DocketNumber： No. 3877-92; No. 3963-92
Filed Date： 3/19/2001
Status： Non-Precedential
Modified Date： 11/21/2020
Decisions will be entered under Rule 155.
APPENDIX A
EPIC Associates 83-XII
Schedule D -- Pro Forma
Cash-Flow and Taxable Income (Loss) Analysis
Through June 30, 1987
Application of Funds 1983 1984 1985
____________________ ____ ____ ____
ANNUAL CASH-FLOW
Rental Income 2001 Tax Ct. Memo LEXIS 80">*81 and repairs /
Interest income $ 356,488.68 $ 186,475.74 $ 1,430,974.63
Interest2001 Tax Ct. Memo LEXIS 80">*82 income -0- -0- 42,072.68
Less: First mortgage
payments
Additional interest
payments
Taxes 59,926.95 30,981.10 233,140.45
Insurance 26,337.55 13,652.53 102,089.36
Audit fees 4,876.62 2,438.31 20,522.44
Maintenance and repairs
Property administration fee 30,600.00 15,300.00 128,775.00
Net cash-flow from operations -339,813.95 -168,492.94 -1,410,631.04
TAXABLE INCOME (LOSS) ANALYSIS
Net cash-flow from operations -339,813.95 -168,492.94 -1,410,631.04
Plus: Mortgage amortization -0- -0- -0-
Other income recognized
Less: Depreciation 173,118.72 86,559.36 728,541.28
Amortization of mortgage
loan fee 2001 Tax Ct. Memo LEXIS 80">*83 16,671.30 8,335.65 70,158.38
Accrued mortgage interest -0- -0- -0-
Net taxable income -529,603.97 -263,387.95 -2,209,330.71
2001 Tax Ct. Memo LEXIS 80">*84 * * * * *
APPENDIX B
EPIC ASSOCIATES 84-III
Schedule D -- Pro Forma
Cash-Flow and Taxable Income (Loss) Analysis
October 1, 1983 Through December 31, 1987
Application of Funds 1983 1984 1985
____________________ ____ ____ ____
Annual cash-flow
Gross rental income from
individuals $ 83,640 $ 294,341 $ 315,619
Less: Rental commissions 5,305 27,885 25,250
Vacancy -0- 69,169 37,874
Net rental income from
individuals 2001 Tax Ct. Memo LEXIS 80">*85 mortgage payments 2001 Tax Ct. Memo LEXIS 80">*86 -149,524 -660,846 -610,809
[Table continued]
Application of Funds 1986 1987 Total
____________________ ____ ____ _____
Annual cash-flow
Gross rental income from
individuals $ 338,435 $ 362,901 $ 1,394,936
Less: Rental commissions 27,075 29,032 114,547
Vacancy 40,612 43,548 191,203
Net rental income from
individuals
Interest income on partnership
funds
Lent to EPIC -0- -0- 12,824
Less: First mortgage payments
Interest expenses on funds lent by
EPIC to the partnership
Taxes 85,004 91,149 349,266
Insurance 9,972 2001 Tax Ct. Memo LEXIS 80">*87 10,693 44,289
Home owner association dues 4,674 5,012 16,446
Audit fees 4,946 4,946 21,074
Maintenance and repairs
Miscellaneous -0- -0- 5,444
Property administration fee 33,000 33,000 140,250
Net cash-flow from operations -445,421 -462,262 -1,913,611
Taxable income (loss) analysis
Net cash-flow from operations -445,421 462,262 -1,913,611
Less: Depreciation 170,742 170,742 725,653
Amortization of mortgage loan fee 13,814 13,814 58,709
Net taxable income -629,976 -646,818 -2,697,972
2001 Tax Ct. Memo LEXIS 80">*88
MEMORANDUM FINDINGS OF FACT AND OPINION
WHALEN, JUDGE: Respondent issued notices of final partnership administrative adjustment (notices of FPAA) in which respondent determined the following adjustments with respect to the partnership items reported by Epic Associates 83-XII (referred to herein as EA 83-XII):
1983 1984 1985
____ ____ ____
Disallow interestand point $ 483,029 $ 556,564 $ 576,848
amortization deductions
Disallow depreciation 173,119 173,119 173,119
deductions
Disallow claimed net investment (341,010) -0- -0-
loss
Disallow qualified investment -0- 303,571 330,529
income
Disallow qualified investment -0- 908,960 909,831
expenses
Disallow excess expenses from 10,859 -0- -0-
net lease2001 Tax Ct. Memo LEXIS 80">*89 property
Disallow investment interest 66,366 -0- -0-
income
Disallow net investment income 29,306 -0- -0-
Disallow investment income -0- 90 1,262
Respondent issued notices of FPAA in which respondent determined the following adjustments with respect to the partnership items reported by Epic Associates 84-III (referred to herein as EA 84-III):
1983 1984 1985
____ ____ ____
Disallow interestand point $ 121,535 $ 536,280 $ 559,662
amortization deductions
Disallow depreciation 56,910 170,742 170,742
deductions
Disallow deductions in -0- -0- 44,219
excess of income
Disallow claimed net (141,142) -0- -0-
investment loss
Disallow qualified investment -0- 217,619 229,131
income
Disallow qualified2001 Tax Ct. Memo LEXIS 80">*90 investment -0- 872,376 997,436
expenses
Disallow net investment income 6,097 -0- -0-
Disallow investment income -0- -0- 494
Among the adjustments summarized above, respondent disallowed all of the interest and depreciation claimed as deductions by each partnership. The principal issues in these cases are whether certain nonrecourse promissory notes issued by each partnership to purchase real estate constitute bona fide indebtedness and whether the activity of each partnership is an "activity not engaged in for profit", as that phrase is defined by section 183(c). Unless stated otherwise, all section references in this opinion are to the Internal Revenue Code as in effect during the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
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. EA 83-XII and EA 84-III are limited partnerships. At the time the instant petitions were filed on their behalf, each2001 Tax Ct. Memo LEXIS 80">*91 partnership was doing business in the State of Virginia, and the tax matters partners of each partnership, William C. Griffith, Jr., and Dottie M. Griffith, resided in Atlanta, Georgia. Both limited partnerships reported income and expenses on a calendar year basis and used the accrual method of accounting.
EA 83-XII
EA 83-XII was formed on December 3, 1982, pursuant to the Uniform Limited Partnership Act of the Commonwealth of Virginia for a 10-year term ending on December 3, 1992. The Amended and Restated Certificate and Agreement of Limited Partnership dated June 1, 1983 (referred to herein as the 83 partnership agreement) describes the business of EA 83-XII in the following terms:
Business of the Partnership
The business of the Partnership shall be to acquire, directly or
indirectly, and finance, fee interests in certain improved
residential real properties and to operate, manage, lease or
otherwise deal with such properties with the objective of
distributing income generated thereby among the Partners as
provided for herein; and to hold such properties for investment
with the objective of capital appreciation2001 Tax Ct. Memo LEXIS 80">*92 therein and to engage
in and perform all acts and activities required in connection
with or incident to the foregoing.
The partnership's sole general partner was Equity Programs Investment Corp. (EPIC), a corporation that was originally incorporated in Virginia in 1974 and was reincorporated in Maryland in 1983. EPIC's business involved the purchase, lease, and sale of residential houses and condominiums. We discuss EPIC at greater length below.
The 83 partnership agreement provides that EPIC's "interest shall be deemed to be a one-percent (1%) share in the Partnership's capital contributions for which it shall contribute" $ 10,580.81. In addition, the 83 partnership agreement authorizes two classes of limited partnership interests: 1 class A unit and 25 class B units. The class A unit was sold to four investors for an aggregate sum of $ 90,000. The purchasers of the class A unit made cash payments totaling $ 50,000 and executed recourse promissory notes totaling $ 40,000 that were payable to the partnership on July 1, 1983. These investors were admitted to the partnership on April 16, 1983.
EA 83-XII also sold 25 class B units of limited partnership interest for2001 Tax Ct. Memo LEXIS 80">*93 $ 38,300 per unit or a total of $ 957,500. Approximately $ 3,300 of the amount paid for each class B unit was paid in cash and the balance of $ 35,000 was paid in the form of a recourse promissory note payable to EX 83-XII in 14 quarterly installments of $ 2,500 each with the last payment due on April 1, 1987.
Before selling the class B units in EA 83-XII, EPIC circulated a confidential private placement offering memorandum dated June 1, 1983 (referred to herein as the 83 offering memorandum). The 83 offering memorandum states that persons who purchased class B units would be admitted to EA 83-XII as limited partners commencing September 1, 1983.
The 83 offering memorandum states that the limited partners' contributions would be used primarily to fund operating deficits of the partnership. The 83 offering memorandum includes the following summary of EA 83-XII's anticipated sources and uses of the proceeds of the offering:
Sources Amount Percent
_______ ______ ______
Proceeds from sale of class A unit $ 90,000 2001 Tax Ct. Memo LEXIS 80">*94 1.66
Proceeds from sale of class B units 957,500 17.68
Capital contribution of general partner 10,581 0.19
First mortgage loans 3,706,150 68.38
Builder rebate [referred to herein 655,319 12.09
as rental deficit contribution] _________ ______
5,419,550 100.00
========= ======
Uses
____
Purchase price of homes 2001 Tax Ct. Memo LEXIS 80">*95 58,350 1.08
Available for cash-flow deficits 1,165,334 21.51
_________ ______
5,419,550 100.00
========= ======
Note: Footnotes omitted.
As set forth above, it was anticipated that $ 58,350 of the proceeds of the offering would be offset by cash-flow deficits through April 15, 1983, and $ 1,165,334 of the offering proceeds would be available for cash-flow deficits after that date. The projected annual income and operating costs of EA 83-XII as set forth in the 83 offering memorandum show an annual operating deficit of $ 345,344 calculated as follows:
Percentage2001 Tax Ct. Memo LEXIS 80">*96 of
Projected Annual Income Amount Total Income
_______________________ ______ _____________
Builder lease $ 65,784 20.30
Rental income (less 20%
vacancy & expense factor) 258,240 79.70
Total projected income 324,024 100.00
Annual Operating Expenditures
Aggregate first mortgage
principal & interest $ 546,102 168.54
Real estate taxes 49,213 15.19
Insurance & homeowner's dues 21,500 6.64
Audit expenses 4,877 1.51
Property administration fee 30,600 9.44
Allowance for maintenance & repairs 17,076 5.27
________ ______
Total projected cash expenditures 669,368 206.59
________ ______
Projected2001 Tax Ct. Memo LEXIS 80">*97 operating deficit 345,344 106.59
======== ======
The 83 offering memorandum also includes a cash-flow analysis for EA 83-XII from inception to June 30, 1987, as set forth in appendix A to this opinion.
In the 83 offering memorandum, it was contemplated that EPIC would finance the partnership's operating deficits by advancing funds to the partnership. The 83 partnership agreement provides that EA 83-XII would pay interest on all unsecured advances of funds by the general partner at the rate of 15 percent per annum. The 83 partnership agreement also permits the partnership to advance to the general partner any funds that were not distributed to the limited partners, and the agreement provides that the general partner would pay interest to EA 83-XII on such advances at the rate of 12 percent per annum.
The 83 partnership agreement provides that cash from operations is to be distributed in the following order of priority: (i) To EPIC to repay any unsecured advances made by EPIC to the partnership together with interest; (ii) to the partners in the ratio that the cumulative cash capital2001 Tax Ct. Memo LEXIS 80">*98 contributions of each partner bear to the cumulative cash capital contributions of the partners until such amounts equal the partners' cumulative cash capital contributions; (iii) 25 percent to EPIC and 75 percent to the limited partners holding the class A and class B units.
The 83 partnership agreement further provides that cash from sales and from financings is to be distributed in the following order of priority: (i) To repay partnership debt secured by the property sold or refinanced and to pay the expenses of selling each property; (ii) to repay any unsecured advances made by EPIC to the partnership together with interest; (iii) to pay EPIC a disposition fee equal to 2.5 percent of the price for which any partnership properties are sold; (iv) to the partners in the ratio that each partner's total cash capital contributions bear to the cumulative cash capital contributions of all partners until such amounts equal the partners' cumulative cash capital contributions; and (v) 25 percent of any remaining amount to EPIC and 75 percent to the limited partners holding class A and class B units.
The partnership agreement specifies that EA 83-XII shall pay the following compensation2001 Tax Ct. Memo LEXIS 80">*99 to EPIC:
Compensations of the General Partner
* * * * * * *
(a) At the time of subscription, a Partnership Organization Fee,
as detailed in the Confidential Private Offering Memorandum for
the Partnership, being 4% of Limited Partners capital
contribution upon admission to the Partnership or a maximum
total payment of $ 41,900 for non-recurring services which may be
incurred before or after formation of the Partnership, to
include furnishing legal, financial, accounting and operational
assistance review of rental schedules and expense forecasts and
other services which do not give rise to the acquisition of
specific properties or the obtaining of financing therefor;
(b) During each full or partial month of the Partnership, the
General Partner shall be paid an administration fee equal to
Fifty and 00/100 ($ 50.00) for each Partnership property;
(c) Such loan origination fees or service fees at commercially
prevailing market rates that may derive from originating or
servicing of any security2001 Tax Ct. Memo LEXIS 80">*100 interests, including mortgages and
deeds of trust, placed upon Partnership property;
(d) Reimbursement of all carrying costs of the Partnership
properties including, but not by way of limitation, interest on
mortgage indebtedness encumbering the properties, incurred prior
to the admission of the Limited Partners to the Partnership;
(e) Two-and-one-half percent (2 1/2%) disposition fee on all
resale of Partnership properties except in connection with an
exchange with a builder for like kind property;
(f) For all unsecured advances of funds to the Partnership, the
General Partner shall be entitled to interest on all such funds
advanced at the rate of 15% per annum; and
(g) Any difference between costs incurred by the General Partner
on pooled insurance policies for all partnerships sponsored by
the General Partner and premiums charged to the Partnership for
all risk insurance coverage (including fire and hazard) for each
Partnership property plus the premium attributable to decreasing
the deductible amount to $ 100 shall be the property2001 Tax Ct. Memo LEXIS 80">*101 of the
General Partner.
PURCHASE OF MODEL HOUSES IN CARROLLTON, TEXAS, FROM RALDON CORP.
EPIC executed a contract entitled Epic Model Home Purchase and Leaseback Agreement (purchase and leaseback agreement), dated December 9, 1982, under which it agreed to purchase five houses located in Carrollton, Texas, from Raldon Corp. (Raldon) for $ 485,995 and to lease the houses back to Raldon for use as model houses for an initial term of 18 months. For each of the five houses, there is a schedule attached to the agreement that lists the address; the base price; the "optional extras" included with the house, such as carpeting, wallpaper, and mirrored walls; the "marketing extras", such as drapes, sprinkler systems, built-ins, and landscaping; the price for each of the extras; and the "purchase price" of the house. The purchase price for each of the five houses was $ 8,000 to $ 10,000 more than the base price because of the "extras".
As one of the conditions of closing under the purchase and leaseback agreement, Raldon agreed to pay EPIC 6 percent of the purchase price of the properties. The agreement provides as follows:
On the Closing Date, Seller [Raldon] 2001 Tax Ct. Memo LEXIS 80">*102 shall pay to Equity
Programs Investment Corporation a sum equal to six percent (6%)
of the Purchase Price of the Properties, and the execution of
this Agreement by Seller shall constitute an irrevocable
assignment to Equity Programs Investment Corporation from the
sale proceeds of a sum sufficient to make the payment due under
this Subparagraph 5.7.
We refer to the amount payable under the above provision as the builder fee.
Another condition under the purchase and leaseback agreement required Raldon to pay at closing the first full month's rent for each of the properties plus the pro rata portion of the monthly rent for the month of closing. The agreement provides as follows:
Seller, as tenant, shall have * * * (ii) paid to Purchaser,
as Landlord, the first full month's Adjusted Monthly Rental for
each of the Properties plus the pro rata portion of the Adjusted
Monthly Rental for the month during which the Closing Date
occurs.
We refer to this amount as the rent advance.
Finally, as a condition to closing, the purchase and leaseback agreement required Raldon to supply to the purchaser2001 Tax Ct. Memo LEXIS 80">*103 an appraisal that showed the value of the property and improvements equal to or greater than the purchase price. The agreement provides as follows:
An appraisal of the Properties and improvements prepared by a
FNMA/FHLMC qualified appraiser acceptable to Purchaser on a
standard FNMA/FHLMC form which shall reflect a value of the
Property and improvements equal to or greater than the Purchase
Price.
EPIC made the following internal cash-flow analysis of the transaction with Raldon:
Raldon Corp. Year 1 Year 2 Year 3
____________ ______ ______ ______
Builder lease payments $ 61,819 $ 30,909 -0-
Tax, ins., HOA reimburse 4,476 2,238 -0-
Tenant rental -0- 17,489 $ 37,776
Rental deficit contribution -0- -0- -0-
Interest income -0- -0- -0-
_______ _______ _______
2001 Tax Ct. Memo LEXIS 80">*104 Total revenue 66,295 50,636 37,776
First trust interest -68,031 -68,031 -68,031
Tax, ins., HOA expense -4,476 -4,476 -4,476
Repairs & maintenance -0- -1,215 -2,430
Property management fee -2,100 -2,100 -2,100
Audit fee -607 -607 -607
Interest on EPIC advances -6,288 -6,288 -6,288
_______ _______ _______
Total expenses -81,502 -82,717 -83,932
Anticipated cash deficit -15,207 -32,081 -46,156
As a percent of purchase -3.13% -6.60% -9.50%
price
[Table continued]
Raldon Corp. Year 4 Total
____________ ______ _____
Builder lease payments -0- $ 92,728
Tax, ins., HOA2001 Tax Ct. Memo LEXIS 80">*105 reimburse -0- 6,714
Tenant rental $ 40,798 96,063
Rental deficit contribution -0- -0-
Interest income -0- -0-
_______ ________
Total revenue 40,798 195,505
First trust interest -68,031 -272,124
Tax, ins., HOA expense -4,476 -17,904
Repairs & maintenance -2,430 -6,075
Property management fee -2,100 -8,400
Audit fee -607 -2,428
Interest on EPIC advances -6,288 -25,152
_______ ________
Total expenses -83,932 -332,083
Anticipated cash deficit -43,134 -136,578
As a percent of purchase -8.88% -28.10%
price
According to the above analysis, EPIC projected a cash deficit from the transaction at the end of the fourth year of $ 136,5782001 Tax Ct. Memo LEXIS 80">*106 or 28.10 percent of the original purchase price (viz $ 485,995). EPIC further projected that the following appreciation rates would be required to recoup the investment in the properties after sales expenses of 7 percent and a disposition fee of 2.5 percent to be paid to EPIC:
Investment Appreciation Rate
__________ _________________
End of 2d year 678,408
End of 4th year
By instrument dated December 22, 1982, EPIC assigned to EA 83- XII EPIC's "right, title and interest" in the purchase and leaseback agreement with Raldon. On December 27, 1982, EA 83-XII closed the purchase of each of the five model houses from Raldon.
To finance its purchase of the2001 Tax Ct. Memo LEXIS 80">*107 subject houses, EA 83-XII borrowed approximately 95 percent of the purchase price of each of the properties from EPIC Mortgage, Inc. (EMI), a corporation affiliated with EPIC. EMI's business was to originate mortgages for EPIC partnerships. At closing, EA 83-XII executed five nonrecourse promissory notes, in the aggregate principal amount of $ 461,675, payable to EMI in monthly installments of interest only on the unpaid principal balance for 5 years at the rate of 14.375 percent. The entire indebtedness under each note was due 5 years after the date of the first payment of interest required under the note.
Each nonrecourse promissory note was secured by a deed of trust bearing the date of closing and recorded on January 3, 1983, in the land records of Denton County, Texas. A mortgage insurance company, Ticor Mortgage Insurance (TMI), issued a commitment and certificate of insurance dated December 28, 1982, providing mortgage insurance for 25 percent of the first loss amount with respect to the mortgage on each of the five properties.
Set out below is a list of each of the properties that EX 83-XII purchased from Raldon, the purchase price of each property, the builder fee, the rent2001 Tax Ct. Memo LEXIS 80">*108 advance, and the amount borrowed with respect to each property:
Purchase Builder Rent
Raldon Corp. Price Fee Advance Loan
____________ ________ _______ _______ ____
2109 Avignon Dr. $ 88,995 $ 5,339.70 $ 1,004 $ 84,525
2111 Avignon Dr. 89,500 5,370.00 1,009 85,025
2113 Avignon Dr. 100,500 6,030.00 1,134 95,475
2115 Avignon Dr. 100,500 6,030.00 1,134 95,475
2117 Avignon Dr. 106,500 6,390.00 1,201 101,175
_______ _________ _____ _______
485,995 29,159.70 5,482 461,675
A settlement statement was prepared for the sale of each house. Each statement shows the above purchase price as the contract sales price of the house and shows the builder fee and rent advance for each house as charges to the seller, Raldon, and, thus, as reductions of the amount due to Raldon. Each statement also shows2001 Tax Ct. Memo LEXIS 80">*109 the total of the "amounts paid by/for" EA 83-XII, as consisting principally of the loan proceeds and the sum of the builder fees and rent advances. The total of these amounts exceeded the amount due from EA 83-XII. Set out below is a summary of the settlement statements showing that a total of $ 8,801.60 was due to the buyer, EA 83-XII, at closing:
Raldon Corp. Buyer Seller
____________ _____ ______
Contract sales price $ 485,995.00 $ 485,995.00
Settlement charges to buyer 2,132.60 -0-
Price adjustment 12.50 12.50
___________ ___________
Gross amount due 488,140.10 486,007.50
Principal amount of loans 461,675.00 -0-
Builder fee 29,159.70 29,159.70
Rent advance 5,482.00 2001 Tax Ct. Memo LEXIS 80">*110 5,482.00
Rental deficit contribution -0- -0-
Other credits 625.00 625.00
Settlement charges to seller -0- 5,835.04
___________ ___________
Total credits 496,941.70 41,101.74
Amount due buyer 8,801.60 -0-
Amount due seller -0- 444,905.76
According to the settlement sheets, the aggregate principal amount of the loans, $ 461,675, was credited as follows:
Buyer Seller Others Total
_____ ______ ______ _____
Settlement charges
to buyer -0- -0- $ 2,132.60 $ 2,132.60
Amount due less loan $ -26,465.10 -0- -0- -26,465.10
Builder fee 29,159.70 -0- -0- 29,159.70
Rent advance2001 Tax Ct. Memo LEXIS 80">*111 5,482.00 -0- -0- 5,482.00
Other credit 625.00 -0- -0- 625.00
Settlement charges
to seller -0- -0- 5,835.04 5,835.04
Amount due seller $ 444,905.76 -0- 444,905.76
___________ ____________ _________ __________
8,801.60 444,905.76 7,967.64 461,675.00
EMI assigned to Community Savings & Loan, Inc. (CSL), a savings and loan association affiliated with EPIC, its interest in each of the promissory notes and related deeds of trust that had been issued by EA 83-XII in connection with its purchase of the five properties from Raldon. EMI made the assignment in an Assignment of Deed of Trust dated March 30, 1983. In the same instrument, CSL further assigned its interest as holder of each promissory note under the related deed of trust to the North Jersey Savings & Loan Association. Thus, shortly after EA 83-XII purchased the subject properties from Raldon, North Jersey Savings & Loan Association purchased the promissory notes that2001 Tax Ct. Memo LEXIS 80">*112 EA 83-XII had issued to EMI.
PURCHASE OF PRODUCTION HOUSES IN ODESSA, TEXAS
EPIC executed a Residential Rental Purchase Agreement (rental purchase agreement) dated December 18, 1982, under which it agreed to purchase seven houses located in the Hollywood View subdivision in Odessa, Texas, from Fox and Jacobs, Inc. (Fox & Jacobs), for $ 394,600. The rental purchase agreement had originally called for the purchase of eight properties for a total of $ 449,500 but was amended by deleting one house sometime before closing.
The rental purchase agreement includes an exhibit B for each of the seven properties that sets forth the base price of the property and the appliances and interior decorations included in the purchase price. This exhibit also lists an "estimated rental amount" for the property. Exhibit C to the rental purchase agreement gives EPIC the right to rent each of the properties and states that, for each property not leased as of the closing date, Fox & Jacobs agrees to pay to the purchaser on the closing date an amount equal to three times the monthly rent for that property as set forth on exhibit B. We refer to this amount as the rent advance.
Under the rental purchase2001 Tax Ct. Memo LEXIS 80">*113 agreement, Fox & Jacobs agreed to pay to EPIC 6.8 percent of the purchase price of the properties. The rental purchase agreement provides for this payment as a condition to "the obligation of the Purchaser to purchase each of the Properties" in the following terms:
On the Closing Date, Seller shall pay to Equity Programs
Investment Corporation a sum equal to six and eight-tenths
percent (6.8%) of the Purchase Price of the Properties, and the
execution of this Agreement by Seller shall constitute an
irrevocable assignment to Equity Programs Investment Corporation
from the sale proceeds of a sum sufficient to make the payment
due under Subparagraph 4.6.
We refer to this sum as the builder fee.
As a further condition to the purchaser's obligation under the rental purchase agreement, Fox & Jacobs agreed to pay to "the Purchaser a sum equal to the percentage as set forth on Exhibit 'A' hereof of the purchase price of each Property as a contribution towards rental deficits" (referred to herein as the rental deficit contribution). The percentages set forth on exhibit A attached to the rental purchase agreement range from2001 Tax Ct. Memo LEXIS 80">*114 16.38 to 17.90 percent. We refer to this payment as the rental deficit contribution.
The rental purchase agreement also provided, as a condition to the purchaser's obligation to purchase the properties, that the "purchaser shall have obtained an appraisal of each of the Properties by a FNMA/FHLMC qualified appraiser * * * which shall reflect the value of each Property equal to or greater than the purchase price applicable to that Property".
