                      106 T.C. No. 12



                UNITED STATES TAX COURT



  HIGHLAND FARMS, INC. AND SUBSIDIARY, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 6642-93.               Filed April 17, 1996.



     P, an accrual basis taxpayer, operates a
continuing-care residential retirement community that
has five types of accommodations: cluster homes or
condominiums; apartments; a lodge; a rest home; and a
skilled nursing health-care center. The rest home and
health-care center are not involved in this case. The
residents purchase the cluster homes or condominiums
for the full purchase price and pay the taxes,
insurance, and utilities for their unit. The cluster
home or condominium owner can transfer the unit only to
P which must repurchase the unit at certain percentages
of the original purchase price during the first 7 years
after purchase and thereafter at not less than 76
percent of the original purchase price. The residents
of the apartments and the lodge must pay a lump-sum
entry fee before taking occupancy and must thereafter
pay a monthly rent. Except for the first 10 percent,
the entry fees for the apartments are refundable on a
prescribed percentage basis over a 5-year period.
Except for the first 5 percent, the entry fees for the
lodge are refundable on a prescribed percentage basis
over a 20-year period.
                               - 2 -

          Held: The cluster home or condominium transactions
     constitute sales rather than financing arrangements so
     that P must include in income the net gains on the
     sales and is not entitled to depreciation deductions on
     the units.
          Held further: The entry fees do not constitute prepaid
     rent or advance payments for services that must be
     reported in the year of receipt. P's reporting of the
     nonrefundable or nonforfeitable portions of the entry
     fees each year clearly reflects income. Commissioner
     v. Indianapolis Power & Light Co., 493 U.S. 203 (1990);
     Oak Industries, Inc. v. Commissioner, 96 T.C. 559
     (1991) applied.



     David M. Furr and John D. Kersh, Jr., for petitioners.

     James E. Gray and Paul G. Topolka, for respondent.



     PARKER, Judge:   Respondent determined a deficiency in

petitioners' Federal income tax in the amount of $2,531,650 and

an addition to tax under section 6661 in the amount of $632,913

for the taxable year 1988.1

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the taxable year before

the Court, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

     After respondent's concession,2 the issues for decision are:


     1
       Respondent also determined that the deficiency meets the
definition of a large corporate underpayment under sec. 6621(c)
as in effect for determining interest for periods after Dec. 31,
1990, and, therefore, that the rate of interest on the deficiency
will be increased by 2 percent over the usual rate determined
under sec. 6621(a)(2).
     2
       Respondent no longer asserts an adjustment of $5,001,633
deriving from the cluster home or condominium "liabilities"; that
                                                   (continued...)
                               - 3 -

(1) Whether partially refundable entry fees paid by residents of

the apartment and lodge units are includable in income in the

year of receipt as advance payments or prepaid rent or are

deposits to be reported ratably in accordance with the accrual of

nonrefundable or nonforfeitable portions; (2) whether the

purchase prices paid by cluster home or condominium purchasers

are sales receipts3 or are loans or financing arrangements; and

(3) whether petitioner Highland Farms, Inc. is liable for the

addition to tax under section 6661.

                         FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

The stipulation of facts and the exhibits attached thereto are

incorporated herein by this reference.

     Highland Farms, Inc. (petitioner), is a corporation duly

organized and existing under the laws of the State of North

Carolina.   Petitioner's principal place of business was located

in Black Mountain, North Carolina, at the time it filed the

petition in this case.   Petitioner is the parent corporation of

its wholly owned subsidiary, Highland Farms Associates, Inc.



(...continued)
is, the unrecognized portions of the cluster home or condominium
receipts equivalent to the repurchase liabilities. This
concession is consistent with respondent's treating the cluster
home or condominium transactions as sales. In the notice of
deficiency, respondent was, in effect, including both the gross
amount of the sales receipts and the gain from the sales.
     3
       The resolution of this issue will determine whether
petitioner Highland Farms, Inc. is allowed depreciation for the
cluster homes and condominiums.
                                - 4 -

     Petitioner operates the Highland Farms Retirement Community

(Highland Farms), a continuing-care residential retirement

community located in the Swannanoa Valley in western North

Carolina, approximately 1 mile west of the town of Black Mountain

and approximately 13 miles east of Asheville.   During 1988,

Highland Farms included five different types of accommodations:

cluster homes or condominiums,4 apartments, a lodge, a rest home,

and a health-care center.   This full-service community allowed

residents to proceed through different levels of independent

and/or assisted living accommodations, if they so chose, as their

needs changed.

     Highland Farms had numerous facilities for leisure

activities and hobbies.   These facilities included lounges for

social functions, a woodworking shop, arts and crafts rooms, a

library, a music room, pianos, organs, a greenhouse, vegetable

gardens, a billiard room, shuffleboard, horseshoes, croquet, a

whirlpool, and a photography darkroom.   The recreational

facilities were generally available without charge for most

Highland Farms residents,5 but petitioner charged for instruction

or materials.    Also located on the premises were a beauty salon,

a barber shop, and a commissary.   Petitioner made available two

guest rooms at reasonable rates.


