Holmes v. U.S.

• Decision Date: 04 June 1996
• Docket Number: D,Nos. 810,1045,s. 810
• Citation: 85 F.3d 956
• Parties: -5077, 64 USLW 2792, 96-1 USTC P 50,299, 34 Fed.R.Serv.3d 924 Eugene HOLMES, Plaintiff, Margaret Holmes, as Voluntary Administrator for Eugene Holmes (Deceased), Plaintiff, and Mark Holmes, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant. ockets 95-6009, 95-6103.
• Court: U.S. Court of Appeals — Second Circuit

Page 956

85 F.3d 956

78 A.F.T.R.2d 96-5077, 64 USLW 2792,

96-1 USTC P 50,299,

34 Fed.R.Serv.3d 924

Eugene HOLMES, Plaintiff Margaret Holmes, as Voluntary Administrator for Eugene Holmes (Deceased), Plaintiff and Mark Holmes, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.

Nos. 810, 1045, Dockets 95-6009, 95-6103.

United States Court of Appeals Second Circuit.

Argued Dec. 22, 1995.

Decided June 4, 1996.

Mark Holmes, Arlington, VA, pro se.

Teresa E. McLaughlin, Tax Division, U.S. Dept. of Justice, Washington, DC (Loretta C. Argrett & Gary R. Allen, Tax Division, U.S. Dept. of Justice, Washington, DC, and Patrick H. NeMoyer, U.S. Attorney's Office, Western District of New York, Buffalo, NY, on the brief), for Defendant-Appellant.

Before: JACOBS and CALABRESI, Circuit Judges, and SPATT, District Judge. ^*

CALABRESI, Circuit Judge:

Combining the advantages of apartment occupancy with those of home ownership has long been a dream of urban dwellers. But direct ownership of "flats" has not been easily achieved. In Roman law, it may well have been forbidden; and at common law, though it was permitted, it was generally viewed as dangerously cumbersome in the absence of express statutory authorization. Nowadays, laws facilitating such "condominium" ownership have been enacted in both civil and common law lands. But long before the advent of such statutes, an alternate form of apartment ownership, the real estate stock-cooperative, had been developed in this country. Once established, it survived and continues to do so despite the flourishing of condominiums. Because the stock-cooperative was, at least in part, an attempt to accomplish by indirection what could not be done simply and straightforwardly, fitting it into the legal topography has not always been easy. ¹ The case before us raises important issues of how such real-estate cooperatives are viewed by the Internal Revenue Code.

Background

In February 1984, Mark Holmes, a young man fresh from University of Chicago Law School, signed a lease to rent apartment 5M in the St. George Tower in Brooklyn Heights for $697.70 per month. The building was soon converted into a cooperative association named the St. George Tower and Grill Owners Corporation ("Corporation"). As is customary in such arrangements, the cooperative association (or "co-op") owned the building, while those who owned the appropriate number of shares in the Corporation obtained thereby the right to occupy one of the apartments in that building.

In the summer of 1984, Mark Holmes and his parents, Eugene and Margaret Holmes, entered into a partnership ("the partnership") to purchase from the Corporation the shares necessary to get the right to occupy apartment 5M. Mark Holmes took a one-half interest in the partnership, and each of his parents took a one-quarter interest in it. In November 1994, the partnership simultaneously 1) bought 773 shares of the Corporation for $60,000, financed entirely by a loan from Long Island Savings Bank; 2) mortgaged the shares to Long Island Savings; 3) executed a proprietary lease with the Corporation for apartment 5M; and 4) executed a lease with Mark Holmes under which he would continue to live in apartment 5M and pay, as rent to the Partnership, $550 per month for the year ending October 1985, and $600 per month for the year ending October 1986.

In 1985, the income received by the Partnership (the rent paid by Mark Holmes) was not sufficient to meet its expenses (the maintenance fees and mortgage interest). The partnership, therefore, sustained a loss, and each partner claimed a proportionate share. Accordingly, in his tax return for the 1985 tax year, Mark Holmes deducted half of the partnership's losses, $10,136. This sum included his share of qualified mortgage interest and property taxes on the apartment (deductions that are not contested here), and one half of the remaining excess of partnership expenses over partnership income.

The IRS audited Mark Holmes and his parents and determined: 1) that the rent Mark Holmes paid was not at a fair market rate; 2) that the partnership's rental activity was not "for profit;" and 3) that, under all the circumstances, Internal Revenue Code § 280A barred the Holmeses from taking the deductions they sought. A deficiency was assessed against them.

