, and the $142,400 payment
received by petitioner would be deemed the sale price of the
McDonald Street property. A taxpayer cannot engage in an
exchange with himself; an exchange ordinarily requires a
“reciprocal transfer of property, as distinguished from a
transfer of property for a money consideration”. Sec. 1.1002-
1(d), Income Tax Regs. - 22 -
WLC did not acquire any of the benefits and burdens of
ownership of the Lawrence Drive property during the 3-month
period it held title to that property. WLC acquired no equity
interest in the Lawrence Drive property. WLC made no economic
outlay to acquire the property. WLC was not at risk to any
extent with respect to the Lawrence Drive property because the
obligation and security interest it gave back on its purported
acquisition of the property were nonrecourse. WLC merely
obligated itself to reconvey to petitioner prior to yearend the
Lawrence Drive property with a substantially completed building
on it that had been built to his specifications and that pursuant
to prearrangement he was obligated to take and pay for.
The parties treated WLC’s holding of title to the Lawrence
Drive property as having no economic significance. The
transaction was not even used as a financing device. No interest
accrued or was paid on the nonrecourse note and mortgage, which
assured that petitioner would get back the Lawrence Drive
property after it had been improved. WLC had no exposure to real
estate taxes that accrued with respect to the property while WLC
held the title; all such taxes were to be paid by petitioner. No
account was to be taken under the terms of the reacquisition
agreement of any value that had been added to the property by
reason of the building constructed in the interim. The - 23 -
construction was financed by petitioner through the bank he was
accustomed to dealing with. Petitioner through his guaranty and
reacquisition obligation was at all times at risk with respect to
the Lawrence Drive property. WLC had no risk or exposure with
respect to the additional outlay of funds required to finance
construction of the building. WLC had no potential for or
exposure to any economic gain or loss on its acquisition and
disposition of title to the Lawrence Drive property.
The reality of the subject transactions as we see them is a
taxable sale of the McDonald Street property to WLC.
Petitioner’s purchase in 1992 of the Lawrence Drive property, on
which he intended to build a new facility for his business as the
replacement for his McDonald Street property, put him in the
position of arranging to improve the Lawrence Drive property, as
well as to sell the McDonald Street property. Petitioner’s prior
quitclaim transfer to WLC of title to the unimproved Lawrence
Drive property, which petitioners try to persuade us was
petitioner’s taxable sale, amounted to nothing more than a
parking transaction by petitioner with WLC, which contractually
bound itself to acquire from petitioner the McDonald Street
property that petitioner was going to relinquish permanently, as
well as to reconvey to petitioner the Lawrence Drive property as - 24 -
soon as the facility to be built thereon to his specifications
was substantially completed.
The reconveyance to petitioner of the Lawrence Drive
property was not part of an exchange by petitioner of the
McDonald Street property. That reconveyance of the Lawrence
Drive property to petitioner merely reunited in his hands the
bare legal title to the Lawrence Drive property with the
beneficial ownership therein that he had continued to hold all
along while the building that he obligated himself to pay for was
being built to his specifications.
In support of their claim that petitioner exchanged the
McDonald Street property for the improved Lawrence Drive
property, petitioners point out that the improved Lawrence Drive
property was different from the unimproved Lawrence Drive
property that he acquired in 1992 and whose title he transferred
to WLC on September 24, 1993. Petitioners state: “Petitioners
sold unimproved land (and reported the transaction) and in the
exchange got back improved real estate they could continue their
business operation in.” It’s true that unimproved property and
improved property are different from each other; they are not
“similar or related in service or use” for the purpose of the
section 1033 rollover provision. See sec. 1.1033(a)-2(c)(9),
Income Tax Regs. However, the transformation of the Lawrence - 25 -
Drive property while title was parked with WLC does not gainsay
our conclusion. In substance, petitioner never disposed of the
Lawrence Drive property and remained its owner during the 3-month
construction period because the transfer of title to WLC never
divested petitioner of beneficial ownership.
Having set forth our analysis and conclusion, we now address
the authorities cited by petitioners6 as favoring their position
or as being distinguishable.
