Vidican v. Commissioner

                       UNITED STATES TAX COURT

The Commissioner determined deficiencies in petitioners' income tax in the following amounts:

           Year                  Deficiency

Findings of Fact

Petitioners, now divorced, were husband and wife during the tax years 1962-1964, and filed joint income tax returns for each of those years with the district director of internal revenue at Los Angeles. At the time the petition herein was filed the husband's address was P.O. Box 1235, Arcadia, California, and the wife's address was 366 Fairview Avenue, Arcadia, California.

Petitioner John Vidican ("Vidican") was licensed as a general contractor and was also licensed as a plumbing contractor, heating contractor and air conditioning contractor. For a period of a number of years beginning around 1950 and continuing through 1964, Vidican would acquire land, and, as general contractor, would build a small apartment house thereon. Generally, he and his family would move into one of the apartments. After the remaining apartments were rented, he would sell the completed property at a substantial profit, and then move into another apartment building constructed by him which had only recently been completed.

Vidican's first venture into a somewhat similar type of operation occurred prior to 1950 and involved a motel rather than an apartment building. It was located on Washington Boulevard in Los Angeles. Vidican, as general contractor, built the motel in partnership with his father-in-law, Louis Mesaros. Both the Vidican and Mesaros families lived in the motel. It was sold in 1949.

The following table sets forth certain information with regard to all of the apartment buildings built and owned by Vidican (including the ones involved herein) in the years 1950-1964:

                                          Date land        Date of

                                        Number of   Date of   Date of

The properties involved in the present case were located at 1122 and 1124 Huntington Drive and 763 Arcadia Avenue - all in Arcadia, California. The land relating to all three of these properties was purchased in December, 1959. The land at 1122 was purchased by Mrs. Vidican's parents and the other two parcels by Vidican. Vidican as general contractor completed construction of a 12-unit apartment building on each of the three parcels in the spring of 1961. As set forth in the table above, the buildings on the Huntington Drive properties were completed on April 10, and the building on Arcadia Avenue was completed on May 17.

Some attempts were made to rent the apartments in the three buildings, but only four or five apartments in each building were rented. One apartment unit at 763 Arcadia was rented throughout the years in issue. Attempts to sell the entire properties as units were unsuccessful. On June 12, 1961 Vidican purchased the interest of his parents-in-law in 1122 Huntington Drive.

He had meanwhile become aware of the condominium laws of California, and sought and obtained permission to sell the apartment units on an individual basis. ¹ This enabled him to sell individual unrented apartments without the necessity of attempting to rent them as would be the case if he were to obtain the best price upon sale of the apartment house as a whole. The application for permission to sell separate apartment units with respect to 1124 Huntington Drive was dated August 30, 1961, and permission was granted October 18, 1961. The application for 1122 Huntington Drive was dated December 6, 1961, and permission was granted February 9, 1962. Similar data with respect to the Arcadia Avenue property do not appear in the record. Vidican advertised these units for sale in local newspapers; an advertisement for 1122 Huntington Drive appeared in a newspaper dated November 11, 1961. The newspaper advertisements contained two telephone numbers; one was for the Vidicans' apartment at 763 Arcadia, and the other was for an office maintained by Vidican and Mesaros in one of the apartment buildings; the advertisements further gave specified office hours.

The following table shows the number of units sold and the gain realized thereon as reported on petitioners' return and undisputed by the Commissioner:

                                  Year     No. of Units       Gain

  Year       Net Income      Dividends      Interest      Net rental

On their joint returns petitioners took the following depreciation deductions with regard to the apartment units in question:

 Year             Properties         Building   Furnishings    Total

In the amendment to their petition, petitioners stated in part:

Respondent has erroneously failed to give credit for depreciation for the years 1962, 1963 and 1964 in the year of sale of the depreciable assets. * * *

* * * It is contended that under the proper interpretation of the provisions of the Internal Revenue Code, depreciation should have been allowed on the depreciable assets for the year of sale.

