The opinion
T.C. Memo. 2001-64
UNITED STATES TAX COURT
EPIC ASSOCIATES 84-III, WILLIAM C. GRIFFITH, JR., AND
DOTTIE M. GRIFFITH, TAX MATTERS PARTNERS, Petitioners
v. COMMISSIONER OF INTERNAL REVENUE, Respondent
EPIC ASSOCIATES 83-XII, WILLIAM C. GRIFFITH, JR., AND
DOTTIE M. GRIFFITH, TAX MATTERS PARTNERS, Petitioners
v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 3877-92, 3963-92. Filed March 19, 2001.
William C. Griffith, Jr., pro se.
Carolyn Lee Harber, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WHALEN, Judge: Respondent issued notices of final
partnership administrative adjustment (notices of FPAA)
in which respondent determined the following adjustments
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with respect to the partnership items reported by Epic
Associates 83-XII (referred to herein as EA 83-XII):
1983 1984 1985
Disallow interest and point $483,029 $556,564 $576,848
amortization deductions
Disallow depreciation 173,119 173,119 173,119
deductions
Disallow claimed net investment (341,010) -0- -0-
loss
Disallow qualified investment -0– 303,571 330,529
income
Disallow qualified investment -0- 908,960 909,831
expenses
Disallow excess expenses from 10,859 -0- -0-
net lease property
Disallow investment interest 66,366 -0- -0-
income
Disallow net investment income 29,306 -0- -0-
Disallow investment income -0- 90 1,262
Respondent issued notices of FPAA in which respondent
determined the following adjustments with respect to the
partnership items reported by Epic Associates 84-III
(referred to herein as EA 84-III):
1983 1984 1985
Disallow interest and point $121,535 $536,280 $559,662
amortization deductions
Disallow depreciation 56,910 170,742 170,742
deductions
Disallow deductions in -0- -0- 44,219
excess of income
Disallow claimed net (141,142) -0- -0-
investment loss
Disallow qualified investment -0– 217,619 229,131
income
Disallow qualified investment -0- 872,376 997,436
expenses
Disallow net investment income 6,097 -0- -0-
Disallow investment income -0- -0- 494
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Among the adjustments summarized above, respondent
disallowed all of the interest and depreciation claimed as
deductions by each partnership. The principal issues in
these cases are whether certain nonrecourse promissory
notes issued by each partnership to purchase real estate
constitute bona fide indebtedness and whether the activity
of each partnership is an "activity not engaged in for
profit", as that phrase is defined by section 183(c).
Unless stated otherwise, all section references in this
opinion are to the Internal Revenue Code as in effect
during the years in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated and are so
found. The stipulation of facts and the exhibits attached
thereto are incorporated herein by this reference.
EA 83-XII and EA 84-III are limited partnerships. At the
time the instant petitions were filed on their behalf, each
partnership was doing business in the State of Virginia,
and the tax matters partners of each partnership, William
C. Griffith, Jr., and Dottie M. Griffith, resided in
Atlanta, Georgia. Both limited partnerships reported
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income and expenses on a calendar year basis and used the
accrual method of accounting.
EA 83-XII
EA 83-XII was formed on December 3, 1982, pursuant to
the Uniform Limited Partnership Act of the Commonwealth of
Virginia for a 10-year term ending on December 3, 1992.
The Amended and Restated Certificate and Agreement of
Limited Partnership dated June 1, 1983 (referred to herein
as the 83 partnership agreement) describes the business of
EA 83-XII in the following terms:
Business of the Partnership
The business of the Partnership shall be to
acquire, directly or indirectly, and finance,
fee interests in certain improved residential
real properties and to operate, manage, lease
or otherwise deal with such properties with
the objective of distributing income generated
thereby among the Partners as provided for
herein; and to hold such properties for invest-
ment with the objective of capital appreciation
therein and to engage in and perform all acts
and activities required in connection with or
incident to the foregoing.
The partnership's sole general partner was Equity
Programs Investment Corp. (EPIC), a corporation that was
originally incorporated in Virginia in 1974 and was
reincorporated in Maryland in 1983. EPIC's business
involved the purchase, lease, and sale of residential
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houses and condominiums. We discuss EPIC at greater length
below.
The 83 partnership agreement provides that EPIC's
"interest shall be deemed to be a one-percent (1%) share in
the Partnership's capital contributions for which it shall
contribute" $10,580.81. In addition, the 83 partnership
agreement authorizes two classes of limited partnership
interests: 1 class A unit and 25 class B units. The class
A unit was sold to four investors for an aggregate sum of
$90,000. The purchasers of the class A unit made cash
payments totaling $50,000 and executed recourse promissory
notes totaling $40,000 that were payable to the partnership
on July 1, 1983. These investors were admitted to the
partnership on April 16, 1983.
EA 83-XII also sold 25 class B units of limited
partnership interest for $38,300 per unit or a total of
$957,500. Approximately $3,300 of the amount paid for each
class B unit was paid in cash and the balance of $35,000
was paid in the form of a recourse promissory note payable
to EX 83-XII in 14 quarterly installments of $2,500 each
with the last payment due on April 1, 1987.
Before selling the class B units in EA 83-XII, EPIC
circulated a confidential private placement offering
memorandum dated June 1, 1983 (referred to herein as the
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83 offering memorandum). The 83 offering memorandum states
that persons who purchased class B units would be admitted
to EA 83-XII as limited partners commencing September 1,
1983.
The 83 offering memorandum states that the limited
partners' contributions would be used primarily to fund
operating deficits of the partnership. The 83 offering
memorandum includes the following summary of EA 83-XII's
anticipated sources and uses of the proceeds of the
offering:
Sources Amount Percent
Proceeds from sale of class A unit $90,000 1.66
Proceeds from sale of class B units 957,500 17.68
Capital contribution of general partner 10,581 0.19
First mortgage loans 3,706,150 68.38
Builder rebate [referred to herein 655,319 12.09
as rental deficit contribution]
5,419,550 100.00
Uses
1
Purchase price of homes 3,901,550 71.98
Sales commissions to broker/dealers 83,800 1.55
[8% of the price paid for each unit]
Escrows and prepaid insurance 20,370 0.38
First mortgage loan origination fees 148,246 2.73
Organization fee to general partner 41,900 0.77
[4% of the price paid for each unit]
Estimated cash-flow deficits through
April 15, 1983 58,350 1.08
Available for cash-flow deficits 1,165,334 21.51
5,419,550 100.00
Note: Footnotes omitted.
1
This amount is $255 more than the actual purchase price, $3,901,295.
As set forth above, it was anticipated that $58,350 of the
proceeds of the offering would be offset by cash-flow
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deficits through April 15, 1983, and $1,165,334 of the
offering proceeds would be available for cash-flow
deficits after that date. The projected annual income
and operating costs of EA 83-XII as set forth in the 83
offering memorandum show an annual operating deficit of
$345,344 calculated as follows:
Percentage of
Projected Annual Income Amount Total Income
Builder lease $65,784 20.30
Rental income (less 20%
vacancy & expense factor) 258,240 79.70
Total projected income 324,024 100.00
Annual Operating Expenditures
Aggregate first mortgage
principal & interest $546,102 168.54
Real estate taxes 49,213 15.19
Insurance & homeowner's dues 21,500 6.64
Audit expenses 4,877 1.51
Property administration fee 30,600 9.44
Allowance for maintenance & repairs 17,076 5.27
Total projected cash expenditures 669,368 206.59
Projected operating deficit 345,344 106.59
The 83 offering memorandum also includes a cash-flow
analysis for EA 83-XII from inception to June 30, 1987,
as set forth in appendix A to this opinion.
In the 83 offering memorandum, it was contemplated that
EPIC would finance the partnership's operating deficits by
advancing funds to the partnership. The 83 partnership
agreement provides that EA 83-XII would pay interest on all
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unsecured advances of funds by the general partner at the
rate of 15 percent per annum. The 83 partnership agreement
also permits the partnership to advance to the general
partner any funds that were not distributed to the limited
partners, and the agreement provides that the general
partner would pay interest to EA 83-XII on such advances at
the rate of 12 percent per annum.
The 83 partnership agreement provides that cash from
operations is to be distributed in the following order of
priority: (i) To EPIC to repay any unsecured advances made
by EPIC to the partnership together with interest; (ii) to
the partners in the ratio that the cumulative cash capital
contributions of each partner bear to the cumulative cash
capital contributions of the partners until such amounts
equal the partners' cumulative cash capital contributions;
(iii) 25 percent to EPIC and 75 percent to the limited
partners holding the class A and class B units.
The 83 partnership agreement further provides that
cash from sales and from financings is to be distributed
in the following order of priority: (i) To repay partner-
ship debt secured by the property sold or refinanced and
to pay the expenses of selling each property; (ii) to repay
any unsecured advances made by EPIC to the partnership
together with interest; (iii) to pay EPIC a disposition
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fee equal to 2.5 percent of the price for which any
partnership properties are sold; (iv) to the partners
in the ratio that each partner's total cash capital
contributions bear to the cumulative cash capital
contributions of all partners until such amounts equal
the partners' cumulative cash capital contributions; and
(v) 25 percent of any remaining amount to EPIC and 75
percent to the limited partners holding class A and class
B units.
The partnership agreement specifies that EA 83-XII
shall pay the following compensation to EPIC:
Compensations of the General Partner
* * * * * * *
(a) At the time of subscription, a Partnership
Organization Fee, as detailed in the Confidential
Private Offering Memorandum for the Partnership,
being 4% of Limited Partners capital contribution
upon admission to the Partnership or a maximum
total payment of $41,900 for non-recurring
services which may be incurred before or after
formation of the Partnership, to include
furnishing legal, financial, accounting and
operational assistance review of rental schedules
and expense forecasts and other services which do
not give rise to the acquisition of specific
properties or the obtaining of financing
therefor;
(b) During each full or partial month of the
Partnership, the General Partner shall be paid
an administration fee equal to Fifty and 00/100
($50.00) for each Partnership property;
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(c) Such loan origination fees or service fees
at commercially prevailing market rates that may
derive from originating or servicing of any
security interests, including mortgages and deeds
of trust, placed upon Partnership property;
(d) Reimbursement of all carrying costs of the
Partnership properties including, but not by way
of limitation, interest on mortgage indebtedness
encumbering the properties, incurred prior to the
admission of the Limited Partners to the
Partnership;
(e) Two-and-one-half percent (2 1/2%) disposi-
tion fee on all resale of Partnership properties
except in connection with an exchange with a
builder for like kind property;
(f) For all unsecured advances of funds to the
Partnership, the General Partner shall be
entitled to interest on all such funds advanced
at the rate of 15% per annum; and
(g) Any difference between costs incurred by the
General Partner on pooled insurance policies for
all partnerships sponsored by the General Partner
and premiums charged to the Partnership for all
risk insurance coverage (including fire and
hazard) for each Partnership property plus the
premium attributable to decreasing the deductible
amount to $100 shall be the property of the
General Partner.
Purchase of Model Houses in Carrollton, Texas, From Raldon
Corp.
EPIC executed a contract entitled Epic Model Home
Purchase and Leaseback Agreement (purchase and leaseback
agreement), dated December 9, 1982, under which it agreed
to purchase five houses located in Carrollton, Texas, from
Raldon Corp. (Raldon) for $485,995 and to lease the houses
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back to Raldon for use as model houses for an initial term
of 18 months. For each of the five houses, there is a
schedule attached to the agreement that lists the address;
the base price; the "optional extras" included with the
house, such as carpeting, wallpaper, and mirrored walls;
the "marketing extras", such as drapes, sprinkler systems,
built-ins, and landscaping; the price for each of the
extras; and the "purchase price" of the house. The
purchase price for each of the five houses was $8,000 to
$10,000 more than the base price because of the "extras".
As one of the conditions of closing under the
purchase and leaseback agreement, Raldon agreed to pay
EPIC 6 percent of the purchase price of the properties.
The agreement provides as follows:
On the Closing Date, Seller [Raldon] shall
pay to Equity Programs Investment Corporation a
sum equal to six percent (6%) of the Purchase
Price of the Properties, and the execution of
this Agreement by Seller shall constitute an
irrevocable assignment to Equity Programs
Investment Corporation from the sale proceeds
of a sum sufficient to make the payment due
under this Subparagraph 5.7.
We refer to the amount payable under the above provision as
the builder fee.
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Another condition under the purchase and leaseback
agreement required Raldon to pay at closing the first full
month's rent for each of the properties plus the pro rata
portion of the monthly rent for the month of closing. The
agreement provides as follows:
Seller, as tenant, shall have * * * (ii)
paid to Purchaser, as Landlord, the first full
month's Adjusted Monthly Rental for each of the
Properties plus the pro rata portion of the
Adjusted Monthly Rental for the month during
which the Closing Date occurs.
We refer to this amount as the rent advance.
Finally, as a condition to closing, the purchase
and leaseback agreement required Raldon to supply to
the purchaser an appraisal that showed the value of the
property and improvements equal to or greater than the
purchase price. The agreement provides as follows:
An appraisal of the Properties and improvements
prepared by a FNMA/FHLMC qualified appraiser
acceptable to Purchaser on a standard FNMA/FHLMC
form which shall reflect a value of the Property
and improvements equal to or greater than the
Purchase Price.
EPIC made the following internal cash-flow analysis
of the transaction with Raldon:
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Raldon Corp. Year 1 Year 2 Year 3 Year 4 Total
Builder lease payments $61,819 $30,909 -0- -0- $92,728
Tax, ins., HOA reimburse 4,476 2,238 -0- -0- 6,714
Tenant rental -0- 17,489 $37,776 $40,798 96,063
Rental deficit contribution -0- -0- -0- -0- -0-
Interest income -0- -0- -0- -0- -0-
Total revenue 66,295 50,636 37,776 40,798 195,505
First trust interest -68,031 -68,031 -68,031 -68,031 -272,124
Tax, ins., HOA expense -4,476 -4,476 -4,476 -4,476 -17,904
Repairs & maintenance -0- -1,215 -2,430 -2,430 -6,075
Property management fee -2,100 -2,100 -2,100 -2,100 -8,400
Audit fee -607 -607 -607 -607 -2,428
Interest on EPIC advances -6,288 -6,288 -6,288 -6,288 -25,152
Total expenses -81,502 -82,717 -83,932 -83,932 -332,083
Anticipated cash deficit -15,207 -32,081 -46,156 -43,134 -136,578
As a percent of purchase -3.13% -6.60% -9.50% -8.88% -28.10%
price
According to the above analysis, EPIC projected a cash
deficit from the transaction at the end of the fourth year
of $136,578 or 28.10 percent of the original purchase
price (viz $485,995). EPIC further projected that the
following appreciation rates would be required to recoup
the investment in the properties after sales expenses of
7 percent and a disposition fee of 2.5 percent to be
paid to EPIC:
Investment Appreciation Rate
1
End of 2d year $615,744 12.56
1 1
End of 3d year 678,408 11.76
1 1
End of 4th year 723,785 10.47
1
EPIC's projection, as contained in the record is difficult to read and this
amount may differ from the projection.
