Internal Revenue Service
Revenue Ruling
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smRev. Rul. 78-30
1978-1 C.B. 133
Sec. 446
IRS Headnote
Liability for loan; dredging costs; distortion of income. A cash method individual who pays the dredging costs of a developer's beach front property with his own funds and the proceeds of a nonrecourse loan from a financial institution that will be paid a portion of the sale price of each lot until the loan is repaid with interest, after which the individual will receive the same portion of the sale price of the remaining lots, may deduct only the portion of the dredging costs paid with his own funds. Further, such costs are deductible only in the year payments are received and only in the ratio that the amount received bears to the total amount expected to be received.
Full Text
Rev. Rul. 78-30 [fn1]
Advice has been requested regarding the treatment of dredging costs under the circumstances described below.
Corporation X, the owner of certain beachfront property, sought to develop the property into 30 lots to offer for sale. In January 1977, A, an unrelated party and an individual investor, utilizing the cash receipts and disbursements method of accounting and reporting on a calendar year basis, entered into a contract (the contract) with corporation X to pay the cost of dredging the property in preparation for its sale in parallel lots. The 80x dollar dredging fee, paid by A to an unrelated dredging company, consisted of 20x dollars of A's funds and a 60x dollar loan to A from an unrelated lending institution bearing interest at 7 percent. A had no liability on the loan in excess of amounts received under contract and X guaranteed and provided property as security for repayment of the loan. Under the contract, Corporation X would pay A 120x dollars for having had the property dredged. The 120x dollars would be paid in 4x dollar increments as each lot was sold. All of such increments were to be paid by A to the lending institution to satisfy the loan until the principal of the loan and accumulated interest were satisfied. Thereafter, A would retain the entire amount of each 4x dollar payment received.
In 1977 A expended 80x dollars to dredge the beachfront property. In A's 1977 Federal income tax return, A reported no income from its investment in the beachfront property and deducted 80x dollars as expenses incurred for the production of income against 100x dollar income from other sources.
The specific issues presented are:
(1) Whether the loan represents a liability of A, and
(2) Whether dredging costs "incurred" by A are deductible for the year in which such costs were paid.
Issue #1
Section 212(1) of the Internal Revenue Code of 1954 provides that, in the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in which made for the production or collection of income.
In order for the 60x dollar portion of the dredging costs paid from the loan to be considered an expenditure of A, it must first be determined that such loan is, in substance, a liability of A.
Rev. Rul. 77-125, 1977-1 C.B. 130, holds that where a taxpayer's only relation to a nonrecourse loan is its formal status as maker, and where (1) payment of the loan is guaranteed and secured by a film owner, and (2) satisfaction of the loan is to come from earnings from the film, or from the film maker's payment under its guarantee agreement, the film owner and not the taxpayer, is considered the true borrower of the funds for Federal income tax purposes. Payments made by the taxpayer out of the proceeds of the loan are thus considered to be disbursed by the taxpayer as agent for the film owner and, therefore, do not constitute expenditures incurred by the taxpayer.
In this case, the loan is made to A but A has no liability with respect to the loan and all proceeds accruing to A from sale of the lots are assigned to the lender until the loan is repaid. Accordingly, the loan is, in substance, made to X and is not a liability of A. Therefore, expenditures from the loan proceeds are not deductible costs incurred by A.
Issue #2
Because only 20x dollars were incurred by A on A's own behalf, Issue #2 relates only to the proper year for deducting the 20x dollar costs.
Section 446(a) of the Code provides that taxable income shall be computed under the method of accounting on the basis of which a taxpayer regularly computes income in keeping the taxpayer's books.
Section 1.446-1(c)(i) of the Income Tax Regulations provides that under the cash receipts and disbursements method, expenditures are to be deducted for the taxable year in which actually made.
Section 446(b) of the Code and section 1.446-1(a)(2) of the regulations provide, in part, that, if the method of accounting used by the taxpayer does not clearly reflect income, the computation of taxable income shall be made under such method as in the opinion of the Commissioner of Internal Revenue does clearly reflect income.
Section 461(a) of the Code provides that the amount of any deduction allowed by subtitle A shall be taken for the taxable year that is the proper taxable year under the method of accounting used in computing taxable income.
Section 1.461-1(a)(1) of the regulations states that if an expenditure results in the creation of an asset having a useful life that extends substantially beyond the close of the taxable year, such expenditure may not be deductible or may be deductible only in part for the taxable year in which made.
Section 446(c)(1) of the Code provides that, subject to the provisions of section 446(a) and (b), a taxpayer may compute taxable income under the cash receipts and disbursements method; an accrual method; any other method permitted by subchapter E of Subtitle A; or any combination of the foregoing methods (hybrid method) permitted under regulations prescribed by the Secretary of the Treasury or the Secretary's delegate.
Section 1.446-1(a)(1) of the regulations provides, in part, that the term "method of accounting" includes not only the over-all method of accounting of the taxpayer but also the accounting treatment of any item.
Section 461 and the regulations thereunder control the time for the allowance of deductions. The timing authority in section 461 is subject to the distortion of income standard in section 446(b). See Burck v. Commissioner, 533 F.2d 768 (2d Cir. 1976); Cole v. Commissioner, 64 T.C. 1091 (1975); and Sandor v. Commissioner, 62 T.C. 469 (1974), aff'd per curiam, 536 F.2d 874 (9th Cir. 1976).
In the present case, the deduction of expenditures in the year incurred would result in a substantial distortion of income.
Although A owns a contract right to payments from the future sale of lots rather than an interest in the land improvement, recovery of the cost of the contract right is directly related to the flow of income from the sale of the lots.
Accordingly, when A is entitled to retain the funds received from the sale of the lots, A may deduct a portion of the 20x dollars each year determined by multiplying the 20x dollars by a ratio of the amounts received and retained by A during the year to the total amount that A expects to receive and retain during the life of the contract.
[fn1] Also released as News Release IR-1921, dated December 23, 1977.