EPIC made the following internal cash-flow analysis of the transaction with Fox & Jacobs:
Fox & Jacobs, Inc. Year 1 Year 2 Year 3
__________________ ______ ______ ______
Builder lease payments -0- -0- -0-
Tax, ins., HOA reimburse -0- -0- -0-
Tenant rental $ 48,740 $ 49,659 $ 53,632
Rental deficit contribution 69,190 -0- -0-
Interest income 6,556 3,935 1,312
_______ _______ _______
Total2001 Tax Ct. Memo LEXIS 80">*115 revenue 124,486 53,594 54,944
First trust interest -62,922 -62,922 -62,922
Tax, ins., HOA expense -7,920 -7,920 -7,920
Repairs & maintenance -2,247 -2,247 -2,247
Property management fee -562 -562 -562
Audit fee -3,360 -3,360 -3,360
Interest on EPIC advances -5,815 -5,815 -5,815
_______ _______ _______
Total expenses -82,826 -82,826 -82,826
Anticipated cash deficit 41,660 -29,232 -27,882
As a percent of purchase 9.27 -6.5 -6.2
price -- check Nos.
[Table continued]
Fox & Jacobs, Inc. Year 4 Total
__________________ ______ _____
Builder lease payments -0- -0-
Tax, ins., HOA reimburse 2001 Tax Ct. Memo LEXIS 80">*116 -0- -0-
Tenant rental $ 57,922 $ 209,953
Rental deficit contribution -0- 69,190
Interest income -0- 11,803
_______ ________
Total revenue 57,922 290,946
First trust interest -62,922 -251,688
Tax, ins., HOA expense -7,920 -31,680
Repairs & maintenance -2,247 -8,988
Property management fee -562 -2,248
Audit fee -3,360 -13,440
Interest on EPIC advances -5,815 -23,260
_______ ________
Total expenses -82,826 -331,304
Anticipated cash deficit -24,904 -40,358
As a percent of purchase -5.54 -8.98
price -- check Nos.
The above analysis is based upon the original plan to purchase eight houses for $ 449,500. As shown above, EPIC projected a cash deficit from that transaction2001 Tax Ct. Memo LEXIS 80">*117 at the end of the fourth year of $ 40,358 or 8.98 percent of the purchase price. EPIC further projected that the following appreciation rates would be required to recoup the investment in the properties after sales expenses of 7 percent and the disposition fee of 2.5 percent to be paid to EPIC:
Appreciation
Investment Rates
__________ ____________
End of 2d year $ 507,668 6.27
End of 3d year 541,663 6.41
End of 4th year 572,185 6.22
EPIC's analysis of the transaction included a computation of the rental deficit contribution. First, EPIC personnel estimated that the project would generate a monthly deficit of $ 2,101, taking into account estimated monthly operating expenses of $ 7,961, tenant rentals of $ 4,600 (with a vacancy rate of 11.7 percent), and monthly contributions of investor capital of $ 1,798. According to the analysis, the present value of the monthly deficit2001 Tax Ct. Memo LEXIS 80">*118 over 36 months discounted at 13 percent is $ 62,364. The analysis, which is reproduced below, designates this amount as the rental deficit contribution:
Operating expenses per month $ 7,961
Tenant rental revenue -4,600
Rent-up factor 0.883
Net tenant rental -4,062
Operating deficit 3,899
Investor contribution
purchase price $ 449,500 x 0.004 -1,798
Net monthly deficit 2,101
Present value of deficit
over 36 mos. at 13%
monthly deficit of 2,101 x 29.68 62,364 [sic]
Rental deficit contribution 62,364
As a percent of purchase price 0.1387408
The rental deficit contribution shown above was calculated using a
net borrowing cost, exclusive of servicing and private mortgage
insurance of 16.75 percent.
2001 Tax Ct. Memo LEXIS 80">*119 The rental deficit contribution computed in the above analysis, $ 62,364, differs from the amount used in EPIC's cash-flow analysis for the project, $ 69,190, and differs from the rental deficit contribution finally negotiated with Fox & Jacobs, $ 67,643.
By instrument dated December 21, 1982, EPIC assigned to EA 83-XII "its entire right, title and interest, as purchaser and landlord" in the rental purchase agreement dated December 18, 1982, with Fox & Jacobs. On December 30, 1982, EA 83-XII closed the purchase of each of the properties.
To finance its purchase of the subject properties, EA 83- XII borrowed approximately 95 percent of the purchase price of each of the properties from EMI. On the closing date, EA 83-XII executed seven nonrecourse promissory notes, in the aggregate principal amount of $ 374,850, payable to EMI with monthly installments of interest only on the unpaid principal balance for 5 years at the rate of 14.375 percent. Thereafter, the notes required EA 83-XII to pay monthly installments of principal and interest for 5 years. The principal amount of each note was due at the end of 10 years, or January 1, 1993. On March 1, 1983, the parties executed an Allonge2001 Tax Ct. Memo LEXIS 80">*120 to Note for each of the seven notes. The Allonge to Note states as follows:
The Note shall bear interest at the rate computed as
follows: (a) the rate of interest for the first sixty (60) full
calendar months of the loan term shall be Fourteen and 375/1000
(14.375%) per annum; (b) thereafter, the rate of interest shall
be adjusted annually, commencing with the sixty-first (61st)
full calendar month of the loan term, to a rate per annum equal
to the sum of the FNMA auction price in effect on the first day
of the calendar month immediately preceding the month of such
adjustment plus 237.5 basis points, payable as follows:
Interest only on the unpaid principal balance, computed as
set forth in (a) above, shall be payable on the first day of
each month commencing April 1, 1983 and on the first day of each
succeeding month through and including March 1, 1988.
Thereafter, payments of monthly installments of principal and
interest at the rate per annum as set forth in (b) above, shall
be fully amortized over the remaining sixty (60) months2001 Tax Ct. Memo LEXIS 80">*121 of the
loan term, except that any remaining indebtedness, if not sooner
paid, shall be due and payable in full on March 1, 1993.
Each nonrecourse promissory note was secured by a deed of trust bearing the closing date. The deeds of trust were recorded in the land records of Ector County, Texas, on January 14, 1983. Each deed of trust was amended on March 1, 1983, to reflect the changes made by the Allonge to Note. A mortgage insurance company, TMI, issued a Commitment and Certificate of Insurance dated January 7, 1983, providing mortgage insurance for 25 percent of the first loss amount with respect to the mortgage on each of the properties.
Set out below is a list of the seven houses that EA-XII purchased from Fox & Jacobs, Inc., together with the purchase price, the builder fee, the rental deficit contribution, the rent advance, and the amount borrowed with respect to each property:
Rental
Deficit
Purchase Builder Contri- Rent
Fox & Jacobs, Inc. Price Fee bution Advance2001 Tax Ct. Memo LEXIS 80">*122 Loan
__________________ _______ _______ _______ _______ ____
1612 Hemphill Ave. $ 57,400 $ 3,903.20 $ 10,039 $ 1,725 $ 54,525
1921 W. 17th St. 54,000 3,672.00 8,847 1,725 51,300
1716 Coronado Ave. 56,900 3,869.20 9,864 1,725 54,050
1720 Coronado Ave. 59,400 4,039.20 10,635 1,725 56,425
1728 Coronado Ave. 54,000 3,672.00 8,847 1,725 51,300
1700 Linda Ave. 56,900 3,869.20 9,864 1,725 54,050
1916 Hollywood Dr. 56,000 3,808.00 9,547 1,725 53,200
_______ _________ ________ ______ _______
Subtotal 394,600 26,832.80 67,643 12,075 374,850
A settlement statement was prepared for the sale of each property. In each case, the statement shows the above purchase price as the "contract sales price" of the property. Each statement also shows the builder fee, the rent advance, and the rental deficit contribution as charges to the seller, Fox & Jacobs, and, thus, as reductions of the amount due to Fox & Jacobs. Each statement2001 Tax Ct. Memo LEXIS 80">*123 also shows the total of the "amounts paid by/for" EA 83-XII, as consisting principally of the loan proceeds and the sum of the builder fees, rent advances, and rental deficit contributions. The total of these amounts exceeded the amount due from EA 83-XII. Set out below is a summary of the settlement statements showing that a total of $ 92,331.55 had been overpaid by or on behalf of the buyer, EA 83-XII:
Fox & Jacobs, Inc. Buyer Seller
__________________ _____ ______
Contract sales price $ 394,600.00 $ 394,600.00
Settlement charges to buyer 1,794.25
___________ ___________
Gross amount due 396,394.25 394,600.00
Principal amount of loans 374,850.00
Builder fee 26,832.80 26,832.80
Rent advance 12,075.00 12,075.00
Rental deficit contribution 67,643.00 67,643.00
Other credits2001 Tax Ct. Memo LEXIS 80">*124 7,325.00 7,325.00
Settlement charges to seller 6,026.94
__________ __________
Total credits 488,725.80 119,902.74
Amount due buyer 92,331.55
Amount due seller 274,697.26
According to the settlement statements, the aggregate principal amount of the loans, $ 374,850, was credited as follows:
Buyer Seller Others Total
_____ ______ ______ _____
Settlement charges
to buyer -0- -0- $ 1,794.25 $ 1,794.25
Amount due less loans $ -21,544.25 -0- -0- -21,544.25
Builder fee 26,832.80 -0- -0- 26,832.80
Rent advance 12,075 -0- -0- 12,075.00
Rental deficit
contribution 67,643.00 2001 Tax Ct. Memo LEXIS 80">*125 -0- -0- 67,643.00
Other credits 7,325.00 -0- -0- 7,325.00
Settlement charges to
seller -0- -0- 6,026.94 6,026.94
Amount due seller $ 274,697.26 274,697.26
__________ ___________ ________ __________
92,331.55 274,697.26 7,821.19 374,850.00
EMI assigned to CSL its interest in each of the promissory notes and related deeds of trust that had been issued by EA 83-XII in connection with its purchase of the seven houses from Fox & Jacobs, Inc. EMI made the assignment in an Assignment of Deed of Trust dated March 31, 1983. In the same instrument, CSL further assigned its interest as holder of each promissory note under the related deed of trust to National Bank of Washington. Thus, shortly after EA 83-XII purchased the subject properties from Fox & Jacobs, National Bank of Washington purchased the promissory notes that EA 83-XII had issued to EMI. Ultimately, Westinghouse Credit Corp. acquired the deeds of trust related to the seven houses.
2001 Tax Ct. Memo LEXIS 80">*126 PURCHASE OF 39 CONDOMINIUM UNITS IN PASEOS CASTELLANOS
EPIC executed a Residential Rental Purchase Agreement (rental purchase agreement) dated December 22, 1982, under which it agreed to purchase 39 condominium units located in the Paseos Castellanos condominium complex in Miami, Florida, from Babcock Co. (Babcock), a subsidiary of Weyerhaeuser, for $ 3,020,700. For each condominium unit covered by the rental purchase agreement, there is attached to the agreement an exhibit B which identifies the unit, its purchase price, and the monthly rent, and lists the appliances and interior decorations that are included in the purchase.
Paseos Castellanos was constructed in 1982. It consists of eight two-story buildings, with 8 units in each building for a total of 64 units. There is a garage for each unit. In each building, there are two one-story units on the second floor, over the garages; four two-story units in the center of the building; and two one-story units on the ground floor at the rear of the building.
The 39 units purchased by EA 83-XII are scattered among seven of the buildings. Seven are one-story units on the second floor, each with two bedrooms, 2-1/2 bathrooms, and 9682001 Tax Ct. Memo LEXIS 80">*127 square feet of living space; 13 are two-story units in the center of the building, each with two bedrooms, 2-1/2 bathrooms, and 1,240 square feet; 12 are two-story units in the center of the building, each with three bedrooms, 1-1/2 bathrooms, and 1,240 square feet; and the remaining 7 are one-story units on the ground level, each with three bedrooms, two bathrooms, and 1,090 square feet.
The purchaser's obligation under the rental purchase agreement to purchase the subject properties was subject to the following condition:
Rental of the Properties to individual tenants shall have been
arranged, or shall be arranged, upon execution by Purchaser of
this Agreement in accordance with the procedures set forth in
Exhibit "C," attached hereto and by this reference made a part
hereof.
According to exhibit C, in the event that EPIC had not leased all of the properties as of the closing date, then Babcock agreed to pay to the purchaser an amount equal to three times the monthly fair market rent of each property not leased as of the closing date as a nonrefundable contribution toward the expense of listing, showing, and leasing such property after2001 Tax Ct. Memo LEXIS 80">*128 the closing date. We refer to this amount as the rent advance.
Under the rental purchase agreement, Babcock agreed to pay to EPIC 6.8 percent of the purchase price of each property on the closing date. We refer to this amount as the builder fee. The agreement further requires as a condition to the purchaser's obligation under the agreement that Babcock pay to the purchaser 19.455 percent of the purchase price of each property "as a contribution towards rental deficits (referred to as the Rental Deficit Contribution)." In this opinion, we refer to this payment as the rental deficit contribution. Finally, the rental purchase agreement provides, as a condition to the purchaser's obligation to purchase the properties, that the "purchaser shall have obtained an appraisal of each of the Properties by a FNMA/FHLMC qualified appraiser * * * which shall reflect the value of each Property equal to or greater than the purchase price applicable to that property".
EPIC made the following internal cash-flow analysis of the transaction with Babcock:
Paseos Castellanos Year 1 Year 2 Year 3
__________________ ______ ______ 2001 Tax Ct. Memo LEXIS 80">*129 ______
Builder lease payments -0- -0- -0-
Tax, ins., HOA reimburse -0- -0- -0-
Tenant rental $ 243,873 $ 246,792 $ 266,536
Rental deficit contribution 659,929 -0- -0-
Interest income 62,531 37,533 12,514
________ ________ ________
Total revenue 966,333 284,325 279,050
First trust interest -424,784 -424,784 -424,784
Tax, ins., HOA expense -71,196 -71,196 -71,196
Repairs & maintenance -15,173 -15,173 -15,173
Property management fee -16,380 -16,380 -16,380
Audit fee -3,793 -3,793 -3,793
Interest on EPIC advances -39,259 -39,259 -39,259
________ ________ ________
Total expenses -570,585 -570,5852001 Tax Ct. Memo LEXIS 80">*130 -570,585
Anticipated cash deficit 395,748 -286,260 -291,535
As a percent of purchase 13.04 -9.43 -9.61
price
[Table continued]
Paseos Castellanos Year 4 Total
__________________ ______ _____
Builder lease payments -0- -0-
Tax, ins., HOA reimburse -0- -0-
Tenant rental $ 287,858 $ 1,045,059
Rental deficit contribution -0- 659,929
Interest income -0- 112,578
________ __________
Total revenue 287,858 1,817,566
First trust interest -424,784 -1,699,136
Tax, ins., HOA expense -71,196 -284,784
Repairs & maintenance -15,173 -60,692
Property management fee -16,380 -65,520
Audit fee -3,793 -15,172
Interest on EPIC2001 Tax Ct. Memo LEXIS 80">*131 advances -39,259 -157,036
________ __________
Total expenses -570,585 -2,282,340
Anticipated cash deficit -282,727 -464,774
As a percent of purchase -9.32 -15.32
price
As shown above, EPIC projected a cash deficit from the transaction at the end of the fourth year of $ 464,774, or 15.32 percent of the purchase price (viz $ 3,034,550). EPIC further projected that the following appreciation rates would be required to recoup the investment in the properties after sales expenses of 7 percent and a disposition fee of 2.5 percent to be paid to EPIC:
Investment Appreciation Rate
__________ _________________
End of 2d year 3405798 5.94
End of 3d year 3755078 7.36
End of 4th year 4094090 7.77
EPIC's analysis of the transaction included a computation of the rental deficit contribution. First, EPIC personnel estimated the monthly deficit from the project, 2001 Tax Ct. Memo LEXIS 80">*132 $ 22,235, taking into account estimated monthly operating expenses of $ 54,696, tenant rentals of $ 22,860 (with a vacancy rate of 11.1 percent), and a monthly contribution of investor capital of $ 12,138. According to the analysis, the present value of the monthly deficit, $ 22,235, discounted over 36 months at 13 percent, is $ 659,929. The analysis, which is reproduced below, designates this amount as the rental deficit contribution:
Operating expenses per month $ 54,696
Tenant rental revenue -22,860
Rent-up factor 0.889
Net tenant rental -20,323
Operating deficit 34,373
Investor contribution
purchase price $ 3,034,550 x 0.004 -12,138
Net monthly deficit 22,235
Present value of deficit
over 36 mos. at 13%
monthly deficit of 22,235 x 29.68 659,929 [sic]
Rental deficit contribution 2001 Tax Ct. Memo LEXIS 80">*133 659,929
As a percent of purchase price 0.2174716
The rental deficit contribution shown above was calculated using a
net borrowing cost, exclusive of servicing and private mortgage
insurance of 16.75.
The rental deficit contribution computed in the above analysis differs from the amount finally negotiated with Babcock, $ 587,676.
By instrument dated December 29, 1982, EPIC assigned to EA 83-XII "all its right, title and interest" in the rental purchase agreement dated December 22, 1982, with Babcock. Thereafter, EA 83- XII closed the sale of each of the 39 condominium units as of December 30, 1982.
To finance its purchase of the condominium units in the Paseos Castellanos complex, EA 83-XII borrowed from EMI approximately 95 percent of the purchase price of each unit. On or about the closing date, EA 83-XII executed 39 nonrecourse promissory notes in the aggregate principal amount of $ 2,869,625 payable to EMI in monthly installments of interest only for 5 years at the rate of 14.375 percent. Thereafter, the notes required EA 83-XII to pay monthly installments of interest and principal for 5 years. The notes required2001 Tax Ct. Memo LEXIS 80">*134 payment in full on January 1, 1993.
EA 83-XII executed an Allonge to Note dated March 1, 1983, for each of the 39 notes providing for a variable interest rate for the second 5-year term. The Allonge to Note extended the date for full payment of the indebtedness to March 1, 1993. EA 83-XII also executed a mortgage on the date of closing for each of the condominium units with EA 83-XII as the mortgagor and EMI as the mortgagee. The mortgages were modified on March 1, 1983, to reflect that the maturity date of the notes had changed from January 1, 1993, to March 1, 1993.
Set out below is a list of the 39 condominium units in the Paseos Castellanos complex that EA 83-XII purchased from Babcock, together with the purchase price, the builder fee, the rental deficit contribution, the rent advance, and the amount borrowed with respect to each condominium unit:
The Babcock
Co. Paseos Contract Builder Rental Deficit Rent
Castellanos Price Fee Contribution Advance Loan
___________ ________ _______ ______________ _______ ____
H 101 $ 82,000 $ 5,576.00 $ 15,953 $ 1,800 $ 77,900
H 102 2001 Tax Ct. Memo LEXIS 80">*135 80,000 5,440.00 15,564 1,800 76,000
H 103 74,500 5,066.00 14,494 1,800 70,775
H 105 80,000 5,440.00 15,564 1,800 76,000
H 106 74,500 5,066.00 14,494 1,800 70,775
H 107 82,000 5,576.00 15,953 1,800 77,900
H 108 68,450 4,654.60 13,317 1,575 65,025
B 105 79,450 5,402.60 15,457 1,800 75,475
B 107 81,450 5,538.60 15,846 1,800 77,375
D 101 81,450 5,538.60 15,846 1,800 77,375
D 105 79,450 5,402.60 15,457 1,800 75,475
D 107 81,450 5,538.60 15,846 1,800 77,375
C 101 81,450 5,538.60 15,846 1,800 77,375
C 102 79,450 5,402.60 15,457 1,800 75,475
C 105 79,450 5,402.60 15,457 1,800 75,475
C 107 81,450 5,538.60 15,8462001 Tax Ct. Memo LEXIS 80">*136 1,800 77,375
C 108 67,450 4,586.60 13,122 1,575 64,075
E 101 82,000 5,576.00 15,953 1,800 77,900
E 102 80,000 5,440.00 15,564 1,800 76,000
E 103 74,500 5,066.00 14,494 1,800 70,775
E 104 68,450 4,654.60 13,317 1,575 65,025
E 105 80,000 5,440.00 15,564 1,800 76,000
E 106 74,500 5,066.00 14,494 1,800 70,775
E 107 82,000 5,576.00 15,953 1,800 77,900
G 101 82,000 5,576.00 15,953 1,800 77,900
G 102 80,000 5,440.00 15,564 1,800 76,000
G 103 74,500 5,066.00 14,494 1,800 70,775
G 104 68,450 4,654.60 13,317 1,575 65,025
G 105 80,000 5,440.00 15,564 1,800 76,000
G 106 74,500 5,066.00 14,494 1,800 70,775
G 1072001 Tax Ct. Memo LEXIS 80">*137 82,000 5,576.00 15,953 1,800 77,900
G 108 68,450 4,654.60 13,317 1,575 65,025
F 101 82,000 5,576.00 15,953 1,800 77,900
F 102 80,000 5,440.00 15,564 1,800 76,000
F 104 68,450 4,654.60 13,317 1,575 65,025
F 105 80,000 5,440.00 15,564 1,800 76,000
F 106 74,500 5,066.00 14,494 1,800 70,775
F 107 82,000 5,576.00 15,953 1,800 77,900
F 108 68,450 4,654.60 13,317 1,575 65,025
_________ __________ _______ ______ _________
Subtotal 3,020,700 205,407.60 587,676 68,625 2,869,625
A settlement statement was prepared for the sale of each condominium unit. Each statement shows the above purchase price as the contract sales price. The statements treat the builder fees, the rent advances, and the rental deficit contributions as charges to Babcock and, thus, as reductions of the amount2001 Tax Ct. Memo LEXIS 80">*138 due to Babcock as seller. In the case of each of the subject condominium units, the "amounts paid by/for" EA 83-XII as shown on each settlement statement is the amount of the loan proceeds. Set out below is a summary of the settlement sheets for the purchase of the 39 condominium units in Paseos Castellanos:
Paseos Castellanos Buyer Seller
__________________ _____ ______
Contract sales price $ 3,020,700.00 $ 3,020,700.00
Price adjustment 476.97 476.97
Other charges 30,934.87 -0-
Gross amount due 3,052,111.84 3,021,176.97
Principal amount of loans 2,869,625.00 -0-
Builder fee 205,407.60
Rent advance -0- 68,625.00
Rental deficit contribution -0- 587,676.00
Other credits 2001 Tax Ct. Memo LEXIS 80">*139 -0- 141,575.39
____________ _____________
Amount due from buyer 182,486.84
Amount due to seller 2,017,892.98
According to the settlement sheets, the aggregate principal amount of the loans, $ 2,869,625, was credited as follows:
Buyer Seller Others Total
_____ ______ ______ _____
Settlement
charges -0- -0- $ 30,934.87 $ 30,934.87
Builder fee $ 205,407.60 -0- -0- 205,407.60
Rent advance 68,625.00 -0- -0- 68,625.00
Rental deficit
contribution 587,676.00 -0- -0- 587,676.00
Other credits -0- -0- 141,575.39 141,575.39
Amount due from
buyer -182,486.84 -0- -0- -182,486.84
Amount due to
seller -0- $ 2,017,892.982001 Tax Ct. Memo LEXIS 80">*140 -0- 2,017,892.98
___________ _____________ __________ ____________
679,221.76 2,017,892.98 172,510.26 2,869,625.00
TMI issued a Commitment and Certificate of Insurance dated January 11, 1983, under which it committed to issue mortgage insurance for 25 percent of the first loss amount with respect to the mortgage on each condominium unit. Subsequently, EMI and CSL executed an Assignment of Mortgage dated March 31, 1983, for each condominium unit transferring their interest in each note to the National Bank of Washington. Thus, shortly after EA 83-XII purchased the subject properties from Babcock, National Bank of Washington purchased the promissory notes that EA 83-XII had issued to EMI. Ultimately, Westinghouse Credit acquired the notes.
In summary, the aggregate contract prices of the properties purchased by EA 83-XII, the aggregate rental deficit contributions attributable to those properties, and the aggregate amounts borrowed are as follows:
Contract Rent Deficit Loan
Price Contribution Amount
2001 Tax Ct. Memo LEXIS 80">*141 ________ ____________ ______
Raldon $ 485,995 -0- $ 461,675
Fox & Jacobs 394,600 $ 67,643 374,850
Babcock 3,020,700 587,676 2,869,625
_________ _______ _________
Total 3,901,295 655,319 3,706,150
The 83 offering memorandum states that investors would break even if the real properties acquired by EA 83-XII appreciated at the annual rate of 7.99 percent over the 4-year period that the partnership planned to hold the properties.
FINANCIAL STATEMENTS FOR EA 83-XII
The general partner prepared and circulated to the limited partners quarterly statements for EA 83-XII entitled "Results of Operations and Taxable Income (Loss)." The record contains the statements for the nine quarters beginning April 16, 1983, and ending June 30, 1985. If the entries designated "current period" on the quarterly statements for a particular year are added, the totals for each year or part of a year during the period beginning April 16, 1983, and2001 Tax Ct. Memo LEXIS 80">*142 ending June 30, 1985, are as follows:
4/16/83 to 1/1/84 to 1/1/85 to
12/31/83 12/31/84 6/30/85
__________ _________ _________
Revenue:
Rental income $ 265,635.60 $ 306,577 $ 158,108
Interest income -- general partner 2,219.83 90 -0-
Other income 274.10 -0- -0-
___________ ________ ________
Total revenue 268,129.53 306,667 158,108
Expenses:
Interest on first mortgage 386,821.70 546,197 273,062
Additional mortgage interest -0- -0- -0-
Other interest expense -0- -0- 2,106
Real estate taxes, insurance, HOA 54,204.89 72,927 39,391
Audit fee 3,545.83 4,900 2,450
Repairs and maintenance2001 Tax Ct. Memo LEXIS 80">*143 1,940.72 32,412 7,260
Property administration fee 21,675.00 30,778 15,300
Interest expense -- general partner -0- 7,147 10,459
Rental commission 24,110.00 21,950 7,461
Legal fees 725.75 7,915 730
Other expenses 77.40 -0- 24
___________ ________ ________
Total expenses 493,101.29 724,226 358,243
Net results of operations -224,971.76 -417,559 -200,135
Taxable income (loss):
Net results of operations -224,971.76 -417,559 -200,135
Plus: mortgage amortization -0- -0- -0-
Less: depreciation 122,625.76 173,120 86,560
Amortization of loan fees 11,808.84 16,672 8,336
Amortization of refinancing -0- -0- -0-
costs
Accrued2001 Tax Ct. Memo LEXIS 80">*144 mortgage interest -0- -0- -0-
___________ ________ ________
Taxable income (loss) -359,406.36 -607,351 -295,031
The above amounts can be compared with the cash-flow projection that was set out in the 83 offering memorandum and is reproduced as appendix A.
