Koufos v. Indiana Dept. of State Revenue, 45T10-9403-TA-00098
| Decision Date | 14 February 1995 |
| Docket Number | No. 45T10-9403-TA-00098,45T10-9403-TA-00098 |
| Parties | James P. KOUFOS and Barbara J. Koufos, Petitioners, v. INDIANA DEPARTMENT OF STATE REVENUE, Respondent. |
| Court | Indiana Tax Court |
Demetri J. Retson, Kevin E. Steele, Burke, Murphy, Costanza & Cuppy, Merrillville, for petitioners.
Pamela Carter, Atty. Gen., Marilyn Meighen, Deputy Atty. Gen., Indianapolis, for respondent.
James P. Koufos and Barbara J. Koufos (the Koufoses) appeal the final determination of the Indiana Department of State Revenue (the Department) disallowing a deduction for interest paid on a mortgage acquired to develop rental property before determining their Indiana adjusted gross income.
This case presents one issue: whether interest paid on a mortgage acquired to develop rental property continues to be "attributable to property held for the production of rents or royalties" under 26 U.S.C.A. § 62(a)(4) after the property is sold.
The Koufoses have a 50 percent interest in a partnership (Partnership) that undertook to develop and operate an apartment complex in Schererville, Indiana. The Partnership acquired real property upon which to build the apartment complex in 1968. It then obtained a series of mortgage loans (Mortgage Loans) from various savings and loans associations (Mortgage Lenders) and used the proceeds of the loans to construct several buildings in the apartment complex. Construction of the apartment complex began in 1970 and was completed in 1979. Upon completion, the apartment complex included 576 residential units.
The Partnership operated the apartment complex as rental property from 1970 to July 21, 1981, and received rental income during that period. On July 21, 1981, the Partnership sold the apartment complex to Balcor Equity Properties Limited--VII (Balcor) for $15,691,485.
To facilitate the sale, the Partnership provided Balcor with "wraparound" financing. Thus, under the terms of the sale and financing agreement, Balcor tendered $4,418,562.61 cash at closing and executed a promissory note to the partners of the Partnership in the amount of $10,789,000. The Partnership transferred the apartment complex to Balcor by warranty deed and Balcor mortgaged the apartment complex back to the Partnership to secure its obligations under the promissory note.
At the time of the sale, the Partner's Mortgage Loans, having a principal balance of $8,601,992.33, were not discharged. Balcor assumed no obligations with respect to the Mortgage Loans and the Partnership remained solely liable for payments on those loans. The parties agreed, however, that Balcor would make payments on the Mortgage Loans directly to the Mortgage Lenders in order to satisfy part of its obligation under the promissory note. Accordingly, the promissory note was drafted so that Balcor's payments on the Mortgage Loans would discharge in the same amounts: 1) the principal and interest owed by the Partnership to the Mortgage Lenders, and 2) the principal and interest owed by Balcor to the Partnership under the promissory note. The remaining balance due by Balcor under the promissory note was approximately $2.2 million. The parties agreed that Balcor would pay the remaining balance, plus interest thereon, in monthly installments directly to the Partnership. Thus, since 1981, Balcor has made two payments every month--one to the Mortgage Lenders and one to the Partnership.
In 1988, the Balcor debt was the only substantial asset of the Partnership. Likewise, its obligations under the Mortgage Loans were its only substantial liabilities. The Partnership received no rental income from the apartment complex in 1988. It did, however, receive $954,740 in interest income from the sale of the apartment complex. The Koufoses share of that interest income was $477,370.
On line 8a of their 1988 Federal Individual Income Tax Return (Form 1040), the Koufoses reported $481,334 gross interest income. Of that amount, $477,370 was interest income from the sale of the apartment complex and included: 1) $424,225 in interest paid by Balcor to the Mortgage Lenders, and 2) $53,145 in interest paid by Balcor directly to the Partnership. On their Schedule A attachment, the Koufoses reported deductible investment interest in the amount of $433,975, which included the $424,225 in interest paid by Balcor to the Mortgage Lenders. The Koufoses reported a federal adjusted gross income of $391,074.
On line 2 of their 1988 Indiana Individual Income Tax Return (Form IT-40), the Koufoses reported $57,109 in interest income. That figure represented the Koufoses' gross interest income of $481,332 less the $424,225 in interest paid by Balcor to the Mortgage Lenders, or the Koufoses' net interest income. The Koufoses reported an Indiana adjusted gross income of minus $23,664.
