Malmstedt v. C.I.R.

Citation578 F.2d 520
Decision Date26 May 1978
Docket Number77-1394,Nos. 77-1393,s. 77-1393
Parties78-2 USTC P 9479 Margaret E. Johnson MALMSTEDT and Bertil Malmstedt, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee. Margaret E. Johnson MALMSTEDT and Bertil Malmstedt, Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.
CourtUnited States Courts of Appeals. United States Court of Appeals (4th Circuit)

Sylman I. Euzent, Kensington, Md., for appellants in 77-1393 and appellees in 77-1394.

William Estabrook, III, Tax Div., Dept. of Justice, Washington, D. C. (Myron C. Baum, Acting Asst. Atty. Gen., Gilbert E. Andrews and Gary R. Allen, Tax Div., Dept. of Justice, Washington, D. C., on brief), for appellee in 77-1393 and appellant in 77-1394.

Before BRYAN, Senior Circuit Judge, and RUSSELL and HALL, Circuit Judges.

DONALD RUSSELL, Circuit Judge:

This controversy arises out of the operation during 1958-1964 of a real estate development business in which the taxpayer was an equal partner. Prior to the formation of this partnership the taxpayer had been involved in the real estate business primarily as a realtor dealing in development property. Her earliest connection with either the real estate or the construction business began in the late 1940s when she became a bookkeeper for a concern so engaged. She, however, did not confine herself, as the years passed, to a bookkeeping role but actively involved herself in all phases of the business. In the early 1950s she left this employment and became an independent realtor, operating primarily in that part of Montgomery County, Maryland, included in the Greater Washington area. In this capacity she met Bertil Malmstedt and became associated with him in his existing business activities.

Bertil Malmstedt had been engaged in the construction and development business since 1937. He began with the construction of garages on Staten Island, New York. This activity was interrupted by the war. After the war, he joined Spiller Construction Company as a partner. This partnership constructed and developed an 86-house complex on Staten Island and the Templeton Knolls project in Riverdale, Maryland, consisting of 300 semi-detached houses. He later severed his connection with Spiller and Company and joined Frank and Company, again, as a partner. Frank and Company, also, was involved in real estate development. The latter partnership developed Fairlawn in the Washington area. It consisted of 257 detached houses. With the completion of this project, he embarked on real estate development and construction of his own, trading under the style generally of Torpet Construction Company (hereinafter referred to as Construction). It was while so engaged that he met the taxpayer and engaged her services initially in locating and aiding him in connection with possible developments in that part of Montgomery County which was within the area generally known as Greater Washington. This connection ripened into a partnership arrangement between Malmstedt and the taxpayer in 1958. 1 The purpose of the partnership was to engage in real estate developments in Montgomery County adjacent to the District of Columbia.

Immediately after its formation, the partnership began aggressively to interest itself in real estate developments in the Montgomery County area. Its first venture seems to have been an offhand development of a small two-acre area known as Beam Court in Bethesda, Maryland in late 1958 or early 1959. The first substantial development undertaken by the partnership, however, took place in 1959. This was the da da Woods development which was intended as a quality residential project. Located in Montgomery County, some ten miles west of the City of Washington, near the C & O Canal National Park and with easy access to the new highway 495, it consisted originally of 30 acres, later enlarged by the acquisition of an additional 15 acres. It was the first development in Montgomery County with all electrical and telephone lines underground. For its design and development of a model house in the extensive development planned in the area, the partnership received first prize by the National Homebuilders. This proposed development led directly into the Gold Mine project, the development of which is primarily the subject of this controversy.

A part of the land involved in da da Woods had been acquired from one Swanson, who also owned the Gold Mine property, consisting of 338 acres, located opposite the da da Woods development. At about the time the partnership acquired the da da Woods tract, Swanson suggested to the partnership the purchase by it of the Gold Mine property. It seems to have been in the mind of Swanson, as well as of the members of the partnership that this property presented a natural expansion of their developments in the area. Negotiations followed between Swanson and the partnership for the purchase of the Gold Mine property by the latter. These resulted in the acquisition of the Gold Mine property by the partnership in November, 1959. The purpose of the acquisition was plainly for purposes of commercial development.

