Goodwin v. Comm'r of Internal Revenue

• Decision Date: 29 December 1980
• Docket Number: Docket No. 12561-77
• Citation: 75 T.C. 424
• Parties: RICHARD C. GOODWIN and ELAINE GOODWIN, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

75 T.C. 424

RICHARD C. GOODWIN and ELAINE GOODWIN, PETITIONERS

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 12561-77

United States Tax Court

Filed December 29, 1980.

Petitioner-husband was a partner in two limited partnerships formed to construct housing projects. Construction of the housing projects was not completed, and the units were not leased to tenants, until after 1972. Both partnerships reported deductions on their 1972 Federal income tax returns for certain loan and mortgage broker fees paid in order to arrange financing for the housing projects. Respondent disallowed petitioner's ratable share of the partnership losses for 1972 to the extent they were attributable to the various loan and broker fee deductions. Held: The partnerships were not engaged in a trade or business under sec. 162(a), I.R.C. 1954, since the projects were not completed or occupied by tenants until after the taxable year. Petitioner's prior activities in the real estate development business are irrelevant in determining whether the expenses were incurred by the partnerships in the course of a trade or business. Madison Gas & Electric Co. v. Commissioner, 72 T.C. 521 (1979), affd. 633 F.2d 512 (7th Cir. 1980), followed. Held, further: Certain loan fees paid to banks to obtain financing for the projects represent charges for services performed rather than compensation for the use of money. Hence, the fees are not deductible as interest under sec. 163(a). Robert E. Schlusser, for the petitioners.

Stephen E. Sokolic, for the respondent.

DAWSON,, Judge:

Judge: Respondent determined a deficiency in petitioners' Federal income tax for the year 1972 in the amount of $32,640.68.¹ During 1972, Richard C. Goodwin was a partner in two real estate limited partnerships, the Bethlehem Development Co. and D. M. Associates, both of which were formed to construct and operate certain housing projects. Respondent disallowed his distributive share of certain expenses deducted by the partnerships. After concessions by the parties, the only issues remaining for decision are:

(1) Whether certain loan and broker fees paid by the partnerships to arrange financing for the housing projects were incurred in the course of a trade or business under section 162(a);² and

(2) Whether certain amounts paid by both partnerships to obtain financing for the housing projects constitute deductible interest under section 163(a) rather than capital expenditures for services rendered.

FINDINGS OF FACT

Some of the facts have been stipulated. The stipulation of facts and the attached exhibits are incorporated herein by reference.

Richard C. Goodwin (hereinafter referred to as petitioner) resided in Mount Holly, N.J., and Elaine Goodwin resided in Jenkintown, Pa., when they filed their petition in this case. Their joint Federal income tax return for the calendar year 1972 was filed with the Internal Revenue Service Center in Philadelphia, Pa.

Petitioner has been in the real estate development business for most of his life. During the 1950's, he built single-family homes with his father and brother in southern New Jersey. When his brother left the family business in the early 1960's, petitioner and his father began doing land development work for other builders in the same area. In the late 1960's, they expanded their land development activities to include projects in eastern Pennsylvania. Most of the projects were developed by partnerships in which petitioner and his father were the principal partners. The projects generally involved the planning and construction of residential townhouse and apartment complexes, and were similar in scope to the projects developed by the limited partnerships herein.

For the sake of clarity, the facts pertaining to each of the limited partnerships involved in this case will be summarized separately.

Bethlehem Development Co.

Bethlehem Development Co. (Bethlehem) was formed by petitioner and his father, Harry J. Goodwin, as a limited partnership under Pennsylvania law. They executed the certificate of limited partnership on April 1, 1972, and it was recorded with the Recorder of Deeds Office, Northampton County, Pa., on June 16, 1972. On July 15, 1972, a limited partnership interest in Bethlehem was conveyed to Berel Altman. Thereafter, petitioner held a 1-percent interest in the partnership as a general partner and a 57.5-percent interest as a limited partner. Bethlehem used the accrual method of accounting in computing its income and losses.

Bethlehem was formed to construct and operate a housing project in accordance with the provisions of section 236 of the National Housing Act, a program administered by the Department of Housing and Urban Development. The purpose of the section 236 program was to induce the construction of low-cost rental housing. If a project was accepted under section 236, the Federal Housing Administration (FHA) would agree, upon completion of the project, to insure the mortgage loan obtained from a private lender. In addition, the FHA would agree to subsidize the owner's interest obligation so as to limit his interest rate to 1 percent. The owner was required to pass on the reduced interest expense to tenants in the form of lower rents. The owner of the project could also arrange for the Government National Mortgage Association (GNMA) to purchase the mortgage and note from the private lender once the loan had been insured by the FHA.

