August 4, 2009
WILLIAM AND MARGARET SITAR, PLAINTIFFS-APPELLANTS,
DIRECTOR, DIVISION OF TAXATION, DEFENDANT-RESPONDENT.
On appeal from the Tax Court of New Jersey, Docket No. 5141-02.
NOT FOR PUBLICATION WITHOUT THE APPROVAL OF THE APPELLATE DIVISION
Argued February 2, 2009
Before Judges Carchman and Sabatino.
Plaintiffs, William and Margaret Sitar, husband and wife appeal from a February 1, 2008 order of the Tax Court granting summary judgment to defendant Director of the New Jersey Division of Taxation (the Director). The judgment upheld the 2002 Final Determination by the Director against plaintiffs for the 1998 tax year, assessing plaintiffs with an additional gross income tax of $122,886.*fn1 The assessment disallowed the capitalization of personal expenses utilized to reflect a higher basis when the same expenses were taken as personal deductions on plaintiffs' federal returns. We now affirm.
The facts are simple and straightforward. Plaintiffs are New Jersey residents who, for "about ten (10) years," owned a large, vacant parcel of property in the Borough of Tinton Falls. In 1998, the plaintiffs sold the land for $10,065,000. They reported the sale in their 1998 federal tax return, utilizing a basis for the property of $3,369,269. As a result of the sale, for tax year 1998, they reported $4,451,319 as "installment sale income" and $4,518,955 in capital gains. On their state return, filed pursuant to the New Jersey Gross Income Tax Act, N.J.S.A. 54A:1-1 to 10-12 (the GIT), the plaintiffs reported a gain of $3,185,286 as income from the sale. The disparity resulted from the capitalization of $2,006,384 in interest and real estate taxes in computing the basis for the state return when those same expenses had been deducted as personal expenses on plaintiffs' federal return. The capitalization of these expenses created a New Jersey tax basis of $5,375,653.
By letter dated August 28, 2001, the Director requested that plaintiffs explain the $1,333,669 difference in capital gains reported on the federal and state tax returns. In response, plaintiffs informed the Director that the difference "represents the additional basis resulting from the Taxpayer capitalizing the interest and taxes on the vacant land during his holding period. The Taxpayer received no New Jersey Tax benefits from his holding of the land."
Thereafter, on October 15, 2001, the Director issued a Notice of Deficiency for the tax year 1998. Plaintiffs responded by sending a protest to the Director. Plaintiffs maintained the property was held for "investment purposes" and that the "assessment should be zero" relying on the Supreme Court's decision in Koch v. Director, Div. of Taxation, 157 N.J. 1 (1999).
The Director issued his Final Determination and calculated the amount due as $122,886, which included $84,557 in tax; a 5% amnesty penalty for $4,228; and interest in the amount of $34,101. The Director noted that the Division "requires the taxpayer annually to take the same depreciation expense allowed for Federal purposes in determining net income." Plaintiffs filed a complaint with the Tax Court seeking an abatement of the "Gross Income Tax assessment . . . ." Following discovery, the parties cross-moved for summary judgment. In granting the Director's motion and denying plaintiffs' cross-motion, Judge Bianco identified the substantive issues of the case.
The crux of the case lies in the reading of [Koch] that we have cited earlier. Plaintiff gives a broad, and in this Court's opinion a very broad, reading for the proposition that [the] New Jersey Legislature intended all taxation to be on a taxpayer's economic gain and not on a return of capital.
Plaintiff asked this Court to capitalize all the carrying costs associated with the holding -- with holding land in a personal manner.
The Court does not find support in New Jersey statutes for such a result or case law for that matter.
He then went on to distinguish Koch, the primary authority relied on by plaintiffs.
[Koch] instructs the Director on computing gain on disposition of property to reduce basis only to the extent that the expenses previously conferred a tax benefit to the taxpayer. [Koch] is, therefore, distinguishable in the present case. In this case plaintiff is arguing that he is being taxed on return of capital because under the federal scheme he may be able to capitalize carrying costs and gain or taX benefit that he was not able to in New Jersey.
