Victory Housing, Inc. v. Commissioner

Victory Housing No. 2, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent Victory Housing, Inc. v. Commissioner Docket No. 30299 United States Tax Court 18 T.C. 466; 1952 U.S. Tax Ct. LEXIS 176; June 6, 1952, Promulgated *176 Decision will be entered under Rule 50. Petitioner, a corporation engaged in the business of owning and renting defense housing, at some time early in the year 1946, decided to sell 82 of its 212 housing units. Petitioner sold the 82 houses during a 6-month period with 42 of them being sold during the fiscal year ending in 1946. Held, the houses sold by petitioner during the fiscal year 1946 were property held primarily for sale to customers in the ordinary course of business, and the gain realized by petitioner was taxable as ordinary income and not as capital gain. Held, further, that a house sold by petitioner during its fiscal year 1945, prior to its decision to dispose of its single family units, was not property which was being held primarily for sale in the ordinary course of its business and petitioner's gain from the sale of this house is taxable as capital gain and not as ordinary income. Carl T. Smith, Esq., for the petitioner. Marvin E. Hagen, Esq., for the respondent. Black, Judge. Murdock, J., dissenting. Rice, J., agrees with this dissent. BLACK *466 This proceeding involves deficiencies in taxes in the amounts and for the fiscal years as follows: *467 Declared value Excess profits Year ended Income tax excess-profits tax tax June 30, 1944 $ 179.45 $ 78.42 June 30, 1945 5,696.51 2,474.01 June 30, 1946 8,593.62 $ 19,477.15 Three issues were raised in the pleadings. Two of these have been disposed of and the adjustments will be given effect under Rule 50. The sole issue for decision is whether the gains realized by petitioner from the sale of houses during the taxable years are taxable as ordinary income or as a long term capital gain. FINDINGS OF FACT. The petitioner Victory Housing No. 2, Inc., was incorporated under the laws of Kansas on October 16, 1942. It filed its corporation income and declared value excess-profits tax returns and excess profits tax returns for the fiscal*178 years ended June 30, 1944, 1945, and 1946, with the collector of internal revenue for the district of Kansas. Petitioner's incorporators were Charles W. Pence, Lige E. Watson, Frank M. Kessler, and Herbert W. Kessler. The incorporators were also the principal stockholders of the petitioner's capital stock of which $ 2,500 was outstanding during the taxable years. Charles W. Pence was president and Frank M. Kessler was secretary-treasurer of the corporation. Each of these officers received a salary of $ 150 per month during the fiscal year ended June 30, 1945, and $ 300 per month during the fiscal year ended June 30, 1946. During the period from 1923 to 1945, Charles W. Pence and Lige E. Watson were partners in the real estate business and in the business of constructing and selling houses in Wichita, Kansas, operating under the firm name of "Watson & Pence." The firm of Watson & Pence bought and sold real estate but it did not buy real estate for investment. The firm built and sold 50 to 75 houses during the period 1926 to 1930, two buildings and one house during the period 1930 to 1934, and approximately 200 houses during the period from 1935 to 1942. Charles W. Pence for a 30-year*179 period, including the years in question, has engaged in the real estate business and the business of constructing and selling houses in Kansas. During the taxable year ended June 30, 1946, and for many years prior thereto Charles W. Pence was a member of the Real Estate Appraisal Board in Wichita, Kansas. Herbert W. Kessler and Frank M. Kessler are brothers. They were during the taxable year ended June 30, 1946, and for many years prior thereto engaged in the lumber business in Wichita, Kansas, which business was known as the Kessler Lumber and Supply Company. *468 During the year 1942, Herbert W. Kessler and Frank M. Kessler built and sold houses located on a 10-acre tract west of Wichita. With the advent of World War II there was an expansion in industry and in the manufacture of airplanes in the vicinity of Wichita. The population of that city increased from about 140,000 in 1940 to approximately 180,000 in 1942 and, as a result, there was an urgent need for new housing facilities in Wichita for migrant workers and their families. During the early part of 1942, Charles W. Pence met with representatives of the Federal Housing Administration and they discussed the possibility*180 of building under Title VI of the National Housing Act housing units in Wichita for rental to defense workers. The officials of F. H. A. explained that they would guarantee a 90 per cent loan on a defense housing project. Subsequently, in July 1942, Pence discussed the matter with Herbert Kessler and Frank Kessler, both of Wichita, and they decided to form a corporation for the purpose of entering into the business of constructing rental houses for defense workers. The purposes for which petitioner was incorporated, as stated in its charter, were: FIFTH: