Odend'hal v. C.I.R.

• Decision Date: 20 November 1984
• Docket Number: No. 83-2210,83-2210
• Citation: 748 F.2d 908
• Parties: -319, 84-2 USTC P 9963 Fortune ODEND'HAL, Jr., and Gloria P. Odend'hal; Fortune Odend'hal, Jr.; William J. Cassidy and Clotilda G. Cassidy; Dean L. Mann and Beverly D. Mann; Ivan V. Magal and Leah R. Magal; Larry M. Stanton and Esther M. Stanton; Robert M. Allen and Frances D. Allen; Charles C. Yu and Marie S. Yu; Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.
• Court: U.S. Court of Appeals — Fourth Circuit

Page 908

748 F.2d 908

55 A.F.T.R.2d 85-319, 84-2 USTC P 9963

Fortune ODEND'HAL, Jr., and Gloria P. Odend'hal; Fortune

Odend'hal, Jr.; William J. Cassidy and Clotilda G. Cassidy;

Dean L. Mann and Beverly D. Mann; Ivan V. Magal and Leah

R. Magal; Larry M. Stanton and Esther M. Stanton; Robert

M. Allen and Frances D. Allen; Charles C. Yu and Marie S.

Yu; Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.

No. 83-2210.

United States Court of Appeals, Fourth Circuit.

Argued Aug. 29, 1984.

Decided Nov. 20, 1984.

Scott P. Crampton, Washington, D.C. (MacDonald, McInerny, Guandolo, Jordan & Crampton, James Dewey O'Brien, Washington, D.C., on brief), for appellants.

Michael J. Roach, Tax Div., Dept. of Justice, Washington, D.C. (Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup, Ann B. Durney, Tax Div., Dept. of Justice, Washington, D.C., on brief), for appellee.

Before WINTER, Chief Judge, SPROUSE, Circuit Judge, and BUTZNER, Senior Circuit Judge.

HARRISON L. WINTER, Chief Judge:

Seven taxpayers in ten consolidated cases appeal from the decisions of the Tax Court determining deficiencies in their income taxes aggregating $496,525.32 for various years within the period 1973-77. The Tax Court sustained the Commissioner's determination that taxpayers were not entitled to deduct depreciation, rental and interest expenses arising from their ownership of a warehouse and food processing facility located on 5.8 acres of land in Cincinnati, Ohio. Taxpayers purchased the facility in December 1972 for $80,000 in cash and $3,920,000 in nonrecourse notes secured by a purchase money mortgage, for a total stated price of $4 million. The Tax Court ruled that the fair market value of the property when purchased by taxpayers did not exceed $2 million, that because of the wide discrepancy between market value and the amount of the nonrecourse notes the latter did not represent genuine indebtedness, that therefore taxpayers could not include the nonrecourse amount in their depreciable basis, and that they could deduct interest and other items only to the extent of their income from the property. Odend'hal v. Commissioner, 80 T.C. 588 (1983).

On appeal, taxpayers contend that, as a factual matter, the Tax Court's finding as to the real cost of the property was clearly erroneous and that, as a matter of law, the Tax Court was bound to recognize the nonrecourse amount for purposes of computing depreciation and the interest deduction. For the latter proposition they rely on Commissioner v. Tufts, 461 U.S. 300, 103 S.Ct. 1826, 75 L.Ed.2d 863 (1983), a case decided after the Tax Court decided the instant litigation. We find no merit in either contention and so we affirm the decision of the Tax Court. We remand the case, however, and require the Tax Court to determine how the allowable amount should be apportioned among the interest, rental expenses, taxes and depreciation deductions.

I.

The published opinion of the Tax Court contains extensive and detailed findings of fact. It is therefore unnecessary for us to recite them at length. We will begin, however, with a summary of the transaction in which taxpayers participated and some prior history of transactions involving the property.

Taxpayers are seven of ten individuals who acquired the improvements on the land, a lease on the land with the right to extend it for 99 years and the benefits of a long-term lease of the improvements made to The Kroger Company (Kroger), which had owned the property until 1951. Taxpayers' acquisition was promoted by Charles M. Fairchild, a real estate syndicator and developer, and his associates. The purchase price was $4 million, paid $80,000 in cash and $3,920,000 in nonrecourse notes secured by a 15-year nonrecourse mortgage. The principal of the mortgage was due in a balloon payment on November 30, 1987, and interest was payable at varying rates during the term of the mortgage. Fairchild and his associates represented that if depreciation was calculated on a useful life of 14.5 years, the cost of leasing the land, mortgage interest and depreciation, less income from Kroger, would result in a negative cash flow before taxes, but anticipated income tax savings for an investor in the 50% tax bracket would convert the negative cash flow from the investment into a positive after tax cash flow. Indeed it was represented that the total positive after-tax cash flow would aggregate $1,238,781 over a 15-year period. The acquisition and method of financing are what is called in common parlance a tax shelter.

