Landry v. Comm'r of Internal Revenue

• Decision Date: 24 June 1986
• Docket Number: Docket No. 20585-81.
• Parties: RONALD G. LANDRY, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

86 T.C. 1284

86 T.C. No. 76

RONALD G. LANDRY, Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 20585-81.

United States Tax Court

Filed June 24, 1986.

P was a limited partner in W, a Texas limited partnership formed for the purpose of constructing and managing an apartment project. W contracted with J and its affiliates for the construction of the project and the provision of certain related services, guarantees, and covenants. The project was constructed in two phases, and W made downpayments to J of $375,000 and $190,000 and executed wraparound notes in favor of J for the remainder of the total purchase prices of $5,775,000 and $1,690,000 for the two phases. W allocated certain portions of the purchase prices to interest and to fees for the services, guarantees, and covenants furnished by J and its affiliates.

HELD: (1) W was engaged in the business of constructing and operating the apartment project with an actual and honest profit objective in 1977; and

(2) W is not entitled to the deductions claimed by it for interest and fees disallowed by the Commissioner because W has failed to establish that its allocations are in accord with economic reality. Some portions of the amounts claimed by W for such purposes are properly allocable to the purchase prices for the apartment project. Buford P. Berry, Thornton Hardie III, J. Y. Robb III, and Dennis J. Grindinger, for the petitioner.

A. Shawn Noonan, for the respondent.

SIMPSON, JUDGE:

The commissioner determined a deficiency of $18,328.69 in the petitioner's Federal income tax for 1977. After a concession by the petitioner, the issues for decision are: (1) Whether Woodscape Associates, Ltd., a limited partnership formed to construct and operate an apartment project in 1977, was engaged in such activity for profit in that year; and (2) whether Woodscape is entitled to deductions claimed by it for the amounts of the purchase price of the apartment project allocated by it to interest and to the payment of certain fees.

FINDINGS OF FACT

Some of the facts have been stipulated, and those facts are so found.

Petitioner Ronald G. Landry maintained his legal residence in Galveston, Tex., at the time of the filing of his petition herein. He filed a timely individual Federal income tax return for 1977 with the Internal Revenue Service Center, Austin, Tex.

Woodscape Associates, Ltd. (Woodscape), is a limited partnership organized and operated under the laws of the State of Texas. Woodscape was formed pursuant to an Agreement of Limited Partnership dated June 28, 1976 (partnership agreement), and its principal place of business is in Dallas, Tex. Woodscape maintains its books and records and files its partnership returns using the accrual method of accounting; it uses a calendar year period for Federal income tax purposes.

Woodscape has two managing general partners, one special general partner, and 26 limited partners. John S. Schneider and Robert F. Sherman are the managing general partners; Dr. Jerry A. Argovitz is the special general partner; and the petitioner is one of the limited partners.

Woodscape was formed for the purposes of acquiring from Jagger Associates, Inc. (Jagger), 11.6187 acres of land in Houston, Tex., constructing a 368-unit garden apartment project on such land, and operating and managing the project. Subsequent to its formation, all of the partners agreed to expand the scope of Woodscape's activities to include acquiring an additional 3.4126 acres of land from Jagger immediately adjacent to the 11.6187-acre parcel, constructing a 112- unit addition to the apartment project, and operating and managing the additional project. The activities and documents associated with the initial 368 apartment units shall be referred to as phase I of the Woodscape project, and the activities and documents associated with the additional 112 units shall be referred to as phase II of the Woodscape project.

Under the terms of the partnership agreement, all income, gains, losses, deductions, and credits are allocated 90 percent to the limited partners and 10 percent to the general partners for Federal income tax purposes. The partnership agreement provides that distributions of net cash flow from operations shall be ‘to the extent feasible, quarter-annually within forty-five (45) days after the end of each calendar quarter.‘

The 10-percent interest of the general partners in distributions of Woodscape is subject to a noncumulative annual cash flow distribution priority in favor of the limited partners equal to 8.5 percent of the capital contributions made by the limited partners. Upon sale or other disposition of Woodscape's property, the partnership agreement provides that the general partners receive a distribution priority to the extent that their share of distributions from operations has previously been distributed to the limited partners in accordance with the distribution priority provision. The partnership agreement further provides that all distributions in excess of the distribution priorities are shared 90 percent to the limited partners and 10 percent to the general partners.

