Derr v. Comm'r of Internal Revenue
| Decision Date | 29 September 1981 |
| Docket Number | Docket No. 8947-77. |
| Parties | WILLIAM O. DERR and THOMASINE G. DERR, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
In early 1973, A decided to syndicate the X limited partnership which would purchase and operate a certain apartment complex. To this end, A published a prospectus offering the sale of X partnership units to Illinois residents. The prospectus promised substantial tax benefits in 1973 from an investment in X and indicated that A's wholly owned corporation, Z, had already contracted to purchase the apartment complex. Nevertheless, Z had not contracted to purchase the apartment before the publication of the prospectus. On June 30, 1973, Z executed the purchase agreement for the apartment complex. On the following day, July 1, 1973, Z entered into sales contract with X whereby it agreed to sell the apartment complex to X. A signed the sales contract on behalf of both X, as general partner, and Z, as president. The terms of the sales contract reflected the tax consequences promised in the prospectus. During 1973, petitioner William O. Derr was a limited partner in X and claimed a deduction for his distributive share of the partnership loss for 1973 on his return for that year. Held: Z's purchase and resale of the apartment complex to X was a sham. X was the real purchaser under the purchase agreement and did not acquire the benefits and burdens of ownership of the apartment complex thereunder until July 1, 1974. Held, further, during 1973, X did not have a depreciable interest in the apartment complex, incur any indebtedness that would allow an interest expense deduction under sec. 163, I.R.C. 1954, or make any deductible expenditures with respect to the operation of the apartment complex. Held, further, petitioners are not entitled to the claimed deduction for Mr. Derr's distributive share of the partnership loss for 1973. Clarence G. Ashby, for the petitioners.
Lewis J. Hubbard, Jr., for the respondent.
Respondent determined a $6,184.80 deficiency in petitioners' 1973 Federal income tax. After a concession by respondent, the sole issue for decision is whether petitioner William O. Derr, a limited partner in the Aragon Apartments partnership, is entitled to deduct his distributive share of the partnership loss for 1973. The resolution of this issue turns on whether the partnership is entitled to various deductions in connection with the ownership and operation of an apartment complex in 1973.
Some of the facts have been stipulated and are found accordingly.
William O. Derr (hereinafter petitioner) and Thomasine G. Derr, husband and wife, resided in Jacksonville, Fla., when they filed their petition in this case. They filed their 1973 joint Federal income tax return with the Office of the Director, Internal Revenue Service Center, Kansas City, Mo.
During 1973, petitioner was a limited partner in the following partnerships: Aragon Apartments, Edens East Apartments, and Manor Apartments. Petitioner acquired these partnership interests as tax shelter investments.
In the early 1970's, Edward J. Reilly (hereinafter Reilly), a registered Illinois securities dealer, was involved extensively in the syndication of real estate limited partnerships. From 1970 through 1972, Reilly was the underwriter of record for 60 Illinois limited partnerships, including Edens East Apartments and Manor Apartments. During 1973, Reilly owned all the capital stock of the following Illinois corporations: Edward J. Reilly Partnerships Inc. (hereinafter Partnerships Inc.) and the Happiest Partner Corp. (hereinafter HPC). Partnerships Inc. was a registered Illinois securities underwriter, and HPC was a licensed Illinois real estate brokerage firm.
In early 1973, the construction of four brick buildings, containing 88 total apartment units, on a parcel of real property located in Des Plaines, Ill., was completed. The land and buildings were known as the Foxcroft Apartments (hereinafter sometimes referred to as the apartment complex), and were owned under an Illinois land trust established on February 15, 1972, of which Victor Smigel (hereinafter Smigel) was the sole beneficiary, and the National Bank of Austin was the trustee. On December 9, 1972, the apartment complex was mortgaged in the name of the trustee to Austin Federal Savings & Loan Association of Chicago (hereinafter Austin Federal) to secure a loan in the principal amount of $1,280,000. The apartment complex was subject to this mortgage through July 1, 1974. The loan was payable in monthly installments of $10,306.90, with the final payment due on December 1, 1996. Neither Smigel nor the National Bank of Austin was personally liable for this loan.
