Smalley v. Commissioner

In 1994 D. G. Smalley (plaintiff) and Rayonier, Inc., entered into an agreement in which Rayonier would have exclusive rights to cut lumber on Smalley’s land for two years in exchange for approximately $517,000. Approximately $505,000 was placed into an escrow account. In 1994 and early 1995, Smalley purchased land containing standing timber using the money in the escrow account but did not receive ownership of the land until 1995, when the owners of the land transferred the deeds to Smalley. On his 1994 income-tax return, Smalley classified his sale of lumber and purchase of land as a like-kind exchange of standing timber for standing timber, arguing that it was covered by § 1031 of the Internal Revenue Code (IRC). Accordingly, Smalley treated the profit from the sale of lumber as a deferred gain. Smalley pointed to § 453 of the IRC, the provision that governs installment sales, which stated that if a taxpayer who sells property is going to receive a payment in a later year, the payment is to be treated as income the year it is received. In the case of a deferred exchange, § 453 incorporated § 1031 and allowed the parties involved in the deferred exchange to wait to pay taxes until the exchange is completed, when the parties have actual or constructive receipt of the property. Smalley argued that he did not have receipt of the exchanged property until he purchased the replacement land using the funds held in escrow. The Commissioner of Internal Revenue (the Commissioner) (defendant) held that the exchange was incorrectly classified. Rather, the contract for lumber cutting involved personal property and could not be in a like-kind exchange for real property. Smalley countered by arguing that regardless of how the exchange was classified, he had a bona fide belief that he was entering into a like-kind exchange, and therefore § 1031 still applied. Smalley petitioned the United States Tax Court for a redetermination.