Prior to the formation of Woodscape, Mr. Schneider and Mr. Sherman had extensive experience in real estate ventures. After receiving his MBA from Harvard University in 1967, Mr. Schneider worked for Donaldson, Lufkin and Jenrette, Inc., as a financial analyst in the firm's institutional marketing division, raising capital for real estate pooled investments. In 1972, Mr. Schneider formed his own real estate investment company, Rohdie-Schneider Associates, Inc. Mr. Sherman joined Mr. Schneider at Rohdie-Schneider Associates in December 1973. Prior to that time, Mr. Sherman had been associated with First National City Bank in New York City (currently Citibank). In 1974, they formed Schneider and Sherman Associates, Inc., a real estate investment corporation and, at all times relevant hereto, owned 100 percent of the stock.

As of June 1976, Mr. Schneider and Mr. Sherman were general partners in 12 real estate limited partnerships which were organized to develop and operate garden apartment projects. Nine of these projects are located in Texas. Five of these nine projects had been completed at the time Woodscape was formed. As of June 1976, the occupancy level of these five completed projects ranged between 83 percent and 100 percent. One of the five Texas projects was sold for a substantial profit in 1983, while each of the other projects has been operating, and continues to operate, at a profit.

Mr. Schneider was primarily responsible for making the economic projections with respect to the proposed acquisition, construction, operation and management of the Woodscape project. He was also primarily responsible for negotiating the land purchase and construction contracts with Jagger. In addition, he extensively analyzed and reviewed the economic aspects of this proposed garden apartment project. Based on his analysis, Mr. Schneider expected a capital appreciation on :he amount paid for the Woodscape project.

Woodscape generated and distributed a positive cash flow of $82,000 in 1979. In each year subsequent thereto until 1984, it continued to generate a substantial positive cash flow. In 1984, an unexpected downturn in the Houston rental market caused a significant drop in Woodscape's occupancy rate resulting in a significant negative cash flow. Woodscape's operations reflected a net taxable income for the year 1982.

Limited partnership interests in Woodscape were offered to selected individuals, including the petitioner, during 1976. In connection with this offering, a Confidential Private Placement Memorandum was prepared in June 1976. This memorandum provided prospective limited partners with detailed information regarding an investment in phase I of the Woodscape project.

On July 24, 1976, the petitioner purchased a 2.25-percent limited partnership interest in Woodscape. In exchange, the petitioner contributed capital of $9,375 in cash and unconditionally agreed to pay an additional $25,000 in two equal installments of $12,500 each. The installments were timely paid in May 1977 and in March 1978.

In January 1977, a second Confidential Private Placement Memorandum was prepared to present prospective limited partners with detailed information regarding an investment in phase II of the Woodscape project. The limited partners in phase I, including the petitioner, agreed to make additional capital contributions to the partnership to develop phase II of the project in the same proportion as their interests in phase I. Consequently, the petitioner maintained his 2.25 percent limited partnership interest in Woodscape. He contributed $4,750 in cash in February 1977 and unconditionally agreed to pay an additional $5,750 in two installments. The first installment of $3,125 was timely paid in January 1978, and the second installment of $2,625 was timely paid in October 1978.

At the time the Woodscape project was constructed, Jagger was one of the top ten builders of multiple residential housing in the country. From its formation in 1964 until commencing construction on the Woodscape project, Jagger had built approximately 6,000 apartment units in Texas. Jagger had leased and managed apartments for over 10 years and was managing more than 800 units in Dallas and Houston as of June 1976.

Woodscape contracted with Jagger for the acquisition of the land and the construction of the initial 368-unit apartment project pursuant to the Purchase and Construction Agreement entered into as of June 28, 1976 (P & C agreement—phase I). This agreement was a completed contract under which Jagger agreed to convey 11.6187 acres of land to Woodscape, construct a 368-unit apartment project on such land, and perform certain other services and commitments stated therein for a total price of $5,775,000. This contract price covered the cost of the land and the improvements to be...