Fargo v. Comm'r
| Decision Date | 26 May 2015 |
| Docket Number | T.C. Memo. 2015-96,Docket No. 166-13.,Docket No. 28970-11 |
| Parties | VICTOR FARGO AND VIRGINIA KING, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent GIRARD DEVELOPMENT, L.P., GIRARD MANAGEMENT CORPORATION, TAX MATTERS PARTNER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
W. Alan Lautanen, for petitioners.
Kathleen A. Tagni and Jeffrey L. Heinkel, for respondent.
GOEKE, Judge: In the consolidated case at docket No. 28970-11, respondent determined a deficiency and a penalty under section 6662(a) withrespect to the joint income tax of petitioners Victor Fargo and Virginia King (Fargo and King) as follows:1
| Year |
| Deficiency |
| Penalty |
| sec. 6662(a) |
| 2002 |
| $322,064 |
| $64,052 |
In the consolidated case at docket No. 166-13, regarding Girard Development, L.P. (GDLP), an entity subject to partnership procedures under section 6226,2 respondent's notice of final partnership administrative adjustment (FPAA) determined that the partnership had realized an ordinary income gain from the sale of property in 2002 of $7,474,645 rather than the reported capital gain of $628,222.
After concessions by respondent,3 the issues remaining for decision are:
(1) whether the sale of the property in question generated capital gain or ordinary income for Fargo and King. We hold that the sale generated ordinary income; (2) whether GDLP's reported basis in the property at issue must be reduced. We hold that the basis must be reduced in part;
(3) whether payments totaling $1,306,000 made by Ms. King's wholly owned S corporation, Girard Management Corp. (GMC), are ordinary and necessary expenses. We hold that they are not;
(4) whether GMC's payments are distributions to Ms. King. We hold that they are not;
(5) whether Fargo and King are entitled to the full amount of a net operating loss carryforward. We hold that they are not;
(6) whether Fargo and King are entitled to deduct additional home mortgage interest. We hold that they are not;
(7) whether Fargo and King are entitled to a deduction for investment interest. We hold that they are not; and
(8) whether Fargo and King are liable for an accuracy-related penalty under section 6662. We hold that they are.
Some of the facts have been stipulated and are so found. When Fargo and King filed their petition, their residence was in California. GDLP's principal place of business was also in California when its petition was filed.
Fargo and King were engaged in the real estate business during all relevant periods. Ms. King is a licensed real estate broker in California. The couple conducted their business through a number of entities, including GMC; Fargo Industries Corp. (FIC), a C corporation wholly owned by Mr. Fargo; King Real Estate, Inc. (KRE), a C corporation wholly owned by Ms. King; Girard Property Corp. (GPC), a C corporation wholly owned by Ms. King; and GDLP, a TEFRA partnership of which Mr. Fargo and Ms. King are directly or indirectly the majority partners and GMC is the tax matters partner. Numerous commercial real estate developments were conducted through their related entities.
The background of the real estate transaction in issue begins in December 1988. FIC acquired a leasehold from La Jolla Medical Building Corp., an unrelated entity, to lease a 2.2-acre parcel of real estate (La Jolla property) including a building and site development plans. The La Jolla property's addresswas 7255 Girard Avenue, La Jolla, California. The owner of the La Jolla property was La Jolla Country Club. FIC acquired the leasehold in the La Jolla property with the plans to develop a 72-unit apartment complex and retail space. The leasehold was purchased for $2,700,000, paid in installments ending in 1990. The lease agreement between FIC and the La Jolla Country Club initially ran through 2008 but was subsequently extended to run through 2042 for additional consideration of $900,000. The lease was extended to allow Fargo and King more time to develop the La Jolla property.
When FIC acquired the leasehold in the La Jolla property, it also acquired the improvements that had been developed by La Jolla Medical Building Corp., including a tenant-occupied medical building and certain plans, drawings, reports, surveys, and permits.
The lease agreement between the La Jolla Country Club and La Jolla Medical Building Corp. was due to expire on August 31, 2008. In order to extend the term of the lease past August 31, 2008, La Jolla Medical Building Corp. had to meet certain conditions precedent, including redeveloping the La Jolla property according to the terms of the lease agreement. FIC acquired La Jolla Medical Building Corp.'s lease with the same constraints.