Opinion

RAUM, Judge: 1. Capital gain v. ordinary income. - During the years in issue, petitioners sold 33 apartment units and realized a total gain of $197,717.63, which they reported as capital gain on their income tax returns for those years. The Commissioner determined that the gain constituted ordinary income. The issue turns on the much -litigated question of whether an item sold is a "capital asset" (as urged by petitioners) or "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business" (as urged by the Commissioner) within the meaning of section 1221. If the apartment units were capital assets, the treatment of gain realized upon their sale is governed by sections 1201 and 1202. If not, the gain represents ordinary income under section 61.

The question is entirely factual, so that each case must be examined in light of its own peculiar circumstances. S. O. Bynum, 46 T.C. 295, 299. While the courts have examined many factors in these cases (see, e.g., Robert W. Pointer, 48 T.C. 906, 915-916), no one factor is determinative. Ralph J. Oace, 39 T.C. 743, 747. For property to be held primarily for sale to customers in the ordinary course of the taxpayer's trade or business, it must be held principally for such purpose. Malat v. Riddell, 383 U.S. 569.

It would serve no useful purpose in this case to indulge in a detailed analysis of all the factors involved or of the many cases in this area. While there are certain factors here that might support the position of each party, it is our conclusion on the balance of all the evidence, and we so find as a fact, that the apartment units sold were held primarily for sale to customers in the ordinary course of petitioners' trade or business. From 1950, Vidican followed a pattern of purchasing land, constructing an apartment building thereon, moving into the building with his family (in most cases), renting apartments until the building was full, and finally selling the property. These ventures were often undertaken in conjunction with his father-in-law. Taken together, these activities constitute a trade or business on the part of Vidican of building and selling apartment properties. With respect to the three properties involved in this case, Vidican sold individual apartments, but his business was essentially that of building and selling the completed properties. The particular method chosen was merely the one thought to be the most advantageous in the circumstances.

An analysis of the petitioners' income form 1957-1964 shows clearly that they relied on the sale of apartment properties rather than on rentals for the great bulk of their income. The rental activities in fact reflected losses, often substantial, for most of those years. Vidican's contracting activities, apart from the construction of his own apartment buildings, appear to have been comparatively negligible, and the remainder of petitioners' income virtually all arose from passive investments (primarily in securities) . Vidican's trade or business from 1950 through the years in issue was that of building and selling apartment properties.

His activities with regard to the three properties here involved support this position. The three buildings were completed in April and May of 1961, and by the end of August 1961 Vidican had applied for permission to sell the apartment units at 1124 Huntington Drive. The apartments at 1122 Huntington Drive were advertised for sale as condominiums even before application for permission to make such sales had been made. Vidican and his father-in-law maintained an office and regular office hours to handle the condominium sales.

Petitioners argue that the three properties were sold only because of difficulties in renting the apartment units and that they were merely "liquidating" an unprofitable investment. Petitioners' pattern of conduct over a number of years, however, was to rent apartments until full and then to sell the entire property. Their rental activities produced losses in most years, and it is clear that petitioners relied on sales rather than on rentals to produce income. In the case of the three properties here involved, the difficulty in renting may have determined the method of sale - i.e., sale of individual apartments rather than sale of the entire only when fully rented. It is noteworthy that only three or four months elapsed between the completion of the buildings and the first application for permission to sell condominiums.

Petitioners further argue that the sales of the first seven apartment buildings were occasioned by personal reasons, such as a desire to be closer to schools, problems with damp climate, difficulties with a swimming pool, a desire for larger quarters, and business problems between Vidican and his father-in-law. While it may be that these purposes were served by selling the properties and moving to new ones, we are convinced that they were not the motivating reasons for the sales. The sales were made to produce income and were part of a pattern.

Petitioners were in the business of building and selling apartment properties during the years in issue. This conclusion is supported both by their similar activities in the past and by their actions with regard to the apartment units here involved. These units were (with one exception above noted) held for sale to customers in the ordinary course of petitioners' trade or business, and the gain from the sales thereof must be treated as ordinary income.