And I note that he did not, in fact, [plaintiffs] did not, in fact, capitalize the expenses for federal purposes.
Plaintiffs want to use this so-called New Jersey basis which was the cost unadjusted for the benefits . . . received under the federal system.
However, in the present matter there was never any right under New Jersey law for the plaintiffs to capitalize the carrying costs in the first place.
Therefore, the Director's assessment here does not result in a [tax on] return of capital as it would have in [Koch]. In essence, carrying costs were never capital in New Jersey. An analysis of other federal taxation schemes as suggested by the plaintiff is not necessary because no double taxation is being done.
Furthermore, applicable New Jersey tax law, namely, [N.J.S.A. 54A:5-1c] plainly requires New Jersey to follow the adjusted federal basis for calculation of net income upon disposition of property.
Add to that plain reading [of] the fact that the Director's assessment is accorded a presumption of correctness as stated in Meadowlands Basketball [Assocs. v. Director, Div. of Taxation, 19 N.J. Tax 85, 90 (Tax 2000)]. And the conclusion is that the assessment must be upheld.
This appeal followed.
On appeal, plaintiffs assert that N.J.S.A. 54A:5-1c, provides a statutory basis for utilization of the federal basis for calculating New Jersey gain; "26 USC §263A [is] an accounting method that meets the requirements of Koch and Moroney [v. Director, Div. of Taxation, 376 N.J. Super. 1 (App. Div. 2005)]" and the calculation of basis for New Jersey and federal income tax purposes is the same.
Before considering plaintiffs' arguments, we recognize that two principles of review apply in our consideration of this appeal. First, "[w]hen reviewing a summary-judgment determination, we apply the same standard as that governing the trial court." Petersen v. Meggitt, 407 N.J. Super. 63, 73 (App. Div. 2009) (citing Prudential Prop. & Cas. Ins. Co. v. Boylan, 307 N.J. Super. 162, 167 (App. Div.), certif. denied, 154 N.J. 608 (1998); Antheunisse v. Tiffany & Co., 229 N.J. Super. 399, 402 (App. Div. 1988), certif. denied, 115 N.J. 59 (1989)). "[T]he role of the trial judge [is] to decide whether the 'competent evidential materials presented, when viewed in the light most favorable to the non-moving party, are sufficient to permit a rational factfinder to resolve the alleged disputed issue in favor of the non-moving party.'" Conrad v. Michelle & John, Inc., 394 N.J. Super. 1, 13 (App. Div. 2007) (quoting Brill v. Guardian Life Ins. Co. of Am., 142 N.J. 520, 540 (1995)). "Summary judgment will be granted where no genuine issue of material fact is present and the movant is entitled to judgment as a matter of law." LaPlace v. Briere, 404 N.J. Super. 585, 591 (App. Div. 2009) (citing R. 4:46-2(c)), certif. denied, ___ N.J. ___ (Apr. 21, 2009).
Second, "we must also recognize 'the Director's expertise, particularly when exercised in the specialized and complex area covered by the provisions' of the Gross Income Tax  Act." Reck v. Dir., Div. of Taxation, 345 N.J. Super. 443, 446 (App. Div. 2001) (quoting Metromedia, Inc. v. Dir., Div. of Taxation, 97 N.J. 313, 327 (1984)), aff'd, 175 N.J. 54 (2002). More broadly,
[w]hen an administrative agency interprets and applies a statute it is charged with administering in a manner that is reasonable, not arbitrary or capricious, and not contrary to the evident purpose of the statute, that interpretation should be upheld, irrespective of how the forum court would interpret the same statute in the absence of regulatory history. [Blecker v. State, 323 N.J. Super. 434, 442 (App. Div. 1999).]