By instrument dated December 22, 1982, EPIC assigned
to EA 83-XII EPIC's "right, title and interest" in the
purchase and leaseback agreement with Raldon. On
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December 27, 1982, EA 83-XII closed the purchase of each
of the five model houses from Raldon.
To finance its purchase of the subject houses, EA 83-
XII borrowed approximately 95 percent of the purchase
price of each of the properties from EPIC Mortgage, Inc.
(EMI), a corporation affiliated with EPIC. EMI's business
was to originate mortgages for EPIC partnerships. At
closing, EA 83-XII executed five nonrecourse promissory
notes, in the aggregate principal amount of $461,675,
payable to EMI in monthly installments of interest only on
the unpaid principal balance for 5 years at the rate of
14.375 percent. The entire indebtedness under each note
was due 5 years after the date of the first payment of
interest required under the note.
Each nonrecourse promissory note was secured by a
deed of trust bearing the date of closing and recorded
on January 3, 1983, in the land records of Denton County,
Texas. A mortgage insurance company, Ticor Mortgage
Insurance (TMI), issued a commitment and certificate of
insurance dated December 28, 1982, providing mortgage
insurance for 25 percent of the first loss amount with
respect to the mortgage on each of the five properties.
Set out below is a list of each of the properties
that EX 83-XII purchased from Raldon, the purchase price
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of each property, the builder fee, the rent advance, and
the amount borrowed with respect to each property:
Purchase Builder Rent
Raldon Corp. Price Fee Advance Loan
2109 Avignon Dr. $88,995 $5,339.70 $1,004 $84,525
2111 Avignon Dr. 89,500 5,370.00 1,009 85,025
2113 Avignon Dr. 100,500 6,030.00 1,134 95,475
2115 Avignon Dr. 100,500 6,030.00 1,134 95,475
2117 Avignon Dr. 106,500 6,390.00 1,201 101,175
485,995 29,159.70 5,482 461,675
A settlement statement was prepared for the sale of
each house. Each statement shows the above purchase price
as the contract sales price of the house and shows the
builder fee and rent advance for each house as charges to
the seller, Raldon, and, thus, as reductions of the amount
due to Raldon. Each statement also shows the total of the
"amounts paid by/for" EA 83-XII, as consisting principally
of the loan proceeds and the sum of the builder fees and
rent advances. The total of these amounts exceeded the
amount due from EA 83-XII. Set out below is a summary of
the settlement statements showing that a total of $8,801.60
was due to the buyer, EA 83-XII, at closing:
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Raldon Corp. Buyer Seller
Contract sales price $485,995.00 $485,995.00
Settlement charges to buyer 2,132.60 -0-
Price adjustment 12.50 12.50
Gross amount due 488,140.10 486,007.50
Principal amount of loans 461,675.00 -0-
Builder fee 29,159.70 29,159.70
Rent advance 5,482.00 5,482.00
Rental deficit contribution -0- -0-
Other credits 625.00 625.00
Settlement charges to seller -0- 5,835.04
Total credits 496,941.70 41,101.74
Amount due buyer 8,801.60 -0-
Amount due seller -0- 444,905.76
According to the settlement sheets, the aggregate
principal amount of the loans, $461,675, was credited as
follows:
Buyer Seller Others Total
Settlement charges to buyer -0- -0- $2,132.60 $2,132.60
Amount due less loan $-26,465.10 -0- -0- -26,465.10
Builder fee 29,159.70 -0- -0- 29,159.70
Rent advance 5,482.00 -0- -0- 5,482.00
Other credit 625.00 -0- -0- 625.00
Settlement charges to seller -0- -0- 5,835.04 5,835.04
Amount due seller $444,905.76 -0- 444,905.76
8,801.60 444,905.76 7,967.64 461,675.00
EMI assigned to Community Savings & Loan, Inc. (CSL),
a savings and loan association affiliated with EPIC, its
interest in each of the promissory notes and related deeds
of trust that had been issued by EA 83-XII in connection
with its purchase of the five properties from Raldon. EMI
made the assignment in an Assignment of Deed of Trust dated
March 30, 1983. In the same instrument, CSL further
assigned its interest as holder of each promissory note
under the related deed of trust to the North Jersey Savings
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& Loan Association. Thus, shortly after EA 83-XII
purchased the subject properties from Raldon, North Jersey
Savings & Loan Association purchased the promissory notes
that EA 83-XII had issued to EMI.
Purchase of Production Houses in Odessa, Texas
EPIC executed a Residential Rental Purchase Agreement
(rental purchase agreement) dated December 18, 1982, under
which it agreed to purchase seven houses located in the
Hollywood View subdivision in Odessa, Texas, from Fox and
Jacobs, Inc. (Fox & Jacobs), for $394,600. The rental
purchase agreement had originally called for the purchase
of eight properties for a total of $449,500 but was amended
by deleting one house sometime before closing.
The rental purchase agreement includes an exhibit B
for each of the seven properties that sets forth the base
price of the property and the appliances and interior
decorations included in the purchase price. This exhibit
also lists an "estimated rental amount" for the property.
Exhibit C to the rental purchase agreement gives EPIC the
right to rent each of the properties and states that, for
each property not leased as of the closing date, Fox &
Jacobs agrees to pay to the purchaser on the closing date
an amount equal to three times the monthly rent for that
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property as set forth on exhibit B. We refer to this
amount as the rent advance.
Under the rental purchase agreement, Fox & Jacobs
agreed to pay to EPIC 6.8 percent of the purchase price
of the properties. The rental purchase agreement provides
for this payment as a condition to "the obligation of
the Purchaser to purchase each of the Properties" in the
following terms:
On the Closing Date, Seller shall pay to
Equity Programs Investment Corporation a sum
equal to six and eight-tenths percent (6.8%)
of the Purchase Price of the Properties, and
the execution of this Agreement by Seller shall
constitute an irrevocable assignment to Equity
Programs Investment Corporation from the sale
proceeds of a sum sufficient to make the payment
due under Subparagraph 4.6.
We refer to this sum as the builder fee.
As a further condition to the purchaser's obligation
under the rental purchase agreement, Fox & Jacobs agreed
to pay to "the Purchaser a sum equal to the percentage as
set forth on Exhibit 'A' hereof of the purchase price of
each Property as a contribution towards rental deficits"
(referred to herein as the rental deficit contribution).
The percentages set forth on exhibit A attached to the
rental purchase agreement range from 16.38 to 17.90
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percent. We refer to this payment as the rental deficit
contribution.
The rental purchase agreement also provided, as a
condition to the purchaser's obligation to purchase the
properties, that the "purchaser shall have obtained an
appraisal of each of the Properties by a FNMA/FHLMC
qualified appraiser * * * which shall reflect the value
of each Property equal to or greater than the purchase
price applicable to that Property".
EPIC made the following internal cash-flow analysis
of the transaction with Fox & Jacobs:
Fox & Jacobs, Inc. Year 1 Year 2 Year 3 Year 4 Total
Builder lease payments -0- -0- -0- -0- -0-
Tax, ins., HOA reimburse -0- -0- -0- -0- -0-
Tenant rental $48,740 $49,659 $53,632 $57,922 $209,953
Rental deficit contribution 69,190 -0- -0- -0- 69,190
Interest income 6,556 3,935 1,312 -0- 11,803
Total revenue 124,486 53,594 54,944 57,922 290,946
First trust interest -62,922 -62,922 -62,922 -62,922 -251,688
Tax, ins., HOA expense -7,920 -7,920 -7,920 -7,920 -31,680
Repairs & maintenance -2,247 -2,247 -2,247 -2,247 -8,988
Property management fee -562 -562 -562 -562 -2,248
Audit fee -3,360 -3,360 -3,360 -3,360 -13,440
Interest on EPIC advances -5,815 -5,815 -5,815 -5,815 -23,260
Total expenses -82,826 -82,826 -82,826 -82,826 -331,304
Anticipated cash deficit 41,660 -29,232 -27,882 -24,904 -40,358
As a percent of purchase 9.27 -6.5 -6.2 -5.54 -8.98
price--check Nos.
The above analysis is based upon the original plan to
purchase eight houses for $449,500. As shown above, EPIC
projected a cash deficit from that transaction at the end
of the fourth year of $40,358 or 8.98 percent of the
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purchase price. EPIC further projected that the following
appreciation rates would be required to recoup the invest-
ment in the properties after sales expenses of 7 percent
and the disposition fee of 2.5 percent to be paid to EPIC:
Appreciation
Investment Rates
End of 2d year $507,668 6.27
End of 3d year 541,663 6.41
End of 4th year 572,185 6.22
EPIC's analysis of the transaction included a
computation of the rental deficit contribution. First,
EPIC personnel estimated that the project would generate a
monthly deficit of $2,101, taking into account estimated
monthly operating expenses of $7,961, tenant rentals of
$4,600 (with a vacancy rate of 11.7 percent), and monthly
contributions of investor capital of $1,798. According to
the analysis, the present value of the monthly deficit
over 36 months discounted at 13 percent is $62,364. The
analysis, which is reproduced below, designates this amount
as the rental deficit contribution:
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Operating expenses per month $7,961
Tenant rental revenue -4,600
Rent-up factor 0.883
Net tenant rental -4,062
Operating deficit 3,899
Investor contribution
purchase price $449,500 x 0.004 –1,798
Net monthly deficit 2,101
Present value of deficit
over 36 mos. at 13%
monthly deficit of 2,101 x 29.68 62,364 [sic]
Rental deficit contribution 62,364
As a percent of purchase price 0.1387408
The rental deficit contribution shown above was calculated using a net
borrowing cost, exclusive of servicing and private mortgage insurance
of 16.75 percent.
The rental deficit contribution computed in the above
analysis, $62,364, differs from the amount used in EPIC's
cash-flow analysis for the project, $69,190, and differs
from the rental deficit contribution finally negotiated
with Fox & Jacobs, $67,643.
By instrument dated December 21, 1982, EPIC assigned
to EA 83-XII "its entire right, title and interest, as
purchaser and landlord" in the rental purchase agree-
ment dated December 18, 1982, with Fox & Jacobs. On
December 30, 1982, EA 83-XII closed the purchase of each
of the properties.
To finance its purchase of the subject properties,
EA 83-XII borrowed approximately 95 percent of the purchase
price of each of the properties from EMI. On the closing
date, EA 83-XII executed seven nonrecourse promissory
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notes, in the aggregate principal amount of $374,850,
payable to EMI with monthly installments of interest only
on the unpaid principal balance for 5 years at the rate of
14.375 percent. Thereafter, the notes required EA 83-XII
to pay monthly installments of principal and interest for
5 years. The principal amount of each note was due at the
end of 10 years, or January 1, 1993. On March 1, 1983, the
parties executed an Allonge to Note for each of the seven
notes. The Allonge to Note states as follows:
The Note shall bear interest at the rate
computed as follows: (a) the rate of interest
for the first sixty (60) full calendar months
of the loan term shall be Fourteen and 375/1000
(14.375%) per annum; (b) thereafter, the rate of
interest shall be adjusted annually, commencing
with the sixty-first (61st) full calendar month
of the loan term, to a rate per annum equal to
the sum of the FNMA auction price in effect on
the first day of the calendar month immediately
preceding the month of such adjustment plus 237.5
basis points, payable as follows:
Interest only on the unpaid principal
balance, computed as set forth in (a) above,
shall be payable on the first day of each month
commencing April 1, 1983 and on the first day
of each succeeding month through and including
March 1, 1988. Thereafter, payments of monthly
installments of principal and interest at the
rate per annum as set forth in (b) above, shall
be fully amortized over the remaining sixty (60)
months of the loan term, except that any remain-
ing indebtedness, if not sooner paid, shall be
due and payable in full on March 1, 1993.
- 23 -
Each nonrecourse promissory note was secured by a deed
of trust bearing the closing date. The deeds of trust were
recorded in the land records of Ector County, Texas, on
January 14, 1983. Each deed of trust was amended on
March 1, 1983, to reflect the changes made by the Allonge
to Note. A mortgage insurance company, TMI, issued a
Commitment and Certificate of Insurance dated January 7,
1983, providing mortgage insurance for 25 percent of the
first loss amount with respect to the mortgage on each of
the properties.
Set out below is a list of the seven houses that
EA-XII purchased from Fox & Jacobs, Inc., together with
the purchase price, the builder fee, the rental deficit
contribution, the rent advance, and the amount borrowed
with respect to each property:
Purchase Builder Rental Deficit Rent
Fox & Jacobs, Inc. Price Fee Contribution Advance Loan
1612 Hemphill Ave. $57,400 $3,903.20 $10,039 $1,725 $54,525
1921 W. 17th St. 54,000 3,672.00 8,847 1,725 51,300
1716 Coronado Ave. 56,900 3,869.20 9,864 1,725 54,050
1720 Coronado Ave. 59,400 4,039.20 10,635 1,725 56,425
1728 Coronado Ave. 54,000 3,672.00 8,847 1,725 51,300
1700 Linda Ave. 56,900 3,869.20 9,864 1,725 54,050
1916 Hollywood Dr. 56,000 3,808.00 9,547 1,725 53,200
Subtotal 394,600 26,832.80 67,643 12,075 374,850
A settlement statement was prepared for the sale of
each property. In each case, the statement shows the above
purchase price as the "contract sales price" of the
- 24 -
property. Each statement also shows the builder fee, the
rent advance, and the rental deficit contribution as
charges to the seller, Fox & Jacobs, and, thus, as
reductions of the amount due to Fox & Jacobs. Each
statement also shows the total of the "amounts paid by/for"
EA 83-XII, as consisting principally of the loan proceeds
and the sum of the builder fees, rent advances, and rental
deficit contributions. The total of these amounts
exceeded the amount due from EA 83-XII. Set out below is
a summary of the settlement statements showing that a total
of $92,331.55 had been overpaid by or on behalf of the
buyer, EA 83-XII:
Fox & Jacobs, Inc. Buyer Seller
Contract sales price $394,600.00 $394,600.00
Settlement charges to buyer 1,794.25 ___________
Gross amount due 396,394.25 394,600.00
Principal amount of loans 374,850.00
Builder fee 26,832.80 26,832.80
Rent advance 12,075.00 12,075.00
Rental deficit contribution 67,643.00 67,643.00
Other credits 7,325.00 7,325.00
Settlement charges to seller __________ 6,026.94
Total credits 488,725.80 119,902.74
Amount due buyer 92,331.55
Amount due seller 274,697.26
According to the settlement statements, the aggregate
principal amount of the loans, $374,850, was credited as
follows:
- 25 -
Buyer Seller Others Total
Settlement charges to buyer -0- -0- $1,794.25 $1,794.25
Amount due less loans $-21,544.25 -0- -0- -21,544.25
Builder fee 26,832.80 -0- -0- 26,832.80
Rent advance 12,075 -0- -0- 12,075.00
Rental deficit contribution 67,643.00 -0- -0- 67,643.00
Other credits 7,325.00 -0- -0- 7,325.00
Settlement charges to seller -0- -0- 6,026.94 6,026.94
Amount due seller __________ $274,697.26 ________ 274,697.26
92,331.55 274,697.26 7,821.19 374,850.00
EMI assigned to CSL its interest in each of the
promissory notes and related deeds of trust that had been
issued by EA 83-XII in connection with its purchase of
the seven houses from Fox & Jacobs, Inc. EMI made the
assignment in an Assignment of Deed of Trust dated
March 31, 1983. In the same instrument, CSL further
assigned its interest as holder of each promissory note
under the related deed of trust to National Bank of
Washington. Thus, shortly after EA 83-XII purchased the
subject properties from Fox & Jacobs, National Bank of
Washington purchased the promissory notes that EA 83-XII
had issued to EMI. Ultimately, Westinghouse Credit Corp.
acquired the deeds of trust related to the seven houses.