     4
       All references to cluster homes hereafter will also
include condominiums. References to condominiums, however, will
be to the condominiums only.
     5
       Cluster home residents were charged a monthly fee for the
recreational facilities; during 1988, this fee was $15 per
occupant, not including materials.
                                 - 5 -

Cluster Homes

     Cluster homes featured individually owned units grouped in

clusters of four to six units with attached carports.    The

cluster homes were available with one, two, or three bedrooms.

Cluster homes were available for purchase only and required

payment of a monthly maintenance fee.    In addition, condominium

units were available for purchase only and required payment of a

monthly maintenance fee.   Petitioner reserved the right to

increase the maintenance fee effective the first of each calendar

year with 30 days' notice to the owners.

      Three legal documents were executed in connection with the

purchase of a cluster home:   a deed, a purchase agreement, and a

lease agreement.   Petitioner's attorney, Charles Worley, drafted

these documents for petitioner's use.    All three documents made

reference to the other two documents.    A copy of the purchase

agreement was attached to the recorded deed, and the terms of the

purchase agreement were also incorporated into the deed by

reference.   Pursuant to the deed, petitioner "bargained and sold"

and conveyed the cluster home unit in fee simple to the

purchaser.   The lease agreement was for the surrounding yard; the

lease payment was $1 per month.    The term of the lease ran "for a

term coinciding with [purchaser's] ownership" of the cluster

home, terminating upon the "sale or other disposition" by the

purchaser of the cluster home.    The purchase agreement remained

in effect as long as the owner occupied the cluster home.

     In the purchase agreement, petitioner agreed to convey and

the purchaser agreed to purchase the identified unit.    In the
                                - 6 -

case of an already existing cluster home, the purchase agreement

required a deposit of 15 percent of the purchase price upon

execution of such agreement and the balance at closing.    If the

cluster home were to be constructed, the initial deposit was 20

percent of the purchase price upon execution of the agreement, 40

percent within 5 days after notification that the house package

had arrived at the construction site, and the balance at closing.

     Cluster home owners were responsible for payment of real

estate taxes on the cluster home and were billed by Buncombe

County individually for those taxes.    Cluster home owners were

responsible for maintaining homeowners' insurance on their units

and were individually billed by their homeowners' insurance

company for the same.    Cluster home owners were also responsible

for payment of their utilities as billed to them individually by

the utility companies.   Petitioner was responsible for

maintaining the lawns, driveways, exteriors of the structures,

and major repairs to appliances and their replacement.

     In the event of total destruction of the cluster home,6 the

cluster home reverted back to petitioner, and the owner was

entitled to keep the proceeds of the insurance policy.    If the

destruction was only partial, the owner had the option to repair

the home or resell it to petitioner in its damaged condition.

Under the latter option, the repurchase price would be reduced by

the cost of restoring the home.

     The purchase agreement placed the following restrictions on

     6
       Total destruction was defined as destruction of over 70
percent of the cluster home.
                               - 7 -

the cluster home owners:

     (1)   Each cluster home owner was required to abide by the

rules and regulations of Highland Farms.

     (2)   Each cluster home owner was prohibited from carrying on

any noxious or offensive activity in the cluster home or on the

grounds of Highland Farms.

     (3)   At least one occupant of the cluster home had to be 55

years of age or older; no occupant could be under 18 years of

age; and no more than three persons could reside in the cluster

home.

     (4)   No cluster home owner could lease or assign any rights

in the cluster home and the ground surrounding the cluster home

without petitioner's express permission.

     (5)   No cluster home owner could convey or attempt to convey

by deed or otherwise any incident of ownership in and to the

cluster home and the grounds surrounding the cluster home without

petitioner's express written permission.

     (6)   The cluster home owner could not make any structural

changes or additions to the cluster home without the written

consent of petitioner.

     With the exception of the destruction provision, if the

owner of a cluster home desired to sell the home or died within

the first 7 years of residence, petitioner was obligated to

repurchase the cluster home for a certain percentage of the

original purchase price according to a schedule in the purchase

agreement.   If this occurred within the first 12 months from the

date of purchase, the repurchase price was the original price
                                 - 8 -

less 6 percent.   Each year thereafter, up to 7 years after the

date of sale, the repurchase price was reduced by an additional 3

percent of the original price.    Anytime after 7 years, the

repurchase price was 76 percent of the original price of the

cluster home.

     Lease and maintenance fee payments that were in arrears for

more than 60 days would accumulate interest at the rate of 9

percent per annum.    Such payments were considered liens on the

ownership of the cluster homes and were required to be paid in

full with interest prior to, or out of, the repurchase monies.

     Cluster home owners were required to give 90 days' notice of

intent to vacate.    Those owners who wished to move into a

Highland Farms apartment would receive the appropriate repurchase

price, plus a credit towards the apartment's entry fee of 1

percent of the cluster home purchase price per year of cluster

home occupancy, up to a maximum of 7 years.      Where petitioner

allowed structural changes, it required the owners to pay the

cost of the addition and amended the original purchase agreement

so that the repurchase price would include not less than 76

percent of the cost of the addition.