Our analysis of the issues involved on this appeal require a recognition of other basic principles specifically relevant to the taxation of income in New Jersey. First, state and federal tax statutes are not parallel. Smith v. Dir., Div. of Taxation, 108 N.J. 19, 32 (1987). Accordingly, "while we should endeavor to interpret our income tax law to be consistent with federal law," such interpretation is not required where it would result in tax consequences not permitted under the GIT. Reck, supra, 345 N.J. Super. at 447. Second, New Jersey "does not allow tax deductions unless they are specifically authorized by statute." King v. Dir., Div. of Taxation, 22 N.J. Tax 627, 632 (App. Div. 2005). Third, the GIT "was intended as a tax on income, shorn of the deductions and items of tax preference in the Federal Income Tax." Smith, supra, 108 N.J. at 30. In other words, the GIT was intended to eliminate loopholes and tax shelters.*fn2 Lastly, the Supreme Court of the United States has observed repeatedly that, while a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not . . . and may not enjoy the benefit of some other route he might have chosen to follow but did not. [Gen. Trading Co. v. Dir., Div. of Taxation, 83 N.J. 122, 136 (1980) (quoting Comm'r. v. National Alfalfa Dehydrating and Milling Co., 417 U.S. 134, 149, 94 S.Ct. 2129, 2137, 40 L.Ed. 2d 717, 727 (1975)) (emphasis added); see also Moroney, supra, 376 N.J. Super. at 5-6 (holding that "[t]he Act provides for the imposition of a tax upon certain specified categories of income, including net gains or income from the sale or disposition of property, as determined in accordance with the method of accounting used for federal income tax purposes") (internal quotations omitted).]
With this background, we address the question of whether a taxpayer's decision to take personal deductions on Schedule A of Form 1040 for real estate taxes and interest associated with real property held for investment, forecloses that taxpayer from utilizing a different accounting method to adjust the property's basis and thus account for those costs in his or her state tax return. Several statutory provisions are relevant to our inquiry. Both parties focus on N.J.S.A. 54A:5-1c, which provides in relevant part:
New Jersey gross income shall consist of the following categories of income:
c. Net gains or income from disposition of property. Net gains or net income, less net losses, derived from the sale, exchange or other disposition of property, including real or personal, whether tangible or intangible as determined in accordance with the method of accounting allowed for federal income tax purposes. For the purpose of determining gain or loss, the basis of property shall be the adjusted basis used for federal income tax purposes, except as expressly provided for under this act, but without a deduction for penalties, fines, or economic benefits excepted pursuant to paragraph (2), or for treble damages excepted pursuant to paragraph (3) of subsection b. of this section.
26 U.S.C.S. § 266 provides:
No deduction shall be allowed for amounts paid or accrued for such taxes and carrying charges as, under regulations prescribed by the Secretary, are chargeable to capital account with respect to property, if the taxpayer elects, in accordance with such regulations, to treat such taxes or charges as so chargeable.
Also, 26 U.S.C.S. § 263A:
Capitalization and inclusion in inventory costs of certain expenses.
(a) Nondeductibility of certain direct and indirect costs.
(1) In general. In the case of any property to which this section applies, any costs described in paragraph (2)--
(A) in the case of property which is inventory in the hands of the taxpayer, shall be included in inventory costs, and
(B) in the case of any other property, shall be capitalized.
(2) Allocable costs. The costs described in this paragraph with respect to any property are--
(A) the direct costs of such property, and
(B) such property's proper share of those indirect costs (including taxes) part or all of which are allocable to such property.
Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.
A fundamental tenet of the income tax system is that no deduction is permitted for purely personal expenses. 26 U.S.C.S. § 262. In addition, no deduction is allowed for capital expenditures, which generally include "[t]he cost of acquisition, construction or erection of buildings, machinery and equipment, furniture and fixtures and similar property having a useful life substantially beyond the taxable year." 26 C.F.R. § 1.263(a)-2(a).
