# Epic Assocs. 84-Iii v. Comm'r > United States Tax Court · March 19, 2001 · 81 T.C.M. 1311 URL: https://www.frixlaw.com/law-library/cases/4333164 ## Case - **Full name:** EPIC ASSOCIATES 84-III, WILLIAM C. GRIFFITH, JR., AND DOTTIE M. GRIFFITH, TAX MATTERS PARTNERS v. COMMISSIONER OF INTERNAL REVENUE, EPIC ASSOCIATES 83-XII, WILLIAM C. GRIFFITH, JR., AND DOTTIE M. GRIFFITH, TAX MATTERS PARTNERS v. COMMISSIONER OF INTERNAL REVENUE - **Court:** United States Tax Court - **Decided:** March 19, 2001 - **Citations:** 81 T.C.M. 1311; 2001 T.C. Memo. 64; 2001 Tax Ct. Memo LEXIS 80 - **Precedential status:** Unpublished - **Opinion:** Opinion - **Cited by:** 0 later opinions in the Frix Law Library ## Citator (automated) - No negative treatment found by the automated citator. That is not the same as a confirmation that the case is good law; read the citing cases. - Full citator and citing cases: https://www.frixlaw.com/law-library/cases/4333164 ## Opinion text 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 - 2 - 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 - 3 - 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 - 4 - 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 - 5 - 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 - 6 - 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 - 7 - 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 - 8 - 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 - 9 - 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; - 10 - (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 - 11 - 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. - 12 - 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: - 13 - 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 - 14 - 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 - 15 - 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: - 16 - 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 - 17 - & 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 - 18 - 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 - 19 - 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 - 20 - 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: - 21 - 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 - 22 - 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 - 63 - 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 - 64 - 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 - 65 - 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: - 66 - 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 - 67 - $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: - 68 - 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 - 69 - 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 - 70 - 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: - 71 - 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 - 72 - 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 - 73 - 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 - 74 - 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". - 76 - 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 - 77 - 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. - 78 - 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 - 79 - 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 - 81 - 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, - 82 - 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 - 83 - 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 - 86 - 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 - 87 - 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. - 88 - 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 - 89 - 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: - 90 - 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 - 91 - 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 [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/cases/4333164. Public record. Not legal advice.