Purchase of 39 Condominium Units in Paseos Castellanos
EPIC executed a Residential Rental Purchase Agreement
(rental purchase agreement) dated December 22, 1982, under
which it agreed to purchase 39 condominium units located
in the Paseos Castellanos condominium complex in Miami,
- 26 -
Florida, from Babcock Co. (Babcock), a subsidiary of
Weyerhaeuser, for $3,020,700. For each condominium unit
covered by the rental purchase agreement, there is attached
to the agreement an exhibit B which identifies the unit,
its purchase price, and the monthly rent, and lists the
appliances and interior decorations that are included in
the purchase.
Paseos Castellanos was constructed in 1982. It con-
sists of eight two-story buildings, with 8 units in each
building for a total of 64 units. There is a garage for
each unit. In each building, there are two one-story units
on the second floor, over the garages; four two-story units
in the center of the building; and two one-story units on
the ground floor at the rear of the building.
The 39 units purchased by EA 83-XII are scattered
among seven of the buildings. Seven are one-story units on
the second floor, each with two bedrooms, 2-1/2 bathrooms,
and 968 square feet of living space; 13 are two-story units
in the center of the building, each with two bedrooms, 2-
1/2 bathrooms, and 1,240 square feet; 12 are two-story
units in the center of the building, each with three
bedrooms, 1-1/2 bathrooms, and 1,240 square feet; and the
remaining 7 are one-story units on the ground level, each
with three bedrooms, two bathrooms, and 1,090 square feet.
- 27 -
The purchaser's obligation under the rental purchase
agreement to purchase the subject properties was subject
to the following condition:
Rental of the Properties to individual tenants
shall have been arranged, or shall be arranged,
upon execution by Purchaser of this Agreement
in accordance with the procedures set forth in
Exhibit "C," attached hereto and by this
reference made a part hereof.
According to exhibit C, in the event that EPIC had not
leased all of the properties as of the closing date, then
Babcock agreed to pay to the purchaser an amount equal to
three times the monthly fair market rent of each property
not leased as of the closing date as a nonrefundable
contribution toward the expense of listing, showing, and
leasing such property after the closing date. We refer
to this amount as the rent advance.
Under the rental purchase agreement, Babcock agreed
to pay to EPIC 6.8 percent of the purchase price of each
property on the closing date. We refer to this amount as
the builder fee. The agreement further requires as a
condition to the purchaser's obligation under the agreement
that Babcock pay to the purchaser 19.455 percent of the
purchase price of each property "as a contribution towards
rental deficits (referred to as the Rental Deficit
- 28 -
Contribution)." In this opinion, we refer to this payment
as the rental deficit contribution. Finally, the rental
purchase agreement provides, as a condition to the
purchaser's obligation to purchase the properties, that the
"purchaser shall have obtained an appraisal of each of the
Properties by a FNMA/FHLMC qualified appraiser * * * which
shall reflect the value of each Property equal to or
greater than the purchase price applicable to that
property".
EPIC made the following internal cash-flow analysis
of the transaction with Babcock:
Paseos Castellanos Year 1 Year 2 Year 3 Year 4 Total
Builder lease payments -0- -0- -0- -0- -0-
Tax, ins., HOA reimburse -0- -0- -0- -0- -0-
Tenant rental $243,873 $246,792 $266,536 $287,858 $1,045,059
Rental deficit contribution 659,929 -0- -0- -0- 659,929
Interest income 62,531 37,533 12,514 -0- 112,578
Total revenue 966,333 284,325 279,050 287,858 1,817,566
First trust interest -424,784 -424,784 -424,784 -424,784 -1,699,136
Tax, ins., HOA expense -71,196 -71,196 -71,196 -71,196 -284,784
Repairs & maintenance -15,173 -15,173 -15,173 -15,173 -60,692
Property management fee -16,380 -16,380 -16,380 -16,380 -65,520
Audit fee -3,793 -3,793 -3,793 -3,793 -15,172
Interest on EPIC advances -39,259 -39,259 -39,259 -39,259 -157,036
Total expenses -570,585 -570,585 -570,585 -570,585 -2,282,340
Anticipated cash deficit 395,748 -286,260 -291,535 -282,727 -464,774
As a percent of purchase 13.04 -9.43 -9.61 -9.32 -15.32
price
As shown above, EPIC projected a cash deficit from the
transaction at the end of the fourth year of $464,774,
or 15.32 percent of the purchase price (viz $3,034,550).
EPIC further projected that the following appreciation
- 29 -
rates would be required to recoup the investment in the
properties after sales expenses of 7 percent and a
disposition fee of 2.5 percent to be paid to EPIC:
Investment Appreciation Rate
End of 2d year 3405798 5.94
End of 3d year 3755078 7.36
End of 4th year 4094090 7.77
EPIC's analysis of the transaction included a
computation of the rental deficit contribution. First,
EPIC personnel estimated the monthly deficit from the
project, $22,235, taking into account estimated monthly
operating expenses of $54,696, tenant rentals of $22,860
(with a vacancy rate of 11.1 percent), and a monthly
contribution of investor capital of $12,138. According
to the analysis, the present value of the monthly deficit,
$22,235, discounted over 36 months at 13 percent, is
$659,929. The analysis, which is reproduced below,
designates this amount as the rental deficit contribution:
- 30 -
Operating expenses per month $54,696
Tenant rental revenue -22,860
Rent-up factor 0.889
Net tenant rental -20,323
Operating deficit 34,373
Investor contribution
purchase price $3,034,550 x 0.004 –12,138
Net monthly deficit 22,235
Present value of deficit
over 36 mos. at 13%
monthly deficit of 22,235 x 29.68 659,929 [sic]
Rental deficit contribution 659,929
As a percent of purchase price 0.2174716
The rental deficit contribution shown above was calculated using a net
borrowing cost, exclusive of servicing and private mortgage insurance
of 16.75.
The rental deficit contribution computed in the above
analysis differs from the amount finally negotiated with
Babcock, $587,676.
By instrument dated December 29, 1982, EPIC assigned
to EA 83-XII "all its right, title and interest" in the
rental purchase agreement dated December 22, 1982, with
Babcock. Thereafter, EA 83-XII closed the sale of each
of the 39 condominium units as of December 30, 1982.
To finance its purchase of the condominium units in
the Paseos Castellanos complex, EA 83-XII borrowed from
EMI approximately 95 percent of the purchase price of each
unit. On or about the closing date, EA 83-XII executed 39
nonrecourse promissory notes in the aggregate principal
amount of $2,869,625 payable to EMI in monthly installments
of interest only for 5 years at the rate of 14.375 percent.
- 31 -
Thereafter, the notes required EA 83-XII to pay monthly
installments of interest and principal for 5 years.
The notes required payment in full on January 1, 1993.
EA 83-XII executed an Allonge to Note dated March 1,
1983, for each of the 39 notes providing for a variable
interest rate for the second 5-year term. The Allonge to
Note extended the date for full payment of the indebtedness
to March 1, 1993. EA 83-XII also executed a mortgage on
the date of closing for each of the condominium units with
EA 83-XII as the mortgagor and EMI as the mortgagee. The
mortgages were modified on March 1, 1983, to reflect that
the maturity date of the notes had changed from January 1,
1993, to March 1, 1993.
Set out below is a list of the 39 condominium units
in the Paseos Castellanos complex that EA 83-XII purchased
from Babcock, together with the purchase price, the builder
fee, the rental deficit contribution, the rent advance, and
the amount borrowed with respect to each condominium unit:
- 32 -
The Babcock Co. Contract Builder Rental Deficit Rent
Paseos Castellanos Price Fee Contribution Advance Loan
H 101 $82,000 $5,576.00 $15,953 $1,800 $77,900
H 102 80,000 5,440.00 15,564 1,800 76,000
H 103 74,500 5,066.00 14,494 1,800 70,775
H 105 80,000 5,440.00 15,564 1,800 76,000
H 106 74,500 5,066.00 14,494 1,800 70,775
H 107 82,000 5,576.00 15,953 1,800 77,900
H 108 68,450 4,654.60 13,317 1,575 65,025
B 105 79,450 5,402.60 15,457 1,800 75,475
B 107 81,450 5,538.60 15,846 1,800 77,375
D 101 81,450 5,538.60 15,846 1,800 77,375
D 105 79,450 5,402.60 15,457 1,800 75,475
D 107 81,450 5,538.60 15,846 1,800 77,375
C 101 81,450 5,538.60 15,846 1,800 77,375
C 102 79,450 5,402.60 15,457 1,800 75,475
C 105 79,450 5,402.60 15,457 1,800 75,475
C 107 81,450 5,538.60 15,846 1,800 77,375
C 108 67,450 4,586.60 13,122 1,575 64,075
E 101 82,000 5,576.00 15,953 1,800 77,900
E 102 80,000 5,440.00 15,564 1,800 76,000
E 103 74,500 5,066.00 14,494 1,800 70,775
E 104 68,450 4,654.60 13,317 1,575 65,025
E 105 80,000 5,440.00 15,564 1,800 76,000
E 106 74,500 5,066.00 14,494 1,800 70,775
E 107 82,000 5,576.00 15,953 1,800 77,900
G 101 82,000 5,576.00 15,953 1,800 77,900
G 102 80,000 5,440.00 15,564 1,800 76,000
G 103 74,500 5,066.00 14,494 1,800 70,775
G 104 68,450 4,654.60 13,317 1,575 65,025
G 105 80,000 5,440.00 15,564 1,800 76,000
G 106 74,500 5,066.00 14,494 1,800 70,775
G 107 82,000 5,576.00 15,953 1,800 77,900
G 108 68,450 4,654.60 13,317 1,575 65,025
F 101 82,000 5,576.00 15,953 1,800 77,900
F 102 80,000 5,440.00 15,564 1,800 76,000
F 104 68,450 4,654.60 13,317 1,575 65,025
F 105 80,000 5,440.00 15,564 1,800 76,000
F 106 74,500 5,066.00 14,494 1,800 70,775
F 107 82,000 5,576.00 15,953 1,800 77,900
F 108 68,450 4,654.60 13,317 1,575 65,025
Subtotal 3,020,700 205,407.60 587,676 68,625 2,869,625
A settlement statement was prepared for the sale of
each condominium unit. Each statement shows the above
purchase price as the contract sales price. The statements
treat the builder fees, the rent advances, and the rental
deficit contributions as charges to Babcock and, thus, as
reductions of the amount due to Babcock as seller. In
the case of each of the subject condominium units, the
"amounts paid by/for" EA 83-XII as shown on each settlement
- 33 -
statement is the amount of the loan proceeds. Set out
below is a summary of the settlement sheets for the
purchase of the 39 condominium units in Paseos Castellanos:
Paseos Castellanos Buyer Seller
Contract sales price $3,020,700.00 $3,020,700.00
Price adjustment 476.97 476.97
Other charges 30,934.87 -0-
Gross amount due 3,052,111.84 3,021,176.97
Principal amount of loans 2,869,625.00 -0-
Builder fee 205,407.60
Rent advance -0- 68,625.00
Rental deficit contribution -0- 587,676.00
Other credits -0- 141,575.39
Amount due from buyer 182,486.84
Amount due to seller 2,017,892.98
According to the settlement sheets, the aggregate principal
amount of the loans, $2,869,625, was credited as follows:
Buyer Seller Others Total
Settlement charges -0- -0- $30,934.87 $30,934.87
Builder fee $205,407.60 -0- -0- 205,407.60
Rent advance 68,625.00 -0- -0- 68,625.00
Rental deficit contribution 587,676.00 -0- -0- 587,676.00
Other credits -0- -0- 141,575.39 141,575.39
Amount due from buyer -182,486.84 -0- -0- -182,486.84
Amount due to seller -0- $2,017,892.98 -0- 2,017,892.98
679,221.76 2,017,892.98 172,510.26 2,869,625.00
TMI issued a Commitment and Certificate of Insurance
dated January 11, 1983, under which it committed to issue
mortgage insurance for 25 percent of the first loss amount
with respect to the mortgage on each condominium unit.
Subsequently, EMI and CSL executed an Assignment of
Mortgage dated March 31, 1983, for each condominium unit
transferring their interest in each note to the National
- 34 -
Bank of Washington. Thus, shortly after EA 83-XII
purchased the subject properties from Babcock, National
Bank of Washington purchased the promissory notes that
EA 83-XII had issued to EMI. Ultimately, Westinghouse
Credit acquired the notes.
In summary, the aggregate contract prices of the
properties purchased by EA 83-XII, the aggregate rental
deficit contributions attributable to those properties,
and the aggregate amounts borrowed are as follows:
Contract Rent Deficit Loan
Price Contribution Amount
Raldon $485,995 -0- $461,675
Fox & Jacobs 394,600 $67,643 374,850
Babcock 3,020,700 587,676 2,869,625
Total 3,901,295 655,319 3,706,150
The 83 offering memorandum states that investors would
break even if the real properties acquired by EA 83-XII
appreciated at the annual rate of 7.99 percent over the
4-year period that the partnership planned to hold the
properties.
Financial Statements for EA 83-XII
The general partner prepared and circulated to the
limited partners quarterly statements for EA 83-XII
entitled "Results of Operations and Taxable Income (Loss)."
