Docket No. 1229-74.United States Tax Court.
Filed October 6, 1975.

Petitioner owned an option to acquire property that Firemen’s wished to own. Firemen’s agreed to advance funds to petitioner so that it could exercise the option and then sell or exchange the option property with Firemen’s. An exchange of properties subsequently occurred. Held, the transaction represents a valid exchange of properties under sec. 1031, I.R.C. 1954, and the funds advanced by Firemen’s represent a loan to petitioner and notPage 7
“boot” received by petitioner on the exchange. Held, further,
petitioner recognized a short-term capital gain on the receipt of other funds attributable to the exchange.

Charles A. Lane and Stephen J. Schwartz, for the petitioner.

Vernon Balmes, for the respondent.


The respondent determined a deficiency in petitioner’s Federal income tax and an addition thereto under section 6653(a), I.R.C. 1954,[fn1] for the taxable year 1970 of $242,352 and $12,118, respectively. Based upon an alternative position respondent determined that the deficiency in petitioner’s Federal income tax and an addition thereto under section 6653(a) would be $153,956.30 and $7,697.82, respectively.

The primary issue presented is whether petitioner realized a short-term capital gain of $425,000 on the exchange of a building, which petitioner acquired through the exercise of an option, for another building. The secondary issue is whether $45,000 which petitioner concedes represents additional gain recognized on the exchange should be characterized as short-term or long-term capital gain. Respondent has conceded that there is no addition to the tax due from the petitioner under section 6653(a) for the taxable year 1970.

Respondent alleges as an alternative position that petitioner realized a long-term capital gain of $565,115 upon the disposition of its option. Based on this position respondent determined a deficiency in petitioner’s Federal income tax and an addition thereto under section 6653(a) for the taxable year 1970 as noted above.

Most of the facts have been stipulated and are so found. The stipulation of facts, together with the exhibits attached thereto, are incorporated herein by this reference.

124 Front Street, Inc. (hereinafter petitioner), is a corporation, organized and existing under the laws of California with its principal place of business in San Francisco, Calif., at the time of filing its petition herein. Petitioner filed its Federal income tax return for 1970 with the Western Service Center, Ogden, Utah.Page 8
Petitioner reports its income on the cash receipts and disbursements method of accounting utilizing the calendar year as its accounting period.

Petitioner was incorporated in 1964 with 80 percent of its stock being issued amongst the family of Harry Sugarman (hereinafter the lessee). Included in this group was Leland C. Spiegelman (hereinafter Spiegelman), the lessee’s son-in-law, who with his wife owned a 20-percent interest. In 1969 Spiegelman served as petitioner’s attorney and financial adviser and represented petitioner throughout the transaction in issue.

In December 1963 the lessee leased from Bernice P. Jourdain, Hugo B. Beier, and Estate of Amelia A. Beier, deceased (hereinafter the Jourdain group), certain real property commonly known as 124 Front Street, San Francisco (hereinafter the option property). Under the terms of the lease, the lessee had the option to purchase the option property after the expiration of 10 years from the commencement of the lease for $200,000.

In 1964 this option was assigned to the petitioner by the lessee for $1,000. During this period and up to 1969 petitioner was basically an inactive corporation with the option and some cash being its only major assets.

Firemen’s Insurance Co. of Newark, N.J. (hereinafter Firemen’s), a property and casualty insurance company, was interested in acquiring the option property. Firemen’s made a written offer to purchase the property in 1967.

Firemen’s interest continued and in 1969 it was being represented by Alander F. Hogland (hereinafter Hogland) who was associated with the San Francisco office of Coldwell, Banker
Co. (hereinafter Coldwell), a real estate brokerage firm. Hogland handled the negotiations between petitioner and Firemen’s with respect to the transaction in issue. He dealt principally with William Matchet (hereinafter Matchet), an executive of Firemen’s who was located in New York, and Spiegelman.

