91 T.C. 371 (1988)
HENRY N. AND MARILYN HULTER, Petitioners
COMMISSIONER OF INTERNAL REVENUE, Respondent
DAVID AND ILSEROSE BRYAN, Petitioners
COMMISSIONER OF INTERNAL REVENUE, Respondent
Nos. 3969-81, 23116-81, 36790-84, 40130-84.
United States Tax Court
August 29, 1988
A limited partnership purported to invest in real property in North Carolina. HELD: (1) Ownership of the real property was not transferred to the partnership; (2) a purported $24.5 million nonrecourse mortgage debt obligation did not represent genuine indebtedness; and (3) the real estate investment activities of the partnership were not engaged in for profit.
Shlomo Aaron Beilis, Donald J. Pols, and James J. Mahon, for the petitioners.
Pamela V. Gibson, Albert A. Balboni, Marvis Knospe, Robert J. Foley, and Robert B. Dugan, for the respondent.
In timely statutory notices of deficiency, respondent determined deficiencies in petitioners' Federal income tax liabilities as follows:
| PETITIONERS HENRY N. AND MARILYN HULTER |
|| Docket No.
| PETITIONERS DAVID AND ILSEROSE BRYAN |
|| Docket No.
These consolidated cases are test cases for investors who were denied deductions for partnership losses relating to their investments in Tudor Associates, Ltd., II. By agreement of the parties, issues not relating to Tudor II were severed prior to trial. The issues for decision at this time are: (1) Whether, and if so when, a sale occurred to Tudor II of real property located in North Carolina; (2) whether a purported $24.5 million nonrecourse debt obligation of Tudor II relating to the sale represented a genuine debt obligation; and (3) whether activities of Tudor II with respect to the acquisition and management of real property constituted an activity engaged in for profit. FINDINGS OF FACT Many facts have been stipulated and are found accordingly. Petitioners Henry N. and Marilyn Hulter are husband and wife and resided in Greenbrae, California, at the time their petition was filed. Petitioners David and Ilserose Bryan are husband and wife and resided in Locust Valley, New York, at the time their petition was filed. Petitioners timely filed joint Federal income tax returns for the years in issue. TUDOR II The Federal income tax deficiencies in dispute relate to partnership losses arising from petitioners' investments in a real estate limited partnership by the name of Tudor Associates, Ltd., II (hereinafter referred to as ‘ Tudor II ‘ ). Tudor II was organized on December 30, 1975, as a Nebraska limited partnership by Boston attorneys George Osserman (‘ Osserman‘ ) and Paul Garfinkle (‘ Garfinkle‘ ). The limited partnership agreement filed on behalf of Tudor II named Zan D. Galloway, Osserman's girlfriend, as sole general partner of Tudor II. No limited partners were identified in the partnership agreement. The principal place of business of Tudor II was located at One Gateway Center, Newton, Massachusetts, and the stated purpose of Tudor II was to invest in and manage real property. Tudor II was one of 12 tax-oriented limited partnerships that Osserman and Garfinkle organized in the Page 373
mid 1970's, in each of which Ms. Galloway was the designated general partner. As general partner of Tudor II, Ms. Galloway performed few duties. She essentially was a front or straw person for Osserman. The professed investment objectives of Osserman and Garfinkle and of corporations and real estate investment partnerships they organized and promoted were to purchase commercial real property that due to poor management and operations had become depressed in value and that could be purchased with favorable, nonrecourse financing. After purchase by a closely-held corporation controlled by Osserman and Garfinkle at a price allegedly determined by a multiple of five times potential annual gross rental income, the property would be resold to one of the limited partnerships Osserman and Garfinkle had formed at a price allegedly determined by a multiple of eight times potential annual gross rental income. Theoretically, negative cash flow in the years immediately following purchase of property would be covered by additional investor funds contributed to the partnership. By improving management of the property, the value and operating income from the property would increase significantly. Operating income was to be used to service the large, nonrecourse debt incurred to purchase the property from Osserman and Garfinkle's controlled corporation. In theory, investing limited partners eventually would receive substantial profits from the partnership's ownership of the real property. In the interim, until the property became profitable, limited partners would receive substantial tax benefits associated with the debt-financed purchase of the property. OCG Enterprises, Inc. (‘ OCG‘ ), the corporate vehicle used to purchase the real property in the first instance, was a Massachusetts corporation formed by Osserman and Garfinkle in 1970, with its principal place of business also located at One Gateway Center in Newton, Massachusetts. Osserman and Garfinkle were the chief operating officers of OCG and indirectly controlled its stock. In early 1975, Osserman negotiated on behalf of OCG for the purchase of real property located in Atlanta, Georgia, Page 374