The purchase price of Gold Mine was $1,000,000, less a $30,000 real estate commission to the partnership. The purchase was financed by the partnership by the execution of a first lien, securing an indebtedness of $375,000 and by the delivery of a note to Swanson, secured by a second lien, for $750,000. 2 The partnership concluded that the best type of development for the property would be as the site of a luxury type hotel. It actively proceeded with such a project. Before it could proceed, however, it was necessary to have the property rezoned for commercial purposes and to arrange for necessary water and sewer connections. After considerable effort, it succeeded in securing both the necessary rezoning and the water for sewer facilities. At the same time it had engaged the services of a nationally known architect to prepare plans and models for the development. In maintaining the property and in arranging for its development, during the period of 1959 to 1964, the partnership expended over $500,000.

The partnership pursued a number of avenues in developing an interest by responsible parties in the operation of the hotel envisaged for the venture. Among those so interested was the Steigenberger group in Frankfurt, Germany. This group indicated by letter in December, 1962 that they thought "that it would be possible that our company might be able to guarantee a rent of about 1 million $." To support this indication of interest, the partnership undertook to secure the necessary financing for the project. The well-known mortgage banking firm of S. L. Hammerman Organization, Inc. in Baltimore, after reviewing an analysis of the financial aspect of the project, indicated that it thought it could secure the necessary financing if the project were supported by an operating agreement as expected with a European hotel operating company. However, Steigenberger unexpectedly changed its position and expressed no further interest in the project.DP During the same time that all this activity in the Gold Mine venture was taking place, the partnership had acquired in 1961 and had undertaken the development of a residential subdivision of a tract of 118 acres in the same general area known as Potomac Ranch. The expense connected with the Gold Mine project and the development of the Potomac Ranch had apparently placed the partnership in financial difficulties. In an attempt to relieve these financial problems, it refinanced in early 1962 the indebtedness to Swanson by obtaining a new loan of $775,000, secured by a second lien on the Gold Mine property. In connection with such loan, they were forced to pay a fee of $150,000. When the partnership was unable to meet interest payments on this new debt, the creditors of the partnership involved in both the Potomac Ranch and the Gold Mine ventures filed foreclosure proceedings in the fall of 1963.

A judicial sale of the Gold Mine property under foreclosure of the second deed of trust thereon resulted in a sale in November, 1963. Malmstedt was not disposed to make any attempt to retain the property by bidding at such judicial sale; the taxpayer, however, wished to make an effort at continuing the venture by so bidding. Because of this difference between the parties, Malmstedt withdrew from the partnership, assigning to the taxpayer his interest. At the judicial sale, the taxpayer entered the highest bid of $1,625,000. She made a deposit of $25,000 against her bid. She was, however, unable to comply and the property was resold in March, 1964, to the holder of the second lien for a bid price of $1,600,000. 3

Thereafter the Service audited the tax returns of the taxpayer for the years 1964, 1965 and 1966. In the course of that audit, the agent asserted a tax deficiency. The Commissioner affirmed the finding of a deficiency and on appeal to the Tax Court the conclusions of the Commissioner, with certain modifications, were affirmed. 4 From that decision of the Tax Court both the taxpayer and the Commissioner have appealed.

The appeal of the taxpayer focuses on the calculation of taxable gain realized by her in connection with the Gold Mine venture. It was the finding of the Tax Court that the taxpayer, despite the fact that she had lost the property along with her share of the more than half million dollars expended on its futile development, realized a substantial capital gain as a result of the sale of the property. This finding rested upon a determination of the taxpayer's basis in the property. It was the taxpayer's position that the partnership basis, for computing gain on the sale, should be the original price of the property, plus all expenses incurred in the development and maintenance of the property during the partnership's ownership and development endeavors. There was no dispute with reference to these two amounts, which the taxpayer claimed aggregated...

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