In May 1969 petitioner, lessee, and Firemen’s entered into an Agreement of Sale and Deposit Receipt under which petitioner would attempt to acquire the option property for $250,000 and subsequently sell or exchange the option property with Firemen’s. Pursuant to this agreement Firemen’s deposited into escrow a $25,000 check payable to the Transamerica Title Insurance Co. (hereinafter Transamerica).Page 9

In June 1969 petitioner offered to buy the option property from the record owner, the Jourdain group, for $250,000. The Jourdain group responded with a counteroffer to sell the property for $425,000. Petitioner desired to acquire the option property at this price, but it did not have the necessary funds. Spiegelman and Hogland discussed this development with Hogland agreeing to determine whether Firemen’s would assist petitioner to acquire the option property.

Firemen’s agreed to assist petitioner and, as a result of negotiations, a second Agreement of Sale and Deposit Receipt (hereinafter the agreement) was executed by petitioner, lessee, and Firemen’s on August 1, 1969. The relevant portions of this agreement are as follows:[fn2]

THIS AGREEMENT is made this 1st day of August, 1969, between 124 FRONT STREET, INC., a corporation (hereinafter called Seller), HARRY SUGARMAN (hereinafter called Lessee), and FIREMEN’S INSURANCE COMPANY OF NEWARK, N.J., a corporation (hereinafter called Purchaser), and relates to the title and a leasehold interest in certain real property (hereinafter called the Property) * * *

* * *

Each party, in consideration of the agreements of the other parties hereto, agrees as follows:

1. The parties shall establish an escrow with American Title Insurance Company, acting through [Transamerica] and Purchaser shall deposit therein contemporaneously with the execution of this agreement the sum of Twenty-Five Thousand Dollars ($25,000.00), evidenced by its check in that amount, as a deposit on account of the agreed purchase price of One Million One Hundred Seventy-five Thousand Dollars ($1,175,000.00) for the Property and cancellation of the leasehold interest of Lessee therein.

* * *

3. Seller agrees to endeavor to acquire title to the property within thirty (30) days after the date of this agreement. If Seller shall acquire title to the Property within said time and if there are no valid objections to the marketability of the title to the Property arising after Purchaser’s original examination of title, the sale of the Property shall be consummated, not later than one hundred ninety (190) days from the date when Seller acquires title to the Property, by delivery to Purchaser of a good and sufficient Grant Deed to the Property in exchange for payment of the purchase price of the Property to Seller and of Lessee’s leasehold estate to Lessee through the above-mentioned escrow.

* * *

5. It is understood and agreed that Seller will attempt to obtain fee title to the Property within the times above mentioned at a cost to Seller not to exceed Four Hundred Twenty-five Thousand Dollars ($425,000.00), such cost toPage 10
include the above-mentioned option price of Two Hundred Thousand Dollars ($200,000.00) as provided in the lease from Owners to Lessee, which option has been transferred to Seller. In no event shall Seller be obligated to pay more than said Four Hundred Twenty-five Thousand Dollars ($425,000.00) to acquire fee title to the property. If Seller cannot obtain fee title for the said sum of Four Hundred Twenty-five Thousand Dollars ($425,000.00) within the times provided in Paragraph 3 above, Purchaser’s deposit in the above-mentioned escrow shall be returned to Purchaser and this agreement shall terminate without further obligation of any party thereto.

6. Seller shall have the right to designate “exchange property” in lieu of all or any portion of the cash payment herein provided at any time prior to the close of escrow and to require that title to such exchange property shall be delivered to Seller as its consideration for the sale of the Property herein provided. If Seller gives written notice to Purchaser of such designation of exchange property, Purchaser agrees to use its best efforts to acquire title to such exchange property within thirty (30) days after receipt of such notice, provided, however, that the total cost to Purchaser for acquisition of such exchange property shall not exceed One Million Twenty-five Thousand Dollars ($1,025,000.00). If such exchange property is designated by Seller, then Seller shall be entitled to control the escrow and instructions issued in connection therewith insofar as the same relate to the exchange property and Purchaser shall conform to Seller’s valid and lawful instructions, provided that the same do not increase Purchaser’s obligation beyond the above-mentioned maximum amount.