As shown above, one of the expenses recorded as having been paid on behalf of EA 83-XII during the quarters beginning April 16, 1983, and ending June 30, 1985, is "interest expense -- general partner" in the amount of zero during 1983, $ 7,147 during 1984, and $ 10,459 during 1985. Three of the quarterly statements contain the following note or words of similar import:
Interest Expense -- GP:
Cash advances by the General Partner necessary to sustain
operations of the partnership continued to be greater than
budget resulting in additional interest expense.
The quarterly statements also record "interest income -- general partner" during this period of $ 2,219.83, $ 90, and zero, respectively.
The record also contains audited financial statements of EX 83-XII for the years2001 Tax Ct. Memo LEXIS 80">*145 ended December 31, 1983 and 1984, that were prepared by a firm of certified public accountants. Included in those financial statements is the following statement of operations and changes in partners' capital:
Year Ended December 31,
_______________________
1984 1983
____ ____
Revenues:
Rental income $ 306,577 $ 287,640
Interest income 90 9,344
Other income -0- 548
_______ ________
306,667 297,532
Expenses:
Interest 539,893 532,724
Depreciation 86,559 86,559
Real estate taxes 2001 Tax Ct. Memo LEXIS 80">*146 49,213 49,224
Amortization 48,096 31,096
Repairs and maintenance 30,866 20,620
Property management fee 30,600 30,600
Rental commissions 21,950 25,460
Homeowner's association dues 20,620 5,624
Insurance 16,438 27,744
Professional fees 12,993 1,347
Other expenses 2,722 1,952
________ ________
859,950 812,950
________ ________
Net loss (553,283) (515,418)
Partners' capital (deficit) 516,606 (10,974)
at beginning of year
Partners' contributions -0- 1,042,998
Partners'2001 Tax Ct. Memo LEXIS 80">*147 distributions (263) -0-
________ _________
Partners' capital (deficit) (36,940) 516,606
at end of year ________ _________
One of the notes accompanying the financial statements deals with related-party transactions and states as follows:
4. Related party transactions
Equity Programs Investment Corporation (EPIC) is the sole
general partner for EPIC Associates 83-XII. The general
partner manages, controls and administers the business of the
Partnership. The general partner is compensated for these
services in accordance with the fee structure set forth in
the Private Placement Offering Memorandum of the Partnership.
The Partnership incurred $ 30,600 of cost per year to EPIC for
these services during 1984 and 1983.
Interest is charged or paid to the Partnership on the due
to/from general partner balance in accordance with the rates
prescribed in2001 Tax Ct. Memo LEXIS 80">*148 the Private Placement Offering Memorandum. The
Partnership incurred $ 7,057 and earned $ 9,344 of interest
to/from EPIC and affiliates during 1984 and 1983,
respectively. While not obligated to do so under the
Partnership agreement, the general partner is anticipated to
advance funds to cover cash flow deficits.
FEDERAL INCOME TAX RETURNS FILED ON BEHALF OF EA 83-XII
For Federal income tax purposes, EA 83-XII reported the following income and expenses for the years in issue:
EA 83-XII 1983 1984 1985
_________ ____ ____ ____
Rent income $ 287,640 $ 306,577 $ 331,743
Late charges 548 -0- -0-
Interest income 9,344 90 1,262
Miscellaneous -0- -0- 883
________ ________ ________
Total gross income 2001 Tax Ct. Memo LEXIS 80">*149 297,532 306,667 333,888
Interest (noninvestment) 466,358 539,893 560,177
Commissions 25,460 21,950 24,846
Insurance 27,744 16,438 18,992
Legal and professional fee 726 8,093 574
Repairs 1,348 30,866 15,075
Taxes 49,224 49,213 45,962
Utilities 464 1,547 951
Homeowners dues 20,620 20,620 25,350
Audit fee 4,900 4,900 3,267
Points amortization 16,671 16,671 16,671
Property management 30,600 30,600 29,837
Real estate tax service 1,278 -0- -0-
Miscellaneous 107 -0- 856
Depreciation 2001 Tax Ct. Memo LEXIS 80">*150 173,119 173,119 173,119
Bad debts -0- 1,174 -0-
Amortization org. expense -0- 3,150 -0-
Recording fees -0- -0- 24
Service fee-EMI -0- -0- 3,413
________ ________ ________
Total expenses 818,619 918,234 -919,114
Net rental income -521,087 -611,567 -585,226
On its Schedule K, Partner's Share of Income Credits, Deductions, etc., for 1983, EA 83-XII reported an ordinary loss of $ 521,087, investment interest expense of $ 66,366, net investment income of $ 29,306, and excess expenses from "net lease property" of $ 10,859; and for purposes of allocating tax preference items to its partners, EA 83-XII reported a net investment loss of $ 341,010.
On its Schedules K for 1984 and 1985, EA 83-XII reported ordinary losses of $ 611,567 and $ 585,226, respectively, and investment income of $ 902001 Tax Ct. Memo LEXIS 80">*151 and $ 1,262, respectively; and for purposes of allocating tax preference items to its partners, EA 83-XII reported qualified investment income of $ 303,571 and $ 330,529, respectively, and qualified investment expenses of $ 908,960 and $ 909,831, respectively.
For depreciation purposes, EA 83-XII treated the aggregate contract price of its 51 properties, $ 3,901,295, less the aggregate rental deficit contribution, $ 655,319, as its aggregate basis in the real estate; viz $ 3,245,976. EA 83-XII allocated 20 percent of that amount to land; viz $ 649,195, and 80 percent to buildings; viz $ 2,596,781. EA 83-XII depreciated the latter amount on a straight- line basis over 15 years and claimed depreciation of $ 173,119 in each of the years in issue.
For each of the years in issue, EA 83-XII was obligated under the promissory notes that it had issued to EMI to pay interest on the aggregate principal amount of the notes, $ 3,706,150, at the annual rate of 14.375 percent. Thus, EA 83-XII was obligated to pay interest to EMI in the aggregate amount of $ 532,759 during each of the years in issue (i.e., $ 3,706,150 x 14.375 percent).
EA 83-XII was also obligated under the 83 partnership agreement2001 Tax Ct. Memo LEXIS 80">*152 to pay interest at the annual rate of 15 percent to compensate the general partner for unsecured advances of funds to the partnership. The returns filed on behalf of EA 83-XII for the years in issue report the following liabilities to the general partner on Schedule L, Balance Sheets:
Year Ended Amount of Advances Accrued Interest
__________ __________________ ________________
12/31/83 $ 2,991 -0-
12/31/84 104,754 $ 7,147
12/31/85 57,567 12,929
EA 83-XII reported the following interest expense on its returns for the years in issue:
1983 1984 1985
____ ____ ____
Interest (noninvestment) $ 466,358 $ 539,893 $ 560,177
Investment interest income 66,366 -0- -0-
________ ________ 2001 Tax Ct. Memo LEXIS 80">*153 ________
Total 532,724 539,893 560,177
The difference between the above amounts and the interest paid or incurred with respect to the partnership's first mortgage notes is as follows:
1983 1984 1985
____ ____ ____
Total interest expense reported $ 532,724 $ 539,893 $ 560,177
Interest on first mortgage notes 532,759 532,759 532,759
________ ________ ________
Difference (35) 7,134 27,418
The record of this case does not explain the above differences.
EA 83-XII paid loan origination fees to EMI in the aggregate amount of $ 148,246 equal to 4 percent of the principal amount of the first mortgage loans (i.e., $ 3,706,150 x 4 percent). This amount was amortized over the life of the loans. For each of the years in issue, EA 83-XII reported "points amortization" expense of $ 16,671 on each of the subject2001 Tax Ct. Memo LEXIS 80">*154 returns.
EA 84-III
EPIC formed EA 84-III on September 14, 1983, pursuant to the Uniform Limited Partnership Act of the Commonwealth of Virginia for a 10-year term ending on September 14, 1993. EPIC was the sole general partner. The Certificate and Agreement of Limited Partnership was amended by the execution and filing of an Amended and Restated Certificate and Agreement of Limited Partnership dated October 1, 1983, which was recorded on December 20, 1983, among the limited partnership records maintained by the clerk of the court of Fairfax County, Virginia. The Certificate and Agreement of Limited Partnership of EA 84-III was amended for a second time on April 1, 1985. The Second Amended and Restated Certificate and Agreement of Limited Partnership (84 partnership agreement) describes the business of EA 84-III in the following terms:
Business of the Partnership
The business of the Partnership has been and shall be to
acquire, directly or indirectly, own and finance fee interests
in certain improved residential real properties and to hold such
properties for investment with the objective of attaining
maximum capital appreciation2001 Tax Ct. Memo LEXIS 80">*155 therein and to engage in and
perform all necessary and proper acts and activities in
connection therewith including, but not limited to, operating,
managing, maintaining, leasing, mortgaging, selling, exchanging
or otherwise dealing with such properties with the objective of
distributing income generated thereby among the Partners as
provided for herein.
The 84 partnership agreement provides that EPIC's "interest shall be deemed to be a one-percent (1%) share in the partnership's capital contributions for which it shall contribute" $ 12,267. In addition, the 84 partnership agreement authorizes five enumerated classes of limited partnership interest, classes A through E, and such additional classes as are authorized by the general partner.
The 84 partnership agreement states that one class A unit, representing an aggregate capital contribution of $ 132,918.89, was sold to four investors, one class B unit, representing a capital contribution of $ 56,900, was sold to one investor, and one class C unit, representing an aggregate capital contribution of $ 208,750, was sold to three investors. It also appears that thereafter two investors2001 Tax Ct. Memo LEXIS 80">*156 made an aggregate capital contribution of $ 51,381.
According to the partnership agreement, if the need for additional equity arose, the general partner could authorize any number of additional classes of limited partnership interest. Purchasers of the additional classes would be admitted to the limited partnership starting on July 1, 1986. The agreement also states that the general partner, in its sole discretion, may authorize future class units from January 1, 1988, through and until the termination of the partnership.
Before offering class D and class E units of limited partnership interest in EA 84-III for sale, EPIC circulated a confidential private placement offering memorandum (84 offering memorandum) dated April 1, 1985. The 84 offering memorandum states that the class A, B, C, D, and E limited partners' contributions would be used primarily to fund operating deficits of EA 84-III. The 84 offering memorandum contains a chart summarizing EA 84-III's anticipated sources and uses of the proceeds of the offering as follows:
Sources Amount Percent
_______ 2001 Tax Ct. Memo LEXIS 80">*157 ______ _______
Proceeds from sale of class A unit $ 132,918 2.32
Proceeds from sale of class B unit 56,900 1.00
Proceeds from sale of class C unit 208,750 3.64
Proceeds from sale of class D unit 75,000 1.31
Proceeds from sale of class E unit 290,850 5.07
Proceeds from sale of additional class(es) 450,000 7.85
Capital contributions of general partner 12,266 0.21
First mortgage loans 3,453,450 60.24
Builder rebates 755,287 13.17
General partner advances 297,400 5.19
_________ _______
Total 5,732,821 100.00
Uses
____
Purchase price of homes 3,956,700 69.02
Sales commissions to broker/dealers 2001 Tax Ct. Memo LEXIS 80">*158 97,153 1.70
Escrows and prepaid insurance 18,070 .32
First mortgage loan origination fees 138,138 2.40
Organizational fee to general partner 85,009 1.48
Estimated cash-flow deficits
through September 30, 1984 473,417 8.26
Available for cash-flow deficits 964,334 16.82
_________ ______
Total 5,732,821 100.00
========= ======
As set forth above, it was anticipated that $ 473,417 of the proceeds of the offering would be offset by cash-flow deficits through September 30, 1984, and $ 964,334 of the offering proceeds would be available for cash-flow deficits after that date.
The projected annual income and operating costs of EA 84- III as set forth in the 84 offering memorandum shows an annual operating deficit of $ 431,115 calculated as follows:
2001 Tax Ct. Memo LEXIS 80">*159 Percentage of
Projected Annual Income Amount Total Income
_______________________ ______ _____________
Rental income (less 20%
vacancy & expense factor) $ 231,293 100.00
________ ______
Total projected income 231,293 100.00
________ ______
Annual Operating Expenditures
Aggregate first mortgage
principal & interest 502,217 217.14
Real estate taxes 72,617 31.40
Insurance & homeowner's
association dues 12,511 5.41
Audit expenses 4,945 2.14
Property administration fee 33,000 14.27
Allowance for maintenance
& repairs 19,783 8.55
Additional interest 2001 Tax Ct. Memo LEXIS 80">*160 17,335 7.49
_______ ______
Total projected cash
expenditures 662,408 286.40
_______ ______
Projected operating deficits 431,115 186.40
_______ ______
The 84 offering memorandum also includes a cash-flow analysis for EA 84-III from October 1, 1983, through December 31, 1987, as set forth in appendix B to this opinion.
In the 84 offering memorandum, it was contemplated that EPIC would finance the partnership's operating deficits by advancing funds to the partnership. The 84 partnership agreement provides that EA 84-III would pay interest on all unsecured advances of funds by the general partner at the rate of 15 percent per annum. The 84 partnership agreement permits the partnership to advance to the general partner any funds that were not distributed to the limited partners, and the agreement provides that the general partner would pay interest to EA 84-III on such advances2001 Tax Ct. Memo LEXIS 80">*161 at the rate of 12 percent per annum.
The 84 partnership agreement provides that cash from operations is to be distributed generally in the following order of priority: (i) To EPIC to repay any unsecured advances made by EPIC to the partnership together with interest; (ii) to the partners in the ratio that the cumulative cash capital contributions of each partner bear to the cumulative cash capital contributions of the partners until such amounts equal the partners' cumulative cash capital contributions; (iii) 25 percent to EPIC and 75 percent to the limited partners holding the class A, B, C, D, E, and additional class units.
The partnership agreement further provides that cash from sales not associated with a liquidation and/or financings is to be distributed generally in the following order of priority: (i) To repay the partnership debt secured by the property sold or refinanced; (ii) to repay general creditors of the partnership, including EPIC, any advances with interest; (iii) to establish such reserves as the general partner deems necessary; (iv) to the partners in the ratio that the cumulative cash capital contributions of each partner bear to the cumulative cash capital contributions2001 Tax Ct. Memo LEXIS 80">*162 of the partners up to the amounts which equal the partners' cumulative cash capital contributions; and (v) 25 percent to EPIC and 75 percent to the limited partners.
The 84 partnership agreement states that EA 84-III shall compensate EPIC as follows:
Compensation of the General Partner and Affiliates
* * * * * * *
(a) At the time of subscription, the General Partner shall
receive seven percent (7%) of each Class A, Class B, Class C,
Class D, Class E and any Additional Class or Classes Limited
Partner's full contribution to the Partnership as a Partnership
organization fee, as defined in the Confidential Private
Offering Memorandum for the Partnership, or a maximum total
payment of eighty-five thousand nine and 32/100 dollars
($ 85,009.32) for nonrecurring services which may be incurred
before or after formation of the Partnership, including the
furnishing of legal, financial, accounting and operational
assistance, reviewing rental schedules and expense forecasts and
providing other services which do not give rise to the
2001 Tax Ct. Memo LEXIS 80">*163 acquisition or leasing of specific properties or the obtaining
of financing therefor.
(b) At the time of subscription to Future Class Units authorized
pursuant to section 8(k), the General Partner, in its sole
discretion, shall receive up to seven percent (7%) of the
proceeds of the full contribution of each holder of a Future
Class Unit for nonrecurring services which may be performed
before or after authorization and sale of such Future Class
Units, which may include furnishing legal, financial, accounting
and operational assistance, reviewing and analyzing the
Partnership's condition and determining the need for an amount
of such additional capital to be raised by the sale of such
Future Class Units.
(c) During each full or partial month of the Partnership, the
General Partner shall be paid a Property Administration Fee
equal to fifty dollars ($ 50) per month for each Partnership
property.
* * * * * * *
(d) Such loan origination fees or service fees as may derive
from originating2001 Tax Ct. Memo LEXIS 80">*164 or servicing any security interests, including
mortgages and deeds of trust, placed upon Partnership property.
(e) Reimbursement of all carrying costs of the Partnership
properties, including, but not limited to, interest on mortgage
indebtedness encumbering the properties incurred prior to the
admission to the Partnership of the Limited Partners.
(f) On all Advances of funds to the Partnership made by the
General Partner pursuant to section 8(a)(xiv), the General
Partner shall be entitled to interest at the rate of fifteen
percent (15%) per annum.
* * * * * * *
(i) Any item of Partnership expense or cost may be paid to an
entity or person affiliated directly or indirectly with the
General Partner, subject only to the requirement that such
affiliated or related person or entity perform such service as
is contracted for or requested in consideration for such cost or
expense.
PURCHASE OF PRODUCTION HOUSES IN TEXAS AND ARIZONA
EPIC entered into a Residential Rental Purchase Agreement (rental purchase agreement), 2001 Tax Ct. Memo LEXIS 80">*165 dated September 16, 1983, under which it agreed to purchase 142 residential properties from U.S. Home Corp. (U.S. Home) for an aggregate purchase price of $ 8,767,850. The location and purchase price of each property is set forth in exhibit A to the rental purchase agreement.
As a condition to the purchaser's obligation under the rental purchase agreement, U.S. Home agreed to pay to EPIC 6.8 percent of the purchase price of each property on the closing date. The rental purchase agreement provides for this payment in the following language:
On the Closing Date, Seller shall pay to Equity Programs
Investment Corporation a sum equal to six and eight-tenths
(6.8%) of the Purchase Price of the Properties, and the
execution of this Agreement by Seller shall constitute an
irrevocable assignment to Equity Programs Investment Corporation
from the sale proceeds of a sum sufficient to make the payment
due under this Subparagraph 4.6.
We refer to this amount as the builder fee.
The rental purchase agreement also requires U.S. Home to pay to the purchaser 3 months' rent for each property under certain conditions. That provision2001 Tax Ct. Memo LEXIS 80">*166 states as follows:
On the Closing Date, Seller shall pay to Purchaser a sum equal
to the total estimated rent for three (3) months, as shown on
Exhibit A for each of the Properties (the "Reserve"). At such
time as all of the Properties have been rented at least once, or
upon the expiration of seven (7) months from the Closing Date,
whichever shall first occur, Purchaser shall refund the Reserve
to Seller, less the product of the rent, as shown in Exhibit A,
times the period of vacancy for each Property since the Closing
Date. For seven (7) full months after the Closing Date,
Purchaser shall furnish Seller written monthly reports detailing
occupancy and rents.In this opinion, we refer to the payment required under the above provision as the rent advance.
The agreement further obligated U.S. Home to pay to the purchaser "a sum equal to the amount as set forth on Exhibit 'A' hereof of the purchase price of each Property as a contribution towards rental deficits (rental deficit contribution)." We refer to this amount as the rental deficit contribution. Finally, the rental purchase agreement conditioned2001 Tax Ct. Memo LEXIS 80">*167 the purchaser's obligation under the agreement on the acquisition of "an appraisal of each of the Properties by a FNMA/FHLMC qualified appraiser on a standard FNMA/FHLMC form which shall reflect the value of each Property equal to or greater than the purchase price applicable to that Property".
EPIC assigned its right, title, and interest as purchaser under the rental purchase agreement with U.S. Home to various limited partnerships of which it was general partner. EPIC assigned its right to purchase 15 of the 142 properties to EA 84-III. On September 19, 1982, EA 84-III purchased the 15 properties it had been assigned for an aggregate purchase price of $ 908,700.
To finance its purchase of the 15 properties, EA 84-III borrowed $ 863,250, approximately 95 percent of the purchase price, from EMI. On the closing date, EA 84-III executed 15 nonrecourse promissory notes in the aggregate principal amount of $ 863,250, payable to EMI with monthly installments of interest only for 5 years at the annual rate of 14.625 percent. Thereafter, the notes required EA 84-III to pay monthly installments of principal and interest for 5 years. The full indebtedness was due and payable on October 1, 1993.
2001 Tax Ct. Memo LEXIS 80">*168 Each nonrecourse promissory note was secured by a deed of trust dated on the closing date. Most of the deeds of trust were recorded either in the land records of Harris County or Bexar County, Texas, or Pima County, Arizona. A mortgage insurance company, Republic Mortgage Insurance Co. (RMIC), issued a commitment and certificate of insurance providing mortgage insurance for 25 percent of the first loss amount with respect to the mortgage on each of the properties.
Set out below is a list of the 15 properties, together with the purchase price, the builder fee, the rental deficit contribution, the rent advance, and the amount borrowed with respect to each property:
Rental Purchase Builder Deficit Houses and Condominiums Price Fee Contrib. _______________________ ________ _______ ________
5419 Heronwood Dr. $ 54,000 $ 3,672.00 $ 6,189 5411 Heronwood Dr. 65,000 4,420.00 9,610 3518 Tower Hill Lane2001 Tax Ct. Memo LEXIS 80">*169 63,750 4,335.00 8,959 12347 Northcliff Manor Dr. 58,500 3,978.00 7,326 13066 Clarewood Dr. 57,000 3,876.00 8,169 6351 S. Briar Bayou Dr. 61,500 4,182.00 8,914 12103 Kingslake Forest Dr. 60,500 4,012.00 8,341 12107 Kingslake Forest Dr. 50,500 3,434.00 5,231 12111 Kingslake Forest Dr. 56,000 3,808.00 6,549 12115 Kingslake Forest Dr. 64,000 4,352.00 9,037 12231 Carola Forest Dr. 59,000 4,114.00 7,482 4850 West Ferret Dr. 71,000 4,828.00 9,905 4107 Medical Dr. (Condo.) 59,950 4,076.60 7,777 13739 Earlywood Dr. 64,000 4,352.00 9,692 6402 Ridgecreek Dr. 64,000 4,352.00 9,692 _______ _________ _______ Total 908,700 61,791.60 122,873
[Table2001 Tax Ct. Memo LEXIS 80">*170 continued]
Rent Houses and Condominiums Advance Loan _______________________ _______ ____
5419 Heronwood Dr. $ 1,395 $ 51,300 5411 Heronwood Dr. 1,395 61,750 3518 Tower Hill Lane 1,425 60,550 12347 Northcliff Manor Dr. 1,425 55,575 13066 Clarewood Dr. 1,275 54,150 6351 S. Briar Bayou Dr. 1,350 58,425 12103 Kingslake Forest Dr. 1,380 57,475 12107 Kingslake Forest Dr. 1,380 47,975 12111 Kingslake Forest Dr. 1,425 53,200 12115 Kingslake Forest Dr. 1,425 60,800 12231 Carola Forest Dr. 1,425 56,050 4850 West Ferret Dr. 1,575 67,450 4107 Medical Dr. (Condo.) 1,425 56,950 13739 Earlywood Dr. 1,350 60,800 6402 Ridgecreek Dr. 1,350 60,800 2001 Tax Ct. Memo LEXIS 80">*171 _______ _______ Total 21,000 863,250
The sale of each property to EA 84-III is reflected on a settlement statement executed on the date of closing that shows the purchase price listed above as the contract sales price. For each of the properties, the total of the "amounts paid by/for" EA 84-III, consisting principally of the loan proceeds and the sum of the builder fee, rent advance, and rental deficit contribution, exceeded the gross amount due from EA 84-III. Set out below is a summary of the settlement statements showing that a total of approximately $ 142,658.49 had been overpaid by or behalf of the buyer, EA 84-III:
U.S. Home Corp. Buyer Seller
_______________ _____ ______
Contract sales price $ 908,700.00 $ 908,700.00
Settlement charges to buyer 18,600.95 -0-
Price adjustment 830.16 830.16
___________ ___________
2001 Tax Ct. Memo LEXIS 80">*172 928,131.11 909,530.16
Principal amount of loans 863,250.00 -0-
Builder fee 61,791.60 61,791.60
Rent advance 21,000.00 21,000.00
Rental deficit contribution 122,873.00 122,873.00
Other credits 1,875.00 1,875.00
Settlement charges to seller -0- 11,320.94
____________ ___________
1,070,789.60 218,860.54
Amount due to buyer 2001 Tax Ct. Memo LEXIS 80">*173 According to the settlement statements, the aggregate principal amount of the loans, $ 863,250, was credited as follows:
U.S. Home Corp. Buyer Seller Others Total
_______________ _____ ______ ______ _____
Settlement charges
to buyer -0- -0- $ 18,600.95 $ 18,600.95
Amount due less loan $ -64,881.11 -0- -0- -64,881.11
Builder fee 61,791.60 -0- -0- 61,791.60
Rent advance 21,000.00 -0- -0- 21,000.00
Rental deficit
contribution 122,873.00 -0- -0- 122,873.00
Other credits 1,875.00 -0- -0- 1,875.00
Settlement charges
to seller -0- -0- 11,320.94 11,320.94
Amount due seller -0- $ 690,669.62 -0- 690,669.62
__________ ___________ _________ __________
142,658.49 690,669.62 29,921.89 863,250.00
In passing, 2001 Tax Ct. Memo LEXIS 80">*174 we note that the parties stipulated that U.S. Home sold to EA 84-III the two houses at 5411 and 5419 Heronwood Drive, and the four houses at 12103, 12107, 12111, and 12115 Kingslake Forest Drive. These six properties are listed among the properties covered by the Residential Rental Purchase Agreement dated September 16, 1983, between EPIC and U.S. Home. Furthermore, the settlement statement for the sale of five of those properties lists the seller as U.S. Homes. The record does not contain the settlement statement for the sale of 12103 Kingslake Forest Drive.
At trial, respondent introduced warranty deeds that show that on or about June 1, 1982, the two properties on Heronwood Drive were transferred by U.S. Home to Tanmis Models, Inc., and on or about August 26, 1983, were transferred by Tanmis Models, Inc., to EA 84- III. Respondent also introduced warranty deeds that show that on or about September 1, 1981, the four properties on Kingslake Forest Drive were transferred by U.S. Home to Dyblof Models, Inc., and on or about August 26, 1983, were transferred by Dyblof Models, Inc., to EA 84-III.