2. Depreciation deductions. - On their returns for the years in issue, petitioners deducted depreciation on those apartment units at 763 Arcadia and their furnishings that had not been sold by the end of the respective years. The Commissioner disallowed these deductions on the ground that the apartments were held primarily for sale, but at trial conceded that deductions for the one apartment unit at 763 Arcadia rented throughout the years in issue were improperly disallowed. In an amendment to their petition, petitioners claimed depreciation deductions for the properties in the year of sale.

Section 167(a) provides for the allowance "as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence) -

     (1) of property used in the trade or business, or

Furthermore, even if the apartment units were held for purposes that would make depreciation deductions in general proper, we think that in the circumstances here involved the doctrine of Massey Motors Inc. v. United States, 364 U.S. 92, would preclude the depreciation deductions claimed in petitioners' returns and amended petition. In Massey Motors, the Supreme Court said (p. 93):

     We have concluded that the reasonable allowance for depreciation

Moreover, under a system where the real salvage price and actual duration of use are relevant, to further insure a correct depreciation base in the years after a mistake has been discovered, adjustments may be made when it appears that a miscalculation has been made.

In the present case, at least by the beginning of 1962, it was apparent both that the useful lives of the buildings and furnishings in petitioners' hands were not going to be 33 1/3 and 10 years, respectively, and that, far from being nothing, the "salvage" ³ value, or resale price, of the buildings and furnishings was going to be in fact far in excess of their cost. Petitioners were required to use this salvage value in computing depreciation, and, while the sale price might not have been precisely determinable, it was clear that it would exceed the cost of the property. Thus no amount would be allowable as a depreciation deduction.

Nothing in the Supreme Court's opinion in Fribourg Navigation Co. v. Commissioner, 383 U.S. 272, is contrary to this result. That case expressly reaffirmed the holding of Massey Motors. See 383 U.S. at 277. Fribourg involved a case where the original estimates of useful life and salvage value were reasonable when made, but where the asset involved was sold for a large gain because of an unexpected sudden and dramatic rise in the market. At the time the asset was acquired, the sale was not anticipated. The Court allowed depreciation based on the original estimates of useful life and salvage value in the year of sale, but stated (p. 277):

It is, of course, undisputed that the Commissioner may require redetermination of useful life or salvage value when it becomes apparent that either of these factors has been miscalculated. The fact of sale of an asset at an amount greater than its depreciated basis may be evidence of such a miscalculation. See Macabe Co., 42 T.C. 1105, 1115 (1964). But the fact alone of sale above adjusted basis does not establish an error in allocation. That is certainly true when, as here, the profit on sale resulted from an unexpected and shortlived, but spectacular, change in the world market.

Petitioners have not shown that this case involved such an unexpected change in the market or that this case is more like Fribourg than like Massey Motors. Unlike Fribourg and Macabe Co., 42 T.C. 1105, 1109, there is nothing in the present case to show that the high salvage value (measured by the amounts obtained on sale) was attributable in any part to appreciation in value during the period that the property was held for sale - a consideration that must not affect the amount of depreciation otherwise allowable. Moreover, to the extent that Fribourg may be thought to support a deduction for depreciation in the year of sale, it is inapplicable here, because it is based upon the assumption that depreciation would otherwise be deductible in other years, an assumption that we have determined to be unfounded on the facts of this case.

Decision will be entered under Rule 50.

² Petitioners did claim a depreciation deduction for the Huntington Drive apartments on their 1961 return. The computations of gains from the sales of these apartments in subsequent years contain only the 1961 depreciation figures (in aliquot portions) under a column entitled "Depreciation allowed (or allowable)."

³ The term "salvage" as used in this connection is a euphemism. It does not refer to junk value; rather, it refers to actual resale value of property that still has a substantial remaining useful life after the intended sale by the taxpayer.