* * *

12. Purchaser agrees within thirty (30) days after the date of this agreement to deposit the sum of Four Hundred Twenty-five Thousand Dollars ($425,000.00) on account of the agreed purchase price of One Million Twenty-five Thousand Dollars ($1,025,000.00) in said escrow, and further agrees that said sum of Four Hundred Twenty-five Thousand Dollars ($425,000.00) may be used by Seller for the purchase of the fee title to the Property. The title company shall be authorized to pay said sum of Four Hundred Twenty-five Thousand Dollars ($425,000.00) on Seller’s behalf to Owners when it has in its possession a grant deed from Owners to Purchaser conveying title and fee to the Property to Seller and instructions authorizing the recordation of said deed and when it has in its possession a grant deed to the Property from Seller to Purchaser plus irrevocable instructions from Seller authorizing the title company to record said deed upon close of escrow and in no event more than One Hundred Ninety (190) days after recordation of the deed from Owners to Seller. If said deed from Owners and said deed from Seller to Purchaser are not both deposited in said escrow within thirty (30) days from the date of this agreement, said sum of Four Hundred Twenty-five Thousand Dollars ($425,000.00) shall be returned to Purchaser.

Based on this agreement, petitioner accepted the Jourdain group’s counteroffer.

Pursuant to the terms of the agreement an escrow account was established on August 20, 1969, with Transamerica in respect toPage 11
the option property. Firemen’s deposited an additional $401,632.35 into the escrow account, which together with the $25,000 previously deposited fulfilled its obligations under the agreement.[fn3] On August 11, 1969, a deed was executed by the Jourdain group naming the petitioner as the grantee of the option property. This deed was deposited into the escrow account on August 20, 1969, and was recorded on August 25, 1969.

On August 21, 1969, irrevocable escrow instructions were entered into between petitioner, Firemen’s, the lessee, and Transamerica. These instructions provide in relevant part as follows:[fn4]

Seller deposits herewith the Deed from Seller to Purchaser covering the above-captioned property. This Deed is hereby irrevocably deposited with you as trustee for the benefit of Purchaser, and you are authorized to record this Deed, from Seller to Purchaser, not less than 190 days after recordation of the Deed from Bernice P. Jourdain to 124 Front Street, Inc., provided, however, that in the event Seller obtains “exchange property” in order to obtain the benefits of a tax deferred exchange, then and in that event, Seller may instruct you to record this Deed within the 190 days.

Also submitted to Transamerica at this time were the following documents: a short form agreement of sale between petitioner as seller and Firemen’s as buyer, a copy of which was recorded, cancellation of the lessee’s existing lease, and a new lease between the lessee and Firemen’s. This new lease, although dated August 22, 1969, was not to take effect until the recordation of the sale of the option property to Firemen’s.

On August 25, 1969, the funds deposited into the escrow account by Firemen’s were distributed to the Jourdain group and others covering the purchase price of the option property and the accompanying fees. For the remainder of 1969 the option property remained in petitioner’s name.

Petitioner on its 1969 Federal tax return reported the option property as its asset and the funds deposited by Firemen’s as its liability. Petitioner also received rent from the option property and reported it as income and claimed a depreciation deduction. Petitioner also insured the option property and in October 1969, Firemen’s refused to make a repair to the option property claiming that it was not the owner.Page 12

In January 1970 Firemen’s offered to purchase for $1,120,000 real property and improvements thereon located at 240 Stockton Street, San Francisco, Calif. (hereinafter the exchange property). Firemen’s offer consisted of $560,000 in cash, a promissory note of $400,000, and taking the exchange property subject to an outstanding note of approximately $160,000. This offer was accepted by the owner of the exchange property, the Schroth Co. (hereinafter Schroth).

Both Firemen’s and Schroth executed escrow instructions and delivered to Transamerica the necessary documents to effect this transaction. Included in Firemen’s instructions was the requirement that Transamerica hold for Firemen’s, marked as canceled, its $400,000 promissory note payable to Schroth. Petitioner was to execute its own promissory note for $400,000 payable to Schroth. This note was delivered on February 16, 1970, when the deeds to the option property and the exchange property were recorded in Firemen’s and petitioner’s names, respectively.

On February 13, 1970, the transaction between Firemen’s and Schroth was closed with Firemen’s receiving the deed to the exchange property. Firemen’s and petitioner then formally exchanged the option and the exchange properties. As a result of these simultaneous and reciprocal transfers, petitioner became the owner of the exchange property subject to two deeds of trust securing aggregate debt of $563,944.34 at an agreed fair market value of $1,120,000.