The relevant code provision, 26 U.S.C.S. § 263A(b)(1), which provides that the capitalization requirement applies to property "produced by the taxpayer." 26 U.S.C.S. § 263A(g)(1), also specifies that "[t]he term produce includes construct, build, install, manufacture, develop, or improve." "Thus, by its terms, the statute requires taxpayers to capitalize indirect costs, such as real estate taxes, that they incur in connection with property they develop." Reichel v. Comm'r, 112 T.C. 14, 17 (1999) (emphasis added).
Under New Jersey's taxation scheme, expenses incurred through a passive investment activity are not business related and, as a result, are not entitled to a deduction. See Sidman v. Dir., Div. of Taxation, 18 N.J. Tax 636, 648-49 (Tax 2000) (holding that interest paid on a loan used to purchase stock in an S Corporation could not be deducted on plaintiff's state income tax), aff'd, 19 N.J. Tax 484 (App. Div.), certif. denied, 170 N.J. 387 (2001); see also Gilligan v. Director, Div. of Taxation, 11 N.J. Tax 414, 420 (Tax Ct. 1991) (holding that margin interest and other expenses incurred in connection with investment activity were not deductible from gross income because they were a result of personal investing). That statement implies that business-related losses are deductible under New Jersey tax law. See Vinnik v. Dir., Div. of Taxation, 12 N.J. Tax 450, 453 (Tax 1992) (holding that "deductions allowable in determining taxable income under the [GIT] pertain to expenses incurred in the production of gross income, such as expenses of a sole proprietorship incurred in the conduct of a business"); see also Marrinan v. Dir., Div. of Taxation, 10 N.J. Tax 542, 547-52 (Tax 1989) (finding that a taxpayer was entitled to offset expenses and losses incurred in securities trading against dividend and interest income because he was engaged full time in the trade or business of a securities trader); Landwehr v. Dir., Div. of Taxation, 6 N.J. Tax 66, 70-73 (Tax 1983) (holding that a manufacturer's representative was an independent contractor, not an employee, and thus entitled to deduct business-related expenses). As a threshold issue, conceded by plaintiffs, the property is properly characterized as "for investment purposes."
Here, in their federal return, plaintiffs chose not to capitalize their expenses but to take a personal deduction for the interest and real estate taxes associated with the property. On their state return, clearly understanding that the expenses were not deductible under the state taxation system, they chose to capitalize the same expenses.
In support of their position, plaintiffs rely on federal statutory authority, 26 U.S.C.S. § 263A (allowing capitalization of certain costs, including taxes, related to the development of real property), as well as Koch, supra, 157 N.J. at 1.
Koch addressed the tax treatment under the GIT of Koch's gain realized from the sale of a partnership interest. Koch purchased a limited partnership interest for $75,000 and agreed to be held personally liable for the company's debt of $218,161. After deducting the company's losses of $211,895 on his federal tax returns, Koch's federal income tax basis was reported as zero.*fn3 Koch then sold his interest in the company. "Thus, the entire amount realized on the sale of his partnership interest was taxable income. He reported $217,785 as capital gain and $50,376 as depreciation recapture income." Id. at 4. Koch then reported only the net gain ($50,000) from the sale on his state income tax reports. The Director, however, asserted that Koch's basis should have been the same one used in his federal return. Id. at 5.
Following the Director's determination, Koch filed suit, claiming that he "did not have to use the federal adjusted basis of his partnership interest in calculating the gain from the sale of that interest" and that he was only responsible for the net gain realized on the sale. The tax court entered judgment for defendant, holding that "adjusted basis for federal income tax purposes must be used," and then we affirmed.
After granting certification, the Court addressed Koch's arguments that: (1) three federal income tax concepts must be looked at in calculating net gain from the disposition of property: the method of accounting used for federal income tax purposes, the use of the federal adjusted basis and "the exclusion of gains to the extent federal rules require non-recognition;" and (2) the Legislature intended the GIT to tax only income and not a return on capital. Id. at 5-11.
