T.C. Memo. 1996-23

UNITED STATES TAX COURT

COOPER RIVER OFFICE BUILDING ASSOCIATES, MANAGEMENT OF

COOPER RIVER, INC., TAX MATTERS PARTNER, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 24016-87. Filed January 24, 1996.

Mervin M. Wilf, for petitioner.

Carol-Lynn Moran, for respondent.

MEMORANDUM OPINION

SWIFT, Judge: This matter is before us on Cooper River

Office Building Associates' (the Partnership's) motion to vacate

decision. 

All Rule references are to the Tax Court Rules of Practice

and Procedure.
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On January 21, 1994, pursuant to our two opinions in Levy v.

Commissioner, 92 T.C. 1360 (1989), and T.C. Memo. 1991-646,

involving 1980, 1981, and 1982, respondent filed a motion for

entry of decision in the instant case involving 1983 and 1984. 

On April 19, 1994, we granted respondent's motion and entered a

decision herein.

In a timely filed motion to vacate, petitioner alleges that,

based on the above-cited opinions, the appropriate interest

deductions that should have been used herein in the Rule 155

computation to calculate the Partnership's 1983 and 1984 income

were grossly understated. 

Respondent objects to petitioner's motion to vacate. 

Respondent asserts that the Rule 155 computation correctly

reflects allowable interest deductions and the monthly payments

of $43,725 that the Partnership made beginning on August 1, 1980,

with respect to a nonrecourse, long-term promissory note. Under

the promissory note, the entire amount of each $43,725 monthly

payment was identified as interest. However, under respondent's

calculation, which was adopted and reflected in the decision

document that was entered in this case (as well as in the

decision document that was entered in Levy v. Commissioner, T.C.

Memo. 1991-646, with regard to 1980, 1981, and 1982), a portion

of each monthly payment was allocated to principal.

In Levy v. Commissioner, 92 T.C. at 1360, we sustained for

1980, 1981, and 1982, respondent's disallowance of the use by the
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Partnership of the Rule-of-78's to calculate the accrual of

interest with respect to the Partnership's indebtedness on the

promissory note. We concluded that the Partnership was required

to calculate the accrual of interest using the economic accrual

of interest. 

In Levy v. Commissioner, T.C. Memo. 1991-646, we concluded

further that only $2,370,000, or approximately 50 percent, of the

$4,770,000 stated principal amount of the above-referred-to

promissory note reflected genuine indebtedness that would be

recognized for Federal income tax purposes. We explained as

follows:

Accordingly, after the cash downpayment paid by

* * * [the Partnership] in the amount of $530,000 is

recognized, the mortgage note indebtedness of * * *

[the Partnership] is treated as having economic

substance only to the extent of $2,370,000 ($2.9

million less $530,000). Interest deductions are

allowed to * * * [the Partnership] only to the extent

they relate to the portion of the mortgage note

indebtedness that is recognized herein and only on the

basis of the economic accrual of interest. 

In light of the above holding and conclusion, respondent

allowed as an interest deduction only that portion of each

$43,725 monthly payment that properly represents interest

relating to the $2,370,000 principal portion of the $4,770,000

stated indebtedness on the promissory note that was recognized

for Federal income tax purposes. Because the monthly payments of

$43,725 actually exceed the allowable interest deduction
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calculated under the economic accrual method, respondent treated

the portion of each monthly payment that does not represent

allowable interest as a repayment of principal. 

Respondent’s calculation thus reduces or amortizes each

month the principal portion of the Partnership’s indebtedness on

the promissory note that is to be recognized for Federal income

tax purposes. Under such calculation, the allowable interest

deduction for each succeeding month is also reduced, and the full

$2,370,000 principal portion of the Partnership’s indebtedness

that is to be recognized for Federal income tax purposes will be

treated as paid off in just over 6 years.

 Petitioner argues that because the Court in the first of the

above Levy opinions, 92 T.C. at 1365, sets forth a schedule of

the precise amount of the interest deductions allowable under the

economic accrual method (based on the Partnership’s total stated

indebtedness on the promissory note of $4,770,000) and because

the Court in the second of the above Levy opinions, T.C. Memo.