On February 13, 1970, petitioner was advised by Coldwell that $45,000 which petitioner was to receive as a part of this transaction was ready to be disbursed to petitioner at its order. On February 16, 1970, Firemen’s sent a letter to Coldwell stating that it had no interest in the $45,000. This amount was subsequently paid to petitioner on June 25, 1970.

Petitioner on its 1970 tax return reported this transaction as an exchange of properties which was covered by the provisions of section 1031. The amount realized included the fair market value of the exchange property, release of indebtedness on the option property (the $426,632 advanced by Firemen’s), and cash of $10,059. Petitioner included in its basis its adjusted basis in the exchange property and the assumption of the indebtedness ($563,944.34) and reported a gain realized of $567,005.

Since the indebtedness incurred exceeded the indebtedness forgiven, petitioner only recognized gain to the extent of the cashPage 13
received. Petitioner now concedes that the additional $45,000 it received represents additional gain recognized on the transaction.

Respondent disallowed this treatment as follows:

(a) It is held that the gain to be recognized upon the exchange of a building located at 124 Front Street, San Francisco, California, for a building located at 240 Stockton Street, San Francisco, is greater than the gain reported per your return by $503.885.00, [sic] in accordance with the computation shown below. The adjustment to the amount of gain to be recognized is based upon the determination that the amount of cash, or “boot” received on the transaction is greater than that shown in the computation per your return. The amounts comprising the cash held to have been received are $425,000.00 placed by the purchaser into an escrow account as an advance payment, $45,000.00 representing a cash reserve account held in escrow and paid to you in July of 1970, and a cash payment of $43,944.00 made on February 13, 1970. The recognized gain is a short-term capital gain, inasmuch as the property given up by you in the exchange was acquired August 25, 1969, and was sold 5 months and 19 days later, on February 13, 1970.

Respondent now concedes that the “amount of cash, or ‘boot’ received on the transaction” is only the $425,000 advanced by Firemen’s and the $10,059 and $45,000 received by petitioner. Only the treatment of the $425,000 and the characterization of the $45,000 are now in issue.

In an amendment to his answer, respondent raised an alternative position that petitioner disposed of its option and received the exchange property in return. Respondent alleges that this transaction does not qualify under the provisions of section 1031 and that petitioner has recognized a long-term capital gain of $565,115. Based on this position respondent calculated a deficiency and an addition to tax under section 6653(a) as noted previously.

The case at bar requires us to determine whether the transaction between petitioner and Firemen’s represents a sale of petitioner’s option or whether it represents an exchange of properties within the provisions of section 1031. If it is the latter we must then determine whether petitioner must include the amount deposited by Firemen’s into the escrow account which petitioner used to exercise its option as gain recognized on the exchange, and whether the $45,000 which petitioner concedes represents additional gain recognized on the exchange should be characterized as short-term or long-term capital gain.Page 14

Respondent’s position, that in reality the transaction between petitioner and Firemen’s was merely a sale of the option, was raised by him in an amendment to his answer to petitioner’s petition. Generally it is the petitioner who must bear the burden of proof in matters before this Court; however, it is the respondent who bears the burden of proof with respect to this position. Rule 142(a), Tax Court Rules of Practice and Procedure.

Respondent’s primary argument is that we should view this transaction in its entirety and not consider its individual, component steps. However we have been presented with a series of legal documents that carefully track the development of this transaction. We do not believe that these documents can be ignored. Furthermore, it appears that the structure of the transaction is consistent with the intent of the parties.

In Leslie Q. Coupe, 52 T.C. 394, 405 (1969), we said:

It is now well settled that when a taxpayer who is holding property for productive use in a trade or business enters into an agreement to sell the property for cash, but before there is substantial implementation of the transaction, arranges to exchange the property for other property of like kind, he receives the nonrecognition benefits of section 1031.Coastal Terminals, Inc. v. United States, 320 F.2d 333 (C.A. 4, 1963); James Alderson, 38 T.C. 215 (1962), reversed on other grounds 317 F.2d 790 (C.A. 9, 1963); Carlton v. United States,385 F.2d 238 (C.A. 5, 1967). Of crucial importance in such an exchange is the requirement that title to the parcel transferred by the taxpayer in fact be transferred in consideration for property received.

