Christensen v. Iowa Dep't of Revenue

944 N.W.2d 895

John Allen CHRISTENSEN and Lila Christensen, Appellants,

v.IOWA DEPARTMENT OF REVENUE, Appellee.

No. 19-0261

Supreme Court of Iowa.

Filed June 19, 2020

Rehearing Denied July 17, 2020

Dennis G. Larson of Larson Law Office, Decorah, for appellants.

Thomas J. Miller, Attorney General, and Hristo Chaprazov, Assistant Attorney General, for appellee.

OXLEY, Justice.

In this administrative agency appeal, John and Lila Christensen (the Christensens) challenge the director of the Iowa Department of Revenue's (Department) determination that capital gains Lila earned from the sale of farmland she inherited from her father and leased on a cash-rent basis do not qualify for the exclusion from Iowa income tax allowed under Iowa Code section 422.7(21)(a ) (2005).¹ The Christensens sought judicial review of that determination, and the district court affirmed. Because neither the Department's interpretation of section 422.7(21)(a ) as delineated in Iowa Administrative Code rule 701—40.38(1)(c ) (2006) nor the director's application of that rule to the facts of this case is irrational, illogical, or wholly unjustified, we likewise affirm.

I. Background Facts.

Lila Christensen's father, Thomas Benson, died in 1989, leaving ninety-six acres of property in Winneshiek County, Iowa, to Lila and her brother, Tom Benson (Tom), as tenants in common. The property consisted of ninety-three acres of farmland and a three-acre homestead. Lila and Tom kept the homestead for their personal use when visiting the area. They continued to cash rent the farmland to their father's tenants, Thomas Frana, who rented and farmed thirty-five acres, and Jeffrey Miller, who, along with his father, rented and farmed the remaining fifty-eight acres. Neither the Christensens nor Tom were farmers or ever farmed this property. John Christensen was an insurance claims examiner until he retired in 1999, and Lila Christensen was an administrator who retired in 2003. The Christensens lived six hours away in Illinois, and Tom (who was a magazine publisher) lived in Des Moines and later in Minnesota during the times relevant to this case.

In 2006, Lila and Tom sold the farmland to the respective tenants who had farmed the land since before Lila and Tom's father's death. Iowa Code section 422.7(21) excludes from taxable income certain capital gains earned from the sale of real property used in an individual taxpayer's business. A taxpayer claims the exclusion as a deduction from "gross income," which includes all capital gains the taxpayer earned. The Christensens claimed a deduction for the $93,036 capital gain Lila received for her share of the farmland sale on their 2006 Iowa individual income tax return.

The Department audited the Christensens’ 2006 income tax return and denied the capital-gain deduction. The Department found the Christensens failed to show they "materially participated" in the business for which the real property was used as required for the deduction. The Department assessed additional income tax of $6616.00, a penalty of $1614.30, and interest of $296.75. The Christensens paid the assessment and filed a formal protest with the Department. The Department filed its answer to the protest on October 16, 2015, triggering a contested case hearing before an administrative law judge (ALJ). The parties engaged in discovery, and a hearing was held on May 20, 2016.

In her January 5, 2017 proposed order, the ALJ identified "[t]he fighting issue" as "whether the Taxpayers demonstrated material participation with respect to the farmland, which was leased on a cash-rent basis during the entire time Christensen held her interest in the property." The parties disputed which part of rule 701—40.38(1)(c ) governed the Christensens’ lease of the farmland. The Department asserted the Christensens’ capital gain was subject to paragraph (4), addressing cash farm leases. The Christensens argued they were not "farmers" to whom that rule was directed but asserted they were engaged in a farm rental business governed by paragraph (7), addressing general rental activities or businesses.

To support their position that they materially participated in a farm rental activity, the Christensens provided evidence that they took over the farm checkbook and responsibilities for paying farm expenses from Lila's brother, Tom, when he retired and moved to Minnesota in 1997. John testified that he and Lila "had an unwritten agreement with [Tom] that the Christensens would do whatever was necessary to maintain the cash farm rental and [Tom] would maintain the house and homestead." The Christensens attested that their "activity included but was not limited to arranging for [their] tenants, working out tenant problems, determining and collecting rents, paying expenses[,] and providing maintenance and care for the property." They also asserted that their "participation in the business constituted substantially all the participation" from 1989 until the property was sold in 2006.