The Holmeses paid the taxes and interest on October 9, 1988, and filed a timely administrative claim for a refund with the IRS. Mark Holmes sought a refund of $5,358.40, plus statutory interest. In October 1994, the IRS partially refunded $772 in erroneously assessed tax, plus $687.50 in interest, but otherwise denied his claim. ² His parents received similar treatment.

The Holmes family then brought suit in district court seeking a further refund. The case was tried to a jury, which returned a verdict in favor of Mark and his parents. In answer to special interrogatories, the jury found that the partnership's rental activity was for profit and it further found that the partnership had charged a fair rent.

The Government filed a motion for judgment as a matter of law, or, in the alternative, for a new trial. The district court denied the motion. It concluded that there was ample evidence from which the jury could reasonably have found that the partnership was engaged in for-profit activity. The district court also found that the jury's verdict that a fair rent had been charged was fully supported by the evidence. Holmes v. United States, 868 F.Supp. 42, 44 (W.D.N.Y.1994). It held, finally, that, regardless of fair rent and for-profit activity, "Section 280A does not apply to the ownership of shares of a cooperative corporation." Id.

The court noted that the section limits loss deductions deriving from the rental of the taxpayer's personal "dwelling unit," and that § 280A(f)(1)(A) defines a "dwelling unit" as including "a house, apartment, condominium, mobile home, boat, or similar property, and all structures or other property appurtenant to such dwelling unit." "It would be illogical," the court stated, "to conclude that shares in or of a cooperative corporation, even though they correlate to the use of a particular apartment, were 'similar property' under the above definition." Id. at 44-45.

In the face of the jury verdict, the Government sought to turn defeat into victory by arguing that even if a fair rent had been charged by a "for profit" activity, Section 280A nevertheless barred or limited the deductions at issue on other grounds. It contended, for example, that the Holmeses had failed to establish that they had entered into a "shared equity financing agreement," within the meaning of § 280A(d)(3), and that this failure precluded the deductions under § 280A. The court, however, held that these, and other similar, government arguments had not been "presented" in the motion for a directed verdict. It therefore refused to consider them, stating that the Holmeses would be "blind-sided" if it were to entertain such theories. Id. at 46 n. 10.

The government, in this appeal, does not challenge the jury verdict and contests only a) whether Section 280A applies to the ownership of cooperative shares, and b) whether the government had preserved various claims arising under Section 280A that it asserts are valid despite the jury's findings. The fair rental and profit motive issues are, therefore, not before us. The government, moreover, has abandoned its claims against the parents, and attacks the judgment below only to the extent that it awards a refund to Mark Holmes ("taxpayer").

Discussion

I.

Since this case raises complicated technical issues of taxation, we begin by setting out the statutory scheme in some detail. Section 212 of the Internal Revenue Code permits a deduction for expenses "for the production or collection of income" or "for the management, conservation, or maintenance of property held for the production of income." In many instances, such deductions can exceed the direct income that gave rise to them. And they may then be taken, by the taxpayer, against other, unrelated income. Limits on § 212 deductions are governed by §§ 261-280H of the Code.

Among these limits are those imposed by § 280A. This section states that "[e]xcept as otherwise provided ... no deduction otherwise allowable under this chapter shall be allowed with respect to the use of a dwelling unit which is used by a taxpayer during the taxable year as a residence." The Code, as we have earlier noted, defines "dwelling unit" as "a house, apartment, condominium, mobile home, boat, or similar property, and all structures or other property appurtenant to such dwelling unit." I.R.C. § 280A(f)(1)(A).

In general, a taxpayer uses a dwelling unit as a residence when she uses the unit "for personal purposes" for the greater of 14 days or 10 percent of the number of days the unit is rented at the fair market price during the taxable year. I.R.C. § 280A(d)(1). A unit is used "for personal purposes" on any day it is used by the taxpayer, any other person who has an interest in the unit, or any "member of the family" of the taxpayer as defined in § 267(c)(4), i.e., his siblings, spouse, ancestors, and lineal descendants. I.R.C. § 280A(d)(2)(A).

Section 280A(d)(3), however, creates a safe-harbor exception to these personal use rules. A taxpayer is treated as not using a dwelling unit for personal purposes if the unit "is rented, at a fair rental, to any person for use as such person's principal residence." In other words, if two parents buy a house and rent it at a fair price to their child as that child's principal residence, these parents are not considered to be using the dwelling unit as a residence for purposes of § 280A(a).

But the "fair rental" exception is itself subject to a restriction: If the tenant "has an interest in the dwelling unit," the exception applies "only if such rental is pursuant to a shared equity financing arrangement." I.R.C. § 280A(d)(3)(B)(...