Sometime in early 1973, Reilly decided to package the Foxcroft Apartments as a limited partnership, using the name Aragon Apartments (hereinafter Aragon or the partnership). To this end, in the spring of 1973, he caused the publication of a prospectus offering the sale of securities (hereinafter partnership units) in Aragon to Illinois residents, pursuant to the Illinois Securities Law of 1953. Aragon was described as a limited partnership “being formed to purchase and hold title to four apartment buildings containing a total of 88 apartment units commonly known as Foxcroft, Des Plaines, Illinois, and personal property used in the operation thereof.” The prospectus provided that Reilly would be the general partner and portrayed him as an expert in both real estate partnership and tax shelter investments.
Partnerships Inc. was named the underwriter-dealer for the offering within the meaning of Illinois law. As the underwriter-dealer, Partnerships Inc. marketed the partnership units in Aragon. The purchase price per partnership unit was $1,721, payable in two installments: (1) $1,000 prior to the closing on the apartment complex in 1973, and (2) $721 on July 1, 1974. The minimum subscription for any limited partner was set at 11 units for a total purchase price of $18,931, with Partnerships Inc. reserving the right to reduce the minimum subscription in the event some limited partners subscribed to more than 11 units.
According to the prospectus, the sale of partnership units would raise $370,000, $340,400 from the limited partners for 92 percent of the total partnership units, and $29,600 from the general partner, Reilly, for the remaining 8 percent. The prospectus stated that all funds raised from the sale of partnership units would be deposited in an escrow account that was under the sole control of Partnerships Inc. In this escrow account, Partnerships Inc. held the funds of various partnerships with which it was associated.
The prospectus provided that the partnership's objectives were “large tax shelters, income and equity growth.” With respect to Aragon's tax shelter potential, the prospectus indicated that the partnership would have “tax deductions in 1973 in excess of operating income and mortgage reduction as a result of prepaid interest, prepaid management fee paid at closing, contract financing ‘points,’ depreciation and personal property bonus depreciation.”
According to the prospectus, HPC had entered into a contract to purchase the Foxcroft Apartments and was prepared to sell its contractual interest in the property to Aragon for a total purchase price of $1,650,000. 1 Aragon would “receive a credit for the mortgage balance of approximately $1,280,000” and pay HPC the balance of $370,000 as follows: (1) $215,000 at closing and (2) $155,000 on July 1, 1974. With respect to the terms of the sale to Aragon, the prospectus further provided:
THE HAPPIEST PARTNER CORPORATION is contracting to sell its contractural interest in the subject real estate. This purchase contract provides for 1974 interest in the amount of $128,000 to be prepaid in 1973. THE HAPPIEST PARTNER CORPORATION, as seller, will accept the prepaid interest as ordinary income so that the partnership can obtain an immediate tax deduction. The monthly cash payments to THE HAPPIEST PARTNER CORPORATION under the purchase contract will be identical with the monthly payments by THE HAPPIEST PARTNER CORPORATION on the mortgage. The effect of this contract on the partnership is to pay 1973 and 1974 interest at closing and add to the contract balance due THE HAPPIEST PARTNER CORPORATION. Interest due for 1975 shall be paid in 1974. Approximately one half of 1976 interest will be paid in 1975 and the balance of the 1976 interest will be paid in 1976.
Please note that although the purchaser's contract balance is higher (because of the addition of prepaid interest), a lower effective interest rate is charged in the purchase contract. However, monthly cash payments are the same, and with the lower interest rate, there is a larger reduction of principal on the purchase contract. It is anticipated that the partnership purchase contract balance will be the same as the first mortgage, about October, 1976, and THE HAPPIEST PARTNER CORPORATION will then assign the beneficial interest in the trust to the Partnership.
While the prospectus stated that the sale to the partnership should be closed no later than July 1, 1973, it warned that “There is no positive assurance that the real estate transaction will be closed and the securities actually issued.”
The prospectus sets forth the following breakdown of the use of the $370,000 to be raised from the sale of the partnership units:
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