The record contains the statements for the nine quarters
- 35 -
beginning April 16, 1983, and ending June 30, 1985. If
the entries designated "current period" on the quarterly
statements for a particular year are added, the totals for
each year or part of a year during the period beginning
April 16, 1983, and ending June 30, 1985, are as follows:
4/16/83 to 1/1/84 to 1/1/85 to
12/31/83 12/31/84 6/30/85
Revenue:
Rental income $265,635.60 $306,577 $158,108
Interest income--general partner 2,219.83 90 -0-
Other income 274.10 -0- -0-
Total revenue 268,129.53 306,667 158,108
Expenses:
Interest on first mortgage 386,821.70 546,197 273,062
Additional mortgage interest -0- -0- -0-
Other interest expense -0- -0- 2,106
Real estate taxes, insurance, HOA 54,204.89 72,927 39,391
Audit fee 3,545.83 4,900 2,450
Repairs and maintenance 1,940.72 32,412 7,260
Property administration fee 21,675.00 30,778 15,300
Interest expense--general partner -0- 7,147 10,459
Rental commission 24,110.00 21,950 7,461
Legal fees 725.75 7,915 730
Other expenses 77.40 -0- 24
Total expenses 493,101.29 724,226 358,243
Net results of operations -224,971.76 -417,559 -200,135
Taxable income (loss):
Net results of operations -224,971.76 -417,559 -200,135
Plus: mortgage amortization -0- -0- -0-
Less: depreciation 122,625.76 173,120 86,560
Amortization of loan fees 11,808.84 16,672 8,336
Amortization of refinancing costs -0- -0- -0-
Accrued mortgage interest -0- -0- -0-
Taxable income (loss) -359,406.36 -607,351 -295,031
The above amounts can be compared with the cash-flow
projection that was set out in the 83 offering memorandum
and is reproduced as appendix A.
As shown above, one of the expenses recorded as having
been paid on behalf of EA 83-XII during the quarters begin-
ning April 16, 1983, and ending June 30, 1985, is "interest
- 36 -
expense--general partner" in the amount of zero during
1983, $7,147 during 1984, and $10,459 during 1985. Three
of the quarterly statements contain the following note or
words of similar import:
Interest Expense--GP:
Cash advances by the General Partner necessary to
sustain operations of the partnership continued
to be greater than budget resulting in additional
interest expense.
The quarterly statements also record "interest income--
general partner" during this period of $2,219.83, $90, and
zero, respectively.
The record also contains audited financial statements
of EX 83-XII for the years ended December 31, 1983 and
1984, that were prepared by a firm of certified public
accountants. Included in those financial statements is the
following statement of operations and changes in partners'
capital:
- 37 -
Year Ended December 31,
1984 1983
Revenues:
Rental income $306,577 $287,640
Interest income 90 9,344
Other income –0- 548
306,667 297,532
Expenses:
Interest 539,893 532,724
Depreciation 86,559 86,559
Real estate taxes 49,213 49,224
Amortization 48,096 31,096
Repairs and maintenance 30,866 20,620
Property management fee 30,600 30,600
Rental commissions 21,950 25,460
Homeowner's association dues 20,620 5,624
Insurance 16,438 27,744
Professional fees 12,993 1,347
Other expenses 2,722 1,952
859,950 812,950
Net loss (553,283) (515,418)
Partners' capital (deficit) 516,606 (10,974)
at beginning of year
Partners' contributions -0- 1,042,998
Partners' distributions (263) –0-
Partners' capital (deficit) (36,940) 516,606
at end of year
One of the notes accompanying the financial statements
deals with related-party transactions and states as
follows:
4. Related party transactions
Equity Programs Investment Corporation
(EPIC) is the sole general partner for
EPIC Associates 83-XII. The general part-
ner manages, controls and administers the
business of the Partnership. The general
partner is compensated for these services
in accordance with the fee structure set
forth in the Private Placement Offering
Memorandum of the Partnership. The
Partnership incurred $30,600 of cost per
- 38 -
year to EPIC for these services during
1984 and 1983.
Interest is charged or paid to the
Partnership on the due to/from general
partner balance in accordance with the rates
prescribed in the Private Placement Offering
Memorandum. The Partnership incurred $7,057
and earned $9,344 of interest to/from EPIC
and affiliates during 1984 and 1983,
respectively. While not obligated to do so
under the Partnership agreement, the general
partner is anticipated to advance funds to
cover cash flow deficits.
Federal Income Tax Returns Filed on Behalf of EA 83-XII
For Federal income tax purposes, EA 83-XII reported the
following income and expenses for the years in issue:
- 39 -
EA 83-XII 1983 1984 1985
Rent income $287,640 $306,577 $331,743
Late charges 548 -0- -0-
Interest income 9,344 90 1,262
Miscellaneous -0- -0- 883
Total gross income 297,532 306,667 333,888
Interest (noninvestment) 466,358 539,893 560,177
Commissions 25,460 21,950 24,846
Insurance 27,744 16,438 18,992
Legal and professional fee 726 8,093 574
Repairs 1,348 30,866 15,075
Taxes 49,224 49,213 45,962
Utilities 464 1,547 951
Homeowners dues 20,620 20,620 25,350
Audit fee 4,900 4,900 3,267
Points amortization 16,671 16,671 16,671
Property management 30,600 30,600 29,837
Real estate tax service 1,278 -0- -0-
Miscellaneous 107 -0- 856
Depreciation 173,119 173,119 173,119
Bad debts -0- 1,174 -0-
Amortization org. expense -0- 3,150 -0-
Recording fees -0- -0- 24
Service fee-EMI -0- -0- 3,413
Total expenses 818,619 918,234 -919,114
Net rental income -521,087 -611,567 -585,226
On its Schedule K, Partner's Share of Income Credits,
Deductions, etc., for 1983, EA 83-XII reported an ordinary
loss of $521,087, investment interest expense of $66,366,
net investment income of $29,306, and excess expenses from
"net lease property" of $10,859; and for purposes of
allocating tax preference items to its partners, EA 83-XII
reported a net investment loss of $341,010.
On its Schedules K for 1984 and 1985, EA 83-XII
reported ordinary losses of $611,567 and $585,226,
respectively, and investment income of $90 and $1,262,
- 40 -
respectively; and for purposes of allocating tax preference
items to its partners, EA 83-XII reported qualified
investment income of $303,571 and $330,529, respectively,
and qualified investment expenses of $908,960 and $909,831,
respectively.
For depreciation purposes, EA 83-XII treated the
aggregate contract price of its 51 properties, $3,901,295,
less the aggregate rental deficit contribution, $655,319,
as its aggregate basis in the real estate; viz $3,245,976.
EA 83-XII allocated 20 percent of that amount to land;
viz $649,195, and 80 percent to buildings; viz $2,596,781.
EA 83-XII depreciated the latter amount on a straight-line
basis over 15 years and claimed depreciation of $173,119
in each of the years in issue.
For each of the years in issue, EA 83-XII was
obligated under the promissory notes that it had issued
to EMI to pay interest on the aggregate principal amount
of the notes, $3,706,150, at the annual rate of 14.375
percent. Thus, EA 83-XII was obligated to pay interest to
EMI in the aggregate amount of $532,759 during each of the
years in issue (i.e., $3,706,150 x 14.375 percent).
EA 83-XII was also obligated under the 83 partnership
agreement to pay interest at the annual rate of 15 percent
to compensate the general partner for unsecured advances of
- 41 -
funds to the partnership. The returns filed on behalf of
EA 83-XII for the years in issue report the following
liabilities to the general partner on Schedule L, Balance
Sheets:
Year Ended Amount of Advances Accrued Interest
12/31/83 $2,991 -0-
12/31/84 104,754 $7,147
12/31/85 57,567 12,929
EA 83-XII reported the following interest expense on
its returns for the years in issue:
1983 1984 1985
Interest (noninvestment) $466,358 $539,893 $560,177
Investment interest income 66,366 -0- -0-
Total 532,724 539,893 560,177
The difference between the above amounts and the interest
paid or incurred with respect to the partnership's first
mortgage notes is as follows:
1983 1984 1985
Total interest expense reported $532,724 $539,893 $560,177
Interest on first mortgage notes 532,759 532,759 532,759
Difference (35) 7,134 27,418
The record of this case does not explain the above
differences.
- 42 -
EA 83-XII paid loan origination fees to EMI in the
aggregate amount of $148,246 equal to 4 percent of the
principal amount of the first mortgage loans (i.e.,
$3,706,150 x 4 percent). This amount was amortized over
the life of the loans. For each of the years in issue,
EA 83-XII reported "points amortization" expense of $16,671
on each of the subject returns.
EA 84-III
EPIC formed EA 84-III on September 14, 1983, pursuant
to the Uniform Limited Partnership Act of the Commonwealth
of Virginia for a 10-year term ending on September 14,
1993. EPIC was the sole general partner. The Certificate
and Agreement of Limited Partnership was amended by the
execution and filing of an Amended and Restated Certificate
and Agreement of Limited Partnership dated October 1, 1983,
which was recorded on December 20, 1983, among the limited
partnership records maintained by the clerk of the court of
Fairfax County, Virginia. The Certificate and Agreement of
Limited Partnership of EA 84-III was amended for a second
time on April 1, 1985. The Second Amended and Restated
Certificate and Agreement of Limited Partnership (84
partnership agreement) describes the business of EA 84-III
in the following terms:
- 43 -
Business of the Partnership
The business of the Partnership has been and
shall be to acquire, directly or indirectly, own
and finance fee interests in certain improved
residential real properties and to hold such
properties for investment with the objective of
attaining maximum capital appreciation therein
and to engage in and perform all necessary and
proper acts and activities in connection there-
with including, but not limited to, operating,
managing, maintaining, leasing, mortgaging,
selling, exchanging or otherwise dealing with
such properties with the objective of distribut-
ing income generated thereby among the Partners
as provided for herein.
The 84 partnership agreement provides that EPIC's
"interest shall be deemed to be a one-percent (1%) share
in the partnership's capital contributions for which it
shall contribute" $12,267. In addition, the 84 partnership
agreement authorizes five enumerated classes of limited
partnership interest, classes A through E, and such
additional classes as are authorized by the general
partner.
The 84 partnership agreement states that one class A
unit, representing an aggregate capital contribution of
$132,918.89, was sold to four investors, one class B unit,
representing a capital contribution of $56,900, was sold
to one investor, and one class C unit, representing an
aggregate capital contribution of $208,750, was sold to
three investors. It also appears that thereafter two
- 44 -
investors made an aggregate capital contribution of
$51,381.
According to the partnership agreement, if the need
for additional equity arose, the general partner could
authorize any number of additional classes of limited
partnership interest. Purchasers of the additional classes
would be admitted to the limited partnership starting on
July 1, 1986. The agreement also states that the general
partner, in its sole discretion, may authorize future class
units from January 1, 1988, through and until the
termination of the partnership.
Before offering class D and class E units of limited
partnership interest in EA 84-III for sale, EPIC circulated
a confidential private placement offering memorandum (84
offering memorandum) dated April 1, 1985. The 84 offering
memorandum states that the class A, B, C, D, and E limited
partners' contributions would be used primarily to fund
operating deficits of EA 84-III. The 84 offering memo-
randum contains a chart summarizing EA 84-III's anticipated
sources and uses of the proceeds of the offering as
follows:
- 45 -
Sources Amount Percent
Proceeds from sale of class A unit $132,918 2.32
Proceeds from sale of class B unit 56,900 1.00
Proceeds from sale of class C unit 208,750 3.64
Proceeds from sale of class D unit 75,000 1.31
Proceeds from sale of class E unit 290,850 5.07
Proceeds from sale of additional class(es) 450,000 7.85
Capital contributions of general partner 12,266 0.21
First mortgage loans 3,453,450 60.24
Builder rebates 755,287 13.17
General partner advances 297,400 5.19
Total 5,732,821 100.00
Uses
Purchase price of homes 3,956,700 69.02
Sales commissions to broker/dealers 97,153 1.70
Escrows and prepaid insurance 18,070 .32
First mortgage loan origination fees 138,138 2.40
Organizational fee to general partner 85,009 1.48
Estimated cash-flow deficits
through September 30, 1984 473,417 8.26
Available for cash-flow deficits 964,334 16.82
Total 5,732,821 100.00
As set forth above, it was anticipated that $473,417 of
the proceeds of the offering would be offset by cash-flow
deficits through September 30, 1984, and $964,334 of the
offering proceeds would be available for cash-flow deficits
after that date.
The projected annual income and operating costs of
EA 84-III as set forth in the 84 offering memorandum shows
an annual operating deficit of $431,115 calculated as
follows:
- 46 -
Percentage of
Projected Annual Income Amount Total Income
Rental income (less 20%
vacancy & expense factor) $231,293 100.00
Total projected income 231,293 100.00
Annual Operating Expenditures
Aggregate first mortgage
principal & interest 502,217 217.14
Real estate taxes 72,617 31.40
Insurance & homeowner's
association dues 12,511 5.41
Audit expenses 4,945 2.14
Property administration fee 33,000 14.27
Allowance for maintenance
& repairs 19,783 8.55
Additional interest 17,335 7.49
Total projected cash
expenditures 662,408 286.40
Projected operating deficits 431,115 186.40
The 84 offering memorandum also includes a cash-flow
analysis for EA 84-III from October 1, 1983, through
December 31, 1987, as set forth in appendix B to this
opinion.
In the 84 offering memorandum, it was contemplated
that EPIC would finance the partnership's operating
deficits by advancing funds to the partnership. The 84
partnership agreement provides that EA 84-III would pay
interest on all unsecured advances of funds by the
general partner at the rate of 15 percent per annum. The
84 partnership agreement permits the partnership to advance
to the general partner any funds that were not distributed
- 47 -
to the limited partners, and the agreement provides that
the general partner would pay interest to EA 84-III on such
advances at the rate of 12 percent per annum.
The 84 partnership agreement provides that cash from
operations is to be distributed generally in the following
order of priority: (i) To EPIC to repay any unsecured
advances made by EPIC to the partnership together with
interest; (ii) to the partners in the ratio that the
cumulative cash capital contributions of each partner bear
to the cumulative cash capital contributions of the
partners until such amounts equal the partners' cumulative
cash capital contributions; (iii) 25 percent to EPIC and 75
percent to the limited partners holding the class A, B, C,
D, E, and additional class units.
The partnership agreement further provides that
cash from sales not associated with a liquidation and/or
financings is to be distributed generally in the following
order of priority: (i) To repay the partnership debt
secured by the property sold or refinanced; (ii) to repay
general creditors of the partnership, including EPIC, any
advances with interest; (iii) to establish such reserves as
the general partner deems necessary; (iv) to the partners
in the ratio that the cumulative cash capital contributions
of each partner bear to the cumulative cash capital
- 48 -
contributions of the partners up to the amounts which equal
the partners' cumulative cash capital contributions; and
(v) 25 percent to EPIC and 75 percent to the limited
partners.
The 84 partnership agreement states that EA 84-III
shall compensate EPIC as follows:
Compensation of the General Partner and Affiliates
* * * * * * *
(a) At the time of subscription, the General
Partner shall receive seven percent (7%) of each
Class A, Class B, Class C, Class D, Class E and
any Additional Class or Classes Limited Partner's
full contribution to the Partnership as a
Partnership organization fee, as defined in the
Confidential Private Offering Memorandum for the
Partnership, or a maximum total payment of
eighty-five thousand nine and 32/100 dollars
($85,009.32) for nonrecurring services which may
be incurred before or after formation of the
Partnership, including the furnishing of legal,
financial, accounting and operational assistance,
reviewing rental schedules and expense forecasts
and providing other services which do not give
rise to the acquisition or leasing of specific
properties or the obtaining of financing
therefor.
