The opinion
T.C. Memo. 1997-477
UNITED STATES TAX COURT
DAVID DOBRICH AND NAOMI DOBRICH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 3832-95, 7382-96. Filed October 20, 1997.
John M. Youngquist and Donald L. Feurzeig, for petitioners.
Daniel J. Parent, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Judge: Respondent determined deficiencies in
petitioners' 1989 and 1990 Federal income tax in the amounts of
$1,111,292 and $1,111,320, respectively, and section 6663(a)1
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code for the years in issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
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civil fraud penalties for 1989 and 1990 of $833,469 and $833,490,
respectively. Respondent determined the income tax deficiency
and penalty in the alternative for 1989 or 1990.
The issues for our consideration are: (1) Whether
petitioners may defer recognition of gain from the disposition of
certain real property under section 1031, (2) if the transaction
does not qualify for section 1031 exchange, whether petitioners
are entitled to report the gain in 1990 under the installment
sale method, and (3) whether petitioners are liable for a fraud
penalty under section 6663.
FINDINGS OF FACT2
At the time the petitions in this case were filed,
petitioners resided in Danville, California. Petitioners are
married and filed joint Federal income tax returns for each of
the years in issue.
During the years in issue, petitioners engaged in real
estate investment and received rental income from commercial and
residential real estate. In 1977, petitioners purchased 137
acres of unimproved real property located in Antioch, California
(Antioch property), for $300,000 and thereafter spent $30,000 in
engineering and consulting fees to improve the property. In
1988, petitioners decided to sell a portion of the Antioch
2
The stipulation of facts and the attached exhibits are
incorporated herein by this reference.
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property to an unrelated third party and granted an option to
purchase 117 acres of the property for $3,969,000, to expire on
August 22, 1989. Petitioners intended to dispose of the property
in a section 1031 exchange for like-kind property to obtain
nonrecognition treatment of the gain realized. They knew that
they had a limited time period after the sale closed to replace
the Antioch property with like-kind property and had to identify
replacement property within 45 days.
Petitioners entered into an agreement with Clack Brothers,
Inc. (Clack Bros.), to act as an intermediary to facilitate a
like-kind exchange of the Antioch property purportedly in
accordance with section 1031 (exchange agreement). Timothy Clack
(Mr. Clack), the president of Clack Bros., is a real estate
attorney and had represented petitioners in real estate
transactions since the 1970's. Pursuant to the exchange
agreement, petitioners assigned the right to receive the Antioch
option proceeds to Clack Bros. On August 22, 1989, the option
holder exercised the option to purchase the Antioch property.
Petitioners transferred the title of the Antioch property to the
purchaser without Clack Bros.' acquiring legal title. The
purchaser paid the $3,969,000 purchase price into an escrow
account by August 22, 1989. Clack Bros. thereafter transferred
$3,862,339.65 of the proceeds into an interest-bearing trust
account in its name and used the remainder for a deposit on
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replacement property chosen by petitioners. Petitioners paid a
portion of the interest earned on the sale proceeds to Clack
Bros. as a fee and retained the remainder of the sale proceeds
interest.
The exchange agreement provided that petitioners would be
entitled to the sales proceeds if they did not identify
replacement property within 45 days of the transfer of the
Antioch property. If petitioners did identify replacement
property, they would have a right to the sales proceeds if they
did not acquire replacement property within 180 days of the
transfer, pursuant to the exchange agreement. A letter attached
to the exchange agreement also informed petitioners of the 45-day
identification period. The 45th day after the transfer was
October 6, 1989, and the 180th day was in February 1990.
Petitioners began looking for replacement property in 1988.
They considered numerous potential replacement properties and met
with several real estate agents. In connection with the
properties they considered, petitioners examined various
information about the properties, such as building plans, income
and expense statements, tenant lists, leases, rents, service and
maintenance contracts on the property, and warranties, in order
to analyze the investment opportunity of the properties.
Petitioners expressed an interest in a number of replacement
properties during the identification period. They offered to
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purchase several different properties, entered into purchase
agreements, and had Clack Bros. make earnest money deposits using
the sales proceeds from the Antioch property. However,
petitioners did not acquire any of these properties. After the
identification period had expired, petitioners continued to
search for possible replacement properties and continued to make
unsuccessful offers as late as December 1989. In January 1990,
petitioners made offers to purchase two parcels of real property:
2001 Contra Costa Boulevard, Pleasant Hill, California, (Pleasant
Hill) and 1032 Skyland Drive, Zephyr Cove, Nevada (Skyland).
