DocketNumber: Docket No. 31916-86
Citation Numbers: 57 T.C.M. 822, 1989 Tax Ct. Memo LEXIS 317, 1989 T.C. Memo. 317
Filed Date: 6/28/1989
Status: Non-Precedential
Modified Date: 11/20/2020
MEMORANDUM FINDINGS OF FACT AND OPINION
PARR,
After concessions, the remaining issue we must decide is whether, for purposes of computing the gross profit ratio under
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts and related exhibits are incorporated herein by this reference.
Petitioners timely filed their joint Federal income tax return for the calendar year 1981 with the Internal Revenue Service Center in Ogden, Utah. At the time the petition in this case was filed, petitioners resided in Tucson, Arizona.
During 1981 and all times relevant to this case, petitioners were partners in an Arizona general partnership, known as ACF Investments (ACF). On February 23, 1979, a joint venture was formed between ACF, Arcadia-Broadway Associates and Mr. Lew S. McGinnis, known as Broadway Centre (Broadway). Broadway was formed for the purpose of constructing and leasing an office building.*319 Broadway financed the construction of the office building with a non-recourse note payable to the Arizona Bank in an original principal amount of $ 5,250,000 (First-Lien Note).
On June 15, 1981, Broadway agreed to sell the constructed office building to Shearson-Murray Real Estate Fund V, Limited (Shearson), at a stated price of $ 9,750,000 (Purchase Agreement). The terms of the sale provided for the payment of $ 4,500,000 in cash or cashier's check at closing, and the execution and delivery by Shearson of a $ 5,250,000 non-recourse wraparound promissory note secured by a wraparound deed of trust.
Article II, paragraph (b) of the Purchase Agreement states in part:
the Wrap-Around Note shall include the unpaid principal balance of an existing first-lien note * * * dated June 7, 1979, executed by Seller and payable to the order of the Arizona Bank in the original principal amount of FIVE MILLION TWO HUNDRED FIFTY THOUSAND DOLLARS ($ 5,250,000.00) but without the Purchaser assuming any liability for the obligations under the First-Lien Note.
Prior to Shearson's purchase of the office building, the First-Lien Note was assigned to Pacific Mutual Life Insurance Company (Pacific*320 Mutual). Pacific Mutual's approval of the sale was required, and Broadway and Shearson each reserved the right to terminate the Purchase Agreement in the event either party objected to any material change in terms required by Pacific Mutual. The sale was closed on August 31, 1981, and title to the office building was transferred to Shearson. On this date, the principal balance due on the First-Lien Note was $ 5,182,811.
The parties have stipulated that Broadway is entitled to report gain recognized on the sale of the office building as an installment sale under
A wraparound note dated August 31, 1981 was prepared in accordance with the Purchase Agreement, signed and delivered to Broadway at closing (Wraparound Note). Specific terms of the Wraparound Note include that: (1) Interest would accrue at the same rate and on the same basis as the First-Lien Note; (2) monthly installments of principal and*321 interest would be paid in amounts equal to the corresponding monthly installments under the First-Lien Note; (3) the maturity date would be the same as under the First-Lien Note; (4) the liability of Shearson or any of its partners in the event of default was limited to their interests in the office building (i.e., the Wraparound Note was non-recourse); (5) Shearson could not prepay (in whole or in part) prior to the time prepayments were permitted under the First-Lien Note without Broadway's consent, and then only if Shearson paid all prepayment penalties required under the First-Lien Note; and (6) Broadway could not prepay, alter, renew, rearrange, restructure, refinance or increase the First-Lien Note without the consent of Shearson. The Wraparound Note also stated that Shearson "has not assumed the obligations under the First-Lien Note or the First-Lien Deed of Trust and nothing contained herein shall be construed to the contrary."
Even though the monthly payments on the First-Lien Note and the Wraparound Note were identical, Broadway realized net interest income as an economic benefit in using wraparound financing. Both promissory notes used amortization schedules prepared*322 under the actuarial interest method. Thus, the portion of each monthly installment representing the payment of interest decreased over the term of the notes. Broadway was already over two years into the amortization of the First-Lien Note at the time the Wraparound Note was cast. Accordingly, the timing difference between amortization schedules resulted in an excess of interest income realized by Broadway on the Wraparound Note over over interest expense paid or incurred on the First-Lien Note.