Apparently, these six properties were models that EPIC acquired from U.S. Home through2001 Tax Ct. Memo LEXIS 80">*175 companies affiliated with EPIC, Tanmis Models, Inc., and Dyblof Models, Inc., and leased back to U.S. Home. Under its agreement with EPIC, U.S. Home had the right to buy each property back at the original purchase price at the end of the lease term.
EMI assigned to CSL its interest in each of the promissory notes and related deeds of trust that had been The 16th promissory note and the related deed of trust are similar to the others, except they refer to unit 101 of The Reflections condominium complex, described below.
PURCHASE OF 40 CONDOMINIUMS UNITS IN THE REFLECTIONS
EPIC executed a Residential Rental Purchase Agreement (rental purchase agreement), dated August 3, 1983, under which it agreed to purchase a condominium complex located in San Antonio, Texas, known as the Reflections from Pitman Properties, Inc., and Japhet Properties, Inc. (herein Pitman & Japhet), for $ 3,048,000. For each condominium unit, there is attached to the agreement an exhibit B that identifies the unit, lists the appliances and furnishings included in the purchase price, and states the estimated monthly rent for the unit.
The Reflections is a 40-unit condominium complex which was new at the time of2001 Tax Ct. Memo LEXIS 80">*176 this transaction in 1983. The complex is composed of seven buildings with a total of 40,356.85 square feet of net rentable living area located on 2.233 acres. The units have fireplaces, parking spaces, 1,135 square feet of storage space, and patios, porches and balconies. There is a pool and exterior landscaping, and one side of the complex faces a man-made lake.
Under the rental purchase agreement, Pitman & Japhet agreed as a condition to closing to pay to EPIC 6.8 percent of the purchase price of each unit. We refer to this amount as the builder fee. As a further condition to closing, Pitman & Japhet agreed to pay to the purchaser a sum equal to the percentage of the purchase price of each unit that is set forth on exhibit A to the agreement as a contribution towards rental deficits (rental deficit contribution). The percentages set forth on exhibit A range from 20.30 percent to 21.39 percent. We refer to this amount as the rental deficit contribution.
As a further condition to EPIC's obligation, the agreement provides:
Rental of the Properties to individual tenants shall have been
arranged, or shall be arranged, upon execution by Purchaser of
the Agreement2001 Tax Ct. Memo LEXIS 80">*177 in accordance with the procedures set forth in
Exhibit "C", attached hereto and by this reference made a part
hereof.
Pursuant to exhibit C, in the event that any of the properties were not leased as of 7 days before closing, Pitman & Japhet agreed to pay to the purchaser, in addition to the rental deficit contribution, an amount equal to three times the monthly rent set forth for each unit that was not rented as of the closing date. We refer to this payment as the rent advance.
The purchaser's obligations under the rental purchase agreement were also subject to the condition that the purchaser shall have obtained "an appraisal of each of the Properties prepared by a FNMA/FHLMC qualified appraiser on a standard FHMA/FHLMC form which shall reflect the value of each Property equal to or greater than the purchase price".
It appears that EPIC assigned to EA 84-III its rights as purchaser under the rental purchase agreement dated August 3, 1983, with Pitman & Japhet. The record does not contain an instrument of assignment. In any event, on September 30, 1983, EA 84-III purchased the 40 condominium units at the Reflections.
To finance its purchase of the condominiums,2001 Tax Ct. Memo LEXIS 80">*178 EA 84-III borrowed $ 2,590,200, approximately 85 percent of the aggregate purchase price, from EMI. EA 84-III executed 40 nonrecourse promissory notes in the aggregate principal amount of $ 2,590,200, that were each payable to EMI with monthly installments of interest at the annual rate of 14.125 percent. The record does not contain any of the 40 promissory notes, but their terms are summarized in the 84 offering memorandum as follows:
Thirty-five month interest only, thirteen months amortizing on
the leases [sic] of a thirty year amortization schedule, six
year level pay fully amortizing, with no adjustments in the
interest rate during the life of the loan.
Each promissory note was secured by a deed of trust and was covered by a private mortgage insurance policy. The record does not contain the deeds of trust or documents relating to the private mortgage insurance. At some time, Philadelphia Savings Fund of Philadelphia acquired the promissory notes that EA 84-III had issued to EMI and EMI assigned each of the 40 deeds of trust to Philadelphia Savings Fund of Philadelphia.
Set out below is a list of the 40 condominiums that EA 84- III purchased2001 Tax Ct. Memo LEXIS 80">*179 together with the purchase price, rental deficit contribution, rent advance, and loan amount:
Rental
Purchase Builder Deficit Rent
Unit Price Fee Contrib. Advance Loan
____ ________ _______ ________ _______ ____
A 101 $ 91,900 $ 6,249.20 $ 19,661 $ 1,800 $ 78,100
A 102 97,900 6,657.20 20,596 1,950 83,200
A 103 97,900 6,657.20 20,596 1,950 83,200
A 104 91,900 6,249.20 19,661 1,800 78,100
B 201 91,900 6,249.20 19,661 1,800 78,100
B 202 97,900 6,657.20 20,597 1,950 83,200
B 203 97,900 6,657.20 20,597 1,950 83,200
B 204 91,900 6,249.20 19,661 1,800 78,100
C 301 91,900 6,249.20 19,661 1,800 78,100
C 302 97,900 6,657.20 20,597 1,950 2001 Tax Ct. Memo LEXIS 80">*180 83,200
C 303 97,900 6,657.20 20,597 1,950 83,200
C 304 91,900 6,249.20 19,661 1,800 78,100
D 401 75,900 5,161.20 15,616 1,575 64,500
D 402 75,900 5,161.20 15,616 1,575 64,500
D 403 75,900 5,161.20 15,616 1,575 64,500
D 404 75,900 5,161.20 15,616 1,575 64,500
E 501 75,900 5,161.20 15,616 1,575 64,500
E 502 57,900 3,937.20 11,751 1,245 49,200
E 503 75,900 5,161.20 15,616 1,575 64,500
E 504 57,900 3,937.20 11,751 1,245 49,200
E 505 57,900 3,937.20 11,751 1,245 49,200
E 506 75,900 5,161.20 15,616 1,575 64,500
E 507 57,900 3,937.20 11,751 1,245 49,200
E 508 75,900 5,161.20 15,616 1,575 64,500
F 601 75,900 5,161.20 2001 Tax Ct. Memo LEXIS 80">*181 15,616 1,575 64,500
F 602 57,900 3,937.20 11,751 1,245 49,200
F 603 75,900 5,161.20 15,616 1,575 64,500
F 604 57,900 3,937.20 11,751 1,245 49,200
F 605 57,900 3,937.20 11,751 1,245 49,200
F 606 57,900 3,937.20 11,751 1,245 49,200
F 607 57,900 3,937.20 11,751 1,245 49,200
F 608 57,900 3,937.20 11,751 1,245 49,200
F 609 57,900 3,937.20 11,751 1,245 49,200
F 610 75,900 5,161.20 15,616 1,575 64,500
F 611 57,900 3,937.20 11,751 1,245 49,200
F 612 75,900 5,161.20 15,616 1,575 64,500
G 701 75,900 5,161.20 15,616 1,575 64,500
G 702 75,900 5,161.20 15,616 1,575 64,500
G 703 75,900 5,161.20 15,616 1,575 64,500
G 704 2001 Tax Ct. Memo LEXIS 80">*182 75,900 5,161.20 15,616 1,575 64,500
_________ __________ _______ ______ _________
Total 3,048,000 207,264.00 632,414 62,640 2,590,200
The sale of each condominium to EA 84-III is reflected on a settlement statement executed on the date of closing that shows the purchase price listed above as the "contract sales price". On each settlement statement, the builder fee, rent advance, and rental deficit contribution are treated as charges to Pitman & Japhet, reducing the amount due Pitman & Japhet. These amounts are also treated as credits to EA 84-III. Set out below is a summary of the settlement statements showing that the aggregate amounts paid by or on behalf of the buyer, EA 84-III, exceeded the aggregate amount due from the buyer by $ 441,356.12:
Pitman & Japhet Properties Buyer Seller
__________________________ _____ ______
Contract sales price $ 3,048,000.00 $ 3,048,000.00
Settlement charges to buyer 16,018.38 -0-
2001 Tax Ct. Memo LEXIS 80">*183 _____________ _____________
3,064,018.38 3,048,000.00
Principal amount of loans 2,590,200.00 -0-
Builder fee 207,264.00 207,264.00
Rent advance 62,640.00 62,640.00
Rental deficit contribution 632,414.00 632,414.00
Adjustments 1,756.50 1,756.00
Other credits 11,100.00 11,100.00
Payoff loans -0- 1,548,548.53
Settlement charges to seller -0- 132,833.00
_____________ ______________
3,505,374.50 2,596,556.03
Amount due buyer 441,356.12
Amount due seller 451,443.97
According to the settlement2001 Tax Ct. Memo LEXIS 80">*184 statements, the aggregate principal amount of the loans, $ 2,590,200, was credited as follows:
Pitman & Japhet
Properties Buyer Seller Others Total
_______________ _____ ______ ______ _____
Settlement charges
to buyer -0- -0- $ 16,018.38 $ 16,018.38
Amount due less
loans $ -473,818.38 -0- -0- -473,818.38
Builder fee 207,264.00 -0- -0- 207,264.00
Rent advance 62,640.00 -0- -0- 62,640.00
Rental deficit
contribution 632,414.00 -0- -0- 632,414.00
Adjustments 1,756.50 -0- -0- 1,756.50
Other credits 11,100.00 -0- -0- 11,100.00
Payoff loans -0- -0- 1,548,548.53 1,548,548.53
Settlement charges
to seller -0- -0- 132,833.00 132,833.00
Amount due seller -0- $ 451,443.97 -0- 2001 Tax Ct. Memo LEXIS 80">*185 451,443.97
__________ ___________ ____________ ____________
441,356.12 451,443.97 1,697,399.91 2,590,200.00
In summary, the aggregate contract prices of the properties purchased by EA 84-III, the aggregate rental deficit contributions attributable to those properties, and the aggregate amounts borrowed are as follows:
Contract Rental Deficit Loan
Price Contribution Amount
________ ______________ ______
U.S. Home $ 908,700 $ 122,873 $ 863,250
Pitman & Japhet 3,048,000 632,414 2,590,200
_________ ________ _________
Total 3,956,700 755,287 3,453,450
The 84 offering memorandum states that investors would break even if the real properties acquired by EA 84-III appreciated at the annual rate of 9.15 percent over the 4-year period that the partnership planned to hold the properties.
FINANCIAL STATEMENTS2001 Tax Ct. Memo LEXIS 80">*186 FOR EA 84-III
The general partner prepared and circulated to the limited partners quarterly statements for EA 84-III entitled "Results of Operations and Tax Income (Loss)". The record contains the statements for the eight quarters beginning September 19, 1983, and ending June 30, 1985. If the entries designated "current period" on the quarterly statements for a particular year are added, the totals for each entry for each year or part of a year during the period beginning September 16, 1983, and ending June 30, 1985, are as follows:
9/19/83 to 1/1/84 to 1/1/85 to
EA 84-III 12/31/83 12/31/84 6/30/85
_________ __________ _________ _________
Revenue:
Rental income $ 76,790.36 $ 228,516 $ 107,858
Interest income -- general partner 6,097.26 -0- -0-
Other income -0- -0- 2,866
__________ ________ ________
Total revenue 2001 Tax Ct. Memo LEXIS 80">*187 82,887.62 228,516 110,724
Expenses:
Interest on first mortgage 118,081.87 504,391 250,902
Additional mortgage interest -0- -0- -0-
Other interest expense -0- -0- 5,000
Real estate taxes, insurance, HOA 26,480.69 83,110 45,240
Audit fee 5,000.00 5,000 2,500
Repairs and maintenance 10,225.44 120,032 30,811
Property administration fee 8,250.00 33,000 16,500
Interest expense -- general partner -0- 28,175 18,680
Rental commission 5,305.42 23,198 10,118
Legal fees 15.00 687 167
Other expenses 140.81 -0- 90
__________ ________ ________
Total expenses 173,499.23 797,593 380,008
Net results of operations 2001 Tax Ct. Memo LEXIS 80">*188 -90,611.61 -569,077 -269,284
Taxable income (loss):
Net results of operations -90,611.61 -569,077 -269,284
Plus: mortgage amortization -0- -0- -0-
Less: depreciation 42,685.50 170,742 85,372
Amortization of loan fees 3,454.45 13,812 6,906
Amortization of refinancing
costs -0- -0- -0-
Accrued mortgage interest -0- -0- -0-
Misc. expenses -0- 28 -5
___________ ________ ________
Taxable income (loss) -136,750.56 -753,659 -361,557
The above amounts can be compared with the cash-flow projection that was set out in the 84 offering memorandum and is reproduced as appendix B.
As shown above, one of the expenses recorded as having been paid on behalf of EA 84-III during the period beginning September 19, 1983, and ending June 30, 1985, is interest expense -- general2001 Tax Ct. Memo LEXIS 80">*189 partner of zero during 1983, $ 28,175 during 1984, and $ 18,680 during 1985. Three of the statements contain the following note or words of similar import:
Interest Expense -- GP:
Cash advances by the General Partner necessary to sustain
operations of the partnership continued to be greater than
budget resulting in additional interest expense.
The quarterly statements also record that EA 84-III received interest income -- general partner of $ 6,097.26 during 1983.
The record contains audited financial statements of EA 84-III for the period beginning September 14 (inception) to December 31, 1983, that were prepared by a firm of certified public accountants. Included therein is the following statement of operations and changes in partners' capital:
Revenues:
Rental income $ 76,790
Interest income 2,756
_______
79,546
Expenses:
2001 Tax Ct. Memo LEXIS 80">*190 Interest 118,082
Depreciation 21,343
Real estate taxes 18,123
Amortization 3,804
Property management fee 8,250
Rental commission 5,305
Insurance 5,480
Repairs and maintenance 8,500
Other 9,759
_______
198,646
Loss from operations (119,100)
Partners' capital contributions 134,334
________
Partners' capital at end of year 2001 Tax Ct. Memo LEXIS 80">*191 15,234
========
One of the accompanying notes deals with related-party transactions and states as follows:
4. Related party transactions
Equity Programs Investment Corporation (EPIC) is the sole
general partner for EPIC Associates 84-III. The general
partner manages, controls and administers the business of the
Partnership. The general partner is compensated for these
services in accordance with the fee structure set forth in
the Private Placement Offering Memorandum of the Partnership.
The Partnership incurred $ 8,250 of cost to EPIC for these
services during 1983. In addition the partnership paid
organization fees to EPIC of $ 83,755.
Interest is charged or paid to the Partnership on the due
to/from general partners balance in accordance with the rates
prescribed in the Private Placement Offering Memorandum. The
Partnership earned $ 2,756 of interest net from EPIC during
1983. While not obligated to do2001 Tax Ct. Memo LEXIS 80">*192 so under the Partnership
agreement, the general partner is anticipated to advance
funds for any cash flow deficits.
The Partnership paid loan origination fees of $ 138,138 to
EPIC Mortgage, Inc., an affiliate of the general partner.
On the basis of the above, it appears that EA 84-III realized interest income from EPIC in 1983 and paid or incurred interest expense on unsecured advances from EPIC in 1984 and 1985 in the following amounts:
1983 1984 1985
____ ____ ____
Interest income -- general partner $ 6,097.26 -0- -0-
Interest expense -- general partner -0- $ 28,175 $ 18,680
_________ _______ _______
6,097.26 (28,175) (18,680)
FEDERAL INCOME TAX RETURNS FILED ON BEHALF OF EA 84-III
For Federal income tax purposes, EA 84-III reported the following income and expenses for the years in issue:
EA2001 Tax Ct. Memo LEXIS 80">*193 84-III 1983 1984 1985
_________ ____ ____ ____
Rent income $ 80,124 $ 228,516 $ 230,130
Interest -0- -0- 494
Total gross income 80,124 228,516 230,624
Interest (noninvestment) 118,082 522,466 545,848
Commissions 5,305 23,198 19,403
Insurance 5,480 16,663 19,894
Legal and professional fee 6,895 687 1,008
Repairs 8,500 19,782 108,459
Taxes 18,123 72,554 72,617
Utilities 1,726 33,555 1,830
Homeowners dues 998 3,993 12,353
Property management fee 8,250 33,000 32,175
Points amortization2001 Tax Ct. Memo LEXIS 80">*194 3,453 13,814 13,814
Miscellaneous 141 606 574
Audit fee -0- 5,000 3,333
Service fee -0- -0- 3,197
Depreciation 56,910 170,742 170,742
________ ________ _________
Total expenses 233,863 916,060 1,005,247
Net rental income -153,739 -687,544 -774,623
On its Schedule K, Partner's Share of Income, Credits, Deductions, etc., for 1983, EA 84-III reported an ordinary loss of $ 153,739, a net investment loss of $ 141,142 for purposes of allocating tax preference items to its partners, and net investment income of $ 6,097 for purposes of computing investment interest. On its Schedules K for 1984 and 1985, EA 84-III reported ordinary losses of $ 687,544 and $ 774,623, respectively, and investment income of zero and $ 494, respectively; and for purposes of allocating tax preference items2001 Tax Ct. Memo LEXIS 80">*195 to its partners, EA 84-III reported qualified investment income of $ 217,619 and $ 229,131, respectively, and qualified investment expenses of $ 872,376 and $ 997,436, respectively.
For depreciation purposes, EA 84-III treated the aggregate contract price of its 55 properties, $ 3,956,700, less the aggregate rental deficit contributions, $ 755,287, as its aggregate basis in the real estate; viz $ 3,201,413. EA 84-III allocated 20 percent of that amount to land; viz $ 640,283, and 80 percent to buildings; viz $ 2,561,130. EA 84-III depreciated the later amount on a straight-line basis over 15 years and claimed deprecation at the annual rate of $ 170,742 in each of the years in issue. EA 84-III claimed a depreciation allowance for 4 months on its 1983 return, $ 56,910, and a depreciation allowance for 12 months on its 1984 and 1985 returns.
For each of the years in issue, EA 84-III was obligated under the promissory notes that it had issued to EMI to pay interest on the aggregate principal amount of the notes, $ 3,453,450. EA 84-III was obligated to pay interest at the annual rate of 14.625 percent on the notes issued to purchase the 15 properties from U.S. Home and was obligated to2001 Tax Ct. Memo LEXIS 80">*196 pay interest at the annual rate of 14.125 percent on the notes issued to purchase the 40 condominium units from Pitman & Japhet. Thus, EA 84-III was obligated to pay interest to EMI in the total amount of $ 492,116.06 during each of the years 1984 and 1985 computed as follows:
Loan Rate Annual Interest
____ ____ _______________
U.S. Home properties $ 863,250 14.625 $ 126,250.31
Pitman & Japhet properties 2,590,200 14.125 365,865.75
_________ ___________
Total 3,453,450 492,116.06
EA 84-III was also obligated under the 84 partnership agreement to pay interest at the annual rate of 15 percent to compensate the general partner for unsecured advances of funds to the partnership. The returns filed on behalf of EA 84-III for the years in issue report the following liabilities to the general partner on Schedule L:
Due to
Taxable2001 Tax Ct. Memo LEXIS 80">*197 Year Ended General Partner Accrued Interest -- G/P
__________________ _______________ _______________________
12/31/83 -0- -0-
12/31/84 $ 165,481 $ 28,174
12/31/85 373,705 42,750
EA 84-III reported noninvestment interest expense on its returns for the years in issue of $ 118,082, $ 552,466, and $ 545,848, respectively. The difference between these amounts and the interest paid or incurred with respect to the partnership's first mortgage notes is as follows:
1983 1984 1985
____ ____ ____
Total interest expense reported $ 118,082 $ 522,466 $ 545,848
Interest on first mortgage notes 2001 Tax Ct. Memo LEXIS 80">*198 The record of this case does not fully explain the above differences.
EA 84-III paid loan origination fees to EMI in the aggregate amount of $ 138,138 equal to 4 percent of the principal amount of the first mortgage loans (i.e., $ 3,453,450 x 4 percent). On the subject returns, EA 84-III claimed a deduction for "amount of points" of $ 3,453, $ 13,814, and $ 13,814, respectively.
EPIC
As mentioned above, EPIC, the general partner of EA 83-XII and EA 84-III, was incorporated in 1974 for the purpose of acquiring residential real properties and providing various services in connection with the acquisition, syndication, management, and disposition of the properties. Between 1975 and 1985, EPIC formed approximately 357 limited partnerships with more than 6,000 limited partners. EPIC was the general partner of each limited partnership. These partnerships owned approximately 17,600 residential dwelling units located throughout the United States and issued approximately 20,500 mortgages totaling approximately $ 1,435,000,000.
When EPIC began its real estate syndication business, it contracted to purchase properties from developers of residential real estate and to lease the properties2001 Tax Ct. Memo LEXIS 80">*199 back to the developers for use as models. Typically, the developers were willing to pay to EPIC a commission, referred to as the builder's fee, of approximately 6 percent of the purchase price of each property and were willing to pay rent on each property for some period in advance.
EPIC would form a limited partnership for the purpose of buying the models. EPIC would assign its rights to purchase the properties to the limited partnership, and the limited partnership would purchase the properties with equity capital contributed by the limited partners. The early limited partnerships financed 75 or 80 percent of the purchase of the properties. These loans were recourse. The limited partnership would lease the models back to the developer on a triple net lease basis during completion of the project, a period ranging from 18 to 24 months.
Typically, the rental income from the properties exceeded the amount needed to service the debt, and the partnership realized a positive cash-flow during the lease term. The plan called for the limited partnership to sell the properties for a profit at the end of the developers' lease term. These early limited partnerships were referred to by EPIC's2001 Tax Ct. Memo LEXIS 80">*200 management as income partnerships.
EPIC's success and the success of its partnerships depended upon the appreciation of the real properties that were purchased by the partnerships. The sales of real estate by EPIC partnerships before 1980, as shown in exhibits to the 83 and 84 offering memoranda, reveal high annual appreciation.
During 1980, mortgage interest rates increased to historic levels, and the real estate market began to deteriorate as a result. The higher interest rates significantly increased the costs of selling properties and reduced profits realized by the partnerships on the sale of properties. Accordingly, in 1980, EPIC's management made the decision to stop selling properties until interest rates fell. EPIC's management believed that, as an interim measure, the company could carry the limited partnerships until interest rates decreased and profit margins returned to normal.
Notwithstanding the cessation of sales, EPIC continued to syndicate real estate partnerships. This was EPIC's core business. EPIC's management did not consider shutting down that business when interest rates increased in 1980 because EPIC's management believed that the company could purchase2001 Tax Ct. Memo LEXIS 80">*201 properties that would appreciate and could be sold for a profit when interest rates declined.
At this time, EPIC's management undertook to revise certain characteristics of the limited partnerships that were syndicated. EPIC's management had realized that if an income partnership held properties after the developer's lease expired, the partnership would realize cash deficits, and it had no mechanism to fund such deficits. EPIC's management wanted greater flexibility in the period of time that a partnership could hold its properties. In order to permit a longer holding period, the partnerships would have to lease properties to individual tenants, and, as a result, the rental stream would decrease substantially because lease rates paid by individual tenants are much lower than the commercial rates paid by developers. However, EPIC found that developers would discount the price of the properties by an amount roughly equivalent to the present value of the difference in rental rates. EPIC referred to this discount as the rental deficit contribution.
Because of the longer holding period, EPIC's management also wanted to increase the loan-to-value ratio of its mortgages to 95 percent in2001 Tax Ct. Memo LEXIS 80">*202 order to help carry the properties. For the same reason, EPIC's management wanted the loans to be nonrecourse.
EPIC found that lenders in the secondary mortgage market would purchase such loans if the lender's risk, taking private mortgage insurance into account, was no greater than 72 percent of the loan. Thus, in the case of a 95-percent loan, for example, a secondary lender would require mortgage insurance of at least 25 percent. In the case of a 90-percent loan, a secondary lender would require mortgage insurance of at least 20 percent, and so on. Through negotiation, EPIC found that private mortgage insurance companies were willing to insure nonrecourse mortgages on residential properties. As a result of negotiations with secondary lenders and private mortgage insurers, EPIC's management found that it could obtain 95-percent nonrecourse financing on single-family houses and condominiums owned by its investment partnerships. Finally, EPIC's management found that investors were willing to purchase interests in the new partnerships for roughly one-half of the anticipated tax losses; i.e., a 2-to-1 ratio. The new partnerships were known internally to EPIC's management as "tax partnerships"2001 Tax Ct. Memo LEXIS 80">*203 to distinguish them from the earlier "income partnerships".
During the period after 1980, EPIC's management also experimented with resyndicating properties from older partnerships and with expandable partnerships. EPIC's management also formed EPIC Residential Network, Inc. (ERNI), to act as a real estate broker to be in position to sell properties when interest rates declined and the real estate market recovered.
Thus, beginning in 1981 or 1982, EPIC expanded its business by entering into agreements to purchase properties that it intended to rent to the public, rather than to the developer. After this change, EPIC did not limit itself to models in a particular project but contracted to buy production houses. This meant that, in some cases, EPIC acquired a substantial inventory of unsold houses in a single project and facilitated the developer's completion of the project.
Under this business plan, EPIC intended to syndicate the properties to limited partnerships which would rent the properties for 4 years before selling them. EPIC calculated the capital contributions of the limited partners to equal one-half of the anticipated tax losses, resulting in a "two-to-one tax write-off. 2001 Tax Ct. Memo LEXIS 80">*204 "
For cash management purposes, EPIC "swept" all funds from all of the partnerships' accounts daily and deposited the funds into a master account maintained by EPIC. EPIC then advanced funds to pay the debts of any of its partnerships that needed funds. The amounts borrowed from each partnership and the amounts advanced to each partnership were accounted for in the books and records of the appropriate partnerships. Interest was credited to partnerships to which EPIC owed money and was charged to partnerships which owed money to EPIC (net borrowers and net lenders). Among the funds swept from the accounts of individual partnerships were the funds received by partnerships upon the acquisition of real properties. EPIC management believed that a default by any of its partnerships would have an adverse impact on the entire EPIC enterprise, and EPIC never permitted any limited partnership to default on a payment until August 1985 when all of the limited partnerships sought protection under the bankruptcy laws.
