Cotton Estate retained by the President represents 5.9 acres, about 1.4 acres of which constitute adjoining beach property.1 To consummate the purchase of this excess portion, Mr. Abplanalp and Mr. Rebozo formed the B & C Investment Company. The President then assigned a beneficial interest in the trust representing this excess portion to the B & C Investment Company. The documents assigning this beneficial interest to the B & C Investment Company were filed at the Title Insurance and Trust Company on December 24, 1970. The assignment of this interest represents approximately 24 acres, including all of the Elmore property. On December 15, 1970, the date of the sale, the remaining Cotton mortgage was $900,000, a $100,000 payment having been made in July 1970. The B & C Investment Company paid the purchase price of $1,249,000 in the following manner. First, the B & C Investment Company assumed $560,000 of the remaining $900,000 mortgage, leaving $340,000 as the amount of the original $1,000,000 promissory note still owed by the President. Second, the B & C Investment Company assumed the remaining $64,000 outstanding with respect to the Elmore loan. Third, Mr. Abplanalp cancelled the $450,000 and $175,000 debts of the President. Thus, the President received no cash for the excess acreage, but rather received his sales price in the form of a reduction in his debts to the extent of $1,249,000 ($560,000+$64,000+ $625,000). 3. Legal Analysis In determining the amount of gain or loss from the sale or other disposition of property, the amount realized from the sale must be compared with the adjusted basis of the property. The difference between the selling price and the adjusted basis determines the amount. of any gain or loss. In the case where property is purchased, the basis of property is the cost or purchase price. To determine the adjusted basis, the original cost is then increased for certain items such as capital improvements and decreased by certain items such as depreciation and depletion.* Where a single tract of property is purchased for a lump sum and, thereafter, only a part of this property is sold, a separate basis for the property retained and the property sold must be established. This is accomplished by equitably allocating a portion of the total cost to the property sold and a portion of the total cost to the property retained. The amount of gain or loss resulting from that portion of the Description 1 Portion of Cotton estate retained by the President (not including beach) Portion of Cotton estate sold to B & C Investment Company that is subject to ease- Acreage 4,516 *1.400 13. 422 1.844 *6.000 2. 934 The legal description states 1.400 acres (plus or minus) and 6.000 (plus or minus) for the beach area for a total of 7.400 acres (plus or minus). The survey map shows 7.95 acres. The difficulty in precisely measuring the beach is due to the shifting of sand. The staff appraiser determined that 15 acres of this difference relates to the portion retained and .40 acres of this difference relates to the portion sold. 2 Int. Rev. Code of 1954, § 1001. 3 Int. Rev. Code of 1954, § 1012. 4 Int. Rev. Code of 1954, §§ 1011 and 1016. property sold is the difference between the selling price and the adjusted basis allocated to the portion sold." It seems clear to the staff that the concept of "equitable apportionment" requires an allocation of the total cost based on the relative fair market values of the respective properties. Although courts have accepted allocations based on simple proration of area, assessed valuation, and the agreement of the parties pursuant to the purchase agreement, little, if any, evidence of fair market value was offered in those cases. For example, in J. S. Cullinan, the Board of Tax Appeals accepted the Commissioner's allocation of total cost of a tract to the individual lots based on assessed values because there was an absence of evidence as to a better method of allocation. Furthermore, in H. F. Bovard, the court stated that the relative assessment value method used by the Commissioner in Cullinan was neither approved nor disproved by the court and was accepted only because the taxpayer failed to overcome the presumptive correctness of the Commissioner's determination of basis. Moreover, in Maudine Neese, the court found that the Commissioner's percentage allocation of cost to individual lots was in error when the taxpayer produced evidence from an expert witness showing the relative values of the lots. Where evidence is presented that one parcel is more valuable than another, the courts have repeatedly said that it is not proper to make an allocation based on a simple proration. In upholding the Commissioner's determination that allocation on a total cost basis should be made on the basis of relative fair market values and not on the basis of a simple proration of area, the court, in Biscayne Bay Islands Co. v. Commissioner,10 stated, "The evidence makes it clear that the waterfront lots were far more desirable and valuable than the interior lots, the ratio, generally speaking, approximating three to one." Similarly, in allocating the total cost among three parcels, the court, in Fairfield Plaza, Inc. v. Commissioner,11 stated, "Such 'equitable' apportionment demands that relative values be reflected. Accordingly, if one parcel is of greater value than another, apportionment solely on the basis of square footage appears inappropriate." In Harlow N. Davock,12 the Tax Court stated that, "If the total consideration is paid for a mixed aggregate of assets, its allocation among the several properties acquired should be based upon the relative value of each item to the value of the whole." 13 In addition, it has been recognized in other cases that a proper allocation of the total cost of property should be based on the relative values of each portion. Thus, it is clear that the great weight of Treas. Reg., § 1.61-6, provides that, "When a part of a larger property is sold, the cost or other basis of the entire property shall be equitably apportioned among the several parts, and the gain realized or loss sustained on the part of the entire property sold is the difference between the selling price and the cost or other basis allocated to such part. The sale of each part is treated as a separate transaction and gain or loss shall be computed separately on each part 5 B.T.A. 996, 1001 (1927). 