     The cluster home purchasers understood that they were

required to transfer the cluster home back to petitioner for a

percentage of the original purchase price.      Petitioner has always

honored its repurchase commitment.       Petitioner has not and as a

practical matter would not have allowed any cluster home owner to

sell the cluster home to a third party, nor would petitioner

approve an owner's subletting the unit, even if the potential
                               - 9 -

purchaser or lessee met the residency requirements of Highland

Farms.   Up to the time of the trial petitioner had allowed only

two transfers of ownership:   (1) A cluster home owner married

another cluster home owner, the wife transferred title of her

unit to herself and her new spouse as tenants by the entireties,

and petitioner repurchased the husband's unit; and (2) an owner

transferred title of his unit to a grantor trust, subject to the

same terms and conditions of the purchase agreement.    Up to the

time of the trial petitioner had resold each repurchased cluster

home for a price higher than its original purchase price.7

     The parties stipulated that the testimony of the cluster

home purchasers would be that the transactions were always

represented to the purchasers as sales, and that at no time did

petitioner make representations to the purchasers, either in

writing or orally, that the transactions were loans or mortgages

or that there was a mortgagor-mortgagee or lender-borrower

relationship between the parties.   Petitioner, however, contends

such a relationship is evident in the purchase agreement.    The

parties also stipulated that it was the cluster home purchasers'

understanding that they were required to transfer their cluster

homes back to petitioner for a percentage (not less than 76

percent) of the original purchase price.   This was also the

understanding of petitioner's president, James Neves.


     7
       Although it had never happened as of the time of the
trial, if real estate market prices fell, petitioner would resell
the repurchased cluster home for a price less than its original
purchase price.
                                   - 10 -

Apartments

     Apartments were available in efficiency, one bedroom, or two

bedroom units.     Each apartment had a private patio or balcony.

All apartments had fully equipped kitchens, electric baseboard

heating, cable television hookup, and adequate closet space.

Each apartment was connected to the fire alarm system and an

emergency call system.     The apartments were linked by enclosed

corridors to all facilities on the premises.

     Apartments were available only upon payment of an entry fee

and monthly rent pursuant to a rental contract.        Petitioner

collected the entire entry fee before the resident moved into an

apartment; no interest accrued on the entry fee.        The monthly

rent included the cost of utilities and emergency nursing

services.    Petitioner reserved the right to revise the monthly

rent.   The entry fees and monthly rent (exclusive of meals) for

the apartments during 1988 were as follows:

     Type of Unit      Entry Fee        Monthly Rent

     Efficiency        $16,000              $470

     One Bedroom        22,000               649

     Two Bedrooms       28,000               829

     Petitioner required the residents of the apartments to dine

in the main dining room 25 times per month; a separate charge

applied to the meal service.       Guests were welcome at meals for a

nominal charge.     Petitioner charged the apartment residents

separately for medical costs and other special services, such as

transportation, housekeeping, and laundry.
                              - 11 -

     The rental contract did not specify the length of the

agreement.   Residents intending to terminate occupancy were

required to give 120 days' notice and were obligated to pay the

rent for that period even if they vacated the premises prior to

the end of the 120-day period, unless a new tenant rented the

unit within that time.   Residents transferring to the health-care

center were required to give only 60 days' notice.    Petitioner

had the right to evict an apartment resident on demand for

failure to keep financial accounts current.   If a resident was

disruptive, created an undue hazard to himself or others, or

failed to abide by the rules and regulations of Highland Farms,

petitioner had the right to terminate the rental agreement.

Should the resident's physical or mental condition become such

that continued occupancy of the apartment would pose a hazard to

the resident or others, petitioner, in consultation with its

medical staff and the resident's family, would attempt to find

suitable accommodation in the lodge, health-care center, or

elsewhere.   The agreement would terminate in the event of

destruction of the building rendering the apartment

uninhabitable, except the agreement would not terminate if

petitioner opted to repair the building and provided the resident

with accommodations during the repair period.

      According to the rental contract, the entry fee was deemed

to have been earned by petitioner:

     Ten (10%) percent at the time the Tenant takes
     occupancy of the Unit.

     Ten (10%) percent during the first year of occupancy,
                              - 12 -

     prorated on a monthly basis.

     Twenty (20%) percent during each of the next four (4)
     years, prorated on a monthly basis.

If a resident terminated the rental contract or died within the

first 5 years, petitioner refunded to the resident or the

resident's estate the portion of the entry fee deemed unearned.

However, petitioner was entitled to offset against this refund

any amounts due under the terms of the agreement, such as health-

care center charges.

The Lodge

     The lodge was a 38-unit residence for those requiring hotel-

type services.   It had two-floor elevator service.   The lodge

offered four types of accommodations all of which had a private

bath:

     (1) Single room--residents of these units were required to

eat in the main dining room three meals per day.

     (2) Studio apartment with combination sink, two-burner range

and refrigerator--residents were required to eat in the main

dining room at least two meals per day.

     (3) Expanded studio apartment with larger kitchen and

approximately 50 percent more living space than a regular

studio--residents were required to eat in the main dining room at

least two meals per day.

     (4) One bedroom apartment with fully equipped kitchen, full

bath, living/dining room, and bedroom with walk-in closet--

residents were required to eat one meal per day in the main

dining room.
                               - 13 -

     Each of the four types of lodge accommodations required

payment of an entry fee and monthly rent in accordance with a

rental contract.    Petitioner could revise the monthly rent with a

minimum of 30 days' notice to the lodge residents.    Separate

payments were made for the meal service, medical costs, and other

services.    The rental contract did not specify the length of the

agreement.   The rights to terminate the contract of both

petitioner and the resident were similar to those rights under

the apartment rental contract.