This Corporation is organized FOR profit and the nature of its business is: To hold, purchase, acquire, sell, convey, lease, mortgage, and dispose of property real or personal, tangible or intangible, including its rights and franchises; to construct buildings, erect dwelling houses, apartments and buildings of all types and kinds and to acquire, purchase, hold, lease, convey mortgage and pledge real and personal property out of the State of Kansas, and to do all things necessary and incidental to such businesses. The private property of the stockholders shall not be subject to the payment of the debts of the corporation. In order*181 to obtain materials for the building of houses, petitioner filed with the Office of Production Management on March 15, 1943, an application for priorities for materials to be used in the construction of 64 single family dwelling houses. In the application petitioner estimated the total cost of completing the project would be $ 256,000 and the application was approved on March 17, 1943. Also priorities previously issued to the firm of Watson & Pence on another defense housing project were assigned to petitioner. During the war years the National Housing Agency (hereinafter referred to as NHA) issued certain general orders, the first of which was NHA General Order No. 60-3, effective February 5, 1943, which was subsequently amended from time to time. This order, as amended, provided that petitioner was required to rent the houses here involved at rentals authorized by NHA and, further, to rent only to authorized war workers. This order, as amended, further provided that the *469 war worker tenant could purchase the house after a minimum period of 4 months, later reduced to 2 months, on specified terms and, at any time subsequent to 60 days after completion of such housing the*182 owner of such housing could petition the NHA to permit such housing to be disposed of otherwise than as provided in subsection 3.01 of General Order No. 60-3. The building materials for both the single and multiple dwelling houses were purchased from the Kessler Lumber Company of Wichita, Kansas, and the amount of $ 100 per house was paid to Watson & Pence as general contractors in connection with the construction of these houses. The average cost of the individual dwellings built by petitioner was $ 3,858.42. Petitioner's investment in its business activities at June 30, 1944, was approximately as follows: Land $ 8,000 Block 4 -- apartments 163,600 51 houses -- Country Club Heights 192,500 32 houses -- Country Club Heights 120,800 Blocks 2 and 3 -- apartments 164,100 Furnishings 31,600 Other assets 35,600 Total assets 716,200 Included in the land investment of petitioner as of June 30, 1944, are 118 vacant lots located in the same subdivision as the single family houses. Also the west one-half of Block 2 and the west one-half of Block 3, Beverly Terrace, were vacant. The latter land, two parcels, was located near petitioner's apartments. The construction*183 of the houses was financed by loans from United Building & Loan Company of Wichita, Kansas, which were guaranteed up to 90 per cent of appraised value by the F. H. A. under Title VI of the National Housing Act. The unpaid balance of the petitioner's mortgages at June 30, 1944, was $ 701,398.45. At the time of entering into business Charles Pence and Herbert Kessler loaned the corporation $ 30,000 but petitioner repaid these loans after a short time. It was first planned that petitioner was to build and rent 48 buildings with four apartments in each building, that is, a total of 192 family rental units in Wichita. Shortly after the project got underway with 32 of these buildings then constructed, the Government officials advised the petitioner that they were in need of one family houses. They explained that the defense workers were moving to Wichita with their families and they preferred individual houses with yards for the children to play in. So, at the request of the Government *470 officials, of the housing units originally planned, 64 were constructed as single houses. In view of the housing needs in Wichita petitioner was authorized to build and did build an additional*184 20 single houses, making a total of 84 single houses erected by petitioner. During the calendar years 1943 and 1944, petitioner built a total of 212 dwelling units of which 84 were single dwellings and 128 units were contained in 32 four-family apartment houses. Upon completion of the houses all of them were rented upon an oral month-to-month tenancy to defense workers for rentals of $ 43.49, $ 46.49, and $ 53.50. The houses were rented at the rates specified in the petitioner's application which had been approved by the Office of Production Management. During the fiscal year ending in 1944, petitioner sold a single dwelling house to Harvey Huxel, who was District Housing priorities manager, for $ 3,845.93. This house which was sold at a loss was sold upon completion. During the fiscal year ending in 1945, petitioner sold a second house for $ 4,874.12 to two women, one of whom was employed by Boeing Aircraft Company. They had purchased