In the instant case, under the agreement between the parties petitioner always had the right to designate exchange property as consideration for the option property in lieu of cash. Petitioner also, as will be discussed later, acquired the option property which was later exchanged for the exchange property.

In Mercantile Trust Co. of Baltimore et al., Executors,32 B.T.A. 82 (1935), the taxpayer entered into an agreement with a title company whereby the taxpayer would either sell or exchange his property with the title company depending on whether the latter could acquire suitable exchange property. Such property was acquired and the transaction was closed with the various parties executing the necessary deeds of conveyance.

Respondent disregarded the form of the transaction and determined that petitioners had sold their property and then purchased the exchange property in two separate transactions. InPage 15
holding for the petitioners we said in Mercantile Trust Co. ofBaltimore et al., Executors, supra at 86:

Respondent admits that the transaction was carried out in a legal manner, and that no fraud was perpetrated. We cannot find that it was a mere device, essentially fictitious. The several agreements and deeds executed, and the cash payments made by the four interested parties were not simulated transactions. They were intended to and did constitute juristic facts — not fictions. The agreements created fixed liabilities. The deeds transferred legal title. The cash payments were real. Petitioners actually conveyed the Baltimore Street property to the Title Co. They likewise received from that company, in exchange, the Lexington Street property and $33,000. These real transactions must here be given their normal effect. So, our single inquiry is whether these facts bring the petitioners in the pending transaction within the scope of the quoted statutory provisions.

We believe this statement can be applied to the case at bar.

In Alderson v. Commissioner, 317 F.2d 790 (9th Cir. 1963), revg. 38 T.C. 215 (1962), the respondent asked the court to uphold its determination that the parties could not successfully disguise their actions and that the taxpayers had sold their property. The court refused, finding “a plan to exchange the properties within the intent of the statute (sec. 1031, I.R.C. of 1954).” Alderson v. Commissioner, supra at 794. The court based this conclusion on an earlier finding that the parties from the outset intended to exchange properties.

After a careful review of the evidence we find no indication that petitioner intended to sell, or that Firemen’s intended to buy, petitioner’s option. We believe the agreement between the parties anticipated a sale or exchange of the option property after petitioner exercised its option.

Respondent also argues that petitioner intended to sell its option (its major asset) when it listed its stock for sale with Coldwell. This listing occurred in 1967 and we believe it is too remote to have a bearing on the transaction in issue.

Consequently, we do not find that petitioner sold its option to Firemen’s, but rather we find a valid plan to exchange properties within the intent of section 1031. Having made this determination we can now move on to a consideration of the consequences of the transaction.

Respondent’s argument is that, even if the parties exchanged properties, the $425,000 represents part of the consideration received by petitioner on the exchange of properties and, as such it is “boot” which must be included as an additional portion ofPage 16
the gain realized that must be recognized. Petitioner argues that the $425,000 represents a loan by Firemen’s to enable it to purchase the option property which was repaid when the properties were exchanged.

Petitioner held an option to purchase property that Firemen’s wished to acquire. Petitioner however did not have the financial resources to exercise the option. Petitioner, through Hogland, asked Firemen’s for assistance in the acquisition of the option property. Negotiations followed which resulted in the agreement as described in our findings of fact. We believe that the agreement and the surrounding circumstances support petitioner’s position.

Under the agreement Firemen’s was to deposit the $425,000 into the escrow account. This sum was to be used by petitioner to purchase the option property. If this goal could not be accomplished, the agreement specifies that the $425,000 was to be returned to Firemen’s. Further, the agreement contemplates a sale or exchange of the option property between the parties. This could only be accomplished after petitioner first acquired the option property.

We do note that, under the agreement after the option property was acquired, it was to be transferred to Firemen’s within a specified period of time. Although petitioner was to have the building for only a short period, we believe that during this time it was the actual owner of the option property.

Petitioner’s title to the option property was acquired in August 1969, and it was not formally transferred to Firemen’s until February 1970. In addition to possessing legal title, it appears that the “benefits and burdens” of ownership were with the petitioner. See Gordon J. Harmston, 61 T.C. 216 (1973), on appeal (9th Cir., Feb. 8, 1974).