7 See also, Hobart J. Hendrick, 35 T.C. 1223, 1232 (1961). 15 B.T.A. 546 (1929). 12 CCH Tax Ct. Mem. 1058, 1061 (1953). 10 23 B.T.A. 731, 735 (1931). 11 39 T.C. 706, 712 (1963). 12 20 T.C. 1075 (1953). 13 Citing C. D. Johnson Lumber Corp., 12 T.C. 348 (1949). 14 Beaver Dam Coal Co. v. United States, 370 F. 2d 414 (6th Cir., 1966); Vernon Hoven, 56 T.C. 50 (1971); Cleveland-Sandusky Brewing Corp., 30 T.C. 539 (1958). Further, this approach is consistent with the rules prescribed by the Secretary of the Treasury for allocating basis between depreciable and nondepreciable property. Treas. Reg. 1.167 (a)-5, relating to apportionment of basis, provides that, in the case of a lump-sum purchase of property, the basis for depreciation cannot exceed an amount which bears the same proportion to the lump-sum as the value of depreciable property at the time of acquisition bears to the value of the entire property at that time. authority in the cases is that a proper apportionment of the cost of property purchased for a lump sum to portions of the property must be based upon relative values at the time of purchase. Based on this and the facts and circumstances of this case (that is, there are distinct differences, which have a significant bearing on value, between the portions sold and retained), the staff believes that the allocation of the total cost basis between that portion of the property sold by the President and that portion of the property retained must reflect the relative fair market values of the separate properties. The staff believes that it is clear that the portion of property retained by the President has a greater relative value per acre than the portion that was sold to the B & C Investment Company. Accordingly, any method which does not reflect relative fair market value, such as simple proration based on acreage or assessed valuation of the entire parcel, would not be appropriate. In addition, it also seems clear that an allocation method based on the agreement of the parties would not be appropriate since evidence of a better method which does reflect fair market values is available.14 Another method of allocating the purchase price of the Cotton estate would be to adopt the very method which Mr. Blech used in allocating the interest on the Cotton mortgage for purpose of the minimum tax on items of tax preference. Interest of $75,000 was paid in 1970 on the Cotton mortgage note of $1,000,000. In computing the minimum tax for 1970, Mr. Blech treated only part of the interest as an item of tax preference (interest on investment indebtedness). He treated 34 percent of the indebtedness as attributable to the 5.9 acres retained by the President, and the interest on that portion was not considered an item of tax preference. The balance of the interest (66 percent) was assigned to the portion of the Cotton tract which was sold to the B&C Investment Company. As a result, Mr. Blech treated $49,500 of the interest paid on the Cotton mortgage as an item of tax preference. If the purchase price of $1.4 million is allocated in the same manner, then 66 percent of the $1.4 million would be allocated as the cost of the acreage sold, resulting in a gain on the sale of $205,601. However, the staff believes that a correct allocation of the total cost basis requires a determination of the fair market value of the property sold and the fair market value of the property retained. Further, it is the staff conclusion that the tax law requires that the allocation of basis be made as of July 15, 1969, the date of purchase.15 14 In the contract for the sale of the beneficial interest, the parties agreed to apportion real estate property taxes in the following ratios: 62.22 percent to the beneficial interest sold to B&C Investment Company and 37.78 percent (approximately 3/8th) to the interest retained by the President. Presumably, the parties tried to allocate the real estate taxes on a fair and equitable basis. Since real estate taxes are based on dollar valuations, it would seem that if it was fair for the President to pay 3/8ths of the taxes imposed on the entire Cotton tract, then he considered that 3/8ths of the total value of the tract was attributable to the 5.9 acres retained by him. If these percentages which were used to apportion taxes were also used to allocate the total cost basis, the sale would result in a gain of $259,632. However, some adjustment would be required to such an allocation approach for any additional taxes resulting from improvements made after the Cotton tract was acquired. In an interview with the President's accountant, Mr. Arthur Blech, the staff was told that these percentages were meaningless as far as an allocation of basis was concerned. He stated that they were simply picked so that they would tie into something. Mr. Blech explained to the staff that the percentages "tie into" that portion of the $360,000 $900.000 mortgage assumed by B&C Investment Company, (i.e., equals 62.22 $340,000 $900.000 percent and equals 37.78 percent.) The assumption of $560,000 by B&C Invest$900.000 ment Company was part of the payment of the $1,249,000 purchase price. 13 Fairfield Plaza, İnc., 39 T.C. 706 (1963); Wellesley A. Ayling, 32 T.C. 704 (1959). 4. Staff Analysis in Determining Fair Market Value For Federal income tax purposes, it is well accepted that the term "fair market value" means the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. 