In 1991 FIC transferred the leasehold in the La Jolla property to GDLP for a capital contribution credit less than FIC's basis in the property. At the time of its formation and the contribution of the leasehold, GDLP entered into various agreements with related parties for the development and management of the La Jolla property. Those agreements provided for the payment of various fees for such services. After GDLP acquired the leasehold, several hurdles to the development of the La Jolla property arose. In the early 1990s the real estate market in La Jolla declined dramatically. As a result, development of the La Jolla property was suspended. Nonetheless, Mr. Fargo sought financing to develop it. In another attempt to obtain financing, GDLP purchased the La Jolla property from the La Jolla Country Club in 1997 in fee simple for $1,750,000.
In 1993 Norby, Inc. (Norby), an unrelated entity with which Mr. Fargo and FIC had previously worked, filed a lawsuit against Mr. Fargo and FIC because Mr. Fargo and FIC had defaulted on a $10 million loan for an unrelated development project. The parties negotiated to partially resolve the Norby litigation with a partnership interest in GDLP, and Norby acquired a partnership interest in GDLP in October 1991. The negotiations resulted in an amended partnership agreement, an amended marketing and brokerage agreement, and a property management agreement.
Through 2001 the La Jolla property was developed for residential use. The extent of physical improvements was limited to minor repairs. These minor repair costs were capitalized and amortized over the course of the holding period. At the end of 2001 the balance of the leasehold improvements was reported to be $73,406.55. Although Fargo and King did not make substantial alterations to the La Jolla property, GDLP capitalized substantial amounts for construction in progress. From 1991 through 2001 GDLP capitalized $1,828,982 of construction in progress. In the years 1999, 2000, and 2001 GDLP incurred costs for construction of $233,000, $216,337, and $999,585, respectively. These costs primarily comprised architecture, engineering, appraisal, permits, and licensing fees.
Before GDLP purchased the leasehold, La Jolla Medical Corp. used the building as rental space for medical offices. After the 1989 acquisition of the leasehold, rental income was generated from tenants occupying the medical offices. From 1989 until the time the property was sold, the rental income was the only income generated from the La Jolla property. In addition to collecting rent, Mr. Fargo's rental companies used the building for their business operations. FIC, GDLP, and other entities owned by Fargo and King used the building as office space for accounting, bookkeeping, and other business purposes.
After 1989 the La Jolla property was maintained as a business location and rental property. In 1993 GDLP entered into an agreement with KRE, a real estate management company owned by Ms. King. The agreement provided that KRE would manage, operate, maintain, and lease the La Jolla property. GDLP paid KRE $3,000 a month for its services.
No substantial efforts were made to solicit potential buyers for the La Jolla property before 2001. GDLP never listed the La Jolla property for sale and never marketed it to real estate developers. The only effort to sell the La Jolla property was made in 1993, when GDLP entered into a marketing and brokerage agreement with GPC, a real estate brokerage company owned by Ms. King. Nonetheless, GPC never undertook substantial efforts to sell the property.
In 2001 Centex Homes, an unrelated entity, made an unsolicited offer to purchase the La Jolla property for $16 million. The purchase price was subsequently renegotiated for $14,500,000 plus a share of the home sales profits. Centex Homes purchased the property from GDLP in 2002 to develop residential townhouses largely on the basis of previous plans that Mr. Fargo's entities developed. The sale contract between GDLP and Centex Homes obligated GDLP to continue its best efforts with the development process already in place. After Centex Homes purchased the property, GDLP incurred subsequent developmentcosts that were reimbursed by Centex Homes. In 2004 GDLP sued Centex Homes. As a result of the litigation, Centex Homes paid GDLP an additional $1,500,000 in full satisfaction of any amounts that may have been due under the sale contract.
In 2002 GDLP calculated its basis in the La Jolla property, accounting for pre-2001 capitalized development costs of $613,060, a payment of $108,531 to GPC for interest on a loan, a payment of $360,000 to GPC for a development fee, a payment of $303,057 to GPC for interest on the development fee, and an unreconciled difference of $518,000.
On September 16, 2002, GMC paid GPC an "incentive development fee" of $456,000 on GDLP's behalf based on the sale price of the property and paid KRE an "additional sales commission" of $350,000. On December 17, 2002, GMC wire transferred $500,000 to FIC also on GDLP's behalf. GDLP had sufficient funds to pay the fees at...
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