     The entry fees and monthly rent (exclusive of meals) for the

lodge units during 1988 were as follows:

     Type of Unit          Entry fee       Monthly Rent

     Single Room           $25,000             $425

     Studio Apartment       26,500              452

     Expanded Studio        35,000              632

     One Bedroom            52,000              844

Petitioner collected the entire entry fee before the resident

moved into a lodge unit.    If the entry fee was received more than

60 days prior to the date of occupancy, the contract called for

petitioner to credit the resident with interest at the rate of 10

percent per annum for the period between the date of deposit and

the date of occupancy.

     If the prospective resident terminated the contract prior to

occupancy, petitioner refunded the entry fee plus any interest,

less a discount of 5 percent of the entry fee.    If the tenant

terminated the contract or died within the first 20 years of
                                - 14 -

occupancy, refunds would be made in accordance with a schedule

attached to the contract, subject to a minimum discount of 5

percent of the entry fee.     Such a schedule is not part of the

record; however, after the first 5 percent the first year, the

balance of the entry fee is taken into income by petitioner over

the next 19 years.

Rest Home

       The 30-bed rest home provided 24-hour nursing care in a

homelike environment.    Many private rooms allowed residents to

use their own furnishings, creating a homelike atmosphere in an

institutional setting.    All meals, housekeeping, and laundry

services were provided.     The rest home did not charge an entry

fee.    There were no adjustments in the notice of deficiency

pertaining to the rest home.

Health-Care Center

       The health-care center (center) was a 60-bed licensed,

skilled nursing facility to serve residents' medical needs and

was approved by Medicare, Medicaid, and major insurance carriers.

All Highland Farms residents had 24-hour skilled nursing care

available to them at a moment's notice.     Nursing care could also

be provided within a residence for a limited time with the prior

approval of the residence director.      Residents of Highland Farms

unable to care for themselves, in a short-term or long-term

illness, were given priority for a bed in the center.     The center

offered physical, speech, and occupational therapy.     The center's

Social Services and Activities Department offered full-time
                               - 15 -

counseling and therapeutic recreational programs for the center's

patients.    The center did not charge an entry fee.   There were no

adjustments in the notice of deficiency pertaining to the health-

care center.

Petitioner's History

     When petitioner entered into this industry in 1969, most

retirement facilities in existence were church-sponsored.    These

were primarily life-care programs requiring a large nonrefundable

lump-sum payment.

     Petitioner was among the first privately owned businesses to

enter this field.    A total of 21 individuals contributed $5,000

each to start the company.    When petitioner was preparing to

build its cluster homes and apartments, bank financing was not

available for retirement communities.    Petitioner viewed the

entry fees and the cluster home purchases as a method of

financing.

     Petitioner filed a Declaration of Condominium (Declaration)

with the Office of the Register of Deeds, Buncombe County, North

Carolina, on April 3, 1987.    The purpose of the Declaration was

to create:

     a condominium development providing for individual
     ownership of the real property estates consisting of
     the area of space contained in each dwelling unit in
     said buildings, and the co-ownership by the individual
     and separate owners thereof, as tenants in common of
     all the remaining real property * * *.

In the Declaration, petitioner agreed to divide the subject

property into 16 "legally described freehold estates" consisting

of the 16 condominium units and one freehold estate consisting of
                                - 16 -

the common area.     Paragraph 21.5 of the Declaration states,

     Leasing or renting of Unit is not prohibited; provided,
     however, that so long as [petitioner] owns or control
     (sic) the Highland Farms Retirement Complex,
     prospective tenants must first be approved by
     [petitioner] for suitability within the Highland Farms
     Complex, which approval shall not be unreasonably
     withheld.

Petitioner filed an amendment to the Declaration on December 31,

1987, adding more units and area to the condominium.

     As of June 27, 1991, the overall average length of occupancy

of an apartment unit by a particular resident was 5 years, 2

months.8    As of June 27, 1991, the overall average length of

occupancy of a lodge unit was 2 years, 4 months.9    Petitioner's

occupancy data was not analyzed on an individual resident basis.

Petitioner opines that if occupancy were calculated on an

individual resident basis, the average length of occupancy would

have been longer than that by unit, since some residents changed

apartments.     The actuarial life expectancies of the lodge

residents10 upon their entry dates ranged from 3.0 years to 15.3

years.     A sample of 15 of the 123 apartment residents exhibited

life expectancies at entry ranging from 5.7 years to 15.3

years.11



     8
       The average length of occupancy for each unit was
calculated, and then the overall average length of occupancy for
all units was calculated.
     9
          See supra note 8.
     10
       This data was compiled using the residents at the time of
the analysis, sometime in mid-1991.
     11
       See supra note 10. This sample was drawn by taking each
eighth account beginning with the eighth account.
                              - 17 -

Petitioner's Financial and Tax Accounting

     Since its incorporation on February 25, 1969, petitioner has

consistently maintained its books and records, and filed its

corporate tax returns, on the accrual method of accounting, using

a taxable year ending December 31.     Its tax accounting has been

consistent with its financial accounting.