(b) At the time of subscription to Future Class
Units authorized pursuant to section 8(k), the
General Partner, in its sole discretion, shall
receive up to seven percent (7%) of the proceeds
of the full contribution of each holder of a
Future Class Unit for nonrecurring services which
may be performed before or after authorization
and sale of such Future Class Units, which may
include furnishing legal, financial, accounting
and operational assistance, reviewing and analyz-
ing the Partnership's condition and determining
- 49 -
the need for an amount of such additional capital
to be raised by the sale of such Future Class
Units.
(c) During each full or partial month of the
Partnership, the General Partner shall be paid
a Property Administration Fee equal to fifty
dollars ($50) per month for each Partnership
property.
* * * * * * *
(d) Such loan origination fees or service fees
as may derive from originating or servicing any
security interests, including mortgages and deeds
of trust, placed upon Partnership property.
(e) Reimbursement of all carrying costs of the
Partnership properties, including, but not
limited to, interest on mortgage indebtedness
encumbering the properties incurred prior to the
admission to the Partnership of the Limited
Partners.
(f) On all Advances of funds to the Partnership
made by the General Partner pursuant to section
8(a)(xiv), the General Partner shall be entitled
to interest at the rate of fifteen percent (15%)
per annum.
* * * * * * *
(i) Any item of Partnership expense or cost
may be paid to an entity or person affiliated
directly or indirectly with the General Partner,
subject only to the requirement that such
affiliated or related person or entity perform
such service as is contracted for or requested
in consideration for such cost or expense.
- 50 -
Purchase of Production Houses in Texas and Arizona
EPIC entered into a Residential Rental Purchase
Agreement (rental purchase agreement), dated September 16,
1983, under which it agreed to purchase 142 residential
properties from U.S. Home Corp. (U.S. Home) for an
aggregate purchase price of $8,767,850. The location and
purchase price of each property is set forth in exhibit A
to the rental purchase agreement.
As a condition to the purchaser's obligation under
the rental purchase agreement, U.S. Home agreed to pay to
EPIC 6.8 percent of the purchase price of each property on
the closing date. The rental purchase agreement provides
for this payment in the following language:
On the Closing Date, Seller shall pay to
Equity Programs Investment Corporation a sum
equal to six and eight-tenths (6.8%) of the
Purchase Price of the Properties, and the
execution of this Agreement by Seller shall
constitute an irrevocable assignment to Equity
Programs Investment Corporation from the sale
proceeds of a sum sufficient to make the payment
due under this Subparagraph 4.6.
We refer to this amount as the builder fee.
The rental purchase agreement also requires U.S. Home
to pay to the purchaser 3 months' rent for each property
under certain conditions. That provision states as
follows:
- 51 -
On the Closing Date, Seller shall pay to
Purchaser a sum equal to the total estimated
rent for three (3) months, as shown on Exhibit
A for each of the Properties (the "Reserve").
At such time as all of the Properties have been
rented at least once, or upon the expiration of
seven (7) months from the Closing Date,
whichever shall first occur, Purchaser shall
refund the Reserve to Seller, less the product
of the rent, as shown in Exhibit A, times the
period of vacancy for each Property since the
Closing Date. For seven (7) full months after
the Closing Date, Purchaser shall furnish Seller
written monthly reports detailing occupancy and
rents.
In this opinion, we refer to the payment required under the
above provision as the rent advance.
The agreement further obligated U.S. Home to pay to
the purchaser "a sum equal to the amount as set forth on
Exhibit 'A' hereof of the purchase price of each Property
as a contribution towards rental deficits (rental deficit
contribution)." We refer to this amount as the rental
deficit contribution. Finally, the rental purchase
agreement conditioned the purchaser's obligation under the
agreement on the acquisition of "an appraisal of each of
the Properties by a FNMA/FHLMC qualified appraiser on a
standard FNMA/FHLMC form which shall reflect the value of
each Property equal to or greater than the purchase price
applicable to that Property".
- 52 -
EPIC assigned its right, title, and interest as
purchaser under the rental purchase agreement with U.S.
Home to various limited partnerships of which it was
general partner. EPIC assigned its right to purchase 15
of the 142 properties to EA 84-III. On September 19, 1982,
EA 84-III purchased the 15 properties it had been assigned
for an aggregate purchase price of $908,700.
To finance its purchase of the 15 properties, EA 84-
III borrowed $863,250, approximately 95 percent of the
purchase price, from EMI. On the closing date, EA 84-III
executed 15 nonrecourse promissory notes in the aggregate
principal amount of $863,250, payable to EMI with monthly
installments of interest only for 5 years at the annual
rate of 14.625 percent. Thereafter, the notes required
EA 84-III to pay monthly installments of principal and
interest for 5 years. The full indebtedness was due and
payable on October 1, 1993.
Each nonrecourse promissory note was secured by a
deed of trust dated on the closing date. Most of the deeds
of trust were recorded either in the land records of Harris
County or Bexar County, Texas, or Pima County, Arizona. A
mortgage insurance company, Republic Mortgage Insurance Co.
(RMIC), issued a commitment and certificate of insurance
providing mortgage insurance for 25 percent of the first
- 53 -
loss amount with respect to the mortgage on each of the
properties.
Set out below is a list of the 15 properties,
together with the purchase price, the builder fee, the
rental deficit contribution, the rent advance, and the
amount borrowed with respect to each property:
Rental
Purchase Builder Deficit Rent
Houses and Condominiums Price Fee Contrib. Advance Loan
5419 Heronwood Dr. $54,000 $3,672.00 $6,189 $1,395 $51,300
5411 Heronwood Dr. 65,000 4,420.00 9,610 1,395 61,750
3518 Tower Hill Lane 63,750 4,335.00 8,959 1,425 60,550
12347 Northcliff Manor Dr. 58,500 3,978.00 7,326 1,425 55,575
13066 Clarewood Dr. 57,000 3,876.00 8,169 1,275 54,150
6351 S. Briar Bayou Dr. 61,500 4,182.00 8,914 1,350 58,425
12103 Kingslake Forest Dr. 60,500 4,012.00 8,341 1,380 57,475
12107 Kingslake Forest Dr. 50,500 3,434.00 5,231 1,380 47,975
12111 Kingslake Forest Dr. 56,000 3,808.00 6,549 1,425 53,200
12115 Kingslake Forest Dr. 64,000 4,352.00 9,037 1,425 60,800
12231 Carola Forest Dr. 59,000 4,114.00 7,482 1,425 56,050
4850 West Ferret Dr. 71,000 4,828.00 9,905 1,575 67,450
4107 Medical Dr. (Condo.) 59,950 4,076.60 7,777 1,425 56,950
13739 Earlywood Dr. 64,000 4,352.00 9,692 1,350 60,800
6402 Ridgecreek Dr. 64,000 4,352.00 9,692 1,350 60,800
Total 908,700 61,791.60 122,873 21,000 863,250
The sale of each property to EA 84-III is reflected on
a settlement statement executed on the date of closing that
shows the purchase price listed above as the contract sales
price. For each of the properties, the total of the
"amounts paid by/for" EA 84-III, consisting principally of
the loan proceeds and the sum of the builder fee, rent
advance, and rental deficit contribution, exceeded the
gross amount due from EA 84-III. Set out below is a
summary of the settlement statements showing that a total
- 54 -
of approximately $142,658.49 had been overpaid by or behalf
of the buyer, EA 84-III:
U.S. Home Corp. Buyer Seller
Contract sales price $908,700.00 $908,700.00
Settlement charges to buyer 18,600.95 -0-
Price adjustment 830.16 830.16
928,131.11 909,530.16
Principal amount of loans 863,250.00 -0-
Builder fee 61,791.60 61,791.60
Rent advance 21,000.00 21,000.00
Rental deficit contribution 122,873.00 122,873.00
Other credits 1,875.00 1,875.00
Settlement charges to seller -0- 11,320.94
1,070,789.60 218,860.54
1
Amount due to buyer 142,658.49
Amount due to seller 690,669.62
1
The record does not contain 4 of the 15 settlement statements and some amounts
composing this total were estimated.
According to the settlement statements, the aggregate
principal amount of the loans, $863,250, was credited as
follows:
U.S. Home Corp. Buyer Seller Others Total
Settlement charges to buyer -0- -0- $18,600.95 $18,600.95
Amount due less loan $-64,881.11 -0- -0- -64,881.11
Builder fee 61,791.60 -0- -0- 61,791.60
Rent advance 21,000.00 -0- -0- 21,000.00
Rental deficit contribution 122,873.00 -0- -0- 122,873.00
Other credits 1,875.00 -0- -0- 1,875.00
Settlement charges to seller -0- -0- 11,320.94 11,320.94
Amount due seller -0- $690,669.62 -0- 690,669.62
142,658.49 690,669.62 29,921.89 863,250.00
In passing, we note that the parties stipulated that
U.S. Home sold to EA 84-III the two houses at 5411 and 5419
Heronwood Drive, and the four houses at 12103, 12107,
12111, and 12115 Kingslake Forest Drive. These six
properties are listed among the properties covered by the
- 55 -
Residential Rental Purchase Agreement dated September 16,
1983, between EPIC and U.S. Home. Furthermore, the
settlement statement for the sale of five of those
properties lists the seller as U.S. Homes. The record does
not contain the settlement statement for the sale of 12103
Kingslake Forest Drive.
At trial, respondent introduced warranty deeds that
show that on or about June 1, 1982, the two properties on
Heronwood Drive were transferred by U.S. Home to Tanmis
Models, Inc., and on or about August 26, 1983, were
transferred by Tanmis Models, Inc., to EA 84-III.
Respondent also introduced warranty deeds that show that
on or about September 1, 1981, the four properties on
Kingslake Forest Drive were transferred by U.S. Home
to Dyblof Models, Inc., and on or about August 26, 1983,
were transferred by Dyblof Models, Inc., to EA 84-III.
Apparently, these six properties were models that EPIC
acquired from U.S. Home through companies affiliated with
EPIC, Tanmis Models, Inc., and Dyblof Models, Inc., and
leased back to U.S. Home. Under its agreement with EPIC,
U.S. Home had the right to buy each property back at the
original purchase price at the end of the lease term.
EMI assigned to CSL its interest in each of the
promissory notes and related deeds of trust that had been
- 56 -
issued by EA 84-III in connection with its purchase of the
15 properties from U.S. Home. EMI made the assignment in
documents entitled Assignment of Deed of Trust that are
dated November 29, 1983. In the same instruments, CSL
further assigned to the National Bank of Washington its
interest as holder of each promissory note under the
related deed of trust. This documents the fact that
shortly after EA 84-III purchased the subject properties
from U.S. Home, National Bank of Washington purchased the
promissory notes that EA 84-III had issued to EMI. Salomon
Brothers, Inc., ultimately acquired the deeds of trust for
all of the 15 properties.
As general partner of EA 84-III, EPIC executed 16
promissory notes dated February 1, 1985. Each of the
notes was payable to CSL in the principal amount of $5,000,
a total of $80,000. Under each of the promissory notes,
EA 84-III promised to pay monthly installments of interest
only on the unpaid principal balance at the annual rate
of 15 percent with the principal due and payable on
February 1, 1987. Fifteen of the promissory notes were
secured by deeds of trust on the 15 properties described
above. Each of the deeds of trust states that it is
"subordinate to the lien of the institutional first deed
of trust which was recorded prior to this Deed of Trust".
- 57 -
The 16th promissory note and the related deed of trust are
similar to the others, except they refer to unit 101 of
The Reflections condominium complex, described below.
Purchase of 40 Condominiums Units in the Reflections
EPIC executed a Residential Rental Purchase Agreement
(rental purchase agreement), dated August 3, 1983, under
which it agreed to purchase a condominium complex located
in San Antonio, Texas, known as the Reflections from Pitman
Properties, Inc., and Japhet Properties, Inc. (herein
Pitman & Japhet), for $3,048,000. For each condominium
unit, there is attached to the agreement an exhibit B that
identifies the unit, lists the appliances and furnishings
included in the purchase price, and states the estimated
monthly rent for the unit.
The Reflections is a 40-unit condominium complex
which was new at the time of this transaction in 1983.
The complex is composed of seven buildings with a total of
40,356.85 square feet of net rentable living area located
on 2.233 acres. The units have fireplaces, parking spaces,
1,135 square feet of storage space, and patios, porches and
balconies. There is a pool and exterior landscaping, and
one side of the complex faces a man-made lake.
- 58 -
Under the rental purchase agreement, Pitman & Japhet
agreed as a condition to closing to pay to EPIC 6.8 percent
of the purchase price of each unit. We refer to this
amount as the builder fee. As a further condition to
closing, Pitman & Japhet agreed to pay to the purchaser a
sum equal to the percentage of the purchase price of each
unit that is set forth on exhibit A to the agreement as a
contribution towards rental deficits (rental deficit
contribution). The percentages set forth on exhibit A
range from 20.30 percent to 21.39 percent. We refer to
this amount as the rental deficit contribution.
As a further condition to EPIC's obligation, the
agreement provides:
Rental of the Properties to individual tenants
shall have been arranged, or shall be arranged,
upon execution by Purchaser of the Agreement
in accordance with the procedures set forth in
Exhibit "C", attached hereto and by this
reference made a part hereof.
Pursuant to exhibit C, in the event that any of the
properties were not leased as of 7 days before closing,
Pitman & Japhet agreed to pay to the purchaser, in addition
to the rental deficit contribution, an amount equal to
three times the monthly rent set forth for each unit that
- 59 -
was not rented as of the closing date. We refer to this
payment as the rent advance.
The purchaser's obligations under the rental purchase
agreement were also subject to the condition that the
purchaser shall have obtained "an appraisal of each of the
Properties prepared by a FNMA/FHLMC qualified appraiser on
a standard FHMA/FHLMC form which shall reflect the value of
each Property equal to or greater than the purchase price".
It appears that EPIC assigned to EA 84-III its rights
as purchaser under the rental purchase agreement dated
August 3, 1983, with Pitman & Japhet. The record does not
contain an instrument of assignment. In any event, on
September 30, 1983, EA 84-III purchased the 40 condominium
units at the Reflections.
To finance its purchase of the condominiums, EA 84-III
borrowed $2,590,200, approximately 85 percent of the
aggregate purchase price, from EMI. EA 84-III executed 40
nonrecourse promissory notes in the aggregate principal
amount of $2,590,200, that were each payable to EMI with
monthly installments of interest at the annual rate of
14.125 percent. The record does not contain any of the
40 promissory notes, but their terms are summarized in the
84 offering memorandum as follows:
- 60 -
Thirty-five month interest only, thirteen months
amortizing on the leases [sic] of a thirty year
amortization schedule, six year level pay fully
amortizing, with no adjustments in the interest
rate during the life of the loan.