Authority in the Court of Appeals for the Seventh Circuit
The only case in the Seventh Circuit--the circuit to which
any appeal would lie in the case at hand--that the parties have
6 Petitioners contend that their advisers relied on two private letter rulings in structuring the subject transactions: Priv. Ltr. Rul. 78-23-035 (Mar. 9, 1978), which they characterize as “nearly identical to the facts in our case”, and Priv. Ltr. Rul. 91-49-018 (Sept. 4, 1991), which they cite as “virtually directly on point (even goes farther than our case) on how a transaction can be structured”. Petitioners’ contentions are unavailing; not only does sec. 6110(j)(3) provide that private letter rulings cannot be cited as precedent, but, unlike the case at hand, the other party to the transaction in both private letter rulings had the risks of ownership during the relevant time period. Similarly, Rev. Rul. 75-291, 1975-2 C.B. 333, and Rev. Rul. 77-297, 1977-2 C.B. 304, cited in Priv. Ltr. Rul. 78- 23-035, don’t help petitioners; not only does this Court regard published rulings as having no precedential value, see Estate of Lang v. Commissioner, 613 F.2d 770, 776 (9th Cir. 1980), affg. on this issue 64 T.C. 404, 406-407 (1975); Intel Corp. & Consol. Subs. v. Commissioner, 102 T.C. 616, 621 (1993); Stark v. Commissioner,86 T.C. 243, 250-251 (1986), but the facts of both rulings, like Priv. Ltr. Rul. 91-94-018 (Sept. 4, 1991), are distinguishable from the case at hand in the same dispositive respect. - 26 -
brought to our attention is Bloomington Coca-Cola Bottling Co. v.
Commissioner, 189 F.2d 14 (7th Cir. 1951), affg. a Memorandum
Opinion of this Court dated Aug. 10, 1950. Petitioners try to
distinguish the Bloomington Coca-Cola Bottling Co. case, but we
find it highly instructive.
The taxpayer had originally reported the transaction in
issue as a sale at a loss in the year it occurred, 1939, but
contended--for 1943 and 1944 excess profits tax purposes--that
the transaction had been an exchange under the statutory
predecessor of section 1031(a) in which no loss had been
recognized. The taxpayer’s change in position was attributable
to its desire not to reduce its excess profits tax base.
The taxpayer had outgrown its old bottling plant and hired a
contractor to erect a new plant, on the taxpayer’s land, at an
agreed cost of $72,500. Included in the consideration paid by
the taxpayer to the contractor was the old bottling plant and the
parcel of land on which it was located, at an agreed value of
$8,000, plus cash of $64,500. The taxpayer reported on its 1939
income tax return a loss of approximately $23,000 on the sale of
the old plant.
As this Court pointed out in its Memorandum Opinion: “Here
the contractor was not the owner of the land upon which the new
building was constructed, never owned the new building, and never
conveyed the new building to the petitioner”. - 27 -
The Tax Court held--and the Court of Appeals affirmed--that
the transaction was in effect the purchase of a new facility, and
not an exchange of unimproved property for improved property,
inasmuch as the taxpayer already owned the land on which the new
plant was constructed. The contractor could not be a party to an
exchange with the taxpayer because the contractor was never the
owner of the property that the taxpayer received in the so-called
exchange. The contractor was merely acting as a service provider
in the construction of the new plant. The only real property to
which the contractor acquired title was the land and old plant
that it received as part payment for the construction services it
provided.
The subject transactions are similar to those in Bloomington
Coca-Cola Bottling Co. v. Commissioner, supra, in significant
respects. The taxpayer sold its old bottling plant (petitioner
sold the McDonald Street property) to the only other party it was
dealing with, the contractor (WLC). The taxpayer hired a
contractor to build a new facility on land that it owned. In the
case at hand, petitioner’s conveyance of title to the unimproved
Lawrence Drive property and the conveyance of that property back
with a substantially completed building on it are to be
disregarded; WLC never acquired any of the benefits and burdens
of ownership of the Lawrence Drive property. WLC acquired no
equity or beneficial interest in the Lawrence Drive property, no - 28 -
risk of loss or opportunity for gain, no exposure to real estate
taxes or other carrying charges, no liability even for interest
on its nonrecourse secured obligation during the interim period.
