Page 1101
91 T.C. 1101 (1988)
BRUCE A. PRABEL AND MARIANNE S. PRABEL, Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
No. 8389-87.
United States Tax Court.
December 29, 1988
Petitioners invested in a real estate investment partnership that calculated accrued interest deductions relating to a long-term partnership loan on the basis of the ‘ Rule of 78's.‘
Held: (1) On the undisputed facts of this case, the use of the Rule-of-78's method of calculating accrued interest deductions relating to the long-term partnership loan does not result in a clear reflection of partnership income; (2) respondent's determination under sec. 446(b), I.R.C. of 1954, as amended, is sustained, and the partnership must calculate its accrued interest deductions relating to the long-term loan on the basis of the economic accrual of interest; (3) respondent's determination does not constitute an improper retroactive application of Rev. Rul. 83-84, 1983-1 C.B. 97. Respondent's motion for summary judgment will be granted, and petitioners' cross motion for summary judgment will be denied.
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John A. Craig and Robert D. Whoriskey, for the petitioners.[1]
Alan E. Cobb, for the respondent.
OPINION
SWIFT, JUDGE:
This matter is before the Court on the parties' cross motions for summary judgment filed under Rule 121. [2] Each party objects to the other party's motion on the merits. Petitioners further object to respondent's motion for summary judgment on the ground that there remain unresolved material issues of fact that would have to be decided before respondent's motion for summary judgment can be granted.
The cross motions for summary judgment raise the following primary issues: (1) Whether a partnership's use of the Rule-of-78's method of accruing interest deductions relating to a long-term real estate loan does not clearly reflect income; and (2) whether respondent may exercise his authority under section 446(b) to change the partnership's method of accruing interest on the loan.
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BACKGROUND
This is a test case concerning the use of the Rule-of-78's method of accruing interest deductions for tax purposes. Petitioners believe that this method is permissible under the all-events test of section 461. Respondent believes that such method, when applied to long-term loans, results in a material distortion of income and that he has authority under section 446 to require the use of the economic-accrual method of accruing interest deductions relating to such loans. The factual matter set forth in this case is based on undisputed facts and exhibits submitted to us in support of the parties' cross motions for summary judgment.
Petitioners Bruce A. Prabel and Marianne S. Prabel are individuals who resided in Chadds Ford, Pennsylvania, at the time they filed their petition. Petitioners are cash basis taxpayers who report their income for tax purposes on a calendar year basis. They filed their Federal income tax returns for 1980, 1981, and 1982 with respondent at Philadelphia, Pennsylvania. Marianne S. Prabel is a party to this action by virtue of having filed joint returns for the years at issue. References to ‘ petitioner‘ in the singular are to Bruce A. Prabel.
In late 1980, a partnership named Quincy Associates, Ltd. (‘ Quincy Associates ‘ ), purchased a shopping center from First Delaware Equity Corporation (‘ FDEC ‘ ) for $2,471,000. The shopping center was located in Quincy, Florida. The purchase price for the shopping center was payable by a cash downpayment of $192,000 and the balance of $2,279,000 by a nonrecourse, 23-year and two-month purchase-money note (hereinafter referred to as the ‘ Note‘ or the ‘ 23-year Note ‘ ). The Note was issued in the total amount of $7,268,249, reflecting the $2,279,000 deferred purchase price and $4,989,249 of stated, precomputed interest. The Note matures on December 31, 2003, and is secured by a mortgage and security agreement issued by Quincy Associates.
The terms of the transaction and of the related Note were the result of dealings between related entities and were not the result of arm's-length negotiations.