On January 16, 1992, after reviewing the Koufoses' Form IT-40 and Form 1040, the Department determined that the income reported on the Form IT-40 did not agree with the income reported on the Form 1040.
Consequently, the Department assessed the Koufoses an additional income tax of $14,403.28, plus penalty and interest. The Koufoses filed a written protest. On June 3, 1992, the Problem Resolution Office determined that the Koufoses could not deduct the interest paid to the Mortgage Lenders from their gross interest income at line 2 of their Form IT-40. The Problem Resolution Office explained that the interest was deductible only as a federal itemized deduction and that federal itemized deductions may not be subtracted from federal adjusted gross income to arrive at Indiana adjusted gross income.
The Koufoses requested an administrative hearing. An administrative hearing was held, and on December 14, 1993, the Department issued a final determination upholding the assessment. On March 14, 1994, the Koufoses filed this appeal. The case is now before the court on the Koufoses' motion for summary judgment.
A motion for summary judgment may be granted "only when there is no genuine issue of material fact and a party is entitled to judgment as a matter of law." Harlan Sprague Dawley, Inc. v. Indiana Dep't of State Revenue (1992), Ind.Tax, 605 N.E.2d 1222, 1224. See also Ind.Trial Rule 56(C). "If no genuine issue of material fact exists, either the movant or the non-movant may be granted summary judgment." Harlan Sprague Dawley, 605 N.E.2d at 1224. All facts and any inferences drawn from those facts, however, will be viewed in a light most favorable to the non-movant. Knauf Fiber Glass GmbH v. State Bd. of Tax Comm'rs (1994), Ind.Tax, 629 N.E.2d 959, 961.
The facts of this case are undisputed and the court is asked only to determine the legal significance of those facts. Consequently, this case is particularly amenable to summary judgment. Id.
Indiana imposes a tax on income earned by individuals at the rate of 3.4% of their Indiana adjusted gross income. IND.CODE 6-3-2-1. Indiana adjusted gross income is defined as federal adjusted gross income subject to certain Indiana modifications. 1 IND.CODE 6-3-1-3.5. Federal adjusted gross income is defined in Section 62 of the Internal Revenue Code. It provides:
(a) GENERAL RULE.--For purposes of this subtitle, the term "adjusted gross income" means, in the case of an individual, gross income minus the following deductions:
* * * * * *
(4) DEDUCTIONS ATTRIBUTABLE TO RENTS AND ROYALTIES.--The deductions allowed by part VI (sec. 161 and following), ... which are attributable to property held for the production of rents or royalties.
Part VI of the Internal Revenue Code contains the various federal itemized deductions that are available to individuals and includes a deduction for "interest paid or accrued within the taxable year on indebtedness," subject to limitations on personal and investment interest. 26 U.S.C.A § 163(a), (d) and (h). Itemized deductions play no role in calculating federal adjusted gross income. See § 62. Under § 62(a)(4), however, a § 163(a) itemizable interest expense that is "attributable to property held for the production of rents or royalties" must be deducted from gross income before arriving at federal adjusted gross income. See also Koshland v. C.I.R. (1953), U.S.Tax Ct., 19 T.C. 860, aff'd (1954), 9th Cir., 216 F.2d 751. Thus, § 62(a)(4) "converts" a § 163(a) itemizable interest expense into a deduction from gross income before arriving at federal adjusted gross income when the interest expense is "attributable to property held for the production of rents or royalties."
Because federal adjusted gross income is used as the computational starting point in Neither the Internal Revenue Service nor any court has specifically addressed the issue in this case. Nevertheless, the plain language of § 62(a)(4) and the structure of the federal tax forms establish that once rental property is sold, any interest paid on a mortgage acquired to develop that rental property is not "attributable to property held for the production of rents or royalties."
determining Indiana adjusted gross income, see I.C. 6-3-1-3.5, it is necessary to ascertain the bounds of § 62(a)(4) in order to determine whether the Koufoses properly determined their Indiana adjusted gross income. The parties agree that if the Koufoses had owned the apartment complex in 1988, the interest paid to the Mortgage Lenders would have been attributable to "property held for the production of rents or royalties" under § 62(a)(4). They disagree, however, as to whether the interest paid to the Mortgage Lenders continued to be "attributable to property held for the production or rents or royalties" under § 62(a)(4) after the apartment complex was sold. It is the Department's position that after the apartment complex was sold, the interest paid to the Mortgage Lenders could be deducted only under § 163(a)
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