the furniture of their landlord, the petitioner's tenant, and wanted to buy the house. Permission to do so was given by the War Production Board. In October of 1945, by order of the War Production Board and the National Housing Agency, all controls*185 and restrictions as to occupancy and disposition of war housing such as the houses herein involved were terminated. Following the termination of World War II, the city of Wichita increased in population and the housing situation became even more critical. Veterans returning from the service found it difficult to obtain housing. The demand for houses in Wichita was very great and in 1946 there was a "seller's market." Frank Kessler had served in the United States Navy and was released from active duty in December 1945. In January 1946, he suggested to the other officers and stockholders of the corporation that the houses should be sold to returning veterans. Pence, the president of petitioner, desired that petitioner keep the houses and Frank Kessler's suggestion was not adopted at that time. Shortly thereafter, however, it was decided that petitioner's one unit dwellings should be sold. The exact date when this decision was reached is not shown in the record but it was sometime early in 1946. Petitioner's officers contacted the tenants individually and notified them that the houses were for sale but that returning veterans would be given preference. Petitioner secured appraisals*186 from the Veterans Administration on its houses and they were sold in accordance with the appraisal prices. The remaining 82 houses owned by petitioner were sold as follows: *471 Period Sale price Number sold $ 5,313.95 [1] 5,315.75 [1] April 10, 1946, to June 30, 1946 5,316.15 [18] 5,503.95 [1] 5,506.15 [21] July 6, 1946, to October 1, 1946 Various [40] Total [82] After the first houses in question were sold during the months of April and May 1946, numerous veterans who were trying to obtain housing contacted Frank M. Kessler at the office of Kessler Lumber Company. He notified the veterans that the houses involved were for sale and suggested they contact the real estate office of Watson & Pence. Charles W. Pence conducted the sales negotiations with the purchasers of the houses in the real estate office and the real estate firm received a 5 per cent commission on the sale of each house for Pence's efforts in selling and negotiating the sale of the 42 houses. Previously Pence's office had been collecting the rents when they were due and for this service it had received nothing. For this reason the stockholders felt that these commissions should *187 be paid the firm for handling the sales transactions. During the fiscal year ended June 30, 1946, approximately seventy per cent of the houses were sold to veterans, approximately twenty per cent to tenants, and ten per cent to other people. Petitioner sustained losses and realized net income from its rental business (excluding gains from the sale of houses) as follows: Fiscal year ended Net per tax return As corrected June 30, 1944 ($ 8,021.71) ($ 847.53) June 30, 1945 (13,290.31) 15,754.06 June 30, 1946 (30,805.21) 1,205.37 The net profit from the sale of 42 houses during the fiscal year ended June 30, 1946, amounts to more than $ 65,000 but less than $ 80,000. 1 Petitioner collected rents in the following amounts: Fiscal year ended Amount June 30, 1944 $ 44,386.65 June 30, 1945 113,403.49 June 30, 1946 109,011.33 *188 For the fiscal year ended June 30, 1945, petitioner reported as long term capital gain the profit from the sale of one house in the amount of $ 735.09. Respondent determined that the gain on such house was $ 748.76 and was taxable as ordinary income for the reason that the *472 property was held "primarily for sale to customers in the ordinary course of your trade or business." For the fiscal year ended June 30, 1946, petitioner reported as long term capital gain the profit from the sale of 42 houses in the amount of $ 79,481.57. Respondent determined that the gain should be decreased to $ 66,295.82 and that such reduced amount was taxable as ordinary income for the reason that the houses were held "primarily for sale to customers in the ordinary course of your trade or business." The petitioner during the fiscal years ending June 30, 1944, June 30, 1945, and June 30, 1946, was engaged in the owning and renting of residential real estate and also for a part of its fiscal year ending June 30, 1946, was engaged in the business of selling real estate, namely, its single family residential units. It did not in any of the taxable years here involved sell or offer for sale any of*189 its four family apartment dwellings. It continued to hold these for rental and investment purposes. The one house which petitioner sold in its fiscal year ending June 30, 1945, was not held at the time sold or at any time prior thereto primarily for sale to customers in the ordinary course of its business. The 42 houses which petitioner sold in its fiscal year ending June 30, 1946, were held primarily for sale to customers in the ordinary course of its business from some date early in the year 1946 and prior