16 In the instant case, the staff believes that the best method for establishing the value of these particular parcels of the property is by an appraisal by a qualified expert appraiser. Although fair market value is a factual issue, the courts, have frequently turned to the testimony of expert appraisers to assist them in determining the value of real estate where the appraiser is well qualified and his testimony is supported by facts. However, it is important that the expert opinion disclose the method of appraisal and justify the use of this method. For the reasons stated above, the staff has commissioned an engineering firm, whose main office is in Santa Ana, California and a local real estate appraiser to determine independently the fair market value of the property sold and the fair market value of the property retained. In selecting these experts, the staff felt it was important to give particular consideration to the following factors: background, reputation, experience with the type of property being appraised, familiarity with the subject property being appraised, and familiarity with similar properties in the San Clemente area. In addition to obtaining an independent appraisal, the staff has reviewed in detail the allocation of basis made by (1) the President's accountant, (2) the Internal Revenue Service, and (3) the accounting firm of Coopers and Lybrand. Based on the appraisal obtained by the staff and a careful review of the allocations made by others in this case, the staff believes that it is appropriate to allocate $1,031,164 of the total cost basis of the Cotton estate to that portion of the property sold to B & C Investment Company and $398.229 to that portion of the property retained by the President. Accordingly, the staff believes that the sale to B & C Investment Company resulted in a gain of $117,836 to the President. Staff analysis of allocations A detailed analysis of these allocations and the staff's appraisal follows. Allocation made on President's return In reporting this transaction on President Nixon's 1970 income tax return, it was stated that the sale to B & C Investment Company did not result in any gain to the President. This was because the amount of the total cost basis that Mr. Blech allocated to that portion of the property sold was exactly equal to the sales price.17 In reviewing this transaction, Mr. Blech provided the staff with a written analysis showing his justification for this allocation. Mr. Blech explained to the staff that the method of allocation which he feels 16 See, cases collected in 10 Mertens, Law of Federal Income Taxation § 59.01 (1970 Revision), and Treas. Reg. § 20.2031-1(b). In attempting to derive a cost basis by using the highest and best use of the property, Mr. Blech determines that $1.249,600 should be the cost of the property sold, thus resulting in a $600 loss. This computation was derived by subtracting from lot sales prices, amounts for development costs, selling expenses and a 15 percent profit for the contractor. However, Mr. Blech's computation did not allocate to the portion sold any portion of the $29,393 cost incurred for sales commissions, soil tests, and other costs. As a result, his method of allocation actually would result in a loss from the sale of $24,736. is most appropriate in this case and the method upon which he relied is to value the portion of property sold and the portion retained from the standpoint of highest and best use. In his analysis, Mr. Blech provided several alternative methods of allocation in an attempt to show that, although he did not feel they were appropriate and did not rely upon them for his allocation, these alternative methods would also result in no gain to the President. The staff has provided a detailed analysis of these alternative methods in Exhibit II-4. Appraisals of San Clemente property Three major attempts at valuing the San Clemente property by appraisal have been undertaken. Arthur Blech, the President's accountant, made his own appraisal of the property in preparing the President's tax return. The Internal Revenue Service had an expert appraisal made as part of its audit of the President's return for the year 1970. The Joint Committee staff had its own expert appraisal made for purposes of its review of the President's return. To determine the market value of a property according to its highest and best use, appraisers normally use one or more of three valuation techniques: the income capitalization technique, the reproduction-cost minus depreciation technique and the comparative sales technique. These techniques are generally accepted by the courts. See Coddington, T.C. Memo. 1960–95. The technique used and accepted by courts, in any particular case, depends on the nature of the property to be appraised. If more than one technique can be applied to a property, a court will often utilize all techniques and base its valuation on an average of the results. The income capitalization technique is usually applied to income producing properties, such as, apartments, hotels, and office buildings. Under this technique, an appraiser takes the estimated annual rent which can be obtained from the property (calculated from prior rentals of the same property or rentals of comparable property) and multiplies it by a capitalization rate (determined by the rates of income and valuations of comparable properties) to obtain the market value of the property. See Estate of Brown, T.C. Memo 1962–249. The reproduction-cost minus depreciation technique can be applied only to buildings or other improvements. The technique is used by estimating the current cost of building a comparable replacement for the existing building and subtracting from that estimated cost the estimated depreciation on the original cost of the building. See Morrisdale Coal Co. v. Comm., 97 F. 2d 292. Since this technique relates only to buildings and other improvements, it is of little use if most of the value of property to be appraised stems from the land. itself, not from any improvements. The third valuation technique used and accepted by the courts, the comparative sales technique, requires discovering the prices of recent sales of comparable properties, calculating general real estate price trends, and from these determining what a buyer would be willing to pay at this time for the appraised property. See Douglas |