Petitioners acquired these properties in February 1990 using the
sales proceeds from the Antioch property.
Petitioners purchased the Pleasant Hill property from a
partnership in which Daniel Fivey was a general partner. The
partnership began construction of a retail shopping center on the
property in mid-1989 and completed construction in February 1990.
The Pleasant Hill property had not been listed for sale with any
real estate brokers. Petitioner husband had previously discussed
another possible replacement property with Mr. Fivey in mid-1989.
During the course of the discussions, Mr. Fivey mentioned the
Pleasant Hill property, which was still under construction and
not available for sale. Petitioner husband did not ask Mr. Fivey
for a tour of the property or for any information about the
property. Petitioners did not express any interest in purchasing
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Pleasant Hill, or otherwise identify Pleasant Hill as replacement
property, at that time or at any time prior to January 1990.
On January 11, 1990, one of petitioners' real estate agents
Kevin Van Voorhis (Mr. Van Voorhis) told petitioner husband that
the Pleasant Hill property was for sale. This was the first time
petitioners had discussed Pleasant Hill with Mr. Van Voorhis, and
petitioner husband did not indicate to Mr. Van Voorhis that he
was familiar with the property. Mr. Van Voorhis informed
petitioner husband that Pleasant Hill could not be part of a
section 1031 exchange for the Antioch property because it was not
identified within the 45-day identification period. On January
26, 1990, petitioners offered to purchase Pleasant Hill for
$3,100,000 and entered into a purchase contract. Petitioners
assigned the purchase contract to Clack Bros., and the purchase
closed on February 15, 1990. The purchase price was paid by
Clack Bros. from the Antioch sales proceeds. Petitioners
negotiated the purchase of Pleasant Hills themselves and paid Mr.
Van Voorhis a finder's fee of $31,000.
Petitioners also looked for residential rental property in
the Lake Tahoe, Nevada, area in 1988 and used Sandra Love (Ms.
Love) as their real estate agent. On October 12, 1989, after the
identification period had expired, petitioners first expressed an
interest in the Skyland property to Ms. Love. They had toured
Skyland that day with another real estate agent but wanted Ms.
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Love to handle the purchase. The Skyland property contains a
waterfront, single-family residence. The house was constructed
during the summer of 1989 and first advertised for sale in June
1989 while under construction. Ms. Love had not previously
discussed the Skyland property with petitioners or shown the
property to them. Petitioners did not indicate to Ms. Love that
they had seen the house prior to October 12, 1989. The next day,
October 13, 1989, petitioners made a verbal offer for the Skyland
property, which they later decided to withdraw. On October 13,
1989, Ms. Love also contacted Mr. Clack, at petitioners' request,
to identify Skyland as replacement property.
After the initial offer, petitioners did not express any
further interest in purchasing Skyland again until January 24,
1990, when they called Ms. Love to inquire as to whether the
Skyland property was still for sale. On January 26, 1990,
petitioners offered to purchase the Skyland property for
$1,200,000 and entered into a purchase contract. Petitioners
assigned the purchase contract to Clack Bros., and the purchase
price was paid by Clack Bros. from the sales proceeds of the
Antioch property. The purchase closed on February 15, 1990.
Petitioners regularly discussed the 45-day identification
requirement with Mr. Clack and with several real estate agents
whom petitioners employed. Mr. Clack repeatedly advised
petitioners to obtain documentation to establish that they had
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identified replacement property within the 45-day period. Mr.
Clack recommended that petitioners purchase replacement property
that had been identified during the 45-day period. Real estate
agents also gave petitioners similar advice, including Mr. Van
Voorhis who recommended that a written identification be
furnished to Mr. Clack as the exchange intermediary. In
September 1989, Mr. Van Voorhis offered to write a letter to Mr.
Clack that identified replacement properties that petitioners
were considering (Van Voorhis letter). Mr. Van Voorhis asked
petitioners which properties to include in the letter and also
included properties that Mr. Van Voorhis had shown to them.