     On November 28, 1990, the American Institute of Certified

Public Accountants (AICPA) released its Statement of Position 90-

8 entitled "Financial Accounting and Reporting by Continuing Care

Retirement Communities" (SOP 90-8).    SOP 90-8 addressed financial

accounting standards, not tax accounting standards, providing

guidance on applying generally accepted accounting principles to

transactions resulting from continuing-care contracts.    The

provisions of SOP 90-8 were effective for fiscal years beginning

on or after December 15, 1990, but accounting changes made so as

to conform to SOP 90-8 were to be applied retroactively.

Petitioner's accountant, David Worley, reviewed petitioner's

accounting methods and found them to be in compliance with SOP

90-8.

     In its books, petitioner recorded the entry fees in "Advance

deposit" account numbers 261 and 262 for the apartments and the

lodge, respectively.   The entry fees were not placed in escrow.

Petitioner recorded 20 percent of the apartment entry fees as

income in the year of receipt, and an additional 20 percent per

year for the next 4 years, reducing account 261 accordingly.

With respect to the lodge entry fees, petitioner recorded 5

percent as income in the year of receipt and the remainder over
                              - 18 -

the next 19 years in accordance with the schedule provided to the

residents as part of the rental contract, reducing account 262

accordingly.   Similarly, for Federal income tax purposes,

petitioner reported as income these same portions of the entry

fees for the apartments and the lodge as they became

nonrefundable or nonforfeitable within that tax year.

     As of January 1, 1988, account 261 had a balance of

$578,038, and account 262 had a balance of $1,066,982, for a

total of $1,645,020.   As of December 31, 1988, account 261 had a

balance of $628,577, and account 262 a balance of $1,131,830, for

a total of $1,760,407.   Thus, during 1988, the accounts had net

increases of $50,539, and $64,848, respectively, for a total net

increase that year of $115,387.

     In its books, petitioner recorded 6 percent of the cluster

home receipts as income in the year received and credited the

remaining 94 percent to an account designated as "Liability for

Repurchase".   Petitioner's books treated a total of 24 percent of

the purchase price as income over a 7-year period, with

corresponding reductions in the liability account, as follows:     6

percent in year 1 and 3 percent per year in years 2 through 7.

The liability for repurchase account was never reduced below 76

percent of the original purchase price of the cluster home.

     For Federal income tax purposes, petitioner did not treat

the cluster home transactions as sales.   Petitioner reported the

proceeds from the cluster home transactions in accordance with

that year's reductions in petitioner's "liability for repurchase"

amounts.   Petitioner also claimed depreciation deductions on the
                                - 19 -

cluster homes.

     Respondent audited petitioner's Federal income tax returns

for the taxable years 1974 and 1975.     Respondent made no changes

to petitioner's method of accounting as a result of that audit.

     Petitioner filed its Federal corporate income tax return

(Form 1120) for the taxable year 1988, based on the calendar

year, using the accrual method of accounting.    Since late 1985,

accountant David Worley (Worley) has prepared petitioner's

returns and financial statements; the accounting firm of

Deloitte, Haskins and Sells (DHS) had prepared those returns and

financial statements completed prior to that time.    Worley's firm

reviewed the previous work of DHS, agreed with their preparation,

and followed the same method.

     In reviewing petitioner's Federal income tax return for the

taxable year 1988, respondent determined that petitioner's method

of accounting for the entry fees did not clearly reflect income

in that the entire amount of the entry fees should have been

reported in the year of receipt.    Respondent adjusted

petitioner's income to include $1,645,020 of unreported entry

fees received through December 31, 1987, plus $115,387 of

unreported entry fees received for taxable year 1988, for a total

adjustment of $1,760,407 related to the entry fees.

     Respondent also determined that petitioner's method of

accounting for the cluster home transactions did not clearly

reflect income in that those transactions should have been

accounted for as sales.   Respondent increased petitioner's

cluster home income by $5,001,633 based on petitioner's stated
                               - 20 -

cluster home liabilities and by $1,079,098, consisting of

cumulative unreported gain on cluster home sales and disallowance

of cluster home depreciation claimed through taxable year 1988.

Respondent has conceded the $5,001,633 adjustment.    See supra

note 2.

     Respondent recomputed deductions for charitable

contributions and net operating losses, calculated the

environmental tax and corresponding deduction, and allowed a

general business credit carryforward.    On January 7, 1993,

respondent issued the notice of deficiency with the resultant

deficiency in tax in the amount of $2,531,650 and an addition for

substantial understatement of income tax under section 6661 in

the amount of $632,913.

                              OPINION

Entry Fees

     Respondent argues that the entry fees are prepaid rent and

are includable in income in the year of receipt.    Petitioner

contends the fees are neither rent nor payment for services,

characterizing these "deposits" merely as a means of financing

the construction of Highland Farms.     Petitioner argues that its

reporting of income from the entry fees is consistent with its

method of keeping its books, and is thus a proper method of

accounting.12   Petitioner also argues that since petitioner has

no guarantee it will be allowed to keep the entire amount of any


     12
       Petitioner also notes that its bookkeeping is in
accordance with AICPA's Statement of Position 90-8 entitled
"Financial Accounting and Reporting by Continuing Care Retirement
Communities", published November 28, 1990.
                               - 21 -

fee, inclusion in income should be ratable as the fees are

"earned".13   We agree with petitioner.