All we are left with, as in Bloomington Coca-Cola Bottling Co.,
is that a building was built for petitioner according to his
specifications on land that he owned and petitioner was obligated
to pay for that building. The taxpayer in Bloomington Coca-Cola
Bottling Co. and petitioner also sold their old property to the
party with whom they dealt in connection with the building of the
new facility.7
Authorities Relied on by Petitioners
We now turn to the cases petitioners rely on to support
their contention that petitioner exchanged the McDonald Street
property for the substantially improved Lawrence Drive property:
J.H. Baird Publg. Co. v. Commissioner, 39 T.C. 608 (1962); Coupe
7 We have found no other like-kind exchange cases in the Seventh Circuit that bear on the issue in the case at hand. However, another Seventh Circuit case worth noting is Patton v. Jonas, 249 F.2d 375 (7th Cir. 1957), which applies the same analysis as the line of Sixth Circuit cases culminating in First Am. Natl. Bank of Nashville v. United States, 467 F.2d 1098 (6th Cir. 1972), which hold that “repo” transactions in tax-exempt bonds are to be treated as secured loans so that the purchaser in form is treated as a lender not entitled to exclude the tax- exempt bond interest from its income; this is because the original seller remains the owner of the bonds for tax purposes. See also Green v. Commissioner, 367 F.2d 823, 825 (7th Cir. 1966), affg. T.C. Memo. 1965-272; Commercial Capital Corp. v. Commissioner, T.C. Memo. 1968-186. Compare Rev. Rul. 74-27, 1974-1 C.B. 24 (repurchase obligation) with Rev. Rul. 82-144, 1982-2 C.B. 34 (separately purchased and paid-for put). - 29 -
v. Commissioner, 52 T.C. 394, 409-410 (1969); 124 Front Street,
Inc. v. Commissioner, 65 T.C. 6 (1975); Biggs v. Commissioner, 69
T.C. 905 (l978), affd. 632 F.2d 1171 (5th Cir. 1980); Fredericks
v. Commissioner, T.C. Memo. 1994-27.
We preface our review of these cases by acknowledging that
they all reflect, to some degree, the liberal interpretation in
favor of taxpayers that this Court and other courts have applied
in cases under section 1031(a)(1). We also observe that none of
these cases concerned a reverse exchange and that all of them are
highly fact specific and therefore distinguishable from the case
at hand. Petitioners have read these cases selectively,
emphasizing in each of them what the taxpayer got away with. In
so doing, petitioners have lost sight of the cumulative adverse
effect on their position of all the facts in the case at hand,
which have led to our conclusion that WLC never acquired
beneficial ownership of the Lawrence Drive property. It would
therefore be a sterile exercise to engage in a detailed
recitation of the facts of these cases and a point-by-point
refutation of their applicability to the case at hand. A couple
of highlights from J.H. Baird Publg. Co. v. Commissioner, supra,
will suffice.
Petitioners try to make something of the fact that the Court
in J.H. Baird Publg. Co. v. Commissioner, 39 T.C. at 618,
distinguished Bloomington Coca-Coca Bottling Co. v. Commissioner, - 30 -
189 F.2d 14 (7th Cir. 1951), on the ground that “It was clear
that the contractor did not own the other property which, it was
claimed, was transferred to the taxpayer in the exchange.” As
already indicated, we have found dispositive in the case at hand
that WLC never acquired beneficial ownership of the Lawrence
Drive property.8 WLC merely served as an accommodation party,
providing the parking place for legal title to the Lawrence Drive
property, while petitioner remained the beneficial owner before
and after and throughout the 3-month focal period of the subject
transactions.
When petitioner conveyed to WLC title to the Lawrence Drive
property, WLC became contractually bound to reconvey it, and
petitioner was bound to take it back, prior to yearend (not much
more than 3 months). Indeed, under Wisconsin law, both parties
were entitled to specific performance of the other party’s
obligation. See Anderson v. Onsager, 455 N.W.2d 885 (Wis. 1990);
Heins v. Thompson & Flieth L. Co., 163 N.W. 173 (Wis. 1917).
It’s difficult to imagine commitments more binding than the
reciprocal obligations of petitioner and WLC in the case at hand.
The conveyance and reconveyance of title to the Lawrence Drive
8 We also observe that J.H. Baird Publg. Co. v. Commissioner, 39 T.C. 608, 618 (1962), on which petitioners rely, applied the concept of beneficial ownership in the taxpayer’s favor. Petitioners have failed to persuade us that the concept of beneficial ownership is an illegitimate importation into the tax law of qualified like-kind exchanges. - 31 -
property must be disregarded as having no tax significance
because, at the end of the day, petitioner ended up where he
started, with title to and beneficial ownership of the Lawrence
Drive property.9
Computational Questions
Petitioners point out that respondent’s deficiency notice,
which made an upward adjustment of $82,569 in long-term gain
realized and recognized by petitioners on the disposition of the
McDonald Street property, which we have found to be the actual
sale, failed to back out the short-term gain of $5,373 that
petitioners reported on the transfer of title to the unimproved
Lawrence Drive property. Petitioners’ point is well taken. It
should be addressed in the Rule 155 computation.
Similarly, other matters not completely resolved, such as
the calculation of additional costs paid by petitioner in
connection with the sale of the McDonald Street property, as well
as his adjusted basis in that property, should be addressed in
the Rule 155 computation of the gain on the sale.