owned by a real estate broker named Jud Kusaba (hereinafter referred to as the ‘ Kusaba property‘ ). It was Osserman's apparent intent that the Kusaba property, after purchase by OCG, would be transferred to Tudor II. Osserman made projections of income, losses, and tax benefits with respect to the Kusaba property and included the projections in private placement memoranda with respect to Tudor II. The purchase, however, by OCG of the Kusaba property was never consummated. During late 1975, investments in Tudor II were solicited through private placement memoranda. Investors were offered partnership units that could be purchased for $55,000 each. Fractional units also could be purchased. One hundred units were to be sold, resulting in a projected total capitalization for Tudor II of $5.5 million. Under the subscription agreements, each investor was to pay the $55,000 as follows: $10,000 cash in the first year and the balance of $45,000 in annual contributions of $7,500 over the next six years. The investors, however, were not obligated to make the annual contributions in years two through seven. The only penalty for failure to pay the optional $7,500 annual contributions was a forfeiture by the investors of a pro rata share of their interests in the partnership. As stated, financial projections of income and losses relating to the specific characteristics and financial history of the Kusaba property were set forth in offering memoranda given to prospective investors, but the Kusaba property was not identified as the basis for the projections. In two subsequent offering memoranda, also relating to Tudor II, some of the real property purportedly acquired by Tudor II was specifically identified. The financial projections set forth in each offering memoranda, however, were based solely on the Kusaba property. No financial projections relating specifically to the properties that were purportedly acquired by Tudor II were set forth in the offering memoranda. Osserman and Garfinkle, or their agents, were successful in subscribing all 100 limited partnership units in Tudor II. A number of units in Tudor II were received by limited partners in exchange for services rendered to the partnership. For example, Ms. Galloway received one unit for her Page 375
agreement to be general partner, and Tudor II's accountant received one unit for accounting services. Osserman and Garfinkle also were limited partners of Tudor II, but the record does not disclose how they paid for their units. Petitioners Henry N. and Marilyn Hulter acquired a fractional interest in Tudor II. They executed an undated subscription agreement with Tudor II and in connection with that agreement, gave a $3,000 personal check to Tudor II dated December 29, 1975. The Hulters also gave $5,000 to Tudor II in each of the years 1976, 1977, and 1978, representing total partnership contributions by the Hulters during the years in issue of $18,000. Petitioners David and Ilserose Bryan also acquired a fractional interest in Tudor II. They executed a subscription agreement and issued a $5,000 check to Tudor II, both dated December 31, 1975. The Bryans paid $3,750 to Tudor II in each of the years 1976 and 1977, and $3,850 in 1978, representing total partnership contributions by the Bryans during the years in issue of $16,350. ACQUISITION BY OCG OF REAL PROPERTY IN NORTH CAROLINA In December of 1975, OCG retained William L. McDonald (‘ McDonald‘ ) to investigate certain real property located in Durham, North Carolina. At that time, the property to be investigated was owned by C. Paul Roberts (‘ Roberts ‘ ), a Durham contractor, or by corporations controlled by Roberts. McDonald inspected several of Roberts' apartment buildings and motels which were threatened with foreclosure. Although McDonald had no authority to enter into contracts to purchase property on behalf of OCG, he and Roberts allegedly came to an understanding that OCG would acquire from Roberts or from his corporations two large apartment complexes...