Kroger, which apparently developed the property, sold it in fee in 1951 to Union Central Life Insurance Company (Union Central) for $5 million in cash under a sale-leaseback arrangement entitling Kroger to occupy the premises for a term of 25 years with an option for four 5-year renewals. Kroger's rent was calculated to return Union Central's original investment over the initial term with interest at the rate of 4.5%. In 1967 Union Central sold the property to Fairchild for $2,670,000, which was approximately Union Central's unamortized investment balance. ¹ Fairchild paid $115,000 in cash and gave a nonrecourse promissory note for $2,555,000 secured by a first mortgage to be paid in 110 monthly installments with varying rates of interest.

Immediately after acquiring the property from Union Central, Fairchild transferred it to a group of investors (the Burwell group) for a stated consideration of $5 million. This consisted of payment of $100,000 in cash, a credit of $2,555,000 for the nonrecourse note and mortgage that Fairchild had given to Union Central (to which the rights of the Burwell group were subject), and a series of 10 nonrecourse promissory notes of $233,000 each (plus another note for $15,000) secured by a second mortgage on the property. ²

As soon as taxpayers committed themselves to Fairchild's promotion, the Burwell group conveyed the improvements on the Kroger property and the benefits of the Kroger lease to Realty Corporation of America (RCA), a corporation controlled by Fairchild, and by a separate conveyance leased the land under the improvements for a term extendable to 99 years to Management Properties, Inc. (Management), another corporation controlled by Fairchild, at varying stated annual rentals. In consideration of the conveyance of the improvements and the Kroger lease, RCA paid $5,000 in cash and gave $463,000 in notes secured by a third mortgage on the property. It acquired the improvements and the Kroger lease subject to the $1,339,000 due under the first mortgage and subject also to $233,000 due under the second mortgage. The latter was to ensure payment of the note assigned to Georgetown University, see n. 2, supra, but the Burwell group in effect promised that RCA would not be subject to the second mortgage to the extent that the mortgage secured performance on the other Burwell notes.

Fairchild then caused RCA and Management, respectively, to convey the improvements and the benefits of the Kroger lease to taxpayers and to sublease to them the underlying land for a term extendable to 99 years. The stated price for the improvements and the Kroger lease was $4 million, consisting of $80,000 in cash and $3,920,000 in nonrecourse promissory notes. The principal of the notes was due in a balloon payment on November 30, 1987. Under the ground lease, taxpayers were required to pay an annual rent in stated amounts which could be increased if the rent paid by Kroger was increased.

II.

We conclude that the Tax Court's finding that the property interests acquired by taxpayers at the time of their acquisition did not have a fair market value in excess of $2 million is not clearly erroneous.

In the trial of the case, the government presented the testimony of two qualified real estate appraisers. Both agreed that the appropriate method of valuing an interest in property subject to a long-term lease, such as the lease to Kroger in this case, is to reduce the anticipated rental income to present value at an appropriate rate of discount and to add the value of the reversion at the end of the lease, likewise discounted to present value. Using this method and employing a 9% rate of interest, one appraiser valued taxpayers' property at $1,990,125. The other expert, using an 8.5% rate of interest and a somewhat different method of evaluating the reversionary interest, valued their property at $1,711,597. Taxpayers presented no expert testimony from a qualified real estate appraiser that their property was worth $4 million.

The testimony of the government's experts was corroborated by evidence of the sale from Union Central to Fairchild. This was obviously an arm's length transaction and the consideration was $2,670,000. This transaction occurred in 1967. It is true, of course, that Fairchild almost immediately sold the property to the Burwell group for a purported consideration of $5 million and the Burwell group in 1973 resold the property to a Fairchild corporation for a purported consideration of $4,134,018. Taxpayers place principal reliance on these transactions to support their argument that the Tax Court's findings as to value is clearly erroneous. We therefore analyze these transactions in greater detail.

At the outset we note that there is nothing in the record to show how or why, with regard to the 1967 sale by Fairchild to the Burwell...