Penalty Question
The subject transactions were structured by petitioner’s
accountant and attorneys after petitioner presented them with the
9 In so doing, the subject transactions satisfy the requirements for application of what the Court of Appeals for the Seventh Circuit has characterized as the most restrictive and rigorous version of the step-transaction doctrine: the binding commitment test. McDonald’s Restaurants, Inc. v. Commissioner, 688 F.2d 520, 525 (7th Cir. 1982), revg. 76 T.C. 872 (l981). - 32 -
accomplished fact of his purchase of the Lawrence Drive property.
Petitioners’ 1993 income tax return, prepared by petitioner’s
accountant, reported a taxable short-term gain of $5,373 on the
sale of “investment land” and reported a like-kind exchange of
“land and building” for “land and building” on Form 8824. The
disclosures were bare bones but adequate to trigger the audit
that led to the deficiency notice and the case at hand.
Respondent determined that petitioners were liable for an
accuracy-related penalty under section 6662(a) and (b)(1) or (2).
Section 6662(a) imposes a 20-percent accuracy-related penalty on
the portion of an underpayment that is due to one or more causes
enumerated in section 6662(b). Respondent relies on subsections
(b)(1) (negligence or intentional disregard of rules or
regulations) or (b)(2) (substantial understatement of income
tax).
Petitioners argue they are not liable for the penalty.
Petitioners point out that a certified public accountant outlined
the subject transactions as they were carried out and prepared
their return and that the deal was structured and the papers
drawn by petitioners’ attorneys. Petitioners contend that they
reasonably relied on professional advice in the preparation of
their return and that they are entitled to relief under the
exceptions that apply to a substantial understatement.
Negligence includes a failure to attempt reasonably to
comply with the Code. See sec. 6662(c). Disregard includes a - 33 -
careless, reckless, or intentional disregard. See id.
Negligence is the failure to exercise due care or the failure to
act as a reasonable and prudent person. See Neely v.
Commissioner, 85 T.C. 934, 947 (1985).
No penalty is imposed for negligence or intentional
disregard of rules or regulations or a substantial understatement
of income if the taxpayer shows that the underpayment is due to
reasonable cause and the taxpayer’s good faith. See sec.
6664(c); secs. 1.6662-3(a), l.6664-4(a), Income tax Regs.
Reasonable cause requires that the taxpayer have exercised
ordinary business care and prudence as to the disputed item. See
United States v. Boyle, 469 U.S. 241 (1985); see also Estate of
Young v. Commissioner, 110 T.C. 297, 317 (1998). The good faith,
reasonable reliance on the advice of an independent, competent
professional as to the tax treatment of an item may meet this
requirement. See United States v. Boyle, supra; sec. 1.6664-
4(b), Income Tax Regs.; see also Richardson v. Commissioner, 125
F.3d 551 (7th Cir. 1997), affg. T.C. Memo. 1995-554; Ewing v.
Commissioner, 91 T.C. 396, 423 (1988), affd. without published
opinion 940 F.2d 1534 (9th Cir. 1991).
Whether a taxpayer relies on advice and whether such
reliance is reasonable depend on the facts and circumstances of
the case and the law that applies to those facts and
circumstances. See sec. 1.6664-4(c)(i), Income Tax Regs. A
professional may render advice that may be relied upon reasonably - 34 -
when he or she arrives at that advice independently, taking into
account, among other things, the taxpayer’s purposes for entering
into the underlying transaction. See sec. 1.6664-4(c)(i), Income
Tax Regs.; see also Leonhart v. Commissioner, 414 F.2d 749 (4th
Cir. 1969), affg. T.C. Memo. 1968-98. Reliance is unreasonable
when the taxpayer knew, or should have known, that the adviser
lacked the requisite expertise to opine on the tax treatment of
the disputed item. See sec. 1.6664-4(c), Income Tax Regs.
In sum, for a taxpayer to rely reasonably upon advice so as
possibly to negate a section 6662(a) accuracy-related penalty
determined by the Commissioner, the taxpayer must prove that the
taxpayer meets each requirement of the following three-prong
test: (1) The adviser was a competent professional who had
sufficient expertise to justify reliance, (2) the taxpayer
provided necessary and accurate information to the adviser, and
(3) the taxpayer actually relied in good faith on the adviser’s
judgment. See Ellwest Stereo Theatres, Inc. v. Commissioner,
T.C. Memo. 1995-610; see also Rule 142(a).
We conclude on the record before us that petitioners
actually relied in good faith on disinterested professional
advisers who structured the transactions and prepared their
return. Petitioners were justified in their reliance,
notwithstanding that we have upheld respondent’s determination - 35 -
that the subject transactions did not qualify as a like-kind
exchange of the Lawrence Drive property. Accordingly, we hold
for petitioners on the penalty issue.
To give effect to the foregoing,
Decision will be entered
under Rule 155.