Each promissory note was secured by a deed of trust and was
covered by a private mortgage insurance policy. The record
does not contain the deeds of trust or documents relating
to the private mortgage insurance. At some time,
Philadelphia Savings Fund of Philadelphia acquired the
promissory notes that EA 84-III had issued to EMI and EMI
assigned each of the 40 deeds of trust to Philadelphia
Savings Fund of Philadelphia.
Set out below is a list of the 40 condominiums that
EA 84-III purchased together with the purchase price,
rental deficit contribution, rent advance, and loan amount:
- 61 -
Rental
Purchase Builder Deficit Rent
Unit Price Fee Contrib. Advance Loan
A 101 $91,900 $6,249.20 $19,661 $1,800 $78,100
A 102 97,900 6,657.20 20,596 1,950 83,200
A 103 97,900 6,657.20 20,596 1,950 83,200
A 104 91,900 6,249.20 19,661 1,800 78,100
B 201 91,900 6,249.20 19,661 1,800 78,100
B 202 97,900 6,657.20 20,597 1,950 83,200
B 203 97,900 6,657.20 20,597 1,950 83,200
B 204 91,900 6,249.20 19,661 1,800 78,100
C 301 91,900 6,249.20 19,661 1,800 78,100
C 302 97,900 6,657.20 20,597 1,950 83,200
C 303 97,900 6,657.20 20,597 1,950 83,200
C 304 91,900 6,249.20 19,661 1,800 78,100
D 401 75,900 5,161.20 15,616 1,575 64,500
D 402 75,900 5,161.20 15,616 1,575 64,500
D 403 75,900 5,161.20 15,616 1,575 64,500
D 404 75,900 5,161.20 15,616 1,575 64,500
E 501 75,900 5,161.20 15,616 1,575 64,500
E 502 57,900 3,937.20 11,751 1,245 49,200
E 503 75,900 5,161.20 15,616 1,575 64,500
E 504 57,900 3,937.20 11,751 1,245 49,200
E 505 57,900 3,937.20 11,751 1,245 49,200
E 506 75,900 5,161.20 15,616 1,575 64,500
E 507 57,900 3,937.20 11,751 1,245 49,200
E 508 75,900 5,161.20 15,616 1,575 64,500
F 601 75,900 5,161.20 15,616 1,575 64,500
F 602 57,900 3,937.20 11,751 1,245 49,200
F 603 75,900 5,161.20 15,616 1,575 64,500
F 604 57,900 3,937.20 11,751 1,245 49,200
F 605 57,900 3,937.20 11,751 1,245 49,200
F 606 57,900 3,937.20 11,751 1,245 49,200
F 607 57,900 3,937.20 11,751 1,245 49,200
F 608 57,900 3,937.20 11,751 1,245 49,200
F 609 57,900 3,937.20 11,751 1,245 49,200
F 610 75,900 5,161.20 15,616 1,575 64,500
F 611 57,900 3,937.20 11,751 1,245 49,200
F 612 75,900 5,161.20 15,616 1,575 64,500
G 701 75,900 5,161.20 15,616 1,575 64,500
G 702 75,900 5,161.20 15,616 1,575 64,500
G 703 75,900 5,161.20 15,616 1,575 64,500
G 704 75,900 5,161.20 15,616 1,575 64,500
Total 3,048,000 207,264.00 632,414 62,640 2,590,200
The sale of each condominium to EA 84-III is reflected
on a settlement statement executed on the date of closing
that shows the purchase price listed above as the "contract
sales price". On each settlement statement, the builder
fee, rent advance, and rental deficit contribution are
treated as charges to Pitman & Japhet, reducing the amount
due Pitman & Japhet. These amounts are also treated as
credits to EA 84-III. Set out below is a summary of the
- 62 -
settlement statements showing that the aggregate amounts
paid by or on behalf of the buyer, EA 84-III, exceeded the
aggregate amount due from the buyer by $441,356.12:
Pitman & Japhet Properties Buyer Seller
Contract sales price $3,048,000.00 $3,048,000.00
Settlement charges to buyer 16,018.38 -0-
3,064,018.38 3,048,000.00
Principal amount of loans 2,590,200.00 -0-
Builder fee 207,264.00 207,264.00
Rent advance 62,640.00 62,640.00
Rental deficit contribution 632,414.00 632,414.00
Adjustments 1,756.50 1,756.00
Other credits 11,100.00 11,100.00
Payoff loans -0- 1,548,548.53
Settlement charges to seller -0- 132,833.00
3,505,374.50 2,596,556.03
Amount due buyer 441,356.12
Amount due seller 451,443.97
According to the settlement statements, the aggregate
principal amount of the loans, $2,590,200, was credited as
follows:
Pitman & Japhet Properties Buyer Seller Others Total
Settlement charges to buyer -0- -0- $16,018.38 $16,018.38
Amount due less loans $-473,818.38 -0- -0- -473,818.38
Builder fee 207,264.00 -0- -0- 207,264.00
Rent advance 62,640.00 -0- -0- 62,640.00
Rental deficit contribution 632,414.00 -0- -0- 632,414.00
Adjustments 1,756.50 -0- -0- 1,756.50
Other credits 11,100.00 -0- -0- 11,100.00
Payoff loans -0- -0- 1,548,548.53 1,548,548.53
Settlement charges to seller -0- -0- 132,833.00 132,833.00
Amount due seller -0- $451,443.97 -0- 451,443.97
441,356.12 451,443.97 1,697,399.91 2,590,200.00
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In summary, the aggregate contract prices of the
properties purchased by EA 84-III, the aggregate rental
deficit contributions attributable to those properties,
and the aggregate amounts borrowed are as follows:
Contract Rental Deficit Loan
Price Contribution Amount
U.S. Home $908,700 $122,873 $863,250
Pitman & Japhet 3,048,000 632,414 2,590,200
Total 3,956,700 755,287 3,453,450
The 84 offering memorandum states that investors would
break even if the real properties acquired by EA 84-III
appreciated at the annual rate of 9.15 percent over the
4-year period that the partnership planned to hold the
properties.
Financial Statements for EA 84-III
The general partner prepared and circulated to the
limited partners quarterly statements for EA 84-III
entitled "Results of Operations and Tax Income (Loss)".
The record contains the statements for the eight quarters
beginning September 19, 1983, and ending June 30, 1985.
If the entries designated "current period" on the quarterly
statements for a particular year are added, the totals for
each entry for each year or part of a year during the
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period beginning September 16, 1983, and ending June 30,
1985, are as follows:
EA 84-III 9/19/83 to 1/1/84 to 1/1/85 to
12/31/83 12/31/84 6/30/85
Revenue:
Rental income $76,790.36 $228,516 $107,858
Interest income--general partner 6,097.26 -0- -0-
Other income -0- -0- 2,866
Total revenue 82,887.62 228,516 110,724
Expenses:
Interest on first mortgage 118,081.87 504,391 250,902
Additional mortgage interest -0- -0- -0-
Other interest expense -0- -0- 5,000
Real estate taxes, insurance, HOA 26,480.69 83,110 45,240
Audit fee 5,000.00 5,000 2,500
Repairs and maintenance 10,225.44 120,032 30,811
Property administration fee 8,250.00 33,000 16,500
Interest expense--general partner -0- 28,175 18,680
Rental commission 5,305.42 23,198 10,118
Legal fees 15.00 687 167
Other expenses 140.81 -0- 90
Total expenses 173,499.23 797,593 380,008
Net results of operations -90,611.61 -569,077 -269,284
Taxable income (loss):
Net results of operations -90,611.61 -569,077 -269,284
Plus: mortgage amortization -0- -0- -0-
Less: depreciation 42,685.50 170,742 85,372
Amortization of loan fees 3,454.45 13,812 6,906
Amortization of refinancing costs -0- -0- -0-
Accrued mortgage interest -0- -0- -0-
Misc. expenses -0- 28 -5
Taxable income (loss) -136,750.56 -753,659 -361,557
The above amounts can be compared with the cash-flow
projection that was set out in the 84 offering memorandum
and is reproduced as appendix B.
As shown above, one of the expenses recorded as having
been paid on behalf of EA 84-III during the period begin-
ning September 19, 1983, and ending June 30, 1985,
is interest expense--general partner of zero during 1983,
$28,175 during 1984, and $18,680 during 1985. Three of
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the statements contain the following note or words of
similar import:
Interest Expense--GP:
Cash advances by the General Partner necessary
to sustain operations of the partnership
continued to be greater than budget resulting
in additional interest expense.
The quarterly statements also record that EA 84-III
received interest income--general partner of $6,097.26
during 1983.
The record contains audited financial statements of
EA 84-III for the period beginning September 14 (inception)
to December 31, 1983, that were prepared by a firm of
certified public accountants. Included therein is the
following statement of operations and changes in partners'
capital:
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Revenues:
Rental income $76,790
Interest income 2,756
79,546
Expenses:
Interest 118,082
Depreciation 21,343
Real estate taxes 18,123
Amortization 3,804
Property management fee 8,250
Rental commission 5,305
Insurance 5,480
Repairs and maintenance 8,500
Other 9,759
198,646
Loss from operations (119,100)
Partners' capital contributions 134,334
Partners' capital at end of year 15,234
One of the accompanying notes deals with related-party
transactions and states as follows:
4. Related party transactions
Equity Programs Investment Corporation
(EPIC) is the sole general partner for EPIC
Associates 84-III. The general partner
manages, controls and administers the
business of the Partnership. The general
partner is compensated for these services in
accordance with the fee structure set forth
in the Private Placement Offering Memorandum
of the Partnership. The Partnership
incurred $8,250 of cost to EPIC for these
services during 1983. In addition the
partnership paid organization fees to EPIC
of $83,755.
Interest is charged or paid to the
Partnership on the due to/from general
partners balance in accordance with the
rates prescribed in the Private Placement
Offering Memorandum. The Partnership earned
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$2,756 of interest net from EPIC during
1983. While not obligated to do so under
the Partnership agreement, the general
partner is anticipated to advance funds for
any cash flow deficits.
The Partnership paid loan origination fees
of $138,138 to EPIC Mortgage, Inc., an
affiliate of the general partner.
On the basis of the above, it appears that EA 84-III
realized interest income from EPIC in 1983 and paid or
incurred interest expense on unsecured advances from EPIC
in 1984 and 1985 in the following amounts:
1983 1984 1985
Interest income–-general partner $6,097.26 -0- -0-
Interest expense--general partner -0- $28,175 $18,680
6,097.26 (28,175) (18,680)
Federal Income Tax Returns Filed on Behalf of EA 84-III
For Federal income tax purposes, EA 84-III reported the
following income and expenses for the years in issue:
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EA 84-III 1983 1984 1985
Rent income $80,124 $228,516 $230,130
Interest -0- -0- 494
Total gross income 80,124 228,516 230,624
Interest (noninvestment) 118,082 522,466 545,848
Commissions 5,305 23,198 19,403
Insurance 5,480 16,663 19,894
Legal and professional fee 6,895 687 1,008
Repairs 8,500 19,782 108,459
Taxes 18,123 72,554 72,617
Utilities 1,726 33,555 1,830
Homeowners dues 998 3,993 12,353
Property management fee 8,250 33,000 32,175
Points amortization 3,453 13,814 13,814
Miscellaneous 141 606 574
Audit fee -0- 5,000 3,333
Service fee -0- -0- 3,197
Depreciation 56,910 170,742 170,742
Total expenses 233,863 916,060 1,005,247
Net rental income -153,739 -687,544 -774,623
On its Schedule K, Partner's Share of Income,
Credits, Deductions, etc., for 1983, EA 84-III reported
an ordinary loss of $153,739, a net investment loss of
$141,142 for purposes of allocating tax preference items
to its partners, and net investment income of $6,097 for
purposes of computing investment interest. On its
Schedules K for 1984 and 1985, EA 84-III reported ordinary
losses of $687,544 and $774,623, respectively, and
investment income of zero and $494, respectively; and for
purposes of allocating tax preference items to its
partners, EA 84-III reported qualified investment income
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of $217,619 and $229,131, respectively, and qualified
investment expenses of $872,376 and $997,436, respectively.
For depreciation purposes, EA 84-III treated the
aggregate contract price of its 55 properties, $3,956,700,
less the aggregate rental deficit contributions, $755,287,
as its aggregate basis in the real estate; viz $3,201,413.
EA 84-III allocated 20 percent of that amount to land;
viz $640,283, and 80 percent to buildings; viz $2,561,130.
EA 84-III depreciated the later amount on a straight-line
basis over 15 years and claimed deprecation at the annual
rate of $170,742 in each of the years in issue. EA 84-III
claimed a depreciation allowance for 4 months on its 1983
return, $56,910, and a depreciation allowance for 12 months
on its 1984 and 1985 returns.
For each of the years in issue, EA 84-III was
obligated under the promissory notes that it had issued to
EMI to pay interest on the aggregate principal amount of
the notes, $3,453,450. EA 84-III was obligated to pay
interest at the annual rate of 14.625 percent on the notes
issued to purchase the 15 properties from U.S. Home and was
obligated to pay interest at the annual rate of 14.125
percent on the notes issued to purchase the 40 condominium
units from Pitman & Japhet. Thus, EA 84-III was obligated
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to pay interest to EMI in the total amount of $492,116.06
during each of the years 1984 and 1985 computed as follows:
Loan Rate Annual Interest
U.S. Home properties $863,250 14.625 $126,250.31
Pitman & Japhet properties 2,590,200 14.125 365,865.75
Total 3,453,450 492,116.06
EA 84-III was also obligated under the 84 partnership
agreement to pay interest at the annual rate of 15 percent
to compensate the general partner for unsecured advances of
funds to the partnership. The returns filed on behalf of
EA 84-III for the years in issue report the following
liabilities to the general partner on Schedule L:
Due to
Taxable Year Ended General Partner Accrued Interest–-G/P
12/31/83 -0- -0-
12/31/84 $165,481 $28,174
12/31/85 373,705 42,750
EA 84-III reported noninvestment interest expense on
its returns for the years in issue of $118,082, $552,466,
and $545,848, respectively. The difference between these
amounts and the interest paid or incurred with respect to
the partnership's first mortgage notes is as follows:
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1983 1984 1985
Total interest expense reported $118,082 $522,466 $545,848
1
Interest on first mortgage notes 123,029 492,116 492,116
Difference (4,947) 30,350 53,732
1
Four months of interest.
The record of this case does not fully explain the above
differences.
EA 84-III paid loan origination fees to EMI in the
aggregate amount of $138,138 equal to 4 percent of the
principal amount of the first mortgage loans (i.e.,
$3,453,450 x 4 percent). On the subject returns,
EA 84-III claimed a deduction for "amount of points"
of $3,453, $13,814, and $13,814, respectively.