Petitioners did not inform Mr. Van Voorhis that they were
interested in either the Skyland or Pleasant Hill properties in
his preparation of this letter. The letter, dated September 18,
1989, identified 10 potential replacement properties and did not
include either the Pleasant Hill or Skyland properties. Despite
this advice, petitioners did not identify either Pleasant Hill or
Skyland in writing or obtain other written documentation.
Moreover, petitioners did not discuss purchasing either the
Pleasant Hill or Skyland property with Mr. Clack, any of their
real estate agents, or the prior owners of the properties during
the 45-day period.
In January 1990, petitioner husband asked Ms. Love to write
a false letter (Skyland letter) addressed to petitioners
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purporting to acknowledge that petitioners had expressed an
interest in purchasing the Skyland property to her as of
September 1989. The letter was backdated to September 19, 1989,
on petitioner husband's request to misrepresent the time by which
Skyland was identified as replacement property. The letter also
incorrectly stated that petitioners had made a verbal offer to
purchase the property on that date. At petitioners' direction,
Ms. Love also changed the date of petitioners' offer for the
Skyland property from January 26, 1990, to a September date.
Petitioners and Ms. Love also re-dated the purchase contract to
September 19, 1989. In January 1990, petitioner husband also
asked Mr. Fivey to write a similar letter to fabricate an
interest in the Pleasant Hill property during the identification
period (Pleasant Hill letter). The letter, backdated to
September 15, 1989, purported to acknowledge petitioner husband's
interest in acquiring Pleasant Hill.
In late October 1989, after the identification period had
expired, petitioner husband had suggested that documents be
backdated in connection with another property that petitioners
were considering but did not acquire. Petitioners offered to
purchase this property, and the purchase offer was backdated to
be within the identification period. On January 8, 1990,
petitioners received a sample letter from Mr. Clack that was used
to prepare the back dated Pleasant Hill and Skyland letters. The
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sample letter was dated September 5, 1989, and addressed to
petitioner husband. Petitioners received this sample letter
before they expressed an interest in acquiring either Pleasant
Hill or Skyland to Mr. Clack.
In January 1990, petitioner husband also wrote a letter to
Mr. Clack which purported to identify five possible replacement
properties, including the Pleasant Hill and Skyland properties.
Petitioner husband backdated the letter to September 18, 1989,
the date of the Van Voorhis letter identifying potential
replacement property.
Petitioners reported the transfer of the Antioch property on
their 1990 tax return as a section 1031 exchange qualifying for
nonrecognition of gain and reported that they identified
replacement property on September 18, 1989. Respondent
determined that the transaction did not qualify as a section 1031
exchange because petitioners did not timely identify the
replacement property. Accordingly, respondent determined that
petitioners must report the gain realized on the Antioch
property.
Petitioners' accountant relied on the false letters
solicited by petitioner husband from Ms. Love and Mr. Fivey to
prepare petitioners' 1989 and 1990 tax returns. Petitioners
indicated to their accountant that they exchanged the Antioch
property pursuant to section 1031 and that the replacement
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properties had been identified within the 45-day identification
period. During the audit of their tax returns, petitioners'
accountant provided to respondent's revenue agent a copy of the
backdated letter that petitioner husband wrote to Mr. Clack
identifying the Pleasant Hill and Skyland properties. Mr. Fivey
sent the Pleasant Hill letter to the revenue agent. Pursuant to
a written plea agreement with the U.S. Department of Justice,
petitioner husband pleaded guilty to two counts of violating
section 7207 for causing the delivery of false documents to the
Internal Revenue Service (IRS).
Petitioners extended the period of limitations to assess and
collect tax for 1989 and 1990 to December 31, 1994, pursuant to
section 6501(c)(4). Respondent timely issued a notice of
deficiency for 1989 and issued a notice of deficiency for 1990 on
April 12, 1996.
OPINION
Generally a taxpayer must recognize the entire amount of
gain or loss on the sale or exchange of property. Sec. 1001(c).
Section 1031(a)(1) allows taxpayers to defer gain or loss from
exchanges of like-kind property held for business or investment
purposes, as distinguished from a cash sale of property followed
by a reinvestment of the proceeds in other property. Barker v.