During the time it was in existence, EPIC formed or acquired a number of subsidiaries and affiliated companies to engage in different aspects of the real estate business. For example, 2001 Tax Ct. Memo LEXIS 80">*205 as mentioned above, EMI originated mortgage loans on behalf of EPIC limited partnerships and received fees for doing so. EMI obtained the funds to originate loans through "warehouse" or interim lines of credit from CSL, an affiliated savings and loan association, and other financial institutions. EPIC sold interests in passthrough certificates or whole loans in the secondary market to other financial institutions. All of the purchase money promissory notes at issue in these cases were sold in the secondary market in one form or another.
Another affiliate, ERSI, managed the properties that were owned by EPIC limited partnerships, other than properties leased back to the developers on net leases. ERSI leased the properties, reviewed tenant applications, collected and accounted for rental income, secured insurance and arranged maintenance and repairs. EPIC paid ERSI a monthly fee of $ 35 of the $ 50 it received for managing each property.
Another affiliate, ERNI, acted as a real estate broker to sell properties. Generally, ERNI received a real estate commission of 6 percent of the sale price of each unit sold.
Another affiliate, Continental Appraisal Group, Inc. (CAG), appraised the2001 Tax Ct. Memo LEXIS 80">*206 residential properties purchased by EPIC partnerships. The appraisals were made either by a member of the CAG staff or by an outside appraiser and reviewed by a staff appraiser. CAG also appraised properties for unrelated lenders. Another company, EPIC Securities, Inc., wholesaled the limited partnership interests in EPIC partnerships and received a percentage of the capital contributions as a commission. Finally, in October 1983, EPIC or one of its affiliates acquired Community Savings & Loan, a Maryland- chartered savings and loan association.
PRIVATE MORTGAGE INSURANCE
While EMI originated the loans at issue, each of the loans was insured by a private mortgage insurance company for 25 percent of the first loss amount. Tricor Mortgage Insurance Co. and Republic Mortgage Insurance Co. (RMIC) issued mortgage insurance covering the first mortgage loans at issue in the instant cases. In addition, EPIC dealt with other mortgage insurance companies, including Mortgage Guarantee Insurance Corp. (MGIC) and Commonwealth Mortgage Assurance Corp. (CMAC).
The private mortgage insurance companies thoroughly investigated the risks presented by EPIC's business. For example, in June 1982, after2001 Tax Ct. Memo LEXIS 80">*207 EPIC had changed the nature of its limited partnerships, representatives of MGIC's appraisal department and underwriting evaluation department made a risk management study of EPIC. The study sets forth a detailed description of EPIC's business and the underwriting risks presented to MGIC from that business. As part of the study, MGIC had conducted spot checks of EPIC's appraisals and had found "inflated property values". The report states as follows:
Based on our spot checks Epic's appraisals had inflated property
values. The value estimates made 2 or 3 years ago by Epic's
appraisers are higher than the value estimates as of the date of
contract and the current value estimates of the properties. It
is not known if Epic Mortgage is aware of this over-valuing in
as much [sic] as they do not have an appraisal department to
review the appraisals.
* * * * * * *
Based on MGIC's 25 spot checks there is overvaluing by Epic that
has resulted in inflated property values and 14 properties with
loan to value ratios in excess of 95%, up to 112%.
2001 Tax Ct. Memo LEXIS 80">*208 a. We can only speculate at the reason for the overvaluing
because Epic Mortgage utilizes independent fee appraisers.
The appraisers might be influenced by the builder's indicated
cost and are finding higher priced comparable sales to
justify this cost rather than carefully studying the
marketplace.
b. The higher value estimates by Epic's appraisers are a result
of using higher priced comparable sales, higher land value
estimates which do not accurately indicate the subject
property's true market value and model upgrade. The model
"upgrades" increase the sales price of the home and typically
make it the highest priced home in the subdivision with the
cost not typically recognized by the end purchaser.
c. Epic should have the same concerns with overvaluing as MGIC
because of losses to the partnership. Epic's expertise may be
in syndication and marketing not property valuation. This
would explain why they are only now setting up an appraisal
review department.
Representatives2001 Tax Ct. Memo LEXIS 80">*209 of MGIC met with EPIC's management on two occasions to discuss possible overvaluation of properties. Circa 1983, MGIC ceased insuring EPIC mortgages. The principal reason given for this action was the concentration of risk represented by EPIC's business and the fact that EPIC had switched from syndicating model properties to production properties. Nevertheless, MGIC wished to retain the renewal business for existing EPIC insurance policies.
Similarly, beginning in December 1983, before agreeing to insure any mortgage loans to an EPIC partnership, Mr. James C. Miller, president of Commonwealth Mortgage Assurance Co. (CMAC), and his staff met on several occasions with representatives of EPIC's management to discuss EPIC's business and the risks that CMAC would face in writing mortgage insurance on mortgage loans issued by EPIC partnerships. A memorandum dated February 24, 1984, written by Mr. Miller before any mortgage insurance was written describes EPIC's business and the risks presented by that business. The memorandum describes the risks as follows:
Risks
They described their program as unique, and it is certainly
entirely different from the normal2001 Tax Ct. Memo LEXIS 80">*210 owner-occupied situation. To
hear them tell it, there is virtually no chance of borrower
default. Their track record of selling to high-income investors
and obtaining the note payments from them has been very good to
date.
The next major risk is that the real estate projects themselves
do not work out. Deprived of rental income, the pool's cash flow
would be negatively impacted. EPIC minimizes this risk by wide
diversification of the properties -- geographically, price and
style. They showed us one sample pool in which the
diversification seemed to be excellent.
There's always the possibility that the general partner, EPIC,
will fail; the most likely form of failure would be a series of
projects that did not rent out adequately. We can review their
project plans to verify that they have adequate margins built in
to minimize this risk. We can also constantly monitor the
financial position of the general partner.
Another risk is that the EPIC property management company will
fail. If the manager is collecting the rents and does not
2001 Tax Ct. Memo LEXIS 80">*211 promptly forward all of the rent to the general partner, the
entire enterprise is in jeopardy. Of course, this is virtually
the entire business of EPIC. Therefore, it is highly improbable
that the property management company would fail alone.
Ultimately, we have the property to look to. Of course, the
critical question is whether or not the property investors are
acquiring the property at a bargain price, or whether EPIC is
overcharging the investors. Presumably, this is what our
underwriting is intended to guard against. We'll have to look at
it carefully to satisfy ourselves that the value is probably
there if we need it. However, I believe that we should be
concerned only with the entire pool because there is no way that
an individual property will go into default -- unless the
general partner can decide to stop making payments on one
individual mortgage.
The rates may be standard, owner-occupied rates on the primary
insurance. Frank Bossle agreed to send me copies of the current
rates of the other PMI companies. He says he is not2001 Tax Ct. Memo LEXIS 80">*212 looking for
a bargain rate, because the cost of the mortgage insurance is
passed on to the customer anyway.
He also says that they do not believe in requiring an insurer to
take property that the insurer doesn't want. They like all their
business relationships to be based upon cooperation and mutual
trust and profitability.
As noted above, one of the risks that Mr. Miller identified related to the value of the property; i.e., "whether or not the property investors are acquiring the property at a bargain price, or whether EPIC is overcharging the investors."
In a later memorandum dated August 24, 1984, after CMAC had written mortgage insurance on a small amount of EPIC's business, Mr. Miller focused on the risk "that the overall market for investment property could become saturated, and/or the EPIC Management might overextend themselves by paying too much for their properties." Mr. Miller instructed his staff to order spot-check appraisals of the EPIC property. The spot-check appraisals did not support the values suggested by EPIC's appraisals, and CMAC was not able to reconcile the differences. Shortly thereafter, in a letter dated2001 Tax Ct. Memo LEXIS 80">*213 August 5, 1985, CMAC ended its business relationship with EPIC.
EPIC's FINANCIAL STATEMENTS
The record contains EPIC's financial statements for 1981, 1982, and 1983. These statements show the following revenue and expenses:
Year Ended
______________________________________
12/31/81 12/31/82 12/31/83
__________ ___________ ____________
Revenues:
Builder Fees $ 8,960,780 $ 15,895,234 $ 18,905,034
Interest income and
loan service fees 3,910,907 8,871,358 8,233,739
Rental income 1,613,598 1,219,852 -0-
Property management fees 972,077 1,357,220 941,616
Partnership organization fees 474,220 4,882,669 9,403,021
Loan origination fees 177,031 2,790,098 7,580,544
Other income 298,442 698,480 443,087
2001 Tax Ct. Memo LEXIS 80">*214 __________ __________ ___________
Total revenue 16,407,055 35,714,911 45,507,041
Costs and Expenses:
Interest expense 4,149,063 7,629,826 3,270,713
Payroll & fringe benefits 3,969,457 8,696,684 8,430,324
Commissions 339,277 3,319,496 8,483,881
Partnership rental expenses 2,799,960 1,916,887 -0-
Other operating expenses 2,411,917 3,991,804 10,000,887
__________ __________ __________
Total expenses 13,669,674 25,554,697 30,185,805
Income from operations 2,737,381 10,160,214 15,321,236
EA 83-XII AND EA 84-III's BANKRUPTCY
In 1985, the Governor of Maryland shut down the State's savings and loan system, and the State required all savings and loan associations subject to Maryland regulation to liquidate their assets or to obtain Federal deposit insurance from the Federal Home Loan Bank Board (FHLBB). CSL, a nonfederally insured Maryland savings and loan, applied2001 Tax Ct. Memo LEXIS 80">*215 for deposit insurance issued by the Federal Savings & Loan Insurance Corp. (FSLIC).
In July 1985, the FHLBB informed CSL that it would not approve CSL's application for FSLIC insurance. As a result, EPIC and its real estate partnerships, including EA 84-III and EA 83-XII, could no longer use CSL as a source of funds necessary for their operations. By August 15, 1985, EA 83-XII and EA 84-III defaulted on their respective obligations under the mortgages and deeds of trust on the properties. Shortly thereafter, EA 83-XII and EA 84-III filed petitions in the U.S. Bankruptcy Court for the Eastern District of Virginia.
NOTICES OF FPAA ISSUED TO EA 83-XII
In the notices of FPAA issued to EA 83-XII for 1983, 1984, and 1985, respondent adjusted the ordinary income reported by the partnership as shown below in the second column for each year:
EA 83-XII 1983 1984
_________ ___________________ ____________________
Rent income $ 287,640 $ 287,640 $ 306,577 $ 306,577
Late charges 548 548 -0- -0-
Interest income2001 Tax Ct. Memo LEXIS 80">*216 9,344 9,344 90 90
Miscellaneous -0- -0- -0- -0-
________ ________ ________ ________
Total gross income 297,532 297,532 306,667 306,667
Interest (noninvestment) 466,358 -0- 539,893 -0-
Commissions 25,460 25,460 21,950 21,950
Insurance 27,744 27,744 16,438 16,438
Legal and professional fee 726 726 8,093 8,093
Repairs 1,348 1,348 30,866 30,866
Taxes 49,224 49,224 49,213 49,213
Utilities 464 464 1,547 1,547
Homeowner dues 20,620 20,620 20,620 20,620
Audit fee 4,900 4,900 4,900 4,900
Points amortization 16,671 -0- 16,671 -0-
Property management2001 Tax Ct. Memo LEXIS 80">*217 30,600 30,600 30,600 30,600
Real estate tax service 1,278 1,278 -0- -0-
Miscellaneous 107 107 -0- -0-
Depreciation 173,119 -0- 173,119 -0-
Bad debts -0- -0- 1,l74 1,174
Amortization organization
expense -0- -0- 3,150 3,150
Recording fees -0- -0- -0- -0-
Service fee-EMI -0- -0- -0- -0-
________ _______ ________ ________
Total expenses 818,619 162,471 918,234 188,551
Total rent income -521,087 135,061 -611,567 118,116
[Table continued]
EA 83-XII 1985
_________ _____________________
Rent income $ 331,743 $ 331,743
Late2001 Tax Ct. Memo LEXIS 80">*218 charges -0- -0-
Interest income 1,262 1,162
Miscellaneous 883 883
________ ________
Total gross income 333,888 333,888
Interest (noninvestment) 560,177 -0-
Commissions 24,846 24,846
Insurance 18,992 18,992
Legal and professional fee 574 574
Repairs 15,075 15,075
Taxes 45,962 45,962
Utilities 951 951
Homeowner dues 25,350 25,350
Audit fee 3,267 3,267
Points amortization 16,671 -0-
Property management 29,837 29,837
Real estate tax service -0- -0-
Miscellaneous 856 856
Depreciation 2001 Tax Ct. Memo LEXIS 80">*219 173,119 -0-
Bad debts -0- -0-
Amortization organization
expense -0- -0-
Recording fees 24 24
Service fee-EMI 3,413 3,413
________ _______
Total expenses 919,114 169,147
Total rent income -585,226 164,741
Respondent also disallowed the investment interest expense of $ 66,366 claimed on the 1983 return.
The "explanation of items" attached to the notice of FPAA for 1983 gives the following explanation of these adjustments:
INTEREST EXPENSE AND POINT AMORTIZATION
* * * * * * *
The deductions shown on your return as interest are not
deductible because it has not been established that the amounts
were for interest on a bona fide debt. Consequently, the
partnership's taxable income is increased.
* * * * * * *
2001 Tax Ct. Memo LEXIS 80">*220 In the event that it is determined that there was an actual
investment associated with the acquisition of the property or
that there was genuine indebtedness on the property, then with
respect to EPIC Associates 83-XII partnership for the taxable
year 1983, this activity was not engaged in for profit and the
allowability of interest expenses incurred is limited to the
investment income of the taxpayer for the taxable year.
Consequently, all interest expenses relative to this activity
are not allowable as deductions against ordinary income, but are
separately stated items subject to the investment interest
limitations.
DEPRECIATION
The deductions shown on your return as depreciation are not
deductible because it has not been established that a bona fide
investment in depreciable property was made. Consequently, the
partnership's taxable income is increased.
In the event that it is determined that there was an actual
investment associated with the acquisition of the property or
that there was genuine indebtedness on the property, 2001 Tax Ct. Memo LEXIS 80">*221 then with
respect to the EPIC Associates 83-XII partnership for the
taxable year 1983 [1984 and 1985], this activity was not engaged
in for profit and only the following deductions are allowable:
(1) The deductions which would be allowable for the taxable
year without regard to whether or not such activity is
engaged in for profit, and
(2) a deduction equal to the amount of the deductions which
would be allowable for the taxable year year [sic] only if
such activity were engaged in for profit, but only to the
extent that the gross income derived from such activity of
the taxable year exceeds the deductions allowable by reason
of paragraph (1) above.
The notices of FPAA for 1984 and 1985 are virtually identical.
Respondent made other adjustments to EA 83-XII's returns for 1983, 1984, and 1985. For taxable year 1983, respondent disallowed the net investment loss of $ 341,010 reported for purposes of allocating tax preference items to its partners, and respondent disallowed the excess expenses from net lease2001 Tax Ct. Memo LEXIS 80">*222 property of $ 10,859 and the investment interest income of $ 29,306. For taxable years 1984 and 1985, respondent disallowed the qualified investment income of $ 303,571 and $ 330,529, respectively, the qualified investment expenses of $ 908,960 and $ 909,831, respectively, and the investment interest income of $ 90 and $ 1,262, respectively. In support of these other adjustments, the notices of FPAA issued to EA 83-XII state that "it has not been established that there was an actual investment associated with the acquisition of the property or that there was genuine indebtedness on the property." In further support of these other adjustments, the notices state that the activity of EA 83-XII for 1983, 1984, 1985, and 1986 "was not engaged in for profit."
NOTICES OF FPAA ISSUED TO EA 84-III
In the notices of FPAA issued to EA 84-III for 1983, 1984, and 1985, respondent adjusted the ordinary income reported by the partnership as shown below in the second column for each year:
EA 84-III 1983 1984
_________ ___________________ ____________________
Rent income $ 80,1242001 Tax Ct. Memo LEXIS 80">*223 $ 80,124 $ 228,516 $ 228,516
Interest -0- -0- -0- -0-
________ _______ ________ ________
Total gross income 80,124 80,124 228,516 228,516
Interest (noninvestment) 118,082 -0- 522,466 -0-
Commissions 5,305 5,305 23,198 23,198
Insurance 5,480 5,480 16,663 16,663
Legal & professional fee 6,895 6,895 687 687
Repairs 8,500 8,500 19,782 19,782
Taxes 18,123 18,123 72,554 72,554
Utilities 1,726 1,726 33,555 33,555
Homeowner dues 998 998 3,993 3,993
Property management fee 8,250 8,250 33,000 33,000
Points amortization 3,453 -0- 13,814 -0-
Miscellaneous 141 2001 Tax Ct. Memo LEXIS 80">*224 141 606 606
Audit fee -0- -0- 5,000 5,000
Service fee -0- -0- -0- -0-
Depreciation 56,910 -0- 170,742 -0-
________ ______ ________ _______
Total expenses 233,863 55,418 916,060 209,038
Net rental income -153,739 24,706 -687,544 19,478
EA 84-III 1985
_________ _____________________
Rent income $ 230,130 $ 230,130
Interest 494 494
________ ________
Total gross income 230,624 230,624
Interest (noninvestment) 545,848 -0-
Commissions 19,403 19,403
Insurance 19,894 19,894
Legal & professional fee 1,008 1,008
Repairs 108,459 108,459
Taxes 2001 Tax Ct. Memo LEXIS 80">*225 72,617 72,617
Utilities 1,830 1,830
Homeowner dues 12,353 12,353
Property management fee 32,175 32,175
Points amortization 13,814 -0-
Miscellaneous 574 574
Audit fee 3,333 3,333
Service fee 3,197 3,197
Depreciation 170,742 -0-
_________ ________
Total expenses 1,005,247 274,843
Net rental income -774,623 -44,219
The explanation of the above adjustments is virtually identical to the explanation in the notices of FPAA issued to EA 83-III, quoted above.
Respondent made a number of other adjustments to EA 84- III's returns for 1983, 1984, and 1985. Respondent disallowed the net investment loss of $ 141,142 and investment interest income of $ 6,097 claimed in 1983. Respondent disallowed qualified investment income of $ 217,619 and qualified investment expenses of $ 872,376 claimed in 1984. Respondent disallowed qualified2001 Tax Ct. Memo LEXIS 80">*226 investment income of $ 229,131, qualified investment expenses of $ 997,436, and investment interest income of $ 494 claimed in 1985. In support of these other adjustments, the notices of FPAA state that "it has not been established that there was an actual investment associated with the acquisition of the property or that there was genuine indebtedness in the property." In further support of the other adjustments, the notices state that the activity of EA 84-III for 1983, 1984, 1985, and 1986 "was not engaged in for profit."
OPINION
In the subject notices of FPAA, respondent disallowed the interest and depreciation deductions that each partnership claimed on its tax returns for 1983, 1984, and 1985. According to the notices of FPAA, the interest deductions are disallowed because "it has not been established that the amounts were for interest on a bonafide [sic] debt." Similarly, according to the notices of FPAA, the depreciation deductions are disallowed because "it has not been established that a bona fide investment in depreciable property was made."
The interest deductions at issue consist principally, but not entirely, of amounts paid or accrued with respect to the nonrecourse2001 Tax Ct. Memo LEXIS 80">*227 promissory notes issued by each partnership for the purchase of the residential properties described above. We sometimes refer to the subject promissory notices as first mortgage notes. The depreciation deductions are based entirely on the portion of the subject promissory notes that each partnership claims as a basis in the residential properties purchased with the notes.
If none of the promissory notes constitutes a bona fide debt, as determined by the notices of FPAA, it follows, as discussed below, that no amount paid or accrued with respect to any of the notes is deductible as interest under section 163(a). Furthermore, if none of the promissory notes constitutes a bona fide debt, it also follows that neither partnership incurred a cost in issuing the notes and neither partnership obtained a basis in any of the properties for depreciation purposes. Thus, the first issue for decision in these cases is whether any of the nonrecourse promissory notes issued by either partnership constitutes a bona fide debt.
A portion of the interest deducted by both partnerships was for "points amortization". These deductions are based upon the loan origination fees paid by both partnerships to2001 Tax Ct. Memo LEXIS 80">*228 EMI. The partnerships treated these fees as additional interest on the first mortgage notes and amortized them over the life of the loans. The second issue for decision in these cases is whether the partnerships are entitled to these deductions for points amortization.
The notices of FPAA also take the position that the activity of each partnership for each of the tax years in issue, 1983, 1984, and 1985, is an "activity not engaged in for profit" within the meaning of section 183(c). The notices of FPAA state: "the allowability of interest expenses incurred is limited to the investment income of the taxpayer for the taxable year." Thus, according to the notices of FPAA, if section 183 applies, then the interest expenses of each partnership must be treated as investment interest subject to limitation under section 163(d). On that basis, the adjustments to the subject returns would be similar in amount to the adjustments determined under the theory, described above, that neither partnership had entered into a bona fide indebtedness during any of the years in issue.
The application of section 183 is not just an alternative theory. The notice of FPAA issued to EA 84-III for 1985 relies2001 Tax Ct. Memo LEXIS 80">*229 on section 183 to disallow net operating expenses of $ 44,219. This is the amount by which the deductions claimed by EA 84-III exceed the partnership's gross income, after the deductions for interest and depreciation are disallowed under the non-bona fide indebtedness theory, described above. Thus, we must consider the application of section 183 no matter how we decide the other issues. This is the third issue for decision in these cases.
It appears that each partnership also deducted, as interest, amounts paid or accrued during the years in issue with respect to certain funds advanced to it by EPIC, as general partner. By implication, the notices of FPAA take the position that any such unsecured advance made by EPIC to either partnership did not create a bona fide indebtedness of the partnership to EPIC and any amount paid or accrued with respect to any such advance is not deductible under section 163(a). This is the fourth issue for decision in these cases.
It also appears that EA 84-III deducted, as interest, amounts paid or accrued during 1985 with respect to 16 promissory notes issued to CSL. Each of those promissory notes was secured by a deed of trust on one of the properties2001 Tax Ct. Memo LEXIS 80">*230 that had been purchased by EA 84-III in 1983. As mentioned above, the notices of FPAA disallow all of the interest deductions claimed by the partnerships on the ground that the amounts deducted were not shown to have been paid as interest on a bona fide debt. Thus, the fifth issue for decision in these cases is whether any of the 16 promissory notes issued by EA 84-III to CSL constitutes a bona fide debt.
NONRECOURSE PROMISSORY NOTES
Generally, a taxpayer is allowed to deduct an amount as interest under section 163(a) if the amount was paid or incurred during the taxable year with respect to genuine indebtedness. See, e.g.,
Indebtedness is not considered genuine, that is, a true loan, if the facts show that the parties to the loan did not intend the principal amount of the indebtedness to be repaid in full. See, e.g.,
We have previously summarized the approaches taken by the courts in determining whether a purported nonrecourse liability is to be treated as true debt for Federal tax purposes. See, e.g.,
There are various approaches which may be taken in
establishing whether a purchaser may treat a nonrecourse
liability as a bona fide debt. One, originating in Estate of
aggregate purchase price unreasonably exceeds the value of the
property securing the note (or when the principal amount of the
note unreasonably2001 Tax Ct. Memo LEXIS 80">*233 exceeds the value of the property securing the
note), the debt will not be recognized. In such instance, the
purchaser acquires no equity in the property by making payments
and, therefore, would have no economic incentive to pay off the
note.
The Estate of Franklin analysis, comparing the purchase price
and size of the note to the fair market value of the property at
the time of purchase, originated in real estate transactions
(see
(9th Cir. 1982);
affd.
to the purchase of cattle (see
and, more recently, to movies (see Wildman v. Commissioner,
supra;
supra).
Another line of cases, in many ways complimentary2001 Tax Ct. Memo LEXIS 80">*234 to the
above, more closely addresses the problem of bona fide loans
where the sole security for such loans is a speculative asset
with an undeterminable value at the time of purchase. This line
of decisions holds that highly contingent or speculative
obligations are not recognized for tax purposes until the
uncertainty surrounding them is resolved.
on other grounds
vacating and remanding on other grounds
1981);
(9th Cir. 1971);
2001 Tax Ct. Memo LEXIS 80">*235
(2d Cir. 1964). For example, in
we held that an obligation to pay $ 444,335.17 of the $ 1,131,000
stated purchase price of a business only out of future "net
profits" was too contingent to be included in the purchaser's
amortizable basis. [Fn. refs. omitted.]
Respondent takes the position in the instant cases that none of the first mortgage notes issued by EA 83-XII or EA 84-III is a bona fide debt because the aggregate principal amount of the notes issued by each partnership exceeds the aggregate fair market value of the property securing the notes and, for that reason, neither partnership had an incentive to repay the notes. See, e.g.,
Petitioners argue that "the fair market value of the properties [purchased by each partnership] was at least equal to the amount of the debt at the time it was incurred." They argue that the fair market value of each of the subject properties is its contract price, as established by a contemporaneous appraisal that was made by an independent, unrelated appraiser. The appraisals reflect the sale of each property to an individual buyer, rather than the bulk sale of all of the properties to a single buyer. Petitioners argue that the promissory note issued to purchase each of the properties, based upon 85 to 95 percent of the contract price, is bona fide indebtedness.
Petitioners emphasize that "each of the nonrecourse mortgages in the partnerships was insured by an unrelated mortgage insurance company" and "was2001 Tax Ct. Memo LEXIS 80">*237 purchased by an unrelated lender shortly after the loan was funded". According to petitioners, the unrelated mortgage insurers and the lenders who acquired the loans in the secondary market each "had the incentive to ascertain that the value of the properties was at least equal to the debt" and the fact that they undertook to participate in the transactions is "evidence that the fair market value of the properties was at least equal to the amount of the debt at the time it was incurred." Petitioners argue that "the unrelated lenders and insurers did due diligence" and, in fact "would have exercised special caution with respect to such loans" because of the unusual nature of the loans. They further argue that the facts show "that there was no attempt by EPIC to conceal the facts."