EPIC
As mentioned above, EPIC, the general partner of
EA 83-XII and EA 84-III, was incorporated in 1974 for
the purpose of acquiring residential real properties
and providing various services in connection with the
acquisition, syndication, management, and disposition
of the properties. Between 1975 and 1985, EPIC formed
approximately 357 limited partnerships with more than 6,000
limited partners. EPIC was the general partner of each
limited partnership. These partnerships owned
approximately 17,600 residential dwelling units located
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throughout the United States and issued approximately
20,500 mortgages totaling approximately $1,435,000,000.
When EPIC began its real estate syndication business,
it contracted to purchase properties from developers of
residential real estate and to lease the properties back
to the developers for use as models. Typically, the
developers were willing to pay to EPIC a commission,
referred to as the builder's fee, of approximately 6
percent of the purchase price of each property and were
willing to pay rent on each property for some period in
advance.
EPIC would form a limited partnership for the purpose
of buying the models. EPIC would assign its rights to
purchase the properties to the limited partnership, and the
limited partnership would purchase the properties with
equity capital contributed by the limited partners. The
early limited partnerships financed 75 or 80 percent of the
purchase of the properties. These loans were recourse.
The limited partnership would lease the models back to the
developer on a triple net lease basis during completion of
the project, a period ranging from 18 to 24 months.
Typically, the rental income from the properties
exceeded the amount needed to service the debt, and the
partnership realized a positive cash-flow during the lease
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term. The plan called for the limited partnership to sell
the properties for a profit at the end of the developers'
lease term. These early limited partnerships were referred
to by EPIC's management as income partnerships.
EPIC's success and the success of its partnerships
depended upon the appreciation of the real properties that
were purchased by the partnerships. The sales of real
estate by EPIC partnerships before 1980, as shown in
exhibits to the 83 and 84 offering memoranda, reveal high
annual appreciation.
During 1980, mortgage interest rates increased to
historic levels, and the real estate market began to
deteriorate as a result. The higher interest rates
significantly increased the costs of selling properties and
reduced profits realized by the partnerships on the sale of
properties. Accordingly, in 1980, EPIC's management made
the decision to stop selling properties until interest
rates fell. EPIC's management believed that, as an interim
measure, the company could carry the limited partnerships
until interest rates decreased and profit margins returned
to normal.
Notwithstanding the cessation of sales, EPIC continued
to syndicate real estate partnerships. This was EPIC's
core business. EPIC's management did not consider shutting
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down that business when interest rates increased in 1980
because EPIC's management believed that the company could
purchase properties that would appreciate and could be sold
for a profit when interest rates declined.
At this time, EPIC's management undertook to revise
certain characteristics of the limited partnerships that
were syndicated. EPIC's management had realized that if an
income partnership held properties after the developer's
lease expired, the partnership would realize cash deficits,
and it had no mechanism to fund such deficits. EPIC's
management wanted greater flexibility in the period of time
that a partnership could hold its properties. In order to
permit a longer holding period, the partnerships would have
to lease properties to individual tenants, and, as a
result, the rental stream would decrease substantially
because lease rates paid by individual tenants are much
lower than the commercial rates paid by developers.
However, EPIC found that developers would discount the
price of the properties by an amount roughly equivalent
to the present value of the difference in rental rates.
EPIC referred to this discount as the rental deficit
contribution.
Because of the longer holding period, EPIC's
management also wanted to increase the loan-to-value ratio
- 75 -
of its mortgages to 95 percent in order to help carry the
properties. For the same reason, EPIC's management wanted
the loans to be nonrecourse.
EPIC found that lenders in the secondary mortgage
market would purchase such loans if the lender's risk,
taking private mortgage insurance into account, was no
greater than 72 percent of the loan. Thus, in the case of
a 95-percent loan, for example, a secondary lender would
require mortgage insurance of at least 25 percent. In the
case of a 90-percent loan, a secondary lender would require
mortgage insurance of at least 20 percent, and so on.
Through negotiation, EPIC found that private mortgage
insurance companies were willing to insure nonrecourse
mortgages on residential properties. As a result of
negotiations with secondary lenders and private mortgage
insurers, EPIC's management found that it could obtain
95-percent nonrecourse financing on single-family houses
and condominiums owned by its investment partnerships.
Finally, EPIC's management found that investors were
willing to purchase interests in the new partnerships
for roughly one-half of the anticipated tax losses; i.e.,
a 2-to-1 ratio. The new partnerships were known internally
to EPIC's management as "tax partnerships" to distinguish
them from the earlier "income partnerships".
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During the period after 1980, EPIC's management
also experimented with resyndicating properties from older
partnerships and with expandable partnerships. EPIC's
management also formed EPIC Residential Network, Inc.
(ERNI), to act as a real estate broker to be in position
to sell properties when interest rates declined and the
real estate market recovered.
Thus, beginning in 1981 or 1982, EPIC expanded its
business by entering into agreements to purchase properties
that it intended to rent to the public, rather than to the
developer. After this change, EPIC did not limit itself
to models in a particular project but contracted to buy
production houses. This meant that, in some cases, EPIC
acquired a substantial inventory of unsold houses in a
single project and facilitated the developer's completion
of the project.
Under this business plan, EPIC intended to syndicate
the properties to limited partnerships which would rent
the properties for 4 years before selling them. EPIC
calculated the capital contributions of the limited
partners to equal one-half of the anticipated tax losses,
resulting in a "two-to-one tax write-off."
For cash management purposes, EPIC "swept" all funds
from all of the partnerships' accounts daily and deposited
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the funds into a master account maintained by EPIC. EPIC
then advanced funds to pay the debts of any of its
partnerships that needed funds. The amounts borrowed
from each partnership and the amounts advanced to each
partnership were accounted for in the books and records
of the appropriate partnerships. Interest was credited to
partnerships to which EPIC owed money and was charged to
partnerships which owed money to EPIC (net borrowers and
net lenders). Among the funds swept from the accounts
of individual partnerships were the funds received by
partnerships upon the acquisition of real properties.
EPIC management believed that a default by any of its
partnerships would have an adverse impact on the entire
EPIC enterprise, and EPIC never permitted any limited
partnership to default on a payment until August 1985 when
all of the limited partnerships sought protection under the
bankruptcy laws.
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During the time it was in existence, EPIC formed or
acquired a number of subsidiaries and affiliated companies
to engage in different aspects of the real estate business.
For example, as mentioned above, EMI originated mortgage
loans on behalf of EPIC limited partnerships and received
fees for doing so. EMI obtained the funds to originate
loans through "warehouse" or interim lines of credit from
CSL, an affiliated savings and loan association, and other
financial institutions. EPIC sold interests in pass-
through certificates or whole loans in the secondary market
to other financial institutions. All of the purchase money
promissory notes at issue in these cases were sold in the
secondary market in one form or another.
Another affiliate, ERSI, managed the properties that
were owned by EPIC limited partnerships, other than
properties leased back to the developers on net leases.
ERSI leased the properties, reviewed tenant applications,
collected and accounted for rental income, secured
insurance and arranged maintenance and repairs. EPIC
paid ERSI a monthly fee of $35 of the $50 it received
for managing each property.
Another affiliate, ERNI, acted as a real estate broker
to sell properties. Generally, ERNI received a real estate
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commission of 6 percent of the sale price of each unit
sold.
Another affiliate, Continental Appraisal Group, Inc.
(CAG), appraised the residential properties purchased by
EPIC partnerships. The appraisals were made either by a
member of the CAG staff or by an outside appraiser and
reviewed by a staff appraiser. CAG also appraised
properties for unrelated lenders. Another company, EPIC
Securities, Inc., wholesaled the limited partnership
interests in EPIC partnerships and received a percentage
of the capital contributions as a commission. Finally,
in October 1983, EPIC or one of its affiliates acquired
Community Savings & Loan, a Maryland-chartered savings
and loan association.
Private Mortgage Insurance
While EMI originated the loans at issue, each of the
loans was insured by a private mortgage insurance company
for 25 percent of the first loss amount. Tricor Mortgage
Insurance Co. and Republic Mortgage Insurance Co. (RMIC)
issued mortgage insurance covering the first mortgage loans
at issue in the instant cases. In addition, EPIC dealt
with other mortgage insurance companies, including Mortgage
- 80 -
Guarantee Insurance Corp. (MGIC) and Commonwealth Mortgage
Assurance Corp. (CMAC).
The private mortgage insurance companies thoroughly
investigated the risks presented by EPIC's business. For
example, in June 1982, after EPIC had changed the nature
of its limited partnerships, representatives of MGIC's
appraisal department and underwriting evaluation department
made a risk management study of EPIC. The study sets forth
a detailed description of EPIC's business and the under-
writing risks presented to MGIC from that business. As
part of the study, MGIC had conducted spot checks of EPIC's
appraisals and had found "inflated property values". The
report states as follows:
Based on our spot checks Epic's appraisals had
inflated property values. The value estimates
made 2 or 3 years ago by Epic's appraisers are
higher than the value estimates as of the date of
contract and the current value estimates of the
properties. It is not known if Epic Mortgage is
aware of this over-valuing in as much [sic] as
they do not have an appraisal department to
review the appraisals.
* * * * * * *
Based on MGIC's 25 spot checks there is over-
valuing by Epic that has resulted in inflated
property values and 14 properties with loan to
value ratios in excess of 95%, up to 112%.
a. We can only speculate at the reason for the
overvaluing because Epic Mortgage utilizes
independent fee appraisers. The appraisers
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might be influenced by the builder's
indicated cost and are finding higher priced
comparable sales to justify this cost rather
than carefully studying the marketplace.
b. The higher value estimates by Epic's
appraisers are a result of using higher
priced comparable sales, higher land value
estimates which do not accurately indicate
the subject property's true market value and
model upgrade. The model "upgrades"
increase the sales price of the home and
typically make it the highest priced home in
the subdivision with the cost not typically
recognized by the end purchaser.
c. Epic should have the same concerns with
overvaluing as MGIC because of losses to the
partnership. Epic's expertise may be in
syndication and marketing not property
valuation. This would explain why they are
only now setting up an appraisal review
department.
Representatives of MGIC met with EPIC's management
on two occasions to discuss possible overvaluation of
properties. Circa 1983, MGIC ceased insuring EPIC
mortgages. The principal reason given for this action was
the concentration of risk represented by EPIC's business
and the fact that EPIC had switched from syndicating model
properties to production properties. Nevertheless, MGIC
wished to retain the renewal business for existing EPIC
insurance policies.
Similarly, beginning in December 1983, before agreeing
to insure any mortgage loans to an EPIC partnership,
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Mr. James C. Miller, president of Commonwealth Mortgage
Assurance Co. (CMAC), and his staff met on several
occasions with representatives of EPIC's management to
discuss EPIC's business and the risks that CMAC would face
in writing mortgage insurance on mortgage loans issued by
EPIC partnerships. A memorandum dated February 24, 1984,
written by Mr. Miller before any mortgage insurance was
written describes EPIC's business and the risks presented
by that business. The memorandum describes the risks as
follows:
Risks
They described their program as unique, and it
is certainly entirely different from the normal
owner-occupied situation. To hear them tell it,
there is virtually no chance of borrower default.
Their track record of selling to high-income
investors and obtaining the note payments from
them has been very good to date.
The next major risk is that the real estate
projects themselves do not work out. Deprived
of rental income, the pool's cash flow would be
negatively impacted. EPIC minimizes this risk
by wide diversification of the properties--
geographically, price and style. They showed
us one sample pool in which the diversification
seemed to be excellent.
There's always the possibility that the general
partner, EPIC, will fail; the most likely form
of failure would be a series of projects that
did not rent out adequately. We can review their
project plans to verify that they have adequate
margins built in to minimize this risk. We can
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also constantly monitor the financial position of
the general partner.
Another risk is that the EPIC property management
company will fail. If the manager is collecting
the rents and does not promptly forward all of
the rent to the general partner, the entire
enterprise is in jeopardy. Of course, this is
virtually the entire business of EPIC.
Therefore, it is highly improbable that the
property management company would fail alone.
Ultimately, we have the property to look to.
Of course, the critical question is whether or
not the property investors are acquiring the
property at a bargain price, or whether EPIC is
overcharging the investors. Presumably, this
is what our underwriting is intended to guard
against. We'll have to look at it carefully to
satisfy ourselves that the value is probably
there if we need it. However, I believe that
we should be concerned only with the entire
pool because there is no way that an individual
property will go into default–-unless the general
partner can decide to stop making payments on one
individual mortgage.
The rates may be standard, owner-occupied rates
on the primary insurance. Frank Bossle agreed to
send me copies of the current rates of the other
PMI companies. He says he is not looking for a
bargain rate, because the cost of the mortgage
insurance is passed on to the customer anyway.
He also says that they do not believe in requir-
ing an insurer to take property that the insurer
doesn't want. They like all their business
relationships to be based upon cooperation and
mutual trust and profitability.
As noted above, one of the risks that Mr. Miller identified
related to the value of the property; i.e., "whether or not
the property investors are acquiring the property at a
- 84 -
bargain price, or whether EPIC is overcharging the
investors."
In a later memorandum dated August 24, 1984, after
CMAC had written mortgage insurance on a small amount of
EPIC's business, Mr. Miller focused on the risk "that the
overall market for investment property could become
saturated, and/or the EPIC Management might overextend
themselves by paying too much for their properties."
Mr. Miller instructed his staff to order spot-check
appraisals of the EPIC property. The spot-check appraisals
did not support the values suggested by EPIC's appraisals,
and CMAC was not able to reconcile the differences.
Shortly thereafter, in a letter dated August 5, 1985, CMAC
ended its business relationship with EPIC.
EPIC's Financial Statements
The record contains EPIC's financial statements for
1981, 1982, and 1983. These statements show the following
revenue and expenses:
- 85 -
Year Ended
12/31/81 12/31/82 12/31/83
Revenues:
Builder Fees $8,960,780 $15,895,234 $18,905,034
Interest income and
loan service fees 3,910,907 8,871,358 8,233,739
Rental income 1,613,598 1,219,852 -0-
Property management fees 972,077 1,357,220 941,616
Partnership organization fees 474,220 4,882,669 9,403,021
Loan origination fees 177,031 2,790,098 7,580,544
Other income 298,442 698,480 443,087
Total revenue 16,407,055 35,714,911 45,507,041
Costs and Expenses:
Interest expense 4,149,063 7,629,826 3,270,713
Payroll & fringe benefits 3,969,457 8,696,684 8,430,324
Commissions 339,277 3,319,496 8,483,881
Partnership rental expenses 2,799,960 1,916,887 -0-
Other operating expenses 2,411,917 3,991,804 10,000,887
Total expenses 13,669,674 25,554,697 30,185,805
Income from operations 2,737,381 10,160,214 15,321,236
EA 83-XII and EA 84-III's Bankruptcy
In 1985, the Governor of Maryland shut down the
State's savings and loan system, and the State required
all savings and loan associations subject to Maryland
regulation to liquidate their assets or to obtain Federal
deposit insurance from the Federal Home Loan Bank Board
(FHLBB). CSL, a nonfederally insured Maryland savings and
loan, applied for deposit insurance issued by the Federal
Savings & Loan Insurance Corp. (FSLIC).