Commissioner, 74 T.C. 555, 561 (1980). Section 1031(a)(3)
governs nonsimultaneous like-kind exchanges. To qualify as a
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nonsimultaneous like-kind exchange, the taxpayer must identify
replacement property to be received in the exchange within 45
days after the date the taxpayer transfers the property
relinquished in the exchange. Sec. 1031(a)(3)(A). In this case,
the 45-day period ended on October 6, 1989.
The parties dispute whether petitioners timely identified
either the Pleasant Hill or Skyland properties as replacement
properties. Petitioners contend that they discussed Pleasant
Hill and Skyland with each other during the identification
period. Petitioners further allege that they drove by the
properties while under construction and that petitioner husband
toured the construction site and inquired about building plans
with construction workers. Petitioners concede that they never
indicated that they were interested in acquiring Pleasant Hill or
Skyland to the prior owners of either property, their exchange
intermediary/attorney, Mr. Clack, or any of their numerous real
estate agents. Petitioners contend that identification of
replacement property to each other was sufficient to meet the
identification requirement of section 1031(a)(3)(A). Respondent
contends that petitioners did not consider purchasing Pleasant
Hill or Skyland during the identification period, and even if
they did, petitioners did not adequately identify either
property.
Section 1031(a)(3) provides:
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For purposes of this subsection, any property received by the
taxpayer shall be treated as property which is not like-kind
property if--
(A) such property is not identified as property to
be received in the exchange on or before the day which
is 45 days after the date on which the taxpayer
transfers the property relinquished in the exchange, or
(B) such property is received after the earlier of--
(i) the day which is 180 days after the date on
which the taxpayer transfers the property relinquished
in the exchange, or
(ii) the due date (determined with regard to
extension) for the transferor's return of the tax
imposed by this chapter for the taxable year in which
the transfer of the relinquished property occurs.
The Secretary issued regulations under section 1031 after the
years in issue which require taxpayers to identify replacement
property in a written document signed by the taxpayer and sent to
either (1) the person obligated to transfer the replacement
property or (2) any person involved in the exchange (e.g., a
party, an intermediary, or an escrow agent) other than the
taxpayer or a disqualified person (the taxpayer's agent or a
related party). Sec. 1.1031(k)-1(c)(2), Income Tax Regs. The
regulations apply to transfers of property made on or after June
10, 1991, or in limited cases, transfers made on or after May 16,
1990. Sec. 1.1031(k)-1(o), Income Tax Regs.
As the regulations do not apply in this case, petitioners
contend that during the years in issue, the proper method of
identification was ambiguous. They argue that section
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1031(a)(3)(A) does not expressly require written identification
or specify to whom identification must be made. Petitioners also
argue that the legislative history for section 1031(a)(3) does
not clarify the required method of identifying replacement
property. The conference report provides
The conference agreement follows the
Senate amendment except that transferors are
permitted 45 days after the transfer to
designate the property to be received * * *.
The conferees note that the designation
requirement in the conference agreement may
be met by designating the property to be
received in the contract between the parties.
It is anticipated that the designation
requirement will be satisfied if the contract
between the parties specifies a limited
number of properties that may be transferred
and the particular property to be transferred
will be determined by contingencies beyond
the control of both parties. * * * [H. Conf.
Rept. 98-861, at 866 (1984), 1984-3 C.B.
(Vol. 2) 1, 120.]
Congress' primary concern in amending section 1031(a)(3) was to
prevent long periods of delay between the exchange of properties,
as occurred in Starker v. United States, 602 F.2d 1341 (9th Cir.
1979). H. Conf. Rept. 98-861, supra, 1984-3 C.B. at 120.
Congress added the 45- and 180-day requirements for like-kind
exchanges to address this concern.
It is not necessary for us to decide whether identification
must be in writing. Rather, we must decide whether the steps
taken by petitioners were sufficient. Petitioners have no
credible evidence that they had considered Pleasant Hill or
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Skyland as replacement properties during the identification
period. During that period, petitioners did not inform anyone,
either verbally or in writing, that they were interested in
either property. Petitioners first expressed an interest in
acquiring Pleasant Hill in January 1990 when the property was
brought to their attention by Mr. Van Voorhis. Petitioner
husband may have briefly discussed Pleasant Hill with Mr. Fivey
during the identification period. However, petitioner husband
concedes that he did not indicate to Mr. Fivey any intention to
acquire Pleasant Hill as replacement property until after the
identification period had expired. Petitioners first indicated
their interest in the Skyland property on October 12, 1989.
