Beck v. Comm'r of Internal Revenue

• Decision Date: 29 September 1980
• Docket Number: Docket No. 6670-78.
• Citation: 74 T.C. 1534
• Parties: JOHN C. BECK and KATHLEEN BECK, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

74 T.C. 1534

JOHN C. BECK and KATHLEEN BECK, PETITIONERS

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 6670-78.

United States Tax Court

Filed September 29, 1980.

Petitioners acquired interests in two limited partnerships. The partnerships in turn acquired legal title to certain undeveloped real estate at prices very substantially in excess of the acquisition cost to the seller less than 1 week earlier. By nonrecourse obligations to an intermediate entity, the partnerships obtained funds originating with the seller with which to pay “points” on nonrecourse purchase-money obligations. Held, the respective arrangements between the seller, the intermediate “lender,” and the partnerships did not give rise to bona fide indebtedness sufficient to support interest deductions. Held, further, such arrangement did not result in interest being “paid” within the intendment of sec. 163(a), I.R.C. 1954. Alan R. Herson and Samuel A. Karlin, for the petitioners.

David P. Fuller, for the respondent.

NIMS, Judge:

Respondent determined a deficiency in petitioners' income taxes for the year 1974 of $29,067. The substantive issue remaining for our decision is whether deductions for loan points and prepaid interest claimed in 1974 by two limited partnerships, Moreno Co. Two and Riverside Two, are allowable under section 163(a). ¹ Should we find against respondent on this issue, we must decide:

(1) Whether deductions claimed by Moreno Co. Two and Riverside Two in 1974 for prepaid interest and loan points caused a material distortion of income and whether, pursuant to section 446(b), the claimed deductions should be allocated over the period for which the interest and points were prepaid.

(2) Whether losses claimed by the petitioners on their 1974 tax return with respect to Moreno Co. Two and Riverside Two should be reduced pursuant to the limitation on investment interest deductions set forth in section 163(d).

(3) Whether the petitioners' adjusted basis in Moreno Co. Two is limited, by operation of section 752(c), to $35,910.

FINDINGS OF FACT

Some of the facts have been stipulated by the parties and are found accordingly. The stipulation of facts and exhibits attached thereto are incorporated by this reference.

The petitioners resided in California at the time their petition was filed.

During the year 1974, petitioners were limited partners in each of two partnerships, Moreno Co. Two (Moreno 2) and Riverside Two (Riverside 2). Moreno 2 and Riverside 2 were 2 of 14 limited partnerships which each purchased a portion of a 350-acre tract of land from Go Publishing Co. (Go Publ.) in December 1974. The overall transaction was promoted by Joseph R. Laird, Jr. (Laird), who also served as president of CAL-AM Corp. (CAL-AM), which was the general partner of these partnerships. The property was acquired on a leveraged basis with each partnership paying substantial loan points and prepaid interest. In 1975, the two limited partnerships sold the property to Bio-Science Resources, Inc. (Bio-Sci). The prepaid interest and interest points were disallowed by the Commissioner.

The Entities

Moreno 2 and Riverside 2 are California limited partnerships that were formed in 1974. The sole general partner of Moreno 2 and Riverside 2 was CAL-AM. Laird has at all times relevant hereto been the president and principal operating officer of CAL-AM. During 1974 and until June of 1978, Kenneth J. Fisher (Fisher) was the secretary of CAL-AM. During the taxable year 1974, the principal place of business of both partnerships as well as CAL-AM was 16055 Ventura Boulevard, Suite 625, Encino, Calif.

On December 26, 1974, petitioners became limited partners in Moreno 2 by subscribing for 10 units of the partnership at $1,026 per unit for a total cost of $10,260. Total contributions to capital to Moreno 2 were $108,000, of which $102,600 (95 percent) was contributed by the limited partners, and $5,400 (5 percent) was contributed by CAL-AM. Accordingly, the petitioners held a 9.5-percent interest in Moreno 2.

On December 31, 1974, petitioners became limited partners in Riverside 2 by subscribing for 100 units of the partnership at $128.25 per unit for a total cost of $12,825. Contributions to capital totaled $13,500, of which 95 percent was contributed by the petitioners as sole limited partners, and $675 (5 percent) was contributed by CAL-AM. Accordingly, the petitioners held a 95-percent interest in Riverside 2.

Laird, who was the promoter of these limited partnership transactions, is an attorney, and he controlled either directly or indirectly many of the entities that are involved in this case. He owned 80 percent of CAL-AM. CAL-AM's board of directors consisted of Laird and Kenneth Yates.