In July 1985, the FHLBB informed CSL that it would
not approve CSL's application for FSLIC insurance. As a
result, EPIC and its real estate partnerships, including
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EA 84-III and EA 83-XII, could no longer use CSL as a
source of funds necessary for their operations. By
August 15, 1985, EA 83-XII and EA 84-III defaulted on their
respective obligations under the mortgages and deeds of
trust on the properties. Shortly thereafter, EA 83-XII and
EA 84-III filed petitions in the U.S. Bankruptcy Court for
the Eastern District of Virginia.
Notices of FPAA Issued to EA 83-XII
In the notices of FPAA issued to EA 83-XII for 1983,
1984, and 1985, respondent adjusted the ordinary income
reported by the partnership as shown below in the second
column for each year:
EA 83-XII 1983 1984 1985
Rent income $287,640 $287,640 $306,577 $306,577 $331,743 $331,743
Late charges 548 548 -0- -0- -0- -0-
Interest income 9,344 9,344 90 90 1,262 1,162
Miscellaneous -0- -0- -0- -0- 883 883
Total gross income 297,532 297,532 306,667 306,667 333,888 333,888
Interest (noninvestment) 466,358 -0- 539,893 -0- 560,177 -0-
Commissions 25,460 25,460 21,950 21,950 24,846 24,846
Insurance 27,744 27,744 16,438 16,438 18,992 18,992
Legal and professional fee 726 726 8,093 8,093 574 574
Repairs 1,348 1,348 30,866 30,866 15,075 15,075
Taxes 49,224 49,224 49,213 49,213 45,962 45,962
Utilities 464 464 1,547 1,547 951 951
Homeowner dues 20,620 20,620 20,620 20,620 25,350 25,350
Audit fee 4,900 4,900 4,900 4,900 3,267 3,267
Points amortization 16,671 -0- 16,671 -0- 16,671 -0-
Property management 30,600 30,600 30,600 30,600 29,837 29,837
Real estate tax service 1,278 1,278 -0- -0- -0- -0-
Miscellaneous 107 107 -0- -0- 856 856
Depreciation 173,119 -0- 173,119 -0- 173,119 -0-
Bad debts -0- -0- 1,l74 1,174 -0- -0-
Amortization organization
expense -0- -0- 3,150 3,150 -0- -0-
Recording fees -0- -0- -0- -0- 24 24
Service fee-EMI -0- -0- -0- -0- 3,413 3,413
Total expenses 818,619 162,471 918,234 188,551 919,114 169,147
Total rent income -521,087 135,061 -611,567 118,116 -585,226 164,741
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Respondent also disallowed the investment interest expense
of $66,366 claimed on the 1983 return.
The "explanation of items" attached to the notice of
FPAA for 1983 gives the following explanation of these
adjustments:
INTEREST EXPENSE AND POINT AMORTIZATION
* * * * * * *
The deductions shown on your return as interest
are not deductible because it has not been
established that the amounts were for interest on
a bona fide debt. Consequently, the partnership's
taxable income is increased.
* * * * * * *
In the event that it is determined that there
was an actual investment associated with the
acquisition of the property or that there was
genuine indebtedness on the property, then with
respect to EPIC Associates 83-XII partnership
for the taxable year 1983, this activity was not
engaged in for profit and the allowability of
interest expenses incurred is limited to the
investment income of the taxpayer for the tax-
able year. Consequently, all interest expenses
relative to this activity are not allowable as
deductions against ordinary income, but are
separately stated items subject to the invest-
ment interest limitations.
DEPRECIATION
The deductions shown on your return as
depreciation are not deductible because it has
not been established that a bona fide investment
in depreciable property was made. Consequently,
the partnership's taxable income is increased.
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In the event that it is determined that there was
an actual investment associated with the
acquisition of the property or that there was
genuine indebtedness on the property, then with
respect to the EPIC Associates 83-XII partner-
ship for the taxable year 1983 [1984 and 1985],
this activity was not engaged in for profit and
only the following deductions are allowable:
(1) The deductions which would be
allowable for the taxable year without
regard to whether or not such activity
is engaged in for profit, and
(2) a deduction equal to the amount
of the deductions which would be
allowable for the taxable year year
[sic] only if such activity were
engaged in for profit, but only to the
extent that the gross income derived
from such activity of the taxable year
exceeds the deductions allowable by
reason of paragraph (1) above.
The notices of FPAA for 1984 and 1985 are virtually
identical.
Respondent made other adjustments to EA 83-XII's
returns for 1983, 1984, and 1985. For taxable year 1983,
respondent disallowed the net investment loss of $341,010
reported for purposes of allocating tax preference items to
its partners, and respondent disallowed the excess expenses
from net lease property of $10,859 and the investment
interest income of $29,306. For taxable years 1984 and
1985, respondent disallowed the qualified investment income
of $303,571 and $330,529, respectively, the qualified
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investment expenses of $908,960 and $909,831, respectively,
and the investment interest income of $90 and $1,262,
respectively. In support of these other adjustments, the
notices of FPAA issued to EA 83-XII state that "it has not
been established that there was an actual investment
associated with the acquisition of the property or that
there was genuine indebtedness on the property." In
further support of these other adjustments, the notices
state that the activity of EA 83-XII for 1983, 1984, 1985,
and 1986 "was not engaged in for profit."
Notices of FPAA Issued to EA 84-III
In the notices of FPAA issued to EA 84-III for 1983,
1984, and 1985, respondent adjusted the ordinary income
reported by the partnership as shown below in the second
column for each year:
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EA 84-III 1983 1984 1985
Rent income $80,124 $80,124 $228,516 $228,516 $230,130 $230,130
Interest -0- -0- -0- -0- 494 494
Total gross income 80,124 80,124 228,516 228,516 230,624 230,624
Interest (noninvestment) 118,082 -0- 522,466 -0- 545,848 -0-
Commissions 5,305 5,305 23,198 23,198 19,403 19,403
Insurance 5,480 5,480 16,663 16,663 19,894 19,894
Legal & professional fee 6,895 6,895 687 687 1,008 1,008
Repairs 8,500 8,500 19,782 19,782 108,459 108,459
Taxes 18,123 18,123 72,554 72,554 72,617 72,617
Utilities 1,726 1,726 33,555 33,555 1,830 1,830
Homeowner dues 998 998 3,993 3,993 12,353 12,353
Property management fee 8,250 8,250 33,000 33,000 32,175 32,175
Points amortization 3,453 -0- 13,814 -0- 13,814 -0-
Miscellaneous 141 141 606 606 574 574
Audit fee -0- -0- 5,000 5,000 3,333 3,333
Service fee -0- -0- -0- -0- 3,197 3,197
Depreciation 56,910 -0- 170,742 -0- 170,742 -0-
Total expenses 233,863 55,418 916,060 209,038 1,005,247 274,843
Net rental income -153,739 24,706 -687,544 19,478 -774,623 -44,219
The explanation of the above adjustments is virtually
identical to the explanation in the notices of FPAA issued
to EA 83-III, quoted above.
Respondent made a number of other adjustments to
EA 84-III's returns for 1983, 1984, and 1985. Respondent
disallowed the net investment loss of $141,142 and
investment interest income of $6,097 claimed in 1983.
Respondent disallowed qualified investment income of
$217,619 and qualified investment expenses of $872,376
claimed in 1984. Respondent disallowed qualified
investment income of $229,131, qualified investment
expenses of $997,436, and investment interest income of
$494 claimed in 1985. In support of these other
adjustments, the notices of FPAA state that "it has not
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been established that there was an actual investment
associated with the acquisition of the property or that
there was genuine indebtedness in the property." In
further support of the other adjustments, the notices state
that the activity of EA 84-III for 1983, 1984, 1985, and
1986 "was not engaged in for profit."
OPINION
In the subject notices of FPAA, respondent disallowed
the interest and depreciation deductions that each part-
nership claimed on its tax returns for 1983, 1984, and
1985. According to the notices of FPAA, the interest
deductions are disallowed because "it has not been
established that the amounts were for interest on a
bonafide [sic] debt." Similarly, according to the notices
of FPAA, the depreciation deductions are disallowed because
"it has not been established that a bona fide investment
in depreciable property was made."
The interest deductions at issue consist principally,
but not entirely, of amounts paid or accrued with respect
to the nonrecourse promissory notes issued by each
partnership for the purchase of the residential properties
described above. We sometimes refer to the subject
promissory notices as first mortgage notes. The
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depreciation deductions are based entirely on the portion
of the subject promissory notes that each partnership
claims as a basis in the residential properties purchased
with the notes.
If none of the promissory notes constitutes a bona
fide debt, as determined by the notices of FPAA, it
follows, as discussed below, that no amount paid or accrued
with respect to any of the notes is deductible as interest
under section 163(a). Furthermore, if none of the
promissory notes constitutes a bona fide debt, it also
follows that neither partnership incurred a cost in issuing
the notes and neither partnership obtained a basis in any
of the properties for depreciation purposes. Thus, the
first issue for decision in these cases is whether any
of the nonrecourse promissory notes issued by either
partnership constitutes a bona fide debt.
A portion of the interest deducted by both partner-
ships was for "points amortization". These deductions
are based upon the loan origination fees paid by both
partnerships to EMI. The partnerships treated these fees
as additional interest on the first mortgage notes and
amortized them over the life of the loans. The second
issue for decision in these cases is whether the
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partnerships are entitled to these deductions for points
amortization.
The notices of FPAA also take the position that the
activity of each partnership for each of the tax years in
issue, 1983, 1984, and 1985, is an "activity not engaged
in for profit" within the meaning of section 183(c). The
notices of FPAA state: "the allowability of interest
expenses incurred is limited to the investment income of
the taxpayer for the taxable year." Thus, according to the
notices of FPAA, if section 183 applies, then the interest
expenses of each partnership must be treated as investment
interest subject to limitation under section 163(d). On
that basis, the adjustments to the subject returns would be
similar in amount to the adjustments determined under the
theory, described above, that neither partnership had
entered into a bona fide indebtedness during any of the
years in issue.
The application of section 183 is not just an
alternative theory. The notice of FPAA issued to
EA 84-III for 1985 relies on section 183 to disallow
net operating expenses of $44,219. This is the amount
by which the deductions claimed by EA 84-III exceed the
partnership's gross income, after the deductions for
interest and depreciation are disallowed under the non-bona
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fide indebtedness theory, described above. Thus, we must
consider the application of section 183 no matter how we
decide the other issues. This is the third issue for
decision in these cases.
It appears that each partnership also deducted, as
interest, amounts paid or accrued during the years in issue
with respect to certain funds advanced to it by EPIC, as
general partner. By implication, the notices of FPAA take
the position that any such unsecured advance made by EPIC
to either partnership did not create a bona fide
indebtedness of the partnership to EPIC and any amount
paid or accrued with respect to any such advance is not
deductible under section 163(a). This is the fourth issue
for decision in these cases.
It also appears that EA 84-III deducted, as interest,
amounts paid or accrued during 1985 with respect to 16
promissory notes issued to CSL. Each of those promissory
notes was secured by a deed of trust on one of the
properties that had been purchased by EA 84-III in 1983.
As mentioned above, the notices of FPAA disallow all of the
interest deductions claimed by the partnerships on the
ground that the amounts deducted were not shown to have
been paid as interest on a bona fide debt. Thus, the fifth
issue for decision in these cases is whether any of the 16
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promissory notes issued by EA 84-III to CSL constitutes a
bona fide debt.
Nonrecourse Promissory Notes
Generally, a taxpayer is allowed to deduct an amount
as interest under section 163(a) if the amount was paid or
incurred during the taxable year with respect to genuine
indebtedness. See, e.g., Knetsch v. United States, 364
U.S. 361 (1960); Lukens v. Commissioner, 945 F.2d 92, 97
(5th Cir. 1991), affg. T.C. Memo. 1990-87; Fox v.
Commissioner, 80 T.C. 972, 1019 (1983), affd. sub nom.
Barnard v. Commissioner, 731 F.2d 230 (4th Cir. 1984);
Hager v. Commissioner, 76 T.C. 759, 773 (1981). Similarly,
a taxpayer is allowed to include purchase money indebted-
ness in the basis of an asset for purposes of computing
the allowance for depreciation under section 167 if the
indebtedness is genuine indebtedness and represents an
actual investment in property. See, e.g., Brannen v.
Commissioner, 722 F.2d 695, 701 (11th Cir. 1984), affg. 78
T.C. 471 (1982); Siegel v. Commissioner, 78 T.C. 659, 684
(1982).
Indebtedness is not considered genuine, that is, a
true loan, if the facts show that the parties to the loan
did not intend the principal amount of the indebtedness to
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be repaid in full. See, e.g., Siegel v. Commissioner,
supra at 688. In the case of nonrecourse indebtedness,
such as that involved in the instant cases, the
indebtedness is a lien that the debtor must satisfy
according to its terms in order to retain possession and
use of the encumbered property, but there is no fixed,
unconditional obligation of the debtor to pay. See, e.g.,
Waddell v. Commissioner, 86 T.C. 848, 898 (1986), affd. 841
F.2d 264 (9th Cir. 1988). However, the lack of personal
liability of the debtor, by itself, does not mean that
nonrecourse indebtedness will not be repaid, nor does it
disqualify the nonrecourse indebtedness from being
considered genuine. See, e.g., Hager v. Commissioner,
supra at 773; Mayerson v. Commissioner, 47 T.C. 340, 351-
352 (1966). A nonrecourse mortgage can be found to be
genuine indebtedness for tax purposes "on the assumption
that the mortgage will be repaid in full." Commissioner v.
Tufts, 461 U.S. 300, 308 (1983).
We have previously summarized the approaches taken by
the courts in determining whether a purported nonrecourse
liability is to be treated as true debt for Federal tax
purposes. See, e.g., Waddell v. Commissioner, supra at
900-902; Fox v. Commissioner, supra at 1019-1021. In Fox
- 97 -
v. Commissioner, supra at 1019-1021, we described these
approaches as follows:
There are various approaches which may be
taken in establishing whether a purchaser may
treat a nonrecourse liability as a bona fide
debt. One, originating in Estate of Franklin
v. Commissioner, 544 F.2d 1045 (9th Cir. 1976),
affg. 64 T.C. 752 (1975), indicates that when
the amount of the aggregate purchase price
unreasonably exceeds the value of the property
securing the note (or when the principal amount
of the note unreasonably exceeds the value of
the property securing the note), the debt will
not be recognized. In such instance, the
purchaser acquires no equity in the property
by making payments and, therefore, would have
no economic incentive to pay off the note.
Estate of Franklin v. Commissioner, supra at
1048-1049. The Estate of Franklin analysis,
comparing the purchase price and size of the
note to the fair market value of the property
at the time of purchase, originated in real
estate transactions (see Estate of Franklin v.
Commissioner, supra; Narver v. C
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