Petitioners acknowledge that the partnerships purchased the properties with substantial discounts and that the partnerships did not pay the contract price for any of the properties purchased. As stated in their posttrial brief: "common sense suggests that a large and astute investor [such as EPIC] would demand price concessions." Thus, petitioners acknowledge that the prices paid by each partnership reflected2001 Tax Ct. Memo LEXIS 80">*238 the discounts or price concessions that a large buyer would expect when buying "in bulk". In fact, as discussed above, EPIC negotiated with the sellers of the properties various "discounts" in the aggregate amount of approximately 20 percent of the contract price of the properties. Furthermore, the tax returns filed on behalf of each partnership compute the partnership's cost basis for each property under section 1012 as the contract price of the property less the rental deficit contribution for that property and claim depreciation on the portion of the cost that was allocated to the improvements. Petitioners argue that the value of each of the subject properties is equal to the contract price notwithstanding the fact that each partnership paid a price that reflected discounts from the contract price. Petitioners argue that such discounts "do not reduce the underlying value of any one item purchased".
Finally, petitioners argue that respondent's evidence relating to the fair market value of the properties is "rife with errors in assumptions and/or judgement and/or application of concepts". Petitioners ask the Court to conclude that respondent's evidence is biased and not worthy of2001 Tax Ct. Memo LEXIS 80">*239 consideration.
Respondent argues that the 106 promissory notes issued by EA 83-XII and EA 84-III should be disregarded for tax purposes "because the debt substantially exceeded the fair market value of the underlying property and lacked economic substance." According to respondent's posttrial brief:
Respondent's appraisals reflect that the nonrecourse debt
by EMI exceeds the actual values of EA83-XII's properties by
39.40% and the actual values of EA84-III's properties by 19.53%
and that EA83-XII and EA84-III "overmortgaged" the 106
properties to support nominal purchase prices that permitted
Epic to receive substantial builder fees, rental deficit
contributions, and rental advances.
Respondent explains the computation of the above percentages as
follows:
Respondent's appraisals reflecting values totalling
$ 2,658,600.00 for the properties acquired by EA83-XII
demonstrate that the nonrecourse debt totalling $ 3,706,150.00
originated by EMI exceeds the actual values by $ 1,047,550.00, or
39.40%. Respondent's appraisals reflecting values totalling
$ 2,889,150.002001 Tax Ct. Memo LEXIS 80">*240 for the properties acquired by EA84-III
demonstrate that the nonrecourse debt totalling $ 3,453,450.00
originated by EMI exceeds the actual values by $ 564,300.00, or
19.53%.
According to respondent, EA 83-XII and EA 84-III "overmortgaged" the 106 properties in order "to generate substantial builder fees, rental deficit contributions, and rental advances necessary to feed EPIC's ravenous appetite for fees to enlarge and maintain EPIC's real estate empire." As an essential element of the "scheme", respondent alleges that "EPIC secured inflated, faulty appraisals to support the nonrecourse debt originated by EMI to acquire the 106 properties." In this connection, respondent asserts that EPIC, through CAG "encouraged outside appraisers to inflate values on properties acquired by the partnerships", such as "by requesting appraisers to value multiple properties purchased in bulk sales as if purchased separately by different individuals." As a result, respondent argues, the nonrecourse debt issued by EA 83-XII and EA 84-III to acquire the properties exceeded the value of the properties. Thus, respondent asserts: "there was no incentive to repay the debt and the debt2001 Tax Ct. Memo LEXIS 80">*241 lacked economic substance."
Respondent also argues that the instant transactions did not "involve unrelated parties and independent appraisers establishing purchase prices." Respondent argues that the transactions "involved related parties" and notes that EPIC, acting through its subsidiary, EMI, "originated, serviced each nonrecourse loan, and was primarily responsible for any due diligence related to the loans." Respondent claims that for at least six properties acquired by EA 84-XII, EPIC, through two subsidiaries "was both the seller and purchaser". Respondent argues that the outside appraisers were not independent because EPIC "influenced their appraisals with guidelines and requests that precluded the use of bulk sale methods in purchases of multiple units." According to respondent, "EPIC, through CAG, influenced the inflated appraisals related to the properties and determined the stated purchase price."
Respondent also argues that the participation of secondary lenders and mortgage insurers does not establish that the value of the properties approximated the debt because there is no evidence that they engaged in due diligence. According to respondent: "the lack of due diligence2001 Tax Ct. Memo LEXIS 80">*242 by secondary lenders and mortgage insurers demonstrates that [the] lenders ignored or did not understand the realities of the EPIC transactions." At the same time, respondent notes the fact that some mortgage insurers refused to insure "newly- created debt on EPIC properties."
The following is a list of the 51 properties purchased by EA 83-XII (viz 12 single-family residences and 39 condominium units) together with the amount of each loan, the value of each property as determined by respondent's appraisers, and the loan to value ratio for each property, computed using respondent's value:
EA 83-XII
Respondent's
Address Loan Amount Value Loan / Value
_______ ___________ ____________ ____________
1612 Hemphill Ave. $ 54,525 $ 57,400 94.99
1921 West 17th St. 51,300 54,000 95.00
1728 Coronado Ave. 51,300 54,000 95.00
1700 Linda Ave. 54,050 56,900 94.99
1716 Coronado2001 Tax Ct. Memo LEXIS 80">*243 Ave. 54,050 1,800,000 159.42
(39 units) __________ _____________ ________
Total 3,706,150 2,658,600 139.40
2001 Tax Ct. Memo LEXIS 80">*244 Respondent's position is that the promissory notes issued by EA 83- XII, comprising 51 of the 106 notes mentioned above, should be disregarded for tax purposes because the aggregate nonrecourse debt represented by those notes exceeds the value of the properties by 39.40 percent.
Similarly, the following is a list of the 55 properties purchased by EA 84-III (viz 14 single-family residences and 41 condominium units) together with the amount of each loan, the value of each property as determined by respondent's appraisers, and the loan to value ratio for each property, computed using respondent's value:
EA 84-III
Respondent's
Address Loan Amount Value Loan/Value
_______ ___________ ____________ ___________
5419 Heronwood Dr. $ 51,300 $ 58,000 88.45
5411 Heronwood Dr. 61,750 65,000 95.00
3518 Tower Hill La. 60,550 55,000 110.09
12347 Northcliffe Manor Dr. 55,575 45,000 2001 Tax Ct. Memo LEXIS 80">*245 123.50
13066 Clarewood Dr. 54,150 48,000 112.81
6351 S. Briar Bayou Dr. 58,425 47,000 124.31
12103 Kingslake Forest Dr. 57,475 46,000 124.95
12107 Kingslake Forest Dr. 47,975 38,000 126.25
12111 Kingslake Forest Dr. 53,200 40,000 133.00
12115 Kingslake Forest Dr. 60,800 52,000 116.92
12231 Carola Forest Dr. 56,050 54,000 103.80
4850 W. Ferret 67,450 71,200 94.73
4107 Medical Dr. (Condo.) 56,950 56,400 100.98
13739 Earlywood Dr. 60,800 57,600 105.56
6402 Ridgecreek Dr. 60,800 55,950 108.67
Reflections Condos 2,100,000 123.34
(40 Units) _________ _________ _______
Total 3,453,450 2,889,150 119.530
2001 Tax Ct. Memo LEXIS 80">*246 Respondent's position is that the promissory notes issued by EA 84- III, comprising 55 of the 106 notes mentioned above, should be disregarded for tax purposes because the aggregate nonrecourse debt represented by those notes exceeds the value of the properties by 19.53 percent.
The above schedules show that respondent tests whether the principal amount of the indebtedness exceeds the value of the property securing it in the aggregate, rather than loan by loan. If the value comparison were made loan by loan, most of the loans issued with respect to the single-family residences would approximate the value of the property securing the loan, even using respondent's values. For example, in the case of the 12 single-family residences acquired by EA 83-XII, as shown in the schedule above, none of the loans issued by the partnership materially exceeds the value of the related property, as determined by respondent's appraisers. Similarly, in the case of the properties acquired by EA 84-III, other than the Reflections condominium units, 7 of the 15 loans issued by the partnership are 110 percent or less of the value of the related property, as determined by respondent's appraisers. Nevertheless, 2001 Tax Ct. Memo LEXIS 80">*247 respondent determined that all of the loans issued by both partnerships are not bona fide because the aggregate principal amount of the loans issued by each partnership exceeds the aggregate value of the properties by 39.4 percent in the case of EA 83-XII and 19.53 percent in the case of EA 84-III. Petitioners do not take issue with this aspect of respondent's approach and the parties do not address the issue whether the value comparison should be made in the aggregate or loan by loan.
In these cases, we must determine whether the fair market value of the properties acquired by each partnership is more or less than the principal amount of the debt that was incurred by the partnership in purchasing the properties. For purposes of making this comparison, we must determine the fair market value of the properties as of the time they were acquired by each partnership. See, e.g.,
The fair market value of an item of property is "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts." E.g.,
The fair market value of real property is based on the highest and best use to which the property could be put on2001 Tax Ct. Memo LEXIS 80">*249 the date of valuation. See, e.g.,
In the process of establishing the fair market value of an item of property on the basis of its highest and best use, it is sometimes necessary to consider the most appropriate market through which the property would change hands from a willing seller to a willing buyer. See, e.g.,
In applying the estate and gift tax regulations to ascertain the fair market value of an item of property for purposes of computing the amount of a charitable contribution deduction, the Court of Appeals in
Rules governing valuations for charitable contributions of
property are distinguishable from valuations in the estate and
gift context because the taxpayer has the opposite incentives in
the two situations: the taxpayer wants to reduce the value of
property for estate and gift tax purposes but, as here, the
taxpayer wishes to inflate the value of property for charitable
donation purposes. The estate and gift tax regulations are aimed
at preventing abusive undervaluation of property; the
regulations governing charitable contributions are not. In the
usual case, however, there should be no distinction between the
measure of fair market value for estate and gift tax and
charitable contribution purposes. Cf. Champion v. Commissioner,
Thus, the Court of Appeals noted that the estate and gift tax regulations were not a perfect fit in considering the charitable deduction in that case because the taxpayers had an incentive to inflate the value of the property, whereas "the estate and gift tax regulations are2001 Tax Ct. Memo LEXIS 80">*252 aimed at preventing abusive undervaluation of property". Id. The same is true in the instant cases. Nevertheless, we also agree with the Court of Appeals that "there should be no distinction between the measure of fair market value". Id.; see also
A sale to the public is a sale to the ultimate consumer of the property, that is, a sale to one of a group of persons who do not purchase the item for resale. See, e.g.,
The above cases may be contrasted with
The appropriate market for estimating the value of an item of property may sometimes be the market in which the taxpayer purchased the property. For example, in
At the outset of our consideration of the instant cases, it is helpful to note several points about the positions of the parties. First, respondent's appraisers valued the single-family houses and one condominium unit on a different basis than they used to value the other 79 condominium units. According to respondent's brief, respondent's appraisers valued the single-family houses acquired by each partnership and one of the condominium units purchased by EA 83-III on a "retail" basis; that is: "As if2001 Tax Ct. Memo LEXIS 80">*257 the properties were purchased separately by individuals." Respondent's brief describes the appraisals of 14 of the single-family houses and the condominium unit at 4107 Medical Drive as follows:
Respondent's appraisals, which were performed 11 to 13 years
after EA83-XII and EA84-III acquired the properties, reflect
RETAIL VALUES of the houses at 2109, 2111, 2115, and 2117
Avignon Drive in Carrollton, the seven houses in Odessa [viz,
1612 Hemphill Avenue, 1921 West 17th Street, 1728 Coronado
Avenue, 1700 Linda Avenue, 1716 Coronado Avenue, 1916 Hollywood
Drive, and 1720 Coronado Avenue], the two houses at 5411 and
5419 Heronwood Drive in Humble, the condominium at 4107 Medical
Drive in San Antonio, the house at 4850 W. Ferret Drive in
Tucson AS IF THE PROPERTIES WERE PURCHASED SEPARATELY BY
INDIVIDUALS. [Emphasis supplied.]
Similarly, respondent's brief describes the appraisals of the other
12 single-family houses as follows:
Respondent's appraisals, which were performed 11 to 13 years
after EA83-XII and EA84-III acquired the properties, reflect
RETAIL VALUES2001 Tax Ct. Memo LEXIS 80">*258 for the residences at 2113 Avignon in Carrollton,
13739 Earlywood Drive and 6402 Ridgecreek Drive in San Antonio,
and 3518 Tower Hill Lane, 12347 Northcliffe Manor Drive, 13066
Clarewood Drive, 6351 S. Briar Bayou, 12231 Carola Forest Drive,
and 12103, 12107, 12111, and 12115 Kingslake Forest Drive in
Houston AS IF PURCHASED SEPARATELY BY INDIVIDUALS. [Emphasis
supplied.]
On the other hand, respondent's appraisers valued the condominium units acquired by each partnership (other than the condominium unit at 4107 Medical Drive) on a "wholesale" basis; that is, as if the purchase consisted "of multiple properties purchased in bulk sales from the same builder." Respondent's brief states as follows:
Respondent's appraisals of the 39 units in Miami and 40-
unit complex in San Antonio, which were performed 11 to 13 years
after EA83-XII and EA84-III acquired the properties, reflect the
WHOLESALE VALUE OF MULTIPLE PROPERTIES PURCHASED IN BULK SALES
FROM THE SAME BUILDER. [Emphasis supplied.]
Second, according to respondent's brief, the difference between the retail value of each single-family2001 Tax Ct. Memo LEXIS 80">*259 property, as determined by respondent's appraisers, and the wholesale value of that property is the amount of the rental deficit contribution. Respondent's brief states as follows:
because each of the [single family] properties was purchased by
Epic in purchases involving multiple houses from the same
builder, a discount in the amount of the rental deficit
contribution of approximately 20% to the retail value is
appropriate to arrive at the wholesale value of each property.
* * *
The above statement echoes the opinion of respondent's appraisers, Messrs. Dalton and Ramos, who valued the Reflections condominium complex that was purchased by EA 84-III. In a memorandum that accompanied their appraisal, Messrs. Dalton and Ramos describe the difference between the wholesale and retail values of the properties as the amount of the rental deficit contribution. The memorandum states as follows:
4. Another way to view the RDC [i.e., rental deficit
contribution] is as the difference between the properties
[sic] retail price over its wholesale price. As discussed
above, the sum of the2001 Tax Ct. Memo LEXIS 80">*260 parts is much greater than the whole.
By selling the properties individually, the owner receives
the greater retail price, while he would get only a wholesale
price if he sold all of the properties to a single investor
in one transaction. That is, multiple purchases from the same
builder demand a wholesale price. The discount would be in
the range of the RDC, or a 20%-25% reduction of the retail
price of each unit if sold separately. The percentage
reduction is supported in the 40-Unit Condominium Complex
appraisal (TAB C). The indicated wholesale value was
estimated at $ 2,100,000. EPIC financed the property based on
a projected retail sale of the property of $ 3,000,000. The
wholesale value is 30% lower than EPIC's projected retail
value.
5. The 40-Unit Condominium Complex (TAB C) was valued at
wholesale as this was the market for these types of
properties. The values obtained for the single-family houses
in TAB's A and B of this report reflect the retail fair
2001 Tax Ct. Memo LEXIS 80">*261 market value of the properties. Multiple sales of single-
family houses were not plentiful at the date of value and at
the present date they are very obscure. A discount, in the
approximate amount of the RDC, for each single-family
property is required if these house were sold wholesale,
i.e., grouped with a multitude of other houses, in one
transaction to a single investor. The RDC was chosen as a
discount from retail to wholesale based on the discussion
presented in (4) above.
Significantly, respondent does not appear to take the position that the builder fees and rent advances are additional discounts that must be applied to the retail value of the property in computing its wholesale value. In this connection, we note the fact that the builder fees were treated as having been paid by the seller to EPIC, as opposed to the partnership, and were reported as income by EPIC, and the fact that the rent advances were treated as rents and were included in the gross income of each partnership.
In summary, respondent's position is that valuing the subject properties as if sold2001 Tax Ct. Memo LEXIS 80">*262 to separate individuals yields the retail value of the properties, whereas valuing them as if purchased in a bulk sale yields the wholesale value of the properties. Furthermore, according to respondent, the difference between the retail value and the wholesale value of a particular property is the discount that EPIC negotiated with each of the sellers, referred to as the rental deficit contribution. Both of these positions are set forth in the memorandum written by Messrs. Dalton and Ramos, the relevant portion of which is quoted above.
Third, the appraisals that were obtained pursuant to EPIC's contracts with the sellers at the time EA 83-XII and EA 84-III purchased the subject properties (referred to herein as the contemporaneous appraisals) valued all of the properties without discount as if each property were sold separately to an individual purchaser. To use respondent's terminology, all of the contemporaneous appraisals valued the properties, both single-family houses and condominiums, on a retail basis. They did not value the subject properties on a wholesale basis; that is, as if purchased in bulk by a single person.
Thus, in valuing the single-family homes and the condominium2001 Tax Ct. Memo LEXIS 80">*263 unit at 4107 Medical Drive, all of the appraisers used the retail market. In valuing the other 79 condominiums, on the other hand, respondent's appraisers used the wholesale market and the contemporaneous appraisals used the retail market.
Fourth, in valuing the subject properties, none of the parties relies upon the values that were established in the contracts between EPIC and the sellers of the properties. Petitioners argue that the transactions were arm's-length transactions between unrelated parties, but they take the position that the value of each property is its contract price, rather than the discounted price that the partnership actually paid for the property. On the other hand, respondent argues that the value of each property is a discounted price, as determined in respondent's appraisals, but not the discounted price that the partnership actually paid for the property.
EPIC negotiated the purchase of the subject properties on behalf of EA 83-XII and EA 84-III from five developers, Fox & Jacobs, Raldon, Babcock, U.S. Home, and Pitman & Japhet. The contracts between EPIC and each of the sellers followed a similar pattern. Each contract set forth a purchase price for each2001 Tax Ct. Memo LEXIS 80">*264 property, referred to herein as the contract price, that was based on the prices that the seller had received from sales of similar properties to individual retail purchasers. The contract provided that the seller would "pay" an amount negotiated between EPIC and the seller called the rental deficit contribution. The seller agreed to "pay" this amount to the purchaser, the limited partnership. The contract further provided that the seller would pay to EPIC a commission of 6.8 percent of the contract price and, under certain conditions, would prepay rent to the purchaser.
In negotiating these contracts with EPIC, each seller was principally interested in the amount that it would net after the above discounts and fees. A representative of one seller, Babcock, testified that his concern was the "bottom line" or "minimum number" and that he permitted EPIC to structure the discounts and fees.
There is nothing in the record of either of the subject cases to suggest that the business interests of EPIC and both limited partnerships were not adverse to the business interests of each of the five developers, nor is there anything to suggest that EPIC and the partnerships did not deal with those2001 Tax Ct. Memo LEXIS 80">*265 companies at arm's length. Respondent does not suggest otherwise. In asserting that "the transactions * * * involved related parties", respondent focuses on EMI, the company affiliated with EPIC that originated the loans, and on CAG, the affiliated appraisal company that obtained contemporaneous appraisals in many cases. The activities of those companies, however, did not establish the prices of the properties. That was done through negotiation between EPIC, the willing buyer, and each of the five developers, the willing seller.
Generally, where there is evidence that parties having adverse economic interests have dealt at arm's length and have assigned a value to certain property, that evidence is viewed as the most reliable basis for a determination of fair market value of the property. See, e.g.,
Single
EA 83-XII Properties Family Condos Total
____________________ ______ ______ _____
Aggregate contract prices $ 880,595 $ 3,020,700 $ 3,901,295
Less: Aggregate rental deficit
contributions 67,643 587,676 655,319
Less: Aggregate builder fees 55,993 205,408 261,401
Less: Aggregate rent advances 17,557 68,625 86,182
________ __________ _________
Contract prices less discounts,
fees, & advances 739,4022001 Tax Ct. Memo LEXIS 80">*267 2,158,991 2,898,393
Respondent's valuation 858,600 1,800,000 2,658,600
Single
EA 84-XII Properties Family 2001 Tax Ct. Memo LEXIS 80">*268 SINGLE-FAMILY HOUSES AND THE CONDOMINIUM AT 4107 MEDICAL DRIVE
As discussed above, all of the appraisals, including respondent's, valued the single-family houses and the condominium unit at 4107 Medical Drive on a retail basis. The reason for this in the case of the single-family houses was suggested in the memorandum of respondent's appraisers, Messrs. Dalton and Ramos, quoted above, when they stated: "Multiple sales of single-family houses were not plentiful at the date of value and at the present date they are very obscure." In effect, it appears that there was not a market for multiple sales of single-family houses in 1982 and 1983 when the properties were purchased.
Furthermore, respondent used the retail value of the single-family houses and the condominium unit at 4107 Medical Drive in computing the percentages and arguing that the aggregate nonrecourse debt exceeded the value of the properties by 39.40 percent in the case of EA 83-XII and 19.53 percent in the case of EA 84-III. Respondent does not argue that the single-family houses and the condominium unit at 4107 Medical Drive should be valued on a wholesale basis. Thus, it appears that respondent agrees with petitioners2001 Tax Ct. Memo LEXIS 80">*269 that these properties should be valued on a retail basis. Accordingly, we shall review the evidence in the record to determine the retail value of the single-family houses and the condominium at 4107 Medical Drive.
The partnerships purchased a total of 26 single-family houses and the condominium unit at 4107 Medical Drive. As to 19 of these 27 properties, the difference between the principal amount of the debt and the fair market value determined by respondent's appraisers is not material. This is certainly true in the case of the 12 single-family properties purchased by EA 83-XII. According to respondent's appraisers, the aggregate value of the 12 properties is $ 858,600, or $ 22,075 more than the aggregate principal amount of the loans, $ 836,525. Similarly, according to respondent's appraisers, the difference between the value of 6 of the 14 single-family properties and the condominium unit at 4107 Medical Drive purchased by EA 84-III and the principal amount of the loan is less than 10 percent. As to these 19 properties, therefore, there is no appreciable difference in the result of the value comparison depending on whether we use respondent's valuation or the contract prices2001 Tax Ct. Memo LEXIS 80">*270 of the properties.
The single-family residences as to which, according to respondent's appraisers, there is a material difference between the value of the property, and the principal amount of the debt are the following:
EA 84-III
Respondent's
Property Loan Value Loan / Value
________ ____ _____________ ____________
3518 Tower Hill Ln. $ 60,550 $ 55,000 110.09
12347 Northcliff Manor 55,575 45,000 123.50
13066 Clarewood Dr. 54,150 48,000 112.81
6351 S. Briar Bayou Dr. 58,425 47,000 124.31
12103 Kingslake Forest 57,475 46,000 124.95
12107 Kingslake Forest 47,975 38,000 126.25
12111 Kingslake Forest 53,200 40,000 133.00
12115 Kingslake Forest 60,800 52,000 116.92
Petitioners' evidence regarding the above eight properties includes contemporaneous appraisals of the properties and testimony of the appraiser,2001 Tax Ct. Memo LEXIS 80">*271 Mr. Paul Lang, regarding the general nature of his appraisals for EPIC. Mr. Lang is a licensed real estate appraiser in the State of Texas and a senior resident associate (SRA) of the Appraisal Institute. He appraised each of the subject eight properties at the time EA 84-III purchased it in 1983.
Mr. Lang's appraisals of the above single-family properties were made on FHLMC/FNMA forms, as required by EPIC's contract with the seller, U.S. Home. Those forms state as follows: "This appraisal is based upon the * * * market value definition * * * stated in FHLMC Form 439 (Rev. 10/78) and FNMA Form 1004B (Rev. 10/78)". That definition of market value is as follows:
DEFINITION OF MARKET VALUE: The highest price in terms of money
which a property will bring, in a competitive and open market
under all conditions requisite to a fair sale, the buyer and
seller, each acting prudently, knowledgeably and assuming the
price is not affected by undue stimulus. Implicit in this
definition is the consummation of a sale as of a specified date
and the passing of title from seller to buyer under conditions
whereby: (1) buyer and seller2001 Tax Ct. Memo LEXIS 80">*272 are typically motivated; (2) both
parties are well informed or well advised, and each acting in
what he considers his own best interest; (3) a reasonable time
is allowed for exposure in the open market; (4) payment is made
in cash or its equivalent; (5) financing, if any, is on terms
generally available in the community at the specified date and
typical for the property type in its locale; (6) the price
represents a normal consideration for the property sold
unaffected by special financing amounts and/or terms, services,
fees, costs, or credits incurred in the transaction. ("Real
Estate Appraisal Terminology," published 1975.)
Mr. Lang used both the sales comparison and the cost approach in valuing the subject properties. In the case of each of the properties, Mr. Lang concluded that the market value of the property was equal to its contract price. At trial, Mr. Lang testified that his appraisals were independent and objective, and that he had inspected each of the properties at the time of the appraisal. The appraisal forms provide support for this testimony. Mr. Lang made notations on the appraisal forms2001 Tax Ct. Memo LEXIS 80">*273 describing specific work on certain of the properties that had to be completed for the valuation to be accurate. Mr. Lang testified that the copies of his appraisals which are in evidence are incomplete in that there is no map showing the comparable sales used in his analysis. The addresses and sale prices for the properties that he used as comparables appear on the forms.
Respondent's appraiser, Mr. Charles Brown, a valuation engineer employed by the Internal Revenue Service, appraised a number of single-family properties purchased by EA 84-III, including the eight properties listed above. At the time of his testimony, Mr. Brown had applied for but had not received the Appraisal Institute's designation as SRA, and he was not licensed as a real estate appraiser in Texas.