Petitioner received the rental income generated by the option property and reported it along with the depreciation deduction associated with the option property on its 1969 tax return. Petitioner also insured the property and Firemen’s, in October 1969, refused to make a repair to the option property claiming it was not the owner. Furthermore, although Firemen’s entered into a lease with the lessee in August 1969, it was not to take effect until Firemen’s had title to the option property.

Respondent introduced the testimony of David L. Hardin, an executive of Firemen’s who was involved in this transaction. HePage 17
testified that neither his files of, nor his personal involvement in, the transaction indicated that Firemen’s intended to make a loan to petitioner.

However, Hardin also testified that his involvement in the transaction was limited. He readily admitted that he did not negotiate its terms and that he was not privy to all of the discussions between Hogland and Matchet. He also described himself as one who executed the instructions of his superiors.

Hardin also testified that Firemen’s, a property and casualty insurance company, was required to maintain a high degree of liquidity so that it could quickly pay claims in the event of a major catastrophe. Firemen’s then did not generally make real estate loans which would restrict its assets. We believe this factor could account for the terms of this agreement, which were written by Firemen’s, and the fact that Firemen’s did not report the disbursement of the $425,000 as a real estate loan on its 1969 annual statement.

Respondent argues that under Aquilino v. United States,363 U.S. 509 (1960), the nature of the relationship between petitioner and Firemen’s must be determined under State law and that, pursuant to the applicable California law, the amount put into the escrow account was not a loan and that Firemen’s was not a creditor of petitioner. Under California law a loan of money is defined as when “one delivers a sum of money to another, and the latter agrees to return at a future time a sum equivalent to that which he borrowed.” Cal. Civ. Code sec. 1912
(West 1954). Such loans are presumed to be made with interest unless it is otherwise agreed when the loan is made. Cal. Civ. Code sec. 1914 (West 1954). See Bott v. American HydrocarbonCorp., 458 F.2d 229 (5th Cir. 1972).

To support his position respondent has cited Milana v. CreditDiscount Co., 27 Cal.2d 335, 163 P.2d 869, 871 (1945), and other California cases in which the determination of whether or not a loan existed was made after a consideration of the particular facts. We believe that the factual pattern of the instant case justifies a finding that the $425,000 represented a loan with which the petitioner could acquire the option property.

The transaction as structured involves three parties — the Jourdain group, petitioner, and Firemen’s. However it appears that Firemen’s played two distinct roles — financier and purchaser. If petitioner had borrowed the necessary funds from aPage 18
fourth party, the option property along with the indebtedness could have then been transferred to Firemen’s. The $425,000 could then have been used by Firemen’s to liquidate the debt. We do not believe that the source of petitioner’s funds should influence our ultimate conclusion.

We believe the facts of this case are consistent with the finding that the funds advanced by Firemen’s represented a loan to petitioner. With these funds petitioner acquired the option property which it then transferred to Firemen’s. Consequently, we believe that the $425,000 does not represent consideration received by petitioner in exchange for the option property, but rather represents an amount received to acquire the option property.

Finally we must determine whether the $45,000 petitioner received on the exchange and which it concedes does represent gain recognized is to be characterized as short-term or long-term capital gain. Title to the option property was formally recorded in petitioner’s name on August 25, 1969. On February 13, 1970, the exchange between petitioner and Firemen’s was closed. On February 16, 1970, less than 6 months beyond August 25, 1969, this deed was formally recorded in Firemen’s name. This fact is dispositive of the issue of long-term versus short-term gain. The question of whether the $45,000 was or was not available within the 6-month period is irrelevant (although we believe it was) once the foregoing factual conclusion is made. William A. Cluff, 17 T.C. 225

Decision will be entered under Rule 155.

[fn1] All statutory references are to the Internal Revenue Code of 1954, as amended, unless otherwise indicated.

[fn2] In this agreement the terms “seller,” “purchaser,” and “property” refer to the petitioner, Firemen’s, and the option property, respectively.

[fn3] The additional $1,632.35 covered various expenses of the transaction.

[fn4] In these instructions the terms “seller,” “purchaser,” and “property” refer to petitioner, Firemen’s, and the option property, respectively.