The Wraparound Note states that monthly payments "shall be made to Commonwealth Land Title Agency of Tucson, Inc. [Commonwealth], an Arizona corporation * * * , as collection agent, in accordance with the terms of that Collection Agreement of even date herewith among Maker [i.e., Shearson], Broadway Centre and * * * [Commonwealth]." The Collection Agreement states that Commonwealth "is authorized to disburse the entire monthly payment to * * * Pacific Mutual * * * [and] [u]pon satisfaction of [the] Pacific Mutual Loan * * * , the remaining balance to be disbursed to * * * Broadway * * *." The Collection Agreement states that Commonwealth "acts only in the capacity of an escrow*323 agent and shall be liable only for monies actually received for applications to this agreement." Commonwealth reserved the right to terminate the Collection Agreement upon 30 days' written notice.
In the event of Broadway's default under the First-Lien Note or First-Lien Deed of Trust, the Wraparound Note states that:
Maker [i.e., Shearson] has the right, but is not obligated, to cure such default and any sums paid to effect such cure shall entitle Maker to receive a credit on the [Wraparound] Note (to be applied against any amounts under the [Wraparound] Note Maker may elect) in an amount equal to 115% of amounts so paid;
Commonwealth was also the trustee under the wraparound deed of trust securing the Wraparound Note (Wraparound Deed of Trust). Under the Wraparound Deed of Trust, the filing of a petition in bankruptcy by or against Shearson was an event of default. In 1985, Shearson filed a petition under Chapter 11 of the Federal bankruptcy code. Since such time, *324 Broadway has made no payments on the First-Lien Note and Shearson has made no payments on the Wraparound Note.
Prior to its bankruptcy, Shearson made required monthly payments on the Wraparound Note to Commonwealth and Commonwealth in turn made the monthly payments on the First-Lien Note to Pacific Mutual. Sometime in 1983, however, Mr. Lew McGinnis moved the collection account to the United Bank without first obtaining the consent of the parties to the Collection Agreement. The collection account was moved back to Commonwealth after only one monthly payment had been missed.
OPINION
The parties have stipulated that Broadway is entitled to report gain recognized on the sale of the office building as an installment sale under
The Wraparound Note provided for payments by Shearson to Broadway beyond the year of sale, 1981. Thus, there was an installment sale under
The dispute in this case centers upon determining the amount of the "total contract price," which represents the denominator of the gross profit ratio under
In computing the total contract price, the sales price of property is to be reduced by the amount of any mortgage "assumed" or taken "subject to" by a buyer, to the extent it does not exceed the seller's basis in the property sold.
Taking property subject*327 to a mortgage means that the buyer pays the seller for the latter's redemption interest, i.e., the difference between the amount of the mortgage debt and the total amount for which the property is being sold, but the buyer does not assume a personal obligation to pay the mortgage debt. The buyer agrees that as between him and the seller, the latter has no obligation to satisfy the mortgage debt, and that the debt is to be satisfied out of the property. Although he is not obliged to, the buyer will ordinarily make the payments on the mortgage debt in order to protect his interest in the property. Where a buyer assumes a mortgage on property, he pays the seller for the latter's redemption interest, and in addition promises the seller to pay off the mortgage debt. The promise of the buyer can ordinarily be enforced by the mortgagee. 5 Tiffany, The Law of Real Property, secs. 1435, 1436 (3d ed. 1939); IV American Law of Property, secs. 16.125, 16.127, 16.128-16.132 (1952). [
In comparison, a "wraparound mortgage" is an*328 agreement under which the purchaser issues to the seller an installment obligation that includes the amount of an underlying mortgage on the property as the principal amount, and the seller uses the payments under the installment obligation to service the underlying mortgage. The seller remains liable on and continues to service the underlying mortgage. Thus, a distinguishing feature of a wraparound mortgage is that payments are made to the seller, and not to an underlying mortgagee, as is the case where a mortgage is assumed or property is taken subject to a mortgage.
In
Since 1955, when this Court found in
However, "A transaction presented as a wraparound would not be taxed as such if the purchaser was, in substance, required to discharge the underlying mortgage or the seller had so little control of the proceeds that he could be said to be required to use them to service the underlying mortgage."
In
Petitioners argue that
Petitioners argue that the collection account in
In determining the substance of the subject transaction, we are more concerned about the nature and effect of the Collection Agreement itself than the reasons why it was established. In any event, Mr. Semro testified that Mr. McGinnis also wanted to use a collection account. Further, we cannot blind ourselves to the obvious benefit to the purchaser (Shearson) in using a collection account to provide assurance that payments made on the Wraparound Note*332 would in turn be used to service the First-Lien Note. Accordingly, we find this aspect of petitioners' argument unpersuasive.
Petitioners also contend that the collection agent in
We are convinced that Broadway gave up sufficient control over the proceeds of the Wraparound Note that it was in substance required to use them to service*333 the First-Lien Note. See
To reflect the foregoing and concessions,