The definition of fair market value used by Mr. Brown is the following:
The most probable price, as of a specified date, in cash, in
terms equivalent to cash, or in other precisely revealed terms,
for which the specified property rights should sell after
reasonable exposure in a competitive market under all conditions
requisite to a fair sale, with the buyer and seller2001 Tax Ct. Memo LEXIS 80">*274 acting
prudently, knowledgeably, and for self-interest, and assuming
that neither is under undue duress.
Thus, Mr. Lang's appraisals are based upon a definition of market value formulated in terms of "the highest price", as contained on the FHLMC/FNMA forms, and Mr. Brown's appraisals are based upon a definition of market value formulated in terms of "the most probable price".
We note that the definition of market value of real property formulated in terms of "the most probable price", as contained on the FHLMC/FNMA forms, was not used in FHLMC/FNMA forms until 1986.
It also defines the market value as the "most probable price
which a property should bring * * *" as opposed to the "highest
price which a property will bring * * *" in the old version.
This change recognizes that the market value of a property
usually falls within a range and that the indicated value is AN
ESTIMATE WHICH SHOULD NOT NECESSARILY BE AT THE HIGHEST PORTION
OF THAT2001 Tax Ct. Memo LEXIS 80">*275 RANGE. [Emphasis supplied.]
Mr. Brown's report states generally that the value of single-family residences in the Houston, Texas, area decreased significantly after 1983. His report states as follows:
These homes closely followed the prevalent Houston area real
estate trends during the early 1980's. Values increased
dramatically until 1983 when values declined sharply for the
next 3 to 6 years.
Mr. Brown appraised the houses in 1995, 12 years after the sales at issue, using both the comparable sales and cost methods. Mr. Brown testified that he inspected the exterior of each house appraised, and that he reviewed the records at the Harris County Appraisal District and at Baca Landata, a company located in Houston, Texas, which assists taxpayers in dealing with the Harris County Appraisal District.
Mr. Brown's approach is illustrated by his appraisal of the property at 3518 Tower Hill Lane. That property is located on a cul-de-sac in the Northcliffe Manor subdivision approximately 12 miles northwest of downtown Houston. It consists of a 1,331-square- foot house and garage built in 1983 on a 5,775-square-foot lot.
Mr. Brown employed the comparable2001 Tax Ct. Memo LEXIS 80">*276 sales approach and the cost approach to value this property. He identified four comparable sales, two sales of comparable houses in 1983 and two sales in 1987. He then used a "comparable sales adjustment grid" to adjust the sale price of each of the comparables to account for differences in the date of sale, location, lot size, size of the improvements, and year built. After determining the adjusted fair market value of each of the comparables, Mr. Brown divided the adjusted value of each property by the square footage of the improvements to arrive at the fair market value per square foot of the comparable.
For example, Mr. Brown determined that the fair market values per square foot of the two comparable sales in 1983 were $ 56.21 and $ 54.40. He found that the fair market values per square foot of the two comparable sales in 1987 were $ 40.98 and $ 38.14. Mr. Brown then chose the relatively low value of $ 40 per square foot as the market value in 1983 of the subject house, referred to in the appraisal report as Tract I. Mr. Brown's report explains his choice as follows:
After the adjustments are made, the fair market value of Tract I
falls in the range of $ 382001 Tax Ct. Memo LEXIS 80">*277 to $ 56 per square foot in 1983. Since
Tract I is one of the largest homes in the subdivision, it shall
command a loan value per square foot, say $ 40.
We note that the size of the improvements was already taken into account in the comparable sales adjustment grid.
Mr. Brown multiplies this value by the square footage of the improvements on Tract I and estimates that the fair market value of the property, on the basis of the sales comparison approach, is $ 53,200. After further adjusting the value by his estimate of the cost to reproduce the house, Mr. Brown's final estimate of the fair market value of the property is $ 55,000.
It appears that Mr. Brown's appraisal is too low. One of the comparable sales in 1983 is a house located on the same cul-de- sac as the subject property, 3510 Tower Hill Lane. That property was 116 square feet smaller and was sold for $ 64,400 ($ 53 per square foot) to an unrelated buyer in the same month that the partnership purchased the subject property. This is $ 9,400 more than Mr. Brown's appraised value of its larger neighbor. Similarly, a second comparable that was 173 square feet smaller than the subject property sold in September2001 Tax Ct. Memo LEXIS 80">*278 1983 for $ 62,500.
In valuing the 11 properties that are the subject of his report, Mr. Brown used a total of 15 comparable sales, 8 from 1983, 1 from 1982, and 6 from 1987. In applying the comparable sales approach, Mr. Brown followed the same approach in valuing the 11 properties. As to each of the properties, he reviewed three to five of the comparables. He adjusted the sales prices of the comparables for age, location, and size, as described above, and computed an adjusted fair market value per square foot of the comparable. He then selected a value per square foot that represented his opinion of the fair market value of the subject property.
Set out below is a summary, for each of the subject properties, of the fair market values per square foot of the comparables that were sold in 1982 or 1983, the fair market values per square foot of the comparables that were sold in 1987, and the fair market value per square foot that was selected by Mr. Brown as the value of the subject property:
Adjusted FMV Per Sq. Ft. of
EA 84-III Properties Tract Comparable Sales in 1982 & 1983
____________________ 2001 Tax Ct. Memo LEXIS 80">*279 _____ ________________________________
3518 Tower Hill Ln. I $ 54.40 $ 56.21 -0-
12347 Northcliff Manor Dr. II 44.73 48.64 -0-
13066 Clarewood Dr. III 50.40 38.35 -0-
6351 S. Briar Bayou Dr. IV 52.91 42.66 -0-
12231 Carola Forest Dr. V 48.97 56.18 $ 57.12
12115 Kings Lake Forest Dr. VI 49.47 56.82 57.70
12111 Kings Lake Forest Dr. VII 44.70 51.60 52.51
12107 Kings Lake Forest Dr. VIII 44.70 51.60 52.51
12103 Kings Lake Forest Dr. IX 47.09 56.82 55.06
5419 Heronwood Dr. X 45.88 48.00 -0-
5411 Heronwood Dr. XI 45.88 48.00 -0-
[Table continued]
Adjusted FMV Per Sq. Ft.
EA 84-III Properties Tract of Comparable Sales in 1987
____________________ _____ ___________________________
35182001 Tax Ct. Memo LEXIS 80">*280 Tower Hill Ln. I $ 40.98 $ 38.14
12347 Northcliff Manor Dr. II 35.89 31.77
13066 Clarewood Dr. III 32.43 -0-
6351 S. Briar Bayou Dr. IV 34.07 -0-
12231 Carola Forest Dr. V 30.87 35.31
12115 Kings Lake Forest Dr. VI 31.20 35.63
12111 Kings Lake Forest Dr. VII 28.29 32.27
12107 Kings Lake Forest Dr. VIII 28.29 32.27
12103 Kings Lake Forest Dr. IX 29.78 33.95
5419 Heronwood Dr. X 32.31 -0-
5411 Heronwood Dr. XI 33.95 -0-
[Table continued]
Subject Property
EA 84-III Properties Tract FMV Per Sq. Ft.
____________________ _____ ________________
3518 Tower Hill Ln. I 2001 Tax Ct. Memo LEXIS 80">*281 $ 40
12347 Northcliff Manor Dr. II 35
13066 Clarewood Dr. III 35
6351 S. Briar Bayou Dr. IV 30
12231 Carola Forest Dr. V 40
12115 Kings Lake Forest Dr. VI 35
12111 Kings Lake Forest Dr. VII 35
12107 Kings Lake Forest Dr. VIII 35
12103 Kings Lake Forest Dr. IX 35
5419 Heronwood Dr. X 35
5411 Heronwood Dr. XI 35
It is readily apparent that, in every case, Mr. Brown selected a fair market value per square foot that is roughly equivalent to the value of the comparable sales in 1987 and is substantially below the value of the comparable sales in 1982 and 1983. In doing so, we believe that Mr. Brown gave undue weight to the comparable sales in 1987 that took place after the value of the subject properties had "declined sharply".
For the above reasons, in comparing the fair market2001 Tax Ct. Memo LEXIS 80">*282 value of the property and the principal amount of the debt, we will treat the amount set forth in the contemporaneous appraisal of the property made by Mr. Lang as the fair market value of each of the eight properties as of September 1983.
CONDOMINIUMS
Unlike the single-family residences, it appears that there was both a retail market and a wholesale market for condominiums at the time the partnerships purchased the condominium units at issue in these cases. Respondent's principal expert witness, Dr. Richard Hewitt III, wrote an article in 1980, in which he described a "double-tiered market" for condominiums. Hewitt, "Condominium/Developed Lot Discounting Concepts…Again", 46 Real Estate Appraiser and Analyst (Jan. -- Feb. 1980). Dr. Hewitt noted that in valuing condominiums some persons advocated using the gross sellout amount, the sum of the retail sale prices of the condominiums, as the market value, while others advocated using a discounted or wholesale value. See id. According to Dr. Hewitt: "both are correct under certain circumstances". Id. Dr. Hewitt wrote the following:
Numerous questions continue to arise relative to what exactly is
market value for2001 Tax Ct. Memo LEXIS 80">*283 condominium/ developed lots. Certain advocates
promote the idea that gross sellout (summation of retail sales
prices) constitutes market value, whereas others have advocated
the use of discounted value (or wholesale value). Actually, both
are correct under certain circumstances due to what can best be
described as a double-tiered market phenomenon. The two-tier
participants consist of end-product users (final condominium
unit owners or final single family dwelling purchasers) and
"interim" purchasers. It is the basic purchase motivation and
investment goal differentials between these two tiers that
result in dramatically different actual price; hence, value
levels. The general misunderstanding of these differentials also
serves as a major stumbling block to the proper appraisal of,
and underwriting of loans for, such projects. In view of this,
the estimate of market value first requires a clear recognition
of value to whom. [Id.]
Petitioners take the position that the fair market value of the condominium units purchased by each partnership is equal to the sum of2001 Tax Ct. Memo LEXIS 80">*284 the contract prices of the units, as determined by the contemporaneous appraisals. As discussed above, the contemporaneous appraisals valued each condominium unit individually, principally using the comparable sales approach. Thus, using the terminology suggested by respondent and Messrs. Dalton and Ramos, as discussed above, the contemporaneous appraisals valued the condominium units purchased by EA 83-XII and EA 84-III in the retail market. Adding together the contract prices of the individual units to derive the value of the condominium complex is the "gross sellout" approach referred to in the portion of Dr. Hewitt's article quoted above. On that basis, the fair market value of the 39 units in Paseos Castellanos that were purchased by EA 83-XII in December 1982 is $ 3,020,700, or $ 151,075 more than the aggregate principal amount of the promissory notes issued by EA 83-XII to purchase those properties. Similarly, on that basis, the fair market value of the 40 units composing the Reflections condominium complex that were purchased by EA 84-III in September 1983 is $ 3,048,000 or $ 457,800 more than the aggregate principal amount of the promissory notes issued by EA 84-III to purchase2001 Tax Ct. Memo LEXIS 80">*285 those units.
Respondent contends that the condominium units purchased by each partnership should be valued on a discounted or wholesale basis. On that basis, respondent contends, the aggregate fair market value of the 39 units in Paseos Castellanos purchased by EA 83-XII is $ 1,800,000, or $ 1,069,625 less than the aggregate principal amount of the promissory notes issued by EA 83-XII. In support thereof, respondent relies on the appraisal report prepared by Mr. Harold Mogul.
Mr. Mogul's report states that the highest and best use of the 39 condominium units is "the use for which the complex was originally designed and constructed: Residential Condominium Development." The report begins by determining "the total retail sales potential" of the units. Mr. Mogul did this by looking to the prices received for 23 units in the same condominium complex that were sold to buyers other than EPIC. Treating these "retail" sales as comparables, Mr. Mogul determined the retail sales potential of the subject 39 condominium units to be $ 2,962,000.
From the total retail sales potential, Mr. Mogul deducted anticipated expenses over a 30-month absorption period in the aggregate amount of $ 797,971, 2001 Tax Ct. Memo LEXIS 80">*286 and he discounted the annual net income to arrive at a wholesale value of the subject condominium units of $ 1,800,000. Respondent acknowledges on brief that Mr. Mogul doubled real estate taxes and association fees in his computations and that using the correct amounts would increase the present worth of the 39 condominium units under Mr. Mogul's discounted cash-flow analysis to $ 1,856,576.
In passing, we note that a representative of Babcock Co. testified at trial that the contract prices of the subject 39 units in Paseos Castellanos were based upon the prices of actual sales of similar units to members of the public. Mr. Mogul's appraisal tends to support that testimony. The total retail sales potential of the units, as determined by Mr. Mogul, $ 2,962,000, differs from the aggregate contract prices of the units, $ 3,020,700, by $ 58,700 or less than 2 percent.
Respondent contends that on a discounted or wholesale basis the aggregate fair market value of the 40 units of the Reflections condominium complex that were purchased by EA 84-III is $ 2,100,000 or $ 490,200 less than the aggregate principal amount of the promissory notes issued by EA 84-III. In support thereof, respondent2001 Tax Ct. Memo LEXIS 80">*287 relies on the appraisal report prepared by Mr. David B. Dalton, an appraiser employed by the Internal Revenue Service, and by Mr. Mark D. Ramos, an Internal Revenue Service engineer.
Messrs. Dalton and Ramos considered the highest and best use of the 40 condominium units in the long term to be "the possible sale of the units individually or as a whole". They considered the short-term highest and best use of the condominium units to be "as apartment units to exploit a possible cash-flow from the residential rental income of the forty units." In their appraisal, Messrs. Dalton and Ramos used the comparable sales approach to arrive at the "wholesale value" of the units, $ 2,100,000, based upon the sale of one apartment building with 36 units. This is an entirely different method than the discounted retail sales method used by Mr. Mogul.
In applying the sales comparison approach to the subject property, Messrs. Dalton and Ramos reviewed four buildings in the same general area that were sold in 1983. Three of the buildings were substantially larger than the Reflections both in the number of units and in square footage, and the appraisers chose not to use those sales because the size differences2001 Tax Ct. Memo LEXIS 80">*288 "would require a large upward adjustment to bring them comparable to the subject." The fourth comparable, the one on which they based their appraisal, involved the sale of an apartment with 36 units that "was purchased for conversion to condominiums" and as of "December 1994, 12 of the 36 units [had] been converted."
The sale price of the apartment building, $ 1,650,000, divided by the number of apartments, 36, works out to a price per unit of approximately $ 45,800. Respondent's appraisers note that the Reflections has a more desirable setting, with a view of a lake, than the comparable and has approximately three-fourths of an acre more land. Accordingly, the appraisers increased the price per unit to $ 52,500, an increase of $ 6,700 per unit, to account for these differences. Their report, however, does not explain how this adjustment was determined. Respondent's appraisers made no adjustment for the fact that the comparable was approximately 3 years old at the time of the time of the sale, whereas the Reflections had just been built.
In passing, we note that their appraisal of the 40 units of the Reflections condominium complex is accompanied by a memorandum, discussed above, 2001 Tax Ct. Memo LEXIS 80">*289 in which Messrs. Dalton and Ramos point out that this "wholesale value is 30 percent lower than EPIC's projected retail value" of the condominiums, "$ 3,000,000", and they suggest that the two values are within the range of what would be expected. Messrs. Dalton and Ramos also state that EPIC over- leveraged the condominiums "by financing the properties at their retail price", and they note that "EPIC financed the Condo's at $ 3,000,000". Thus, their memorandum implies that the sum of the retail values of the condominium units is $ 3,000,000 or $ 48,000 less than the sum of the contract prices of the condominiums, $ 3,048,000.
It is evident from the above that the threshold question in these cases is whether the condominiums should be valued on a retail basis or on a wholesale basis. If we decide that the condominiums should be valued in the retail market, then it appears that the fair market value of the condominiums exceeds the amount of debt. This is true whether we base the retail values of the properties on the contract prices, as argued by petitioners, or the retail prices implied in the reports of respondent's appraisers. On the other hand, if we decide that the condominiums2001 Tax Ct. Memo LEXIS 80">*290 should be valued in the wholesale market, then it appears that the fair market value of the condominiums is less than the amount of debt. This is true whether we base the wholesale values on the amounts set forth in respondent's appraisals or the prices that each partnership actually paid for the condominiums. As the court noted in
None of the appraisers who testified in these cases considered this issue. Mr. Seph Pomerantz, who prepared the contemporaneous appraisals of the 39 units in Paseos Castellanos, testified that his firm was asked to appraise the units individually and not in bulk. He further testified that he would not have completed his appraisals in the same fashion if he had been asked for a bulk appraisal.
Similarly, Mr. Mogul's letter transmitting his appraisal report to respondent's counsel states that the report was made for the purpose of estimating the fair market value of the 39 condominium units in Paseos Castellanos as of December 30, 1982, "assuming sale2001 Tax Ct. Memo LEXIS 80">*291 of thirty-nine units to a single purchaser." Thus, as he further stated during his testimony, Mr. Mogul appraised the condominium units as property to be held by a single investor, or "entrepreneur".
Finally, Mr. Dalton, who appraised the 40 units of the Reflections, testified at trial that his "assignment [from respondent] was, how much should EPIC have paid for this property." In the memorandum attached to their appraisal, Messrs. Dalton and Ramos make the following statement:
The fair market value of the properties acquired by Epic
Associates 84-III is based on the market place in which they
were acquired, the wholesale market. As such, the fair market
value is the price paid by Epic Associates 84-III to the seller,
without regard to any RDC (rental deficit contribution) or other
supposed Builder Rebate.
They do not explain why the fair market value of the properties acquired by EA 84-III must be determined in "the market place in which they were acquired, the wholesale market" when, as they also recognize, EA 84-III purchased the properties for resale and received special discounts in the purchase price from the sellers.
2001 Tax Ct. Memo LEXIS 80">*292 The report of respondent's principal expert witness, Dr. Richard Hewitt III, does not explicitly discuss the appropriate market for determining the value of the subject properties. Dr. Hewitt's report does suggest that the value of the subject properties must be based upon the bulk purchase price, the wholesale price, rather than the value of each single unit because:
The potential market risk [to each partnership] is actually
related to multiple units and not a single unit as would be
unrealistically reflected by the EPIC/CAG approach of solely
obtaining individual unit appraisals.
In his testimony, Dr. Hewitt elaborated on that concept as follows:
What I was illustrating in the report is that if you look at the
way Epic appraised the properties, they specifically, by the
directive of their captive appraisal group, dictated that the
appraisals be done on an individual basis, despite the reality
that their purchases were done in bulk.
And what I am saying is is [sic] that discount was
represented because of the fact that they, in fact, had a risk
exposure relating2001 Tax Ct. Memo LEXIS 80">*293 to a bulk purchase, so they paid a fair price
for buying 50, 60, 150 or 200.
They may have -- and I am trying to illustrate, which is
really the difficult concept in this whole Epic matter -- is
there is a significant difference between the one-house-at-a-
time appraisal versus the risk, the portfolio risk of having 50,
having 100, having 250.
On the basis of that statement, respondent asks the Court to make the following finding of fact:
Because market risk for EA83-XII and EA84-III related to
multiple units acquired in bulk sales and not single units
acquired in separate transactions and the appraisals obtained by
Epic for the properties were only on an individual basis using
market and cost approaches, the separate appraisals for each
property did not realistically reflect the market risk or value
to EA83-XII and 84-III. [Emphasis supplied.]
We agree with Dr. Hewitt that each partnership made bulk purchases of the properties and received special discounts from the sellers and that each partnership undoubtedly paid a fair price for the properties that it purchased. 2001 Tax Ct. Memo LEXIS 80">*294 We agree with Dr. Hewitt that each partnership purchased the properties for resale. As Dr. Hewitt stated:
Someone buying, in the case of Epic, 40, 100, 200 homes at a
pop, obviously, is not going to live in those homes. The intent
from a typical market purchaser's standpoint, if you were to buy
a hundred homes, would be to resell those.
We further agree with Dr. Hewitt that the contemporaneous appraisals valuing each property individually do not reflect the bulk purchases made by each partnership.
The question that we must decide, however, is whether, for purposes of determining the bona fides of the subject indebtedness, the fair market value of the properties must be determined in the wholesale market, the market in which the partnerships purchased the properties, or the retail market, the market in which the partnerships planned to resell the properties. The thrust of respondent's position is that the fair market value of the properties, as stated by Messrs. Dalton and Ramos: "is based on the marketplace in which they were acquired, the wholesale market." Neither respondent nor respondent's witnesses provide a reason why this must be the case.
2001 Tax Ct. Memo LEXIS 80">*295 During his testimony, Dr. Hewitt touched on the appropriate market for valuing property and, contrary to respondent's position, his testimony suggests that the subject properties should be valued in the retail market. On cross-examination, Dr. Hewitt answered a number of questions from petitioners' representative about the value of a bag of peanuts as purchased by an individual, on the one hand, or the value of the same bag of peanuts as purchased by a bulk purchaser, such as an airline, on the other hand. On redirect, the following exchange took place between Dr. Hewitt and respondent's attorney:
Q. Mr. Hewitt, you and Mr. Griffith talked about buying
peanuts, where he could go buy one bag of peanuts and Delta
could go buy another bag of peanuts. Let's do this example:
You could go to the grocery store where a bottle of Coca-cola
sells for 50 cents a bottle, and you can buy a six-pack for
$ 2.
You bought a six-pack. Do you value your acquisition at $ 2
or $ 3?
A. Of course not. You would value it based on what you paid
for it, because it takes2001 Tax Ct. Memo LEXIS 80">*296 into account the discount. The only
way you could achieve the higher number would be to go into
the soda-dispensing business and sell out individual Cokes to
individual users of one Coke after another.
Dr. Hewitt's response suggests that the purchaser must value the property on the basis of the amount paid, unless the purchaser is a person who is in the business of reselling the property, like each of the subject partnerships, and receives a discount from the seller. In such a case, the purchaser is entitled to value the property at the resale value; i.e., $ 3 in the hypothetical example posited by respondent's counsel, or $ 1 more than the buyer paid for the property.
Dr. Hewitt's testimony on this point is consistent with the cases, discussed above, involving the determination of the appropriate market to use in estimating the value of an item of property. See, e.g.,
It is evident that the subject condominium units were ready for immediate sale to individual purchasers and that individual purchasers were among the "customary purchasers" of condominiums. It is also evident that neither partnership was the ultimate consumer of the condominiums. The partnerships purchased the condominiums in bulk purchases and received substantial discounts from the sellers, the developers of the properties. The partnerships purchased the condominiums for the purpose of reselling them to owner occupants after leasing them for a period of time. See
Furthermore, in the instant cases, retail valuation of the condominium units appears to have been approved by the marketplace. As discussed in the findings of fact, the specific loans at issue were initially made by EMI, which originated2001 Tax Ct. Memo LEXIS 80">*298 the loans and continued to service them; but the loans were insured by private mortgage insurance companies and were sold to unrelated lenders in the secondary mortgage market. Tricor and RMIC are the private mortgage insurance companies that issued mortgage insurance covering the loans at issue in the instant cases.
The information submitted as part of Dr. Hewitt's report confirms, as one would suspect, that the private mortgage insurers thoroughly investigated EPIC's business and were particularly careful to investigate the risks relating to the values of the properties that EPIC syndicated. That information also shows that the private mortgage insurers had occasion to review appraisals submitted by EPIC in connection with its application for mortgage insurance and, in some cases, the private mortgage insurers ordered spot appraisals to compare with EPIC's appraisals. It would be readily evident from reviewing the contemporaneous appraisals that EPIC had valued each of the condominiums and other residential properties purchased by its limited partnerships on an individual or retail basis and not on a discounted or wholesale basis. Therefore, the record suggests that the private2001 Tax Ct. Memo LEXIS 80">*299 mortgage insurers knew or had reason to know that EPIC valued the properties that it purchased on a retail, rather than on a wholesale, basis. We do not mean to suggest that the private mortgage insurers gave advance approval to the specific loans at issue in these cases or to any other loans but only that the private mortgage insurers knew that EPIC valued the properties on a retail basis.
Respondent argues that we should disregard the actions of the private mortgage insurers and secondary lenders on the ground that there is no evidence that the mortgage insurers and secondary lenders performed due diligence. Respondent argues that they "ignored or did not understand the realities of the EPIC transactions." We disagree. While the record does not show what due diligence was conducted by or on behalf of the secondary lenders, Dr. Hewitt's testimony and the material submitted with Dr. Hewitt's report confirm that the private mortgage insurers conducted due diligence with respect to the EPIC loans, including risk assessments, spot appraisals, and other forms of due diligence and, in fact, two companies, MGIC and CMAC, ceased insuring EPIC loans after spot appraisals disclosed values2001 Tax Ct. Memo LEXIS 80">*300 that were lower than the values shown on the EPIC's appraisals.
RETAIL VALUATION OF THE SUBJECT PROPERTIES
Respondent's appraisers valued the 26 single-family houses and the condominium unit at 4107 Medical Drive in the retail market. As discussed above, in the case of 19 of these properties the difference between respondent's value and the contract price of the property is not material. As to those properties, we have used respondent's values in comparing the aggregate fair market value of the properties to the aggregate principal amount of the debt. As to 8 of these 27 properties, as discussed above, we do not agree with respondent's appraisals and, for purpose of making the value comparison required in these cases, we accept the values established by the contemporaneous appraisals.
As to the 39 units of Paseos Castellanos purchased by EA 83-XII and the 40 units of the Reflections purchased by EA 84-III, respondent's appraisers used the wholesale market, rather than the retail market, to value the units. However, the aggregate retail value of the 39 units of Paseos Castellanos is implied in Mr. Mogul's appraisal report when he finds that the total retail sales potential of the2001 Tax Ct. Memo LEXIS 80">*301 units is $ 2,962,000. Similarly, the aggregate retail value of the 40 units of the Reflections is implied by Messrs. Dalton and Ramos in the memorandum that accompanied their appraisal report when they referred to $ 3,000,000 as the "retail price" of the units. In comparing the aggregate fair market value of the properties to the aggregate principal amount of the debt, we shall use the retail values of the condominiums implied in the reports of respondent's appraisers.