     Section 446(a) provides that taxable income shall be

computed under the method of accounting on the basis of which the

taxpayer regularly computes its income in keeping its books.      The

accrual method of accounting is one permissible method of

computing taxable income.   Sec. 446(c)(2).    Petitioner is an

accrual method taxpayer and has kept its books regularly in

accordance with this method.

     However, financial accounting and income tax accounting

methods have divergent objectives.      Thor Power Tool Co. v.

Commissioner, 439 U.S. 522, 542-543 (1979).     "Given this

diversity, even contrariety, of objectives, any presumptive

equivalency between tax and financial accounting would be

unacceptable."   Id.   The general rule specifying use of the

taxpayer's method of accounting is limited to cases where such

method clearly reflects income.    Id. at 541; see American



     13
       For the first time in its brief, petitioner raised the
statute of limitations as a defense, arguing that respondent is
precluded from including entry fees and cluster home receipts
received during those years now barred by sec. 6501. The defense
of the statute of limitations must be affirmatively pleaded.
Rule 39. It is untimely for petitioner to raise it in its brief,
and we need not consider it. Brown v. Commissioner, 24 T.C. 256,
264 (1955); Rule 34(b)(4) and (5); Rule 41.
     Additionally, adjustments in accordance with sec. 481, as
these would be if respondent is correct in her position, are not
precluded by the statute of limitations. Knight-Ridder
Newspapers, Inc. v. United States, 743 F.2d 781, 797 (11th Cir.
1984); Graff Chevrolet Co. v. Campbell, 343 F.2d 568, 571-572
(5th Cir. 1965); W.S. Badcock Corp. v. Commissioner, 59 T.C. 272,
288-289 (1972), revd. on another issue 491 F.2d 1226 (5th Cir.
1974).
                              - 22 -

Automobile Association v. United States, 367 U.S. 687 (1961).

Petitioner, thus, cannot simply rely on the consistency of its

tax accounting with its bookkeeping as a sufficient basis for

upholding its treatment of income.

     In considering the tax treatment of deposits, the Supreme

Court has held:

     Whether these payments constitute income when received,
     however, depends on the parties' rights and obligations
     at the time the payments are made. * * * Whether these
     customer deposits are the economic equivalents of
     advance payments, and therefore taxable upon receipt,
     must be determined by examining the relationship
     between the parties at the time of the deposit. The
     individual who makes an advance payment retains no
     right to insist upon the return of the funds; so long
     as the recipient fulfills the terms of the bargain, the
     money is its to keep. The customer who submits a
     deposit to the [taxpayer] * * * retains the right to
     insist upon repayment * * * and the [taxpayer]
     therefore acquires no unfettered "dominion" over the
     money at the time of receipt.

Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203,

211-212 (1990) (emphasis in original).    The taxpayer's

unrestricted use of the funds is not dispositive.     Id. at 209-

210; Oak Industries, Inc. v. Commissioner, 96 T.C. 559, 570

(1991).   Whether the taxpayer pays or accrues interest on the

depositor's behalf is not a controlling factor.     Id. at 571.
"The key is whether the taxpayer has some guarantee that he will

be allowed to keep the money."     Commissioner v. Indianapolis

Power & Light Co., supra at 210.

     In Indianapolis Power & Light, the taxpayer required

customers with suspect credit to deposit an amount equal to twice

the customer's estimated monthly utility bill to insure prompt

payment of their bills.   These deposits were refundable upon the
                              - 23 -

customers' demonstrations of acceptable credit.    The Supreme

Court held that the utility customers' deposits were not advance

payments, since the customers were under no obligation to

purchase goods or services, and the customers' behavior

controlled the amounts of the refunds.   Therefore, the customers'

deposits were not taxable income.

     Similarly, in Oak Industries, Inc. v. Commissioner, supra,

the deposits were intended as offsets to any unpaid fees, damages

to equipment, or any other costs to the taxpayer due to a

customer's breach.   The customer who performed according to his

or her obligations had a right to a refund of the deposit.      These

deposits were not taxable income to the taxpayer.

     In the instant case, the residents of the apartments and the

lodge, if they decided to move out of their units, had a right to

a refund of a portion of their entry fees in accordance with the

schedules stated in their respective rental contracts.    The

refunds were within the residents' control, and petitioner had

"no unfettered 'dominion' over the money at the time of receipt".

At the time the entry fees were paid, the only amounts petitioner

was guaranteed to be allowed to keep were the nonrefundable

portions.   Thus, we hold that the refundable portions were not

advance payments for services or prepaid rent.14    As a result,


     14
       The parties submitted expert reports that purported to
show the fair market rental value of the units. Neither expert
was called to testify, the parties having represented to the
Court that their experts had met and reached agreement as to the
fair market rental value of the units. A joint exhibit embodying
their joint conclusions was prepared and filed with the Court at
the conclusion of the trial. That joint exhibit is neither clear
                                                   (continued...)
                               - 24 -

petitioner is not required to include the entire amount of the

entry fees in income in the year of receipt.    Only the

nonrefundable or nonforfeitable amounts each year constitute

income.    Petitioner included in income for a specific taxable

year those portions of the entry fees for the apartments and the

lodge that became nonrefundable or nonforfeitable within that tax

year.    This method of accounting for the entry fees clearly

reflects income.    It was an abuse of discretion for respondent to

conclude that the fees must be included in petitioner's income

for the year of receipt.    We hold for petitioner on this issue.