Petitioners claim that they drove by the house with a real estate
agent in the summer of 1989 while it was under construction.
They did not express an interest in purchasing Skyland at that
time. They also contend that they drove by both properties by
themselves on several occasions and that petitioner husband
viewed the construction site.
However, there is no evidence, other than their testimony,
that petitioners considered purchasing these properties or
expressed an interest in the properties during the identification
period. Throughout the end of 1989, petitioners made a number of
offers and entered into purchase contracts on other properties as
replacements for the Antioch property, including an offer in
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December 1989. Petitioners claim that by October 6, 1989, they
had decided to purchase Pleasant Hill and Skyland. However, they
rely solely on their own testimony in that regard. Apart from
their testimony there is no evidence that they saw the Skyland
property before October 12, 1989 or the Pleasant Hill property
before January of 1990. Even if they had seen either property on
the dates alleged, that would likely not be sufficient to meet
the identification requirement.
Although petitioners are not specifically educated in tax
matters, they are sophisticated real estate investors.
Petitioners repeatedly discussed the identification requirement
with their advisers and were advised as to the adequate measures
of identification. We find that petitioners understood the
importance of timely identification. Indeed, they asked Ms. Love
to identify Skyland to Mr. Clack when they made a verbal offer.
Nevertheless, they never disclosed their alleged interest in the
Pleasant Hill or Skyland properties during the identification
period to anyone, not to Mr. Clack, their real estate agents, or
the prior owners. Petitioners failed to mention either property
to Mr. Van Voorhis in September 1989 when Mr. Van Voorhis
prepared an identification letter to Mr. Clack. Moreover,
petitioner husband did not indicate any prior interest in
Pleasant Hill and acted as if he were unfamiliar with the
property when Mr. Van Voorhis first approached him about it. As
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petitioners knew and understood the need to timely identify
replacement property, it is highly improbable that petitioners
would have kept any actual interest in these properties to
themselves. Under these circumstances, we find to be untrue
petitioners' testimony that their decisions to acquire Pleasant
Hill and Skyland as replacement property were made during the
identification period. As further evidence of the incredible
nature of his testimony, petitioner husband repeatedly testified
that he was not familiar with the 45-day identification
requirement. Yet, Mr. Clack and several real estate agents
testified that they regularly discussed the requirement with
petitioners and that petitioner husband appeared to understand
it.
We find that petitioners did not take any steps to identify
Pleasant Hill or Skyland as replacement property during the
identification period. Moreover, if taxpayers were permitted to
identify replacement property between themselves without
notifying an unrelated party or another party to the exchange,
the identification requirement would be meaningless. Designation
between married taxpayers would also create problems with the
limitation on the number of properties permitted to be identified
and would essentially be the equivalent of permitting taxpayers
to identify an unlimited number of replacement properties. See
St. Laurent v. Commissioner, T.C. Memo. 1996-150. We conclude
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that petitioners did not identify the Pleasant Hill or Skyland
properties as replacement property within the time period
required by section 1031(a)(3)(A). Accordingly, the gain
realized from the sale of the Antioch property is recognizable.
In the notices of deficiency, respondent determined the gain
realized on the sale of the Antioch property without regard to
petitioners' basis in the property. Section 1001 provides that
the gain from the sale of property is the excess of the amount
realized over the adjusted basis. The adjusted basis of property
is its basis (cost) as determined under section 1011 and as
adjusted by section 1016. Sec. 1012. The basis is adjusted for
the costs of improvements and betterments made to the property.
Sec. 1016(a)(1); sec. 1.1016-2(a), Income Tax Regs.
Petitioners paid $300,000 for 137 acres of the Antioch
property and sold 117 acres of the property in the transaction at
issue in this case. Petitioners' original basis in the 117
acres, based on the $300,000 purchase price, is $256,204, as
conceded by respondent. Petitioners also expended approximately
$30,000 in engineering and consulting costs to improve the 137
acres of the Antioch property. We find that petitioners' basis
in the 117 acres of the Antioch property is $281,825, and their
gain realized is $3,687,175 ($3,969,000-$281,825).