The following schedules show the aggregate retail value of the properties purchased by each partnership as compared to the aggregate debt:
EA 83-XII Properties Loan Value Loan / Value
____________________ ____ _____ ____________
1612 Hemphill Ave. $ 54,525 $ 57,400 94.99
1921 W. 17th St. 51,300 54,000 95.00
1728 Coronado Ave. 51,300 54,000 95.00
1700 Linda Ave. 54,050 56,900 94.99
1716 Coronado Ave. 54,050 56,900 94.99
1916 Hollywood Dr. 2001 Tax Ct. Memo LEXIS 80">*302 53,200 56,000 95.00
1720 Coronado Ave. 56,425 59,400 94.99
2109 Avignon Dr. 84,525 84,000 100.63
2111 Avignon Dr. 85,025 85,000 100.03
2113 Avignon Dr. 95,475 91,000 104.92
2115 Avignon Dr. 95,475 100,500 95.00
2117 Avignon Dr. 101,175 106,500 95.00
Paseos Castellanos 2,869,625 2,962,000 96.88
_________ _________ ______
Total 3,706,150 3,823,600 96.93
EA 84-XII Properties Loan Value Loan / Value
____________________ ____ _____ ____________
5419 Heronwood Dr. $ 51,300 $ 58,000 88.45
5411 Heronwood Dr. 61,750 65,000 95.00
3518 Tower Hill Lane 60,550 63,750 94.98
12347 Northcliff Manor Dr. 55,575 2001 Tax Ct. Memo LEXIS 80">*303 58,500 95.00
13066 Clarewood Dr. 54,150 57,000 95.00
6351 S. Briar Bayou Dr. 58,425 61,500 95.00
12103 Kings Lake Forest Dr. 57,475 60,500 95.00
12107 Kings Lake Forest Dr. 47,975 50,500 95.00
12111 Kings Lake Forest Dr. 53,200 56,000 95.00
12115 Kings Lake Forest Dr. 60,800 64,000 95.00
12231 Carola Forest Dr. 56,050 54,000 103.80
4850 West Ferret Dr. 67,450 71,200 94.73
4107 Medical Dr. 56,950 56,400 100.98
13739 Earlywood Dr. 60,800 57,600 105.56
6402 Ridgecreek Dr. 60,800 55,950 108.67
The Reflections 2,590,200 3,000,000 86.34
_________ __________ _______
Total 3,453,450 3,889,900 88.78
As shown above, on a retail basis, the aggregate fair market value of the subject properties exceeds2001 Tax Ct. Memo LEXIS 80">*304 the aggregate amount of the debt. Accordingly, on the basis of the record of these cases, we find that the debt incurred by each partnership in purchasing the subject properties is bona fide indebtedness.
POINTS AMORTIZATION
Both partnerships paid loan origination fees to EMI equal to 4 percent of the principal amounts of the first mortgage loans. This amounted to $ 148,246 in the case of EA 83-XII and $ 138,138 in the case of EA 84-III. These fees were nonrefundable and were similar in amount to origination fees charged by other lenders. As discussed above, they were paid in connection with bona fide indebtedness. Accordingly, we agree with petitioners that these fees are deductible ratably over the life of the first mortgage loans. See
PROFIT MOTIVE
Respondent determined in the subject notices of FPAA that the activity conducted by each partnership, EA 83-XII and EA 84-III, during each of the years in issue, was an "activity not engaged in for profit" within the meaning of
Petitioners do not contend that the partnerships are entitled to deductions under section 212. Accordingly, we must redetermine whether EA 83-XII and EA 84-III are entitled to deductions under
Generally, in the case of an activity to which
The depreciation deductions claimed by each partnership under
On the other hand, the interest deductions claimed by each partnership under
2001 Tax Ct. Memo LEXIS 80">*308 In the case of a limited partnership, the profit motive determination under
The determination whether an activity is engaged in for profit is to be made by reference to objective standards, taking into account all of the facts and circumstances of each case. See
As a preliminary matter, we note that none of the parties to these cases contends that either partnership conducted more than one activity. 2001 Tax Ct. Memo LEXIS 80">*309 See generally
The regulations list the following nine factors that should be taken into account in determining whether an activity was engaged in for profit: (1) The manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectations that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) any elements of personal pleasure or recreation. See
The properties purchased by EA 83-XII and EA 84-III were highly leveraged and produced operating losses. The2001 Tax Ct. Memo LEXIS 80">*310 offering memorandum issued by each partnership disclosed the fact that the partnership would incur such operating losses and that the properties had to appreciate in value in order for an investor to realize a profit. The offering memorandum issued for EA 83-XII projected a break-even appreciation rate of 7.99 percent, and the offering memorandum for EA 84-III projected a break-even appreciation rate of 9.15 percent. The appreciation rates required for a profit were high, but there is nothing in the record of these cases to show that, as of the initiation of either partnership, such appreciation rates could not be achieved. For example, respondent's appraiser, Mr. Charles D. Brown, testified that in Houston, Texas, property values increased during 1981, 1982, and 1983, even though interest rates were increasing. He testified that if interest rates had dropped, then the real estate market in Houston "would have gone even more ballistic."
Moreover, in an internal memorandum, prepared in late 1983 or early 1984, a member of EPIC's management noted that "since 1964, mortgage rates have averaged 2.75% above the inflation rate" and "appreciation rates have also averaged 2.09% above the2001 Tax Ct. Memo LEXIS 80">*311 inflation rate." On the basis of these relationships, the memorandum concludes that EPIC's "partnerships could be expected to generate positive economic benefits". The memorandum also notes that there have been periods, notably 1980, 1981, and 1982, when home price appreciation performed below average, relative to inflation and interest rates.
Respondent takes the position that neither EPIC nor any of its limited partnerships, including EA 83-XII and EA 84-III, ever intended to realize a profit. Respondent's position is that EPIC formed EA 83-XII and EA 84-III and other limited partnerships in order to "satisfy its ravenous appetite for funds necessary to support its real estate empire." According to respondent, the centerpiece of EPIC's "scheme" involved overmortgaging the properties purchased by each partnership "by obtaining inflated, defective appraisals to support nominal purchase prices that permitted EPIC to generate substantial builder fees, rental deficit contributions, and rental advances". Respondent also contends that EPIC's projected break-even appreciation rates of 7.99 percent and 9.15 percent "were approximately twice as high as the actual appreciation rates from 19802001 Tax Ct. Memo LEXIS 80">*312 to 1985" and that EPIC failed to disclose its inability to sell the properties of older partnerships, the adverse market conditions in the housing industry, the re-syndications of properties from "matured" partnerships into new properties, the use of defective appraisals to arrive at inflated values, the purchase of properties for partnerships from EPIC subsidiaries, the nature and use of the "sweep" account, and the payment and appraisal fee for property not purchased by EA 83-XII. We disagree.
Under respondent's view of the facts, EPIC was interested only in obtaining lump-sum payments from new property acquisitions and the fees attributable to those new properties. Respondent ignores the fact that EPIC's business of syndicating real estate partnerships depended upon the perceived success of the limited partnerships that it syndicated. As a result, EPIC advanced a high percentage of the lump-sum payments and fees that it realized from the acquisition of new properties to satisfy the obligations of older partnerships, and thus to make sure that none of the partnerships defaulted on its obligations. In choosing to make those advances and prevent any default, the management of EPIC2001 Tax Ct. Memo LEXIS 80">*313 continued to believe that it could carry the properties until interest rates decreased and the real estate market turned around. Respondent also ignores the fact that EPIC was entitled to 25 percent of the net profits from the sale of properties, so-called back-end appreciation. Mr. Clayton McQuistion, an important member of EPIC's management, referred to this as "a gigantic profit opportunity".
Based upon the record of these cases, we find that EPIC, acting as the general partner of both EA 83-XII and EA 84-III, engaged in the activities of both partnerships with an actual and honest objective of making a profit.
EPIC's ADVANCES TO EA 83-XII AND EA 84-III
As mentioned above, respondent determined in the subject notices of FPAA that the deductions for interest claimed by each partnership with respect to the unsecured advances made by EPIC were not allowed on the ground that any such interest expenses were not paid or accrued on bona fide indebtedness. Respondent cites
Petitioners argue that the advances in this case constitute bona fide indebtedness rather than equity. In support of that argument, petitioners review each of the 13 factors that were taken into account by the court in
(1) the names given to the certificates evidencing the
indebtedness; (2) the presence or absence of a fixed maturity
date; (3) the source of payments; (4) the right to enforce
payment of principal and interest; (5) participation in
2001 Tax Ct. Memo LEXIS 80">*315 management flowing as a result; (6) the status of the
contribution in relation to regular corporate creditors; (7) the
intent of the parties; (8) "thin" or adequate capitalization;
(9) identity of interest between creditor and stockholder; (10)
source of interest payments; (11) the ability of the corporation
to obtain loans from outside lending institutions; (12) the
extent to which the advance was used to acquire capital assets;
and (13) the failure of the debtor to repay on the due date or
to seek a postponement.
See also
Some of the above factors support respondent's position that the advances are equity. For example, there was no fixed maturity date for repayment of the advances, and the only realistic source of repayment was from gains from the sale of partnership properties. Furthermore, it is unlikely that either partnership could have obtained credit on the same basis from outside sources.
Other factors support petitioners' position that the advances2001 Tax Ct. Memo LEXIS 80">*316 are debt. For example, the partnership agreement governing each partnership treats the unsecured advances as indebtedness, establishes an interest rate, and gives EPIC the right to collect payment of the advances from the partnership. Furthermore, the advances were disproportionate to EPIC's interest in the partnership.
Certain other factors do not clearly indicate that the advances were either debt or equity. For example, EPIC did not receive increased management control over either partnership by reason of the advances, but, as general partner, EPIC already exercised full management control of both partnerships. Similarly, it appears that the advances were used for all partnership needs.
We believe that the weight of the evidence tips in favor of finding that the subject unsecured advances are equity when we consider the intent of the parties. In our view, EPIC's management placed these funds at the risk of the business and had no reasonable expectation of repayment without regard to the success of all of the partnerships. As discussed above, EPIC's management anticipated that EA 83-XII and EA 84-III would have surplus cash during their early lives but that each partnership eventually2001 Tax Ct. Memo LEXIS 80">*317 would incur operating deficits and would need to receive advances from EPIC in order to avoid defaults.
Other than the sale of a partnership's properties, a partnership had only four sources of cash to fund these operating deficits: Capital contributions by the limited partners, partnership income consisting primarily of rental income, builder rebates, and general partner advances. EPIC's management realized that its ability to remain in business would be hurt if any of its limited partnerships defaulted on an obligation. EPIC's management recognized that EPIC had to advance funds to its partnerships. EPIC's management also recognized that the advances would not realistically be repaid until and unless the properties were sold at a profit. An internal memorandum prepared sometime after September 1983 states as follows:
To the extent anticipated operating deficits are greater than
depreciation (5.3% of purchase price), one half of this deficit
must be funded by sources other than limited partner
contributions. To the extent we initially over-estimate
partnership income in the offerings, all of the increased
operating deficit will2001 Tax Ct. Memo LEXIS 80">*318 come from the general partner.
On the basis of the testimony at trial and the above, we find that EPIC's advances to both partnerships were in the nature of equity rather than indebtedness. Accordingly, any "interest" attributable to such advances claimed as a deduction by either partnership for any of the years in issue is not allowable under
SIXTEEN PROMISSORY NOTES EACH IN THE PRINCIPAL AMOUNT OF $ 5,000
As mentioned above, EA 84-III issued 16 promissory notes payable to CSL each in the principal amount of $ 5,000 and dated February 1, 1985. Each promissory note was secured by a deed of trust also dated February 1, 1985, in favor of CSL. Eleven of the deeds of trust purport to have been filed on September 6, 1985, with the County Clerk of Harris County, Texas. Five of the deeds of trust do not appear to have been filed.
In the bankruptcy filing that was made on behalf of EA 84- III, CSL is listed as a secured creditor with respect to 16 promissory notes in the aggregate amount of $ 80,000. The filing also states that accrued interest in the amount of $ 4,000 is payable to CSL as a secured creditor.
At trial, respondent introduced appraisals of the subject 162001 Tax Ct. Memo LEXIS 80">*319 properties as of February 1, 1985, and respondent argues on brief that the appraisals demonstrate that the value of the underlying properties declined or did not appreciate enough to support the new debt. Set out below is a list of the 16 properties that shows the sum of the original purchase money indebtedness, plus $ 5,000, the value of each such property on February 1, 1985, as determined by respondent's appraisers, and the difference between those amounts:
EA 84-111 Properties Loan + $ 5,000 Value 2/1/85 Difference
____________________ _____________ ____________ __________
5419 Heronwood Dr. $ 56,300 $ 55,000 -$ 1,300
5411 Heronwood Dr. 66,750 62,000 -4,750
3518 Tower Hill Lane 65,550 50,000 -15,550
12347 Northcliff Manor Dr. 60,575 42,000 -18,575
13066 Clarewood Dr. 59,150 46,000 -13,150
6351 S. Briar Bayou Dr. 63,425 45,000 -18,425
12103 Kings Lake Forest Dr. 62,475 44,000 -18,475
121072001 Tax Ct. Memo LEXIS 80">*320 Kings Lake Forest Dr. 52,975 36,000 -16,975
12111 Kings Lake Forest Dr. 58,200 38,000 -20,200
12115 Kings Lake Forest Dr. 65,800 48,000 -17,800
12231 Carola Forest Dr. 61,050 50,000 -11,050
4850 West Ferret Dr. 72,450 74,287 1,837
4107 Medical Dr. 61,950 58,846 -3,104
13739 Earlywood Dr. 65,800 60,098 -5,702
6402 Ridgecreek Dr. 65,800 58,324 -7,476
The Reflections, unit 101 69,755 54,790 -14,965
_________ _______ ________
Total 1,008,005 822,345 -185,660
In the case of the property at 4850 West Ferret Drive, it appears, according to respondent's evidence, that the value of the property as of February 1, 1985, $ 74,287, exceeds the amount of the indebtedness, $ 72,450. Accordingly, it appears that respondent's evidence shows that the2001 Tax Ct. Memo LEXIS 80">*321 second trust note secured by that property was valid indebtedness. Furthermore, in the case of the properties at 5419 Heronwood Drive, 5411 Heronwood Drive, 4107 Medical Drive, and 13739 Earlywood Drive, the difference reflected in respondent's appraisals is not material.
Petitioners presented no evidence to substantiate the fair market value of any of the subject properties as of February 1, 1985. Petitioners argue that the 16 promissory notes are, in fact, "unsecured debt" and are bona fide indebtedness without regard to the value of the property. Initially, petitioners argued that "the promissory notes were not recorded until after the bankruptcy filing", and thus the notes had "no substance in the eyes of the bankruptcy court." On the basis of that premise, petitioners argued: "respondent should not be allowed to rely upon defective documents to assert that those notes represented secured debt". Petitioners further argued that the notes should be treated as unsecured debt "indistinguishable from the unsecured advances which they replaced."
In their reply brief, petitioners withdrew the factual assertion that the 16 promissory notes replaced unsecured advances made by EPIC. They2001 Tax Ct. Memo LEXIS 80">*322 continue to take the position that the validity of the notes should be determined without regard to the value of the 16 properties in 1985 for either of two reasons. First, petitioners argue that the notes were related to "an $ 80,000 line of credit from Community" that is described in respondent's brief as "a nonrecourse line of credit with Community [CSL] totalling $ 80,000 secured by notes of limited partners", and thus petitioners contend that the 16 promissory notes were "adequately secured" without regard to the value of the real estate. Second, they argue that "the real estate was never legal security for the promissory notes; therefore, the value of the real estate in 1985 is irrelevant." We disagree.
Each of the 16 promissory notes states that it "is the Note described in and secured by a Deed of Trust dated February 1, 1985, on property located in HARRIS COUNTY, State of TEXAS", and each note sets forth the address of the property. Each related deed of trust provides a legal description and an address of the property securing the note. Those documents are complete in and of themselves and make no reference to "an $ 80,000 line of credit from Community". In form, each of2001 Tax Ct. Memo LEXIS 80">*323 the 16 promissory notes purports to be secured by one of the 16 properties. Furthermore, petitioners do not take issue with the premise of respondent's argument that each of the 16 promissory notes that was issued by EPIC, the general partner of each partnership, to CSL, an affiliated savings and loan associate, is a nonrecourse obligation. Accordingly, we agree with respondent that none of the promissory notes can be treated as bona fide indebtedness unless petitioners prove that the amount of the debt does not unreasonably exceed the value of the property securing it. See, e.g.,
As mentioned above, petitioners introduced no evidence of the value of any of the properties as of February 1, 1985. There is no evidence to show that the fair market values of the properties on February 1, 1985, exceed the aggregate indebtedness secured by the property at that time, except in the case of the property at 4850 West Ferret Drive, as to which respondent's evidence shows that the fair market value exceeds the amount of the debt, and except in the2001 Tax Ct. Memo LEXIS 80">*324 case of the properties at 5419 Heronwood Drive, 5411 Heronwood Drive, 4107 Medical Drive, and 13739 Earlywood Drive, as to which the discrepancies between the fair market value of the property and the amount of the debt are negligible. Accordingly, we hereby sustain respondent's adjustment disallowing any interest deduction claimed by EA 84-III on its 1985 return attributable to the remaining 11 promissory notes payable to CSL issued by EA 84-III on February 1, 1985.
To reflect the foregoing,
Decisions will be entered under Rule 155.
APPENDIX A
EPIC Associates 83-XII
Schedule D -- Pro Forma
Cash-Flow and Taxable Income (Loss) Analysis
Through June 30, 1987
Application of Funds 1983 1984 1985
____________________ ____ ____ ____
ANNUAL CASH-FLOW
Rental Income 2001 Tax Ct. Memo LEXIS 80">*325 17,533.96 6,660.78
Less: First mortgage
payments 2001 Tax Ct. Memo LEXIS 80">*326 mortgage interest -0- -0- -0-
Net taxable income -361,174.98 -521,632.60 -533,531.21
[Table continued]
Application of Funds 1986 1987 Total
____________________ ____ ____ _____
ANNUAL CASH-FLOW
Rental Income
Interest income $ 356,488.68 $ 186,475.74 $ 1,430,974.63
Interest income -0- -0- 42,072.68
Less: First mortgage
payments
Additional interest
payments
Taxes 59,926.95 30,981.10 233,140.45
Insurance 26,337.55 13,652.53 102,089.36
Audit fees 4,876.62 2,438.31 20,522.44
Maintenance and repairs
Property administration fee 30,600.002001 Tax Ct. Memo LEXIS 80">*327 15,300.00 128,775.00
Net cash-flow from operations -339,813.95 -168,492.94 -1,410,631.04
TAXABLE INCOME (LOSS) ANALYSIS
Net cash-flow from operations -339,813.95 -168,492.94 -1,410,631.04
Plus: Mortgage amortization -0- -0- -0-
Other income recognized
Less: Depreciation 173,118.72 86,559.36 728,541.28
Amortization of mortgage
loan fee 16,671.30 8,335.65 70,158.38
Accrued mortgage interest -0- -0- -0-
Net taxable income -529,603.97 -263,387.95 -2,209,330.71
2001 Tax Ct. Memo LEXIS 80">*328 * * * * *
APPENDIX B
EPIC ASSOCIATES 84-III
Schedule D -- Pro Forma
Cash-Flow and Taxable Income (Loss) Analysis
October 1, 1983 Through December 31, 1987
Application of Funds 1983 1984 1985
____________________ ____ ____ ____
Annual cash-flow
Gross rental income from
individuals $ 83,640 $ 294,341 $ 315,619
Less: Rental commissions 5,305 27,885 25,250
Vacancy -0- 69,169 37,874
Net rental income from
individuals 2001 Tax Ct. Memo LEXIS 80">*329 mortgage payments 2001 Tax Ct. Memo LEXIS 80">*330 -149,524 -660,846 -610,809
[Table continued]
Application of Funds 1986 1987 Total
____________________ ____ ____ _____
Annual cash-flow
Gross rental income from
individuals $ 338,435 $ 362,901 $ 1,394,936
Less: Rental commissions 27,075 29,032 114,547
Vacancy 40,612 43,548 191,203
Net rental income from
individuals
Interest income on partnership
funds
Lent to EPIC -0- -0- 12,824
Less: First mortgage payments
Interest expenses on funds lent by
EPIC to the partnership
Taxes 85,004 91,149 349,266
Insurance 9,972 2001 Tax Ct. Memo LEXIS 80">*331 10,693 44,289
Home owner association dues 4,674 5,012 16,446
Audit fees 4,946 4,946 21,074
Maintenance and repairs
Miscellaneous -0- -0- 5,444
Property administration fee 33,000 33,000 140,250
Net cash-flow from operations -445,421 -462,262 -1,913,611
Taxable income (loss) analysis
Net cash-flow from operations -445,421 462,262 -1,913,611
Less: Depreciation 170,742 170,742 725,653
Amortization of mortgage loan fee 13,814 13,814 58,709
Net taxable income -629,976 -646,818 -2,697,972
2001 Tax Ct. Memo LEXIS 80">*332
1. It is assumed that the Raldon Corp. leases will terminate
June 30, 1984. It is assumed that after builder lease terminations,
all properties will be rented out to individuals at 8-percent market
value. In order to project the market of value the properties at the
time they are rented out, it is assumed they will appreciate 9
percent per year. For all rentals to individuals, projected income is
reduced by 20 percent to allow for vacancies and rental commissions.↩
2. Loan payments are not expected to increase within the period
of these projections.↩
3. Fifteen percent per year on net advances to the partnership.
The amount decreases at the beginning of each quarter by the amount
of the quarterly investment minus the Organization Fee. It increases
during the year by the amount of the negative cash-flow. To the
extent EPIC owes the partnership money, interest will be paid at 12
percent per year.↩
4. While the houses are leased to the builder, the builder is
responsible for all maintenance and repairs. Thereafter, it is
assumed that these payments will amount of 0.5 percent per year of
the original purchase price.↩
5. Not applicable to this partnership.↩
1. The year 1983 and the first three quarters of 1984 contain
actual operating history; thereafter, it is assumed that the rent
will increase 7 percent per year. During the period that the
properties are assumed to be rented to individual tenants, projected
income is reduced by 8 percent to allow for rental commissions and 12
percent yearly to allow for vacancies.↩
2. Loan payments are not expected to increase during this
period.↩
3. Fifteen percent per year on net advances by EPIC to the
partnership. The amount decreases at the beginning of each quarter by
the amount of the quarterly investment minus the Organization Fee. It
increases during the year by the amount of the negative cash-flow. To
the extent EPIC owes the Partnership money, interest will be paid at
12 percent per year.↩
4. It is assumed that these expenses will amount to 0.5 percent
per year of current property value.↩
1. This amount is $ 255 more than the actual purchase price,
$ 3,901,295.↩
1. EPIC's projection, as contained in the record is difficult
to read and this amount may differ from the projection.↩
1. The record does not contain 4 of the 15 settlement
statements and some amounts composing this total were estimated.↩
1. Four months of interest.↩
1. At trial, respondent's appraiser conceded that this value
should equal the contract price of the property, $ 56,900.↩
2. This is the aggregate amount for all 39 condominium units.↩
1. This is the aggregate amount for all 40 condominium units in
the Reflections.↩
1. Includes the condominium at 4107 Medical Drive in San
Antonia, Texas.↩
1. It is assumed that the Raldon Corp. leases will terminate
June 30, 1984. It is assumed that after builder lease terminations,
all properties will be rented out to individuals at 8-percent market
value. In order to project the market of value the properties at the
time they are rented out, it is assumed they will appreciate 9
percent per year. For all rentals to individuals, projected income is
reduced by 20 percent to allow for vacancies and rental commissions.↩
2. Loan payments are not expected to increase within the period
of these projections.↩
3. Fifteen percent per year on net advances to the partnership.
The amount decreases at the beginning of each quarter by the amount
of the quarterly investment minus the Organization Fee. It increases
during the year by the amount of the negative cash-flow. To the
extent EPIC owes the partnership money, interest will be paid at 12
percent per year.↩
4. While the houses are leased to the builder, the builder is
responsible for all maintenance and repairs. Thereafter, it is
assumed that these payments will amount of 0.5 percent per year of
the original purchase price.↩
5. Not applicable to this partnership.↩
1. The year 1983 and the first three quarters of 1984 contain
actual operating history; thereafter, it is assumed that the rent
will increase 7 percent per year. During the period that the
properties are assumed to be rented to individual tenants, projected
income is reduced by 8 percent to allow for rental commissions and 12
percent yearly to allow for vacancies.↩
2. Loan payments are not expected to increase during this
period.↩
3. Fifteen percent per year on net advances by EPIC to the
partnership. The amount decreases at the beginning of each quarter by
the amount of the quarterly investment minus the Organization Fee. It
increases during the year by the amount of the negative cash-flow. To
the extent EPIC owes the Partnership money, interest will be paid at
12 percent per year.↩
4. It is assumed that these expenses will amount to 0.5 percent
per year of current property value.↩
Knetsch v. United States ( 1960 )
Hambuechen v. Commissioner ( 1964 )
Estate of Franklin v. Commissioner ( 1975 )
Kingbay v. Commissioner ( 1966 )
Narver v. Commissioner ( 1980 )
Anselmo v. Commissioner ( 1983 )
United States v. Curtis L. Parker and Martha Parker ( 1967 )
Albany Car Wheel Company, Inc. v. Commissioner of Internal ... ( 1964 )
Douglas Goldman and Evelyn K. Goldman v. Commissioner of ... ( 1967 )
Donald Feldman and Patricia Feldman, A/K/A Patsy Jane ... ( 1994 )
United States v. Cartwright ( 1973 )
Albany Car Wheel Co. v. Commissioner ( 1963 )
Skripak v. Commissioner ( 1985 )
Herrick v. Commissioner ( 1985 )
William B. Akers and Jo Ann Akers v. Commissioner of ... ( 1986 )
Stinnett's Pontiac Service, Inc., Richard W. Stinnett and ... ( 1984 )
Estate of Travis Mixon, Jr. v. United States ( 1972 )
Crc Corporation v. Commissioner of Internal Revenue. Crc ... ( 1982 )
Mayerson v. Commissioner ( 1966 )