Cluster Home Transactions

     Respondent has treated the cluster home and condominium

transactions as sales, requiring the gain from these transactions

to be included in income in the year of receipt and disallowing

the depreciation deductions petitioner took with respect to these

units.    Petitioner argues that its obligation to repurchase a

cluster home or condominium unit created a security transaction

in the nature of a mortgage, not a sale.    We agree with

respondent.

     "Under North Carolina law, the test for determining whether

a conveyance with an option to repurchase represents a true sale



(...continued)
nor helpful to the Court, and on brief the parties seem unable to
agree as to what their experts supposedly agreed to. The Court
has disregarded both parties' expert reports and the experts'
joint exhibit. After notice petitioner could increase the
monthly rental payments for the apartment or lodge units, without
regard to the entry fees. The Court rejects respondent's
suggestion that the entry fees represent prepaid rent that
somehow makes up for supposed below market rental rates.
                              - 25 -

or merely a loan with a security interest focuses on the intent

of the parties and not the form of the transaction."   Redic v.

Gary H. Watts Realty Co., 762 F.2d 1181, 1185 (4th Cir. 1985)

(citing O'Briant v. Lee, 214 N.C. 723, 200 S.E. 865 (1939)).     The

intention to create a mortgage must be established, not by simple

declaration of the parties, but by proof of the facts and

circumstances outside the deed which are inconsistent with an

absolute purchase.   Redic v. Gary H. Watts Realty Co., supra at

1186; O'Briant v. Lee, 214 N.C. at 731, 200 S.E. at 870.

     The North Carolina Supreme Court has identified six factors

to be considered in determining whether a transaction is a sale

or a loan:

     (1) whether there was a debtor-creditor relationship
     created at the time of the transaction * * *; (2)
     whether the "grantor" remains in possession or whether
     the grantee takes immediate possession of the property
     * * *; (3) whether the "grantor" was under distress and
     hard-pressed for money at the time of the transaction
     * * *; (4) whether the transaction originated out of an
     application for a loan * * *; (5) whether the purported
     sale price is less than the net worth of the property
     * * *; and (6) whether the "grantor" was obligated to
     exercise the "option to repurchase." * * *

Redic v. Gary H. Watts Realty Co., supra at 1186 (citations

omitted).

     In deciding whether a transaction constitutes a sale for tax

purposes, this Court considers whether the burdens and benefits

of ownership have passed to the purported purchaser; this is a

question of fact to be ascertained from the intentions of the

parties as evidenced by the written agreements read in the light

of the attending facts and circumstances.   Grodt & McKay Realty,
Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981).   Factors
                                - 26 -

considered have included:

     (1) Whether legal title passes * * *; (2) how the
     parties treat the transaction * * *; (3) whether an
     equity was acquired in the property * * *; (4) whether
     the contract creates a present obligation on the seller
     to execute and deliver a deed and a present obligation
     on the purchaser to make payments * * *; (5) whether
     the right of possession is vested in the purchaser
     * * *; (6) which party pays the property taxes * * *;
     (7) which party bears the risk of loss or damage to the
     property * * *; and (8) which party receives the
     profits from the operation and sale of the property
     * * *.

Id. at 1237-1238 (citations omitted).

     The cluster home and condominium transactions arose not out

of petitioner's seeking a loan, but out of the purchasers' buying

housing units in a retirement community.    Petitioner made no

representations to the purchasers, either orally or in writing,

that the transactions were loans or mortgages.    Petitioner agreed

to convey in fee simple and the purchasers agreed to purchase the

specified cluster home or condominium for the designated purchase

price.   Legal title passed from petitioner to the purchasers, and

the deeds were recorded.    The purchasers, then the owners of the

cluster homes or condominiums, took possession of their cluster

homes or condominiums and paid the property taxes, the fire and

liability insurance, and the utility bills for the unit.    The

owners received the proceeds of the fire and liability insurance

in the event of a loss.     If an owner did not repair a partially

destroyed cluster home or condominium, petitioner would deduct

the repair costs from the repurchase price.    While the repurchase

price of a cluster home or condominium was less than its original

sales price, it cannot be said that the original sales price was
                                   - 27 -

less than the full value of the cluster home or condominium.15

The purchase agreement required the owners to obtain petitioner's

permission to assign or convey the property; this indicates that

cluster home owners had the right to assign or convey their

cluster homes, although as a practical matter transfers had

occurred in only two instances as of the time of the trial.         The

Declaration of Condominium gave condominium owners the right to

lease or rent their units with petitioner's approval of the

prospective tenant; the Declaration of Condominium also provided

that petitioner could not unreasonably withhold its approval.          On

balance these facts support the conclusion that the transactions

were sales, rather than mortgages.

     In the early years of its business, petitioner was unable to

obtain commercial financing for the construction of its

retirement community and was in need of funds.          The accelerated

payment schedule for cluster homes to be built as compared to

those already built supports this.          However, petitioner's

continuing need for funds after constructing the initial units is

not shown by the record in this case.