to April 10, 1946 when the first of the 42 houses here involved were sold and were so held at the time when sold. OPINION. The question in this proceeding is whether the gain from the sale of houses by petitioner during the fiscal years is taxable as capital gain as petitioner contends or as ordinary income as the respondent contends. The applicable statutes are contained in section 117(a) and section 117(j) of the Internal Revenue Code. During the taxable years before us section 117(j) (1) of the Code reads as follows: SEC. 117. CAPITAL GAINS AND LOSSES. * * * * (j) Gains from Losses from Involuntary Conversion and from the Sale or Exchange of Certain Property Used in*190 the Trade or Business. -- (1) Definition of property used in the trade or business. -- For the purposes of this subsection, the term "property used in the trade or business" means property used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 23 (l), held for more than 6 months, and real property used in the trade or business, held for more than 6 months, which is not (A) property of a kind which would properly be includible in the inventory of the taxpayer if on hand at the close of the taxable year, or (B) property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. Such term also includes timber with respect to which subsection (k) (1) or (2) is applicable. *473 In the instant proceeding there is no doubt but that the houses in question were property used in the petitioner's trade or business of a character which is subject to the allowance for depreciation on real property used in the petitioner's trade or business within the meaning of section 117(j), for the individual dwellings in question were rented by petitioner and during the taxable years deductions*191 for depreciation have been allowed on them. Thus, the general definition appearing before the two exclusions provided for in subsections (A) and (B) is satisfied. That provision of the Code continues, however, and in subsection (B) excludes from the definition of "property used in the trade or business" the property held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer's trade or business. To some extent these provisions of the Code may be overlapping, Rollingwood Corporation v. Commissioner (C. A. 9, 1951), 190 F. 2d 263. Whether or not the houses sold by petitioner satisfy the requirements of subsection (B) depends upon the fact situation, and the burden is on the petitioner to show that the houses sold during the taxable years were not held primarily for sale to customers in the ordinary course of its trade or business. In the recent case of Mauldin v. Commissioner (C. A. 10), 195 F. 2d 714, affirming 16 T. C. 698, the court said: There is no fixed formula or rule of thumb for determining whether property sold by the taxpayer was held by*192 him primarily for sale to customers in the ordinary course of his trade or business. Each case must, in the last analysis, rest upon its own facts. There are a number of helpful factors, however, to point the way, among which are the purposes for which the property was acquired, whether for sale or investment; and continuity and frequency of sales as opposed to isolated transactions. [Citing cases.] * * * The facts in the instant case seem to clearly establish that petitioner constructed these houses primarily for rental purposes and not for sale and they were so held and used until some time early in the year 1946. Therefore, we have found in our Findings of Fact that the one house which petitioner sold in its fiscal year ending June 30, 1945, was not being held primarily for sale to customers in the ordinary course of its business. The profit which petitioner realized from the sale of this house is taxable as capital gain as petitioner contends and not as ordinary income as the Commissioner has determined. As to the gain from the sale of this house, the petitioner is sustained. However, after a careful consideration and study of all the facts we are unable to make the same*193 kind of holding as to the gains which petitioner realized from the sale of the 42 single family houses during its fiscal year ending June 30, 1946. We think that the facts which were proved at the hearing of this proceeding justify our finding of fact that "The 42 houses which petitioner sold in its fiscal year ending June 30, 1946, were held primarily for sale to *474 customers in the ordinary course of its business from some date early in the year 1946 and prior to April 10, 1946 when the first of the 42 houses here involved were sold." In the course of the testimony of petitioner's witness Charles E. Pence the following questions and answers occur: Q Do you recall having a discussion with Mr. Frank Kessler concerning these houses along the latter part of 1945 or the first of 1946? A Yes; we had quite a little discussion on them. Q Where did that discussion take place? A When we were at lunch a couple of times and over to the lumber yard two or three times. Q Will you state what you might have said at these times you refer to and what Mr. Kessler said? A Well, about that time we had many returned veterans in our