Installment Method
Petitioners argue that they are entitled to report any gain
that they must recognize from the sale of the Antioch property in
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1990 under the installment method of section 453. Section 453
permits taxpayers to report gain from the sale of property in the
year payment is received. Payment includes amounts either
actually or constructively received by the taxpayer. Sec.
15A.453-1(b)(3)(i), Temporary Income Tax Regs., 46 Fed. Reg.
10710 (Feb. 4, 1981). Taxpayers are not entitled to report gain
under the installment method if they directly or indirectly
control the sales proceeds or receive the economic benefit
therefrom. Roberts v. Commissioner, 643 F.2d 654, 656 (9th Cir.
1981) (citing Rushing v. Commissioner, 441 F.2d 593, 598 (5th
Cir. 1971), affg. 52 T.C. 888 (1969)), affg. 71 T.C. 311 (1978);
Estate of Silverman v. Commissioner, 98 T.C. 54, 64 (1992).
Respondent contends that petitioners are not entitled to use
the installment sale method because petitioners constructively
received the sales proceeds and received economic benefits from
the proceeds in 1989. Respondent argues that petitioners
obtained control over the sales proceeds when they were deposited
into the Clack Bros.' trust account. The funds were used to make
earnest money deposits on replacement properties that petitioners
wanted to acquire, and petitioners negotiated the purchase price
on the properties. Based on these facts, respondent contends
that petitioners directed how and when the sale proceeds were
spent and, thus, had control over the sales proceeds.
Respondent argues that a seller cannot defer gain
recognition under the installment method by placing the purchase
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price with a third party for payment to the seller in a later
year. Respondent relies on a line of cases, including Griffith
v. Commissioner, 73 T.C. 933 (1980); Pozzi v. Commissioner, 49
T.C. 119 (1967); and Oden v. Commissioner, 56 T.C. 569 (1971),
among others, which found that the seller no longer looked to the
buyer for payment and expected to collect the sales proceeds from
a third-party source, such as an escrow account. Petitioners,
however, argue that the cases cited by respondent did not involve
circumstances where substantial restrictions existed on the
seller's right to the third-party funds. Money deposited in an
escrow account by a buyer is not deemed to be constructively
received by the seller if the seller's right to receive the funds
is subject to substantial limitations or restrictions. Stiles v.
Commissioner, 69 T.C. 558, 563 (1978); Champy v. Commissioner,
T.C. Memo. 1994-355; see sec. 1.451-2, Income Tax Regs.
Here, the exchange agreement provides that petitioners were
to transfer the Antioch property to Clack Bros. in exchange for
property to be identified by petitioners. To accomplish this,
petitioners were to transfer title and assign the proceeds from
the option agreement on the Antioch property to Clack Bros.
Under the agreement, Clack Bros. would have became the seller;
however, petitioners did not follow the agreement in that they
retained title and transferred it directly to the purchaser.
Clack Bros. did receive the sales proceeds and deposited them
into the trust account. Although the exchange agreement provided
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that petitioners were not entitled to exercise control over the
sales proceeds and Clack Bros. was obligated to use the sales
proceeds to acquire replacement property designated by
petitioners, we do not find the agreement with Clack Bros. to be
a sufficient basis for finding a restriction on petitioners'
ability to use the proceeds of sale.
Petitioners, as a guise, named 10 properties within the 45-
day period with no apparent intention to use them as replacement
properties. When the replacement properties suitable to
petitioners were designated (after the 45-day period),
petitioners, with Clack's cooperation and participation,
backdated documents to make it appear that the properties had
been timely identified. In this setting, we hold that
petitioners have failed to show that any restriction on their
ability to use the proceeds was sufficient to avoid constructive
receipt in 1989. Accordingly, petitioners are not entitled to
installment reporting into the 1990 taxable year.
Fraud Penalty
Section 6663(a) imposes a penalty equal to 75 percent of any
underpayment that is due to fraud. Fraud is defined as an
intentional wrongdoing designed to evade tax believed to be
owing. Edelson v. Commissioner, 829 F.2d 828, 833 (9th Cir.
1987), affg. T.C. Memo. 1986-223; Bradford v. Commissioner, 796
F.2d 303, 307 (9th Cir. 1986), affg. T.C. Memo. 1984-601.