Under the terms of the Note, in November and December of 1980, and during the following 23 years, Quincy Associates is obligated to make monthly payments to FDEC of
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principal and interest in the amount of $17,166.67. In 1980, 1981, 1982, and 1983, additional lump-sum payments also were due. The total payments each year (including the lump-sum payments due in years 1980, 1981, 1982, and 1983) that Quincy Associates is obligated to make are as follows:
| 1984 through 2003 |
206,000 |
| Cumulative total |
5,379,000 |
On maturity of the Note in the year 2003, an additional balloon payment of $1,889,249 is due in order to pay off the principal balance of the Note. The balloon payment represents only principal because, under Quincy Associates' method of allocating the annual cash payments due between principal and interest, only $389,751 of the total cash payments due over the term of the Note are to be allocated to principal, leaving in year 2003 a principal balance outstanding of $1,889,249. Pursuant to the terms of the Note, Quincy Associates had the right, at its discretion, to prepay in whole or in part the outstanding principal of the Note. In the event of a full or partial prepayment, Quincy was required to pay all unpaid and accrued interest thereon. The Note further provided that in the event of prepayment - Partial prepayments will be allocated first to the Interest Element and then to the Principal Element in accordance with the ‘ Rule of 78.‘ On prepayment of this Note in whole, the mortgagor will receive a credit for the unearned portion of the Interest Element determined in accordance with the ‘ Rule of 78‘ . The Rule of 78's (also referred to as ‘ sum of the years digits‘ ) is a method of allocating payments due on loans between principal and interest. It originated in the 1930's as a simplified method, in the absence of computers, of computing rebates on consumer installment loans where the
Page 1105 loans were prepaid. Under the Rule of 78's, each separate installment period relating to a loan has associated with it an arithmetic fraction, which fraction (if repayment of the loan occurs in that period) is applied to the total precomputed interest due over the term of the loan. The product of that calculation is regarded as the portion of the total precomputed interest that was earned from origination of the loan until the time of prepayment. The balance of the total precomputed interest is credited or rebated to the debtor's account. Scott, ‘ Answering questions about the ‘ Rule of 78ths,’ ‘ 68 Banking 124 (Sept. 1976), contains a concise explanation of the history of the Rule of 78's. The computation required under the Rule of 78's has been explained simply as follows: The rule of 78's is based on he idea of a 12-month loan repayable in equal installments. If the borrower takes out a $1200 loan, he has the use of 12 $100 bills the first month, 11 $100 bills the second month, 10 the third month, and only one the last month. During the full 12 months, he therefore has the use of 78 $100 bills (12 plus 11 plus 10 . . . plus 1). The number 78 becomes the denominator of the fraction, while the numerator depends upon when the prepayment takes place. If prepayment is made at the 7th installment, 57/78 of the total finance charge » is regarded has having� been earned by the creditor (the numerator is the sum of 12, 11, 10, 9, 8 and 7). * * * this would amount to 57/78 of $211.68 » the total interest due on the loan�, or approximately $155. Therefore, » the debtor's� rebate due on August 1 would be approximately $57. » 1 Fonseca, Handling Consumer Credit Cases, sec. 3:7 p. 101 (3d ed. 1986). Fn. ref. omitted.� Where the loan has more than 12 payment periods, the denominator under the Rule of 78's is different but the basic calculation is the same. The sum of the digits of the total number of payment periods for the loan is used as the denominator, and the sum of the digits of the particular month in which prepayment occurs is the numerator (e.g., prepayment at the end of the second month of a 24-month installment loan will result in the use of the fraction 47 divided by 300 for computing interest due on prepayment of the loan). For financial accounting purposes, payments due each month on the Note are allocated between principal and
Page 1106 interest under the Rule of 78's. Because payments due in most of the first 13 years of the Note are significantly less than the interest accruals in those years under the Rule of 78's, the actual payments due each month from Quincy Associates are allocated almost exclusively to interest. In 1981 through 1992 (see chart, infra at 11), the payments due will not be sufficient to cover the amount of interest calculated under the Rule of 78's and negative amortization will occur (i.e., interest calculated each month under the Rule of 78's, but not due, is carried over to subsequent years). Under the terms of the Note, no further interest accrues on the unpaid interest that creates the negative amortization (i.e., no compounding of interest occurs). For Federal income tax purposes, Quincy Associates reports its income on the accrual method of accounting, but the amount of interest relating to the Note that is accrued each year is not limited to the amount of the payments due each year. Instead, for tax purposes, interest is accrued by Quincy Associates with respect to the Note solely on the basis of the Rule-of-78's method as if Quincy Associates had the liability each year to pay FDEC the full amount of interest calculated under the Rule of 78's. We emphasize that the amount of interest accrued under this method, for tax purposes, is not limited to the...