office who wanted to buy houses. You couldn't hardly build houses*194 in 1946; it was getting pretty rough. A lot of those boys would accuse us of sitting around while they were in the war. They wanted to buy houses. It struck me with possible advancing market conditions -- Mr. Hagen: If the Court please, respondent objects to this line of testimony on the grounds it is speculative, also not responsive to the question. The Court: I overrule the objection. A Frank kind of insisted we had better begin letting them have them. They wore me down. I felt like the Government had given them a pretty good chance for a cheap investment; but I would rather have kept them all that period of time. Petitioner's witness Frank M. Kessler who is a stockholder and treasurer of petitioner and who was released from the Navy January 10, 1946, testified in part as follows: Q Shortly after your return home was there some conversation between you and the other stockholders and officers regarding the houses which are in controversy? A Yes, sir. Q What was the nature of that? Just tell the Court. A We had conversations in the early part of January as to the properties which were owned by Victory Housing No. 2, and at that time I expressed my opinion to the stockholders*195 that it would appear to me that from all I could read the newspapers on my return from overseas, that veterans were having a pretty rough time getting housing; and in my opinion Victory Housing should change its policy as to the ownership of these houses and should make it possible for them to be owned by veterans returning from Service. At that time my opinion in the matter was overruled by the other stockholders, but at subsequent meetings which were held -- not regular stockholders meetings, but meetings between my brother and myself and Pence; the three of us controlled the majority of the stock in the corporation. We periodically had lunch together -- apparently I was able to drive my point home to the other stockholders that we had performed a service to the country in building these, this war housing during the war, we had fulfilled our obligations to the Federal Housing. Now we had a further obligation and that was to provide veterans returning with housing. And the reason that that was more firmly driven home to me and perhaps my arguments with my partners or with my -- the other members *475 of the corporation were more effective was by reason of the fact, Your Honor, *196 that when I left for service my job in the lumber yard was pure and simple selling. When I came back, my terminal leave was over and I got back in the business, I found I was no longer a salesman. We had nothing to sell. It was impossible to get building material; it was impossible to build houses. And we began to feel that, contrary to popular conception, that Wichita would be the No. 1 "bus town" during the rapid increase in population during the war. It began to develop the town was going to level off, and that Boeing, whose peak employment was something over thirty thousand, was shut down and became a ghost plant. In spite of that, the town began to pick up population. And for that reason housing became even more critical. It was impossible for returned veterans to obtain housing. So I was able to prevail upon the others in this corporation and we did offer these houses to veterans who came in to inquire about them. [Emphasis added.] The exact date when petitioner first offered these single family houses for sale is not shown by the record but it was some time early in the year 1946. Thus, under the foregoing testimony and other evidence in the record, we have made*197 our finding of fact that: "The 42 houses which petitioner sold in its fiscal year ending June 30, 1946, were held primarily for sale to customers in the ordinary course of its business from some date early in the year 1946 and prior to April 10, 1946 when the first of the 42 houses here involved were sold and were so held at the time when sold." True it is that petitioner did not advertise the houses for sale. That was not necessary in order to sell them because there was a "seller's market" in housing in Wichita at that time. All parties seem to agree on that fact. It is best illustrated by the fact that from April 10, 1946, to June 30, 1946, petitioner sold 42 houses and from July 6, 1946, to October 1, 1946, petitioner sold the remaining 40 single family houses which it owned. The frequency of these sales, we think, meets the continuity test which the Court mentioned in Mauldin v. Commissioner, supra.On this issue we hold in favor of the Commissioner. Cf. Rollingwood Corporation v. Commissioner, supra, affirming a Memorandum Opinion of this Court, and Albert Winnick, 17 T. C. 538.