Respondent has the burden of proving fraud by clear and
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convincing evidence. Sec. 7454(a); Rule 142(b).3 To satisfy
this burden, respondent must prove that petitioners intended to
evade taxes known to be owing by conduct intended to conceal,
mislead, or otherwise prevent the collection of taxes. Rowlee v.
Commissioner, 80 T.C. 1111, 1123 (1983).
The existence of fraud is a question of fact to be resolved
upon consideration of the entire record. DiLeo v. Commissioner,
96 T.C. 858, 874 (1991), affd. 959 F.2d 16 (2d Cir. 1992); Estate
of Pittard v. Commissioner, 69 T.C. 391 (1977). Fraud is never
presumed and must be established by independent evidence that
establishes fraudulent intent. Edelson v. Commissioner, supra;
Beaver v. Commissioner, 55 T.C. 85, 92 (1970). Fraud may be
proven by circumstantial evidence because direct evidence of the
taxpayer's fraudulent intent is seldom available. Spies v.
United States, 317 U.S. 492 (1943); Rowlee v. Commissioner,
supra; Gajewski v. Commissioner, 67 T.C. 181, 199 (1976), affd.
without published opinion 578 F.2d 1383 (8th Cir. 1978). The
3
Petitioners had raised the defense that the period for
assessment had expired when respondent issued the notice of
deficiency for the 1990 year. The 1990 year comes into play in
the context of this case if petitioners are entitled to
installment sale treatment. In that event respondent would also
have the burden of proving that an exception to the general
period of limitations applies. Stratton v. Commissioner, 54 T.C.
255, 289 (1970). That question is mooted by our holding that
petitioners are not entitled to installment reporting. Even if
petitioners had been successful on the installment reporting
issue, respondent has carried the burden of showing a fraudulent
return, and, therefore, the period for assessment would not have
expired prior to issuance of the deficiency notice. Sec.
6501(c)(1).
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taxpayer's entire course of conduct may establish the requisite
fraudulent intent. Stone v. Commissioner, 56 T.C. 213, 223-224
(1971); Otsuki v. Commissioner, 53 T.C. 96, 105-106 (1969).
Courts have developed several indicia of fraud, or "badges
of fraud", which include: (1) Understatement of income, (2)
inadequate books and records, (3) failure to file tax returns,
(4) implausible or inconsistent explanations of behavior, (5)
concealment of assets, (6) failure to cooperate with tax
authorities, (7) filing false Forms W-4, (8) failure to make
estimated tax payments, (9) dealing in cash, (10) engaging in
illegal activity, and (11) attempting to conceal illegal
activity. Douge v. Commissioner, 899 F.2d 164, 168 (2d Cir.
1990); Bradford v. Commissioner, supra at 307; Recklitis v.
Commissioner, 91 T.C. 874, 910 (1988). This list is
nonexclusive. Miller v. Commissioner, 94 T.C. 316, 334 (1990).
The strongest evidence of fraud in this case consists of the
false documents that petitioner husband prepared and solicited to
make it appear that petitioners expressed an interest in the
Pleasant Hill and Skyland properties within the identification
period. Submitting false documents to the IRS is an indication
of fraud. Stephenson v. Commissioner, 79 T.C. 995, 1007 (1982),
affd. 748 F.2d 331 (6th Cir. 1984); Association Cable TV, Inc. v.
Commissioner, T.C. Memo. 1995-596.
Petitioners contend that their attorney Mr. Clack advised
them to obtain the false documents. Petitioners maintain that
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they relied on Mr. Clack's advice and that they did not know that
written identification was required and did not realize the
significance of the false, backdated letters. We believe,
however, that petitioner husband initiated the idea of backdating
documents and falsifying identification and, more importantly,
that petitioners knew their misrepresentations were fraudulent.
Mr. Clack maintains that it was petitioner husband's idea to
falsify documents. In late October 1989, petitioner husband
suggested backdating and falsifying a purchase offer and contract
for another property not ultimately purchased by petitioners in
order to fraudulently obtain section 1031 tax deferral. Mr.