The ALJ was concerned with the vagueness of the Christensens’ evidence. The Christensens stated in interrogatory answers that they negotiated leases, maintained fences and cattle buildings, cleaned brush from fence lines, arranged tiling "when needed," monitored farming practices, and handled related paperwork, but they failed to provide details such as how many times per year or what was involved in "maintenance." They estimated they spent a "minimum of 130 h[ou]rs/year" without substantiating the time. The ALJ found John's testimony at the hearing to be equally vague.

[John] confirmed that he did not keep track of their trips to the farm or keep logs, calendars, or any type of records to document the time they devoted to the farm rental activity. He said that he visited the farm several times a year, either with his wife or by himself. [John] had some free time with his job and enjoyed the area. Sometimes he stayed at the farm for several days or a week or more. While there he "did whatever needed to be done."

But John was unable to provide any specific details or time estimates when asked about the "fence repairs, building maintenance, and brush clearing" he claimed he and Lila performed on an "as needed" basis. Instead, he consistently testified only that "they did ‘whatever needed to be done.’ "

Frana, one of the tenant farmers, testified at the hearing. Despite living a quarter of a mile from the farmland, he never witnessed the Christensens repairing fence; in fact, he could not recall there ever being a need to repair any fencing. Nor did he ever see the Christensens clearing brush on the property, though he did recall giving the Christensens the name of someone who might be interested in the work when they asked him if he would clear brush for them. Frana also testified about a tiling project he hired to be done in December 2004. The other tenant asked Frana to extend the tiling work through his part of the farm to the road, and Frana agreed, paying $1300 for the additional tiling. After the job was complete, Frana asked the Christensens to pay half, and they agreed.

The ALJ expressly found John's testimony vague and the details he did provide contradicted by other evidence in the record. Based on Frana's contrary testimony, the ALJ discredited John's testimony that he arranged and paid for tiling. She also discredited John's testimony that he and Lila cleared brush from the fence lines, noting that the lease agreement required the tenants to keep the property clear of weeds and brush.

The ALJ found that John's

primary rental activity appear[ed] to have been the dealing with the tenants and annually negotiating the farm leases. Both tenants were experienced farmers who had farmed this ground for many years.... [John] had no problems with these tenants and renewed or renegotiated their leases each year.... [H]e used a standard form lease agreement and the amount of rent was [the] only term of the lease that changed from year-to-year.

... Negotiation of the rental rate in years when it did change could involve up to two hours of discussion.

The ALJ relied on rule 701—40.38(1)(c )(4) for cash farm leases, noting it was first added to the capital-gain rule in 1993 and had remained essentially unchanged since. The ALJ concluded that the Christensens’ position was "inconsistent with the plain terms of rule 701—40.38, past application of the rule, and the Department's long-standing interpretation of the Iowa capital gain deduction as it applies to the sale of farmland held for rental."

The ALJ also rejected the Christensens’ argument that they met the general "material participation" tests contained in rule 701—40.38(1)(c ) based on an "absence of proof of the specific nature, amount, or frequency of their activity related to rental of the farmland." The ALJ concluded,

The record shows some participation in rental activities by the [Christensens]. But the nature and amount of proven activity related to rental of the farmland falls far short of the regular, continuous, and substantial activity required to support a finding of material participation in a business activity.

Based on a lack of evidence, the ALJ concluded the Christensens did not meet the material-participation standard, regardless of the rule specifically addressing cash farm leases.

The Christensens timely appealed the ALJ's determination to the director. The director held a hearing on April 25, 2017, and issued a final order on May 25, 2017, adopting and approving the ALJ's findings of facts and conclusions of law set forth in the proposed order. In response to the Christensens’ equal protection challenge to rule 701—40.38, the director concluded she lacked authority to declare a rule unconstitutional.

The Christensens filed a timely petition for judicial review in the Iowa District Court for Winneshiek County from the director's final order. The district court held a hearing on August 3, 2018. In its January 14, 2019 order, the district court...