The Bethlehem project called for construction of 211 townhouses on a 20-acre section of a tract of land purchased in the late the 1960's called the Bethlehem Tract. Petitioner and his father had previously developed two other sections within the Bethlehem Tract, building a total of 225 townhouses over the course of prior years.

On August 31, 1972, the Philadelphia National Bank (PNB) agreed to loan Bethlehem $3,416,400 to fund construction of the Bethlehem Townhouse Apartments project. The mortgage and note which Bethlehem executed in favor of PNB provided for amortization of principal over a period of approximately 40 years beginning February 1, 1974; prior to that date, Bethlehem was liable for accrued interest only. Under the loan agreement, Bethlehem was required to obtain both an FHA insurance commitment and a GNMA purchase commitment with regard to the loan before any funds could be disbursed to the mortgagor. To help arrange the financing and obtain the necessary commitments, Bethlehem had previously enlisted the services of a mortgage brokerage firm, Bogley, Harting, Mahoney & Lebling, Inc. (Bogley). In connection with these matters, Bogley performed the following services:

(1) Analyzed architectural drawings and figures to ensure compliance with FHA requirements;

(2) Prepared and submitted to FHA a feasibility proposal and documentation necessary to obtain a firm commitment;

(3) Negotiated with FHA frequently, regarding such matters as the number of housing units, architectural feasibility, and mortgage amount; and

(4) Submitted to GNMA certain information which the agency required before it would issue a purchase commitment.

For these services, Bogley charged a fee equal to 0.5 percent of the mortgage loan, or $17,082. The fee was paid by Bethlehem on September 26, 1972, using funds advanced by Goodwin Homes, Inc.

Before issuing its commitment to insure the project upon completion of construction, FHA reviewed the application for economic feasibility by analyzing factors such as ground value, rent levels, cost estimates, and construction budgets. For these services, FHA charged an examination fee equal to 0.3 percent of the loan amount, or $10,249.20. On April 17, 1972, Bogley paid this fee on behalf of Bethlehem, using funds advanced to Bethlehem by Harry J. Goodwin.

On July 21, 1972, after determining the project to be feasible, the FHA issued a commitment to insure the mortgage loan to the extent of $3,416,400. The commitment was conditioned on the payment of an FHA inspection fee equal to 0.5 percent of the loan amount, or $17,082, which was subsequently paid by Bogley on behalf of Bethlehem using funds advanced to Bethlehem by Goodwin Homes, Inc. ³ On July 28, 1972, GNMA issued its commitment to purchase the mortgage, which commitment was to remain effective until July 29, 1974. For the issuance of the commitment, GNMA charged a fee equal to 1 percent of the loan amount, or $34,164. This fee was paid by Bogley on behalf of Bethlehem on July 28, 1972, using funds advanced to Bethlehem by Goodwin Homes, Inc.

As a condition to obtaining the loan, Bethlehem was also required to pay PNB a 1-percent fee, $34,164, as payment for services rendered by the bank in connection with the processing and administration of the loan. These services included the following:

(1) Review of the economic feasibility of the project, including an analysis of financial statements, credit reports, and cost breakdowns; (2) Analysis of title report;

(3) Preparation and presentation of report for the PNB loan committee;

(4) Preparation of loan documents;

(5) Processing the contractor's monthly requisitions for loan advances;

(6) Inspection of the project during construction by PNB inspectors and outside inspectors; and

(7) Preparation of documents necessary to obtain the FHA insurance endorsement and to effect the transfer of the mortgage and note to GNMA upon completion of the project.

Bethlehem paid $5,000 of the $34,164 fee on December 28, 1972. The balance was paid in 1973. The fee was intended to cover the costs of services generally performed by the bank on such loans and was not tied to the specific costs incurred by it in connection with the Bethlehem loan. No portion of the fee represented compensation for the use of money.

Construction of the housing project was commenced in October 1972 and was not completed until the fall of 1973. Consequently, no tenants occupied the project, and Bethlehem received no income during 1972. On July 31, 1974, GNMA purchased...