The Court reversed and remanded concluding that the GIT evidenced an intent to tax only those transactions from which a taxpayer derived an economic gain. Id. at 9, 14. Summarizing its decision and Koch's position, the Court stated:
Koch is not requesting any special New Jersey tax treatment. He has gained no tax benefit under the Act and is not seeking one. He is requesting only that he be taxed on his actual economic gain and not on fictitious income. He seeks to be treated as the Legislature intended. That is, he correctly asserts that his return of capital should not be taxed. [Id. at 14 (emphasis added).]
The Court added:
In accordance with well-established rules of statutory construction, our interpretation of section 5-1c harmonizes its three basic concepts and effectuates the Legislature's plan that the return of capital not be taxed. Because we find under section 5-1c that an adjustment must be made to taxpayer's federal adjusted basis for New Jersey income tax purposes, we need not reach the applicability of the federal tax benefit rule. [Ibid. (Emphasis added).]
Koch informs us that the adjusted basis used on the federal return should generally be utilized on a state return, and the Director should harmonize the result of using the federal adjusted basis with other aspects of the GIT. Specifically, the method of accounting used for federal income tax purposes and the federal non-recognition rules must be considered to ensure that a fair and equitable result is achieved. With respect to the issues in this appeal, Koch is instructive but is also distinguishable.
As noted in Koch, the GIT creates a number of categories from which gross income can be derived. Id. at 6. "One of those categories is the net gains or income that arise from the disposition of property." Ibid. Koch's expenses were business related, a permitted deductible expense. Moreover, as noted by Judge Bianco, "[Koch] instructs New Jersey taxing authorities, when computing gain on disposition of property according to [N.J.S.A.] 54A:5-1(c), to reduce basis only to the extent that expenses previously conferred a tax benefit to the taxpayer."
Koch instructs us that N.J.S.A. 54A:5-1c "sets forth three federal income tax concepts that are to be applied in calculating net gain: (1) the method of accounting used for federal income tax purposes, (2) the use of the federal adjusted basis, and (3) the exclusion of gains to the extent federal rules require non-recognition." Id. at 6-7 (citing Walsh v. Dir., Div. of Taxation, 10 N.J. Tax 447, 459 (Tax 1989), aff'd per curiam, 240 N.J. Super. 42 (App. Div. 1990)). These principles provide a resolution here congruent with that reached by the Tax Court.
Plaintiffs here reduced their federal income tax liability by taking an annual deduction of the property's carrying costs as personal expenses in their Schedule A. They did not capitalize those expenses on the property over the ten years in which they admittedly held the property (with the exception of certain costs from 1986-1989). Plaintiffs now argue that 26 U.S.C.S. § 263A permits such capitalization and therefore, because it would be an accepted form of accounting at the federal level, the defendant must accept it.
We reject this argument. Plaintiffs' attempts to capitalize those costs ignore a number of New Jersey decisions, which have held that a taxpayer must use "the method of accounting used for federal income tax purposes" as well as the basis (or adjusted basis) on the federal return. See Moroney, supra, 376 N.J. Super. at 5-6 (quoting N.J.S.A. 54A:5-1c). In Koch, the taxpayer sought to reduce his basis as a result of business related losses on his federal return, not carrying costs related to a piece of property used solely for investment purposes. Koch was permitted to use his cost basis on the state return, not a basis that reflected capital costs.
Finally, we reject plaintiffs' argument that the computation of the basis for purposes of the GIT is the same as that for federal income tax purposes. Plaintiffs' seek to "have it both ways" - to take a personal deduction for federal purposes and take the same expenses and capitalize them for purposes of the GIT. The disparate treatment of these expenses is what the GIT seeks to avoid. Nothing in Koch or Moroney suggests that such conduct is envisioned by the GIT.
Judge Bianco clearly understood this distinction, and we affirm substantially for the reasons set forth in his thoughtful and thorough oral opinion of February 1, 2008, as supplemented by his written opinion of April 10, 2008.