     Petitioner assumed an obligation to repurchase the cluster

home or condominium for a minimum of 76 percent of the original

purchase price when the purchaser died or decided to sell the

unit.        If the unit were totally destroyed by fire or other



        15
       Petitioner points to the repurchase price in support of
its contention that the transaction is a mortgage. Petitioner
does not address the nature of the excess of the original price
over the repurchase price, nor the fact that the repurchase price
decreases over 7 years and then remains constant thereafter.
                              - 28 -

disaster, the cluster home would revert to petitioner without

repurchase by petitioner, but the owner received the insurance

proceeds.   Additionally, petitioner controlled whether it would

be obligated to repurchase through its power to grant or deny

permission to convey the property.     This "obligation" to

repurchase was an advantage rather than a disadvantage in that

petitioner, by selling the cluster homes itself, reaped the

difference between the repurchase amounts and the higher resale

prices.   Where petitioner repurchased cluster homes and resold

them, petitioner received all of the profits; this tends to weigh

against the transactions' being sales.     However, while the

cluster home or condominium owner did not receive the benefit of

any appreciation in the fair market value of the unit, the owner

was assured of receiving at least 76 percent of the original

purchase price.   In the event that the real estate market for

retirement homes collapsed, petitioner could bear any loss.

Thus, petitioner and the owner each had both a benefit and a

detriment in the repurchase arrangement.     While the cluster home

or condominium owner had to forgo the benefit of possible

appreciation, he or his estate was assured of receiving at least

76 percent of his original purchase price, an assurance that

aging members of a retirement community might find attractive,

particularly compared to the usual church-sponsored retirement

communities that required large, nonrefundable upfront payments.

     Some of the above aspects of this transaction support

petitioner's proposed characterization while others support

respondent's.   Under these circumstances, we believe that the
                               - 29 -

most significant factor is the characterization of the parties to

the transaction in their written agreement.     Both petitioner and

the "purchasers" of the properties in question had a significant

interest in that characterization.      The "sale" characterization

used in the documents for underlying transactions gave the

purchasers ownership which was potentially important for purposes

of the purchasers' deduction of interest and real estate taxes.

If petitioner prevails, those tax benefits, and possibly others,

would be jeopardized.   In similar situations, we have required

taxpayers who attempt to recharacterize the written terms of a

transaction to adduce strong proof that the written contract was

without economic substance.    North American Rayon Corp. v.

Commissioner, 12 F.3d 583 (6th Cir. 1993), affg. T.C. Memo. 1992-

610; Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967),

vacating and remanding 44 T.C. 549 (1965); Ullman v.

Commissioner, 264 F.2d 305, 308 (2d Cir. 1959), affg. 29 T.C. 129

(1957).   Petitioner has failed to produce such strong proof.

Based on all of the above facts and circumstances, we hold that

the cluster home or condominium transactions were sales.     In

light of this, petitioner had no depreciable interest in the

cluster homes or condominiums, and respondent properly disallowed

deductions for depreciation.    Weiss v. Wiener, 279 U.S. 333
(1929); Taube v. Commissioner, 88 T.C. 464 (1987).      Petitioner is

also taxable on the net gain on the sales transactions.     See

supra notes 2, 13.

Section 6661 Addition to Tax

     Section 6661 provides for an addition to tax for the
                                - 30 -

substantial understatement of income tax.    A substantial

understatement in the case of a corporation is an understatement

that exceeds the greater of (1) 10 percent of the tax required to

be shown on the return, or (2) $10,000.    Sec. 6661(b)(1).   If the

taxpayer has substantial authority for the tax treatment of the

item in question, or if the taxpayer adequately discloses the tax

treatment of the item on the return, then the amount of the

understatement for purposes of this section will be reduced by

that portion of the understatement which is attributable to that

item.   Sec. 6661(b)(2)(B).

     Petitioner made no disclosures on its return, so we need

only consider whether substantial authority exists for

petitioner's tax treatment of any of the items leading to the

understatement.    "There is substantial authority for the tax

treatment of an item only if the weight of the authorities

supporting the treatment is substantial in relation to the weight

of authorities supporting contrary positions."     Sec. 1.6661-

3(b)(1), Income Tax Regs.     The substantial authority standard is

less stringent than a "more likely than not" standard, but

stricter than a reasonable basis standard.    Sec. 1.6661-3(a)(2),

Income Tax Regs.

     As was stated above, the test under North Carolina law for

determining whether a conveyance with an option to repurchase

represents a true sale or merely a loan with a security interest

focuses on the intent of the parties.     Redic v. Gary H. Watts

Realty Co., 762 F.2d at 1185.    This intention must be established

by the facts and circumstances.     Id. at 1186.   Our consideration
                               - 31 -

of these facts and circumstances led to our conclusion that the

cluster home and condominium transactions were sales, as

respondent contended.    However, some factors supported

petitioner's position.    Given the peculiarly factual nature of

the inquiry, we think that petitioner can be said to have had

substantial authority for its treatment of the cluster home and

condominium transactions.    Therefore, we hold that petitioner is

not liable for the addition to tax for substantial

understatement.

     To reflect the above holdings and respondent's concession,


                                     Decision will be entered

                                under Rule 155.