*198 In the Winnick case, among other things, we said: * * * There may be a change of intent between the time of acquisition and the time of sale, and if property originally acquired for investment is held in the taxable year primarily for sale to customers in the regular course of trade or business, the gain realized in the taxable year is not subject to capital gain treatment. This conclusion is based on the language of section 117 which, in the definition portions of both subsections (a) and (j), speaks of "property held by the taxpayer" rather than property "acquired" or "purchased." Richards v. Commissioner, 81 F. 2d 369. This view was expressed clearly in the McGah case supra, where we said: It has been held that an original status of property is not determinative of the question of whether it was, at the time of its sale, held for investment purposes or for sale to customers. See Carl Marks & Co., 12 T. C. 1196, 1202, *476 where this Court said that the "crucial factor to consider in determining the character of" the property in question is the purpose for which it was held during the period *199 in question, i. e., in the taxable year. It is unnecessary to reexamine in detail the legal questions involved but these cases above cited are authority for the following propositions of law relevant here: The question is one primarily of fact with the burden on petitioner. The tests most frequently applied are the continuity and frequency, and substantiality of sales, though other factors are relevant. An original purpose of rental is not binding on subsequent years. The fact of renting properties does not preclude their being held for sale to customers in the ordinary course of trade or business. On the last proposition, see also King v. Commissioner, 189 F. 2d 122, affirming a Memorandum Opinion of this Court, certiorari denied 342 U.S. 829. Having considered all the facts, we hold that the 42 houses in question were held primarily for sale to customers in the ordinary course of trade or business during the taxable year in question, and consequently the gains realized from their sales were ordinary income. Decision will be entered under Rule 50. MURDOCK Murdock, J., dissenting: I do not find in this case*200 or in other decided cases a satisfactory rationale in regard to the application of section 117(j). This case presents the difficulty rather clearly. Back of section 117(j) is the thought that a part or all of the profit realized from a sale was due to an increase in value which occurred during the period while the property was held for investment and Congress has deemed it proper to tax that profit as a capital gain as distinguished from the ordinary gain which results from sales to customers in the ordinary course of a business. A decision of the owner to sell must necessarily precede every sale, and after he makes that decision he is holding the property for sale until he succeeds in selling it. This taxpayer was not in the business of selling property, but if he had happened to be in the business of selling similar property, then his sale of this property would be just like the sale of any other property in that business. Yet it has been recognized that property, which under some circumstances would be held primarily for sale to customers in the ordinary course of the owner's business can, nevertheless, be held by that same taxpayer, not for that purpose, but for another so*201 that when he sells, section 117 (j) will apply. The petitioner was formed "for the purpose of entering into the business of constructing rental houses for defense workers." It never built any houses for sale and it had no sales force. It was not organized *477 for selling. The houses in question were built in accordance with the purpose of the corporation as rental houses and they were actually rented for a number of years. They were only a part, and, apparently, not the greater part, of the rental housing owned by the corporation. It had a broker sell them. The petitioner never changed its business or original purpose to include a selling business, and it never converted the 42 houses from its rental business to any such new selling business. These facts are different from those in the Winnick case. I should think that a taxpayer, organized as the petitioner was to construct rental properties and not as a selling organization, should be permitted to sell even a substantial number of its units, at least through a broker, without losing the benefit of section 117(j), and if that can happen in any case, I do not understand what there is about this case which prevents *202 the application of 117(j). Maybe section 117(j) would not apply to this petitioner if, for example, it went into the selling business and decided to use its rental houses as stock in trade to carry on that selling business. But it did not do that and this record fails to show that it had any customers or that it had a course of business of selling houses for profit or that these particular houses were held for sale to customers in the ordinary course of any such business. So I do not understand why the result reached is the right one. Footnotes 1. The net sales price of the 42 houses was $ 239,542.90. The amount of gain realized by petitioner depends upon the adjusted basis of the houses, which figure is to be computed under Rule 50 after giving effect to the depreciation rates as stipulated. Petitioner reported on its return a gain of $ 79,481.57 and in the deficiency notice respondent computed a gain of $ 66,295.82.↩