Clack denies that he advised petitioners to falsify documents to
establish timely identification but admits that he assisted
petitioners in perpetuating this fraud. Mr. Clack provided a
backdated sample letter that petitioners used in soliciting the
Pleasant Hill and Skyland letters. Mr. Clack contends that he
believed that petitioners in fact had expressed an interest in
the Pleasant Hill and Skyland properties during September to Ms.
Love and Mr. Fivey and that he did not know that the letters were
false (other than being improperly backdated). Petitioners
received the sample letter from Mr. Clack before they expressed
interest in acquiring Pleasant Hill or Skyland. Most likely,
petitioners obtained the letter because they intended to create a
false impression that they had timely identified whatever
property they acquired.
- 25 -
Petitioners had repeated discussions with their real estate
agents and Mr. Clack about the identification requirement and the
need to adequately identify replacement property. Mr. Clack
advised petitioners of the need to acquire property that had been
identified during the 45-day period. Mr. Van Voorhis and other
real estate agents counseled petitioners to have written
documentation of their identification. When Mr. Van Voorhis
first showed Pleasant Hill to petitioners, he informed them that
it could not qualify as replacement property because it was not
timely identified. A letter attached to the exchange agreement
clearly informed petitioners of the need to identify property
within 45 days of the sale of the Antioch property.
We find in this setting petitioners cannot rely on Mr.
Clack's advice as an excuse for their fraudulent conduct. They
knew their actions were fraudulent because of the repeated advice
they received. Petitioners were not misled into committing fraud
by their attorney, as they contend. See Medieval Attractions
N.V. v. Commissioner, T.C. Memo. 1996-455. We consider it
probative that petitioner husband pleaded guilty to submitting
false documents to respondent's revenue agent in violation of
section 7207. Although this conviction does not alone establish
fraudulent intent to evade taxes, it is evidence of petitioner
husband's intent and propensity to defraud. Petzoldt v.
Commissioner, 92 T.C. 661, 701-702 (1989); Alvarez v.
Commissioner, T.C. Memo. 1995-414.
- 26 -
Petitioners are highly successful, effective, and
sophisticated real estate investors. They knew that they had not
timely identified Pleasant Hill or Skyland as replacement
property and that the transaction did not qualify as a section
1031 exchange. Petitioners reported the transaction as a section
1031 exchange and knowingly and deceptively deferred tax on over
$3.5 million in taxable gain. Petitioners willfully took steps
to disguise the taxable sale as a section 1031 exchange.
Petitioner husband knowingly solicited fabricated letters from
Mr. Fivey and Ms. Love. He also knowingly intended to commit
fraud when he backdated a letter to Mr. Clack in which petitioner
husband purported to identify Pleasant Hill and Skyland. It is
likely that petitioner husband intended this letter to replace
the Van Voorhis letter which identified 10 replacement
properties, not including either Pleasant Hill or Skyland.
Petitioners were involved in the preparation of these false
documents and presented them to their accountant and to the IRS
as part of their tax returns and in support of their reporting
during the audit.
Petitioners argue the false documents were not fraudulent
because written identification was not required under section
1031(a)(3)(A) and the regulations thereunder during the years in
issue. This case involved more than fabricated written
identification. We have found that petitioners did not show any
interest in the Pleasant Hill property or the Skyland property
- 27 -
within the identification period, and we do not believe their
self-serving and uncorroborated testimony that, during the
identification period, they discussed these properties with each
other and decided to buy them.
Although they knew that they had not identified Pleasant
Hill or Skyland even verbally, petitioners misrepresented to the
IRS that they had in fact identified the replacement property and
reported the transaction as a section 1031 exchange. Petitioners
knew that they would owe a substantial amount of tax if they did
not timely identify replacement property. The law is clear with
respect to this issue. Petitioners fabricated timely
identification and obtained false documents to substantiate their
claim. Petitioners knew that the letters were false and that
their tax returns were false. The false letters, even if not
required for adequate identification, are evidence of fraud. See
Association Cable TV, Inc. v. Commissioner, T.C. Memo. 1995-596.
Petitioners' conduct presents clear and convincing evidence
of their intent to defraud. Accordingly, petitioners are liable
for a section 6663 fraud penalty for 1989.
To reflect the foregoing,
Decisions will be entered
under Rule 155 in docket No. 3832-
95 and for petitioners in docket
No. 7382-96.