Bio-Sci is an affiliate of CAL-AM. Laird is its president, and Fisher was its secretary during 1975 and until June of 1978. At all times relevant, Laird controlled the activities and functions of Bio-Sci.

The partnerships borrowed the money with which to pay the loan points from J.E.C. Mortgage Corp. (J.E.C.), which is a California corporation with its principal place of business in Los Angeles, Calif. Laird controlled the activities and functions of J.E.C.

Ultimately, by 1978, the subject properties, as well as properties purchased in 1974 by other limited partnerships promoted by Laird, were all acquired by North Coast Financial, Inc. (North Coast Financial), an Oregon corporation affiliated with CAL-AM. North Coast Financial was controlled by Laird.

Transactions

During the latter half of December 1974, CAL-AM, as promoter and general partner, established 14 limited partnerships which acquired approximately 350 contiguous acres of unimproved land in Riverside County, Calif. The offering circular for these limited partnerships described the terms of the transaction in detail, and it also contained an extensive discussion of the prospects for the 350-acre parcel. Standing alone on page 1 of the Moreno 2 circular was the following statement: “$10,260 investment * * * $41,135—-total 1974 tax loss. Each additional investment of $1,026.00 equals an additional $4,113.50 1974 tax loss.”

The offering circulars of Moreno 2 and Riverside 2 described the promoters' program for master planning and development of the 350-acre tract which included the respective partnerships' land. Subsequent to 1974, the year in question, substantial development of the entire tract occurred. Most of the development took place, however, after the partnerships had conveyed their land to Bio-Sci in 1975.

Laird and his associates basically looked upon their responsibility as that contained in the partnership agreements. However, neither agreement contained any commitment on the part of anyone to develop the partnership land or the 350-acre tract. Likewise, no prior verbal commitment to do so was ever made to the partnerships.

Notwithstanding the absence of such an agreement of commitment, a letter from Laird, on behalf of CAL-AM, to Southern California Financial Corp., dated May 20, 1975, reads in pertinent part as follows:

In June 1974, CAL-AM initiated a program to solicit investors for the immediate development of 240 acres west of Morrison Street. * * * Under the development program, CAL-AM would Master Plan the property and obtain approvals from the various governmental agencies for specific densities, land use, and offsite requirements for the project. Builders would then be invited to come in and improve the property within the framework of the Master Plan thus satisfying the obligations of CAL-AM to its investors.

Ten of the 14 partnerships (including the two to which petitioners belonged) acquired their interests in the 350-acre tract from Go Publ. on essentially identical terms: i.e., a very small cash downpayment, a nonrecourse purchase-money loan from Go Publ. secured by an all-inclusive trust deed, and a second nonrecourse loan from J.E.C. to fund the loan point payment which was also secured by a trust deed. These partnerships then sold the properties to Bio-Sci in 1975 for little or no cash and large nonrecourse notes. The properties then passed through related entities and in 1978 were acquired by North Coast Financial.

As detailed below, Moreno 2 acquired eight lots in 1974 and disposed of these lots in November 1975; Riverside 2 acquired one lot in 1974 and disposed of it in 1975.

a. Moreno Co. 2

On September 12, 1972, Kenneth E. Fisher and Betty Louise Fisher, his wife, purchased eight parcels of unimproved land located in Riverside County, Calif., denominated lots 16-3, 16-4, 16-5, 16-6, 25-3, 25-4, 25-5, and 25-6. ² Kenneth E. Fisher is the father of Kenneth J. Fisher (referred to above as Fisher), who, at the time of this transaction, was an employee of Southern California Financial Corp. The purchase price was $320,000, of which $288,000 was represented by a promissory note secured by a first trust deed on the subject lots.

On October 31, 1972, Kenneth E. Fisher and Betty Louise Fisher sold the eight lots to K. E. Fisher Enterprises, Inc., for $512,000. Payment of the entire purchase price was made by a promissory note secured by an all-inclusive trust deed on the eight lots.

On November 1, 1972, K. E. Fisher Enterprises sold the lots, four each to two partnerships, Moreno Properties 3 and Moreno Properties 4: ³ The costs to each partnership was $258,823; each partnership paid $823 down and borrowed the balance, each giving two deeds of trust on their newly acquired property in the amounts of $219,300 and $38,700.

On December 26, 1974, CAL-AM purchased the eight lots from Moreno Properties 3 and Moreno Properties 4 of $82,500 and $103,500, respectively. The $82,500 consisted of $165 cash and a promissory note in the amount of $82,335 secured by an all-inclusive trust deed on the subject lots; the $103,500 consisted of $375 cash and a $103,125 promissory note with similar security.

On December 27, 1974, CAL-AM sold 20 contiguous parcels of unimproved land...