1991-646, recognized for Federal income tax purposes

approximately one-half or $2,370,000 of the $4,770,000 stated

principal on the indebtedness, petitioner should now be allowed

to treat the same percentage, or one-half, of each monthly

$43,725 payment (namely, $21,862) as interest properly accruable

under the economic accrual method and to disregard the balance of

each monthly payment for purposes of calculating, for subsequent
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months and years, the principal balance due on the indebtedness

and the proper accrued interest deduction thereon.

Petitioner emphasizes the following points: (1) That under

the express terms of the Partnership’s promissory note, the

monthly payments of $43,725 were to represent "interest" only;

(2) that the Partnership’s total stated principal indebtedness on

the promissory note of $4,770,000 was to remain outstanding for

the initial 17-year term of the promissory note and was to be

refinanced at the end of 17 years with a new 20-year promissory

note that would then be amortized over the next 20 years with

payments of principal and interest; (3) that the enforceability

under State law of the terms of the initial 17-year promissory

note is not affected by our disregard, solely for Federal income

tax purposes, of a portion of the principal amount of the

Partnership’s indebtedness; and (4) that to apply to principal

the portion of each $43,725 monthly payment that is not accruable

as interest (under the economic accrual method of calculating

interest) would represent an impermissible disregard of the

interest-only feature of the Partnership’s monthly payments

during the initial 17-year term of the promissory note and would

represent an impermissible rewrite by the Court of the

Partnership’s indebtedness to a term of just over 6 years. 

The following language from petitioner's memorandum in

support of the instant motion elaborates further on petitioner’s

position --
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the respondent has rewritten the mortgage obligation to

suit her convenience. It is axiomatic that state law

is to be applied in determining whether an obligation

is legally enforceable between the parties to the

contract. This doesn't mean, of course, that state law

will control the federal income tax consequences of a

particular obligation, but what it does mean is that

the federal tax laws cannot change that obligation. 

Respondent apparently believes that, because 50% of the

interest payments are deductible, the remaining 50% of

the interest payments made to the mortgagee are really

principal payments.

There is no suggestion that the partnership's

mortgage note was unenforceable under state law. It

was a valid mortgage in which interest payments were

due according to its terms -- a 37 year period, 11%

interest and interest only for the first 17-year

period. The mortgage also provided for amortization of

principal, but beginning after the 17th year of the

mortgage term.

* * * * * * *

In the instant case, * * * the payments of

interest to the mortgagee cannot be transformed into a

payment of principal. [Citations omitted.]

In summary, under petitioner’s calculation, the $2,370,000

principal indebtedness on the Partnership’s promissory note that

is to be recognized herein would not be amortized. That

$2,370,000 principal indebtedness would remain the same

throughout 1983 and 1984, and throughout the entire 17-year

initial term of the indebtedness. Therefore, under petitioner’s

calculation, the proper interest deduction allowable for 1983 and

1984 (and for each of the other 17 years of the initial term of
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1 Twelve months times monthly interest of $21,862 (one-half of

each monthly payment of $43,725) equals $262,344.

the Partnership’s indebtedness) using the economic accrual of

interest would be the same (namely, $262,344 each year).1

Set forth below, in schedule format, is respondent's

calculation for 1980 through 1985 of the proper monthly economic

accrual of interest on the $2,370,000 principal portion of the

Partnership’s stated indebtedness that is to be recognized in

this case, taking into account the fact that each monthly payment

of $43,725 exceeds the proper economic accrual of interest and

treating the portion of each monthly payment that does not

qualify as interest as a repayment of principal:

 Portion of Portion of

 Monthly Monthly

Amount of Payment Payment Balance

 Monthly Allocated Allocated Due on

Payment For Payment to Interest to Principal Principal 

1980

August $ 43,725 $ 21,725 $ 22,000 $2,348,000

September 43,725 21,523 22,202 2,325,798

October 43,725 21,320 22,405 2,303,393

November 43,725 21,114 22,611 2,280,783

December 43,725 20,907 22,818 2,257,965

1980 Total $218,625 $106,589 $112,036

1981

January $ 43,725 $ 20,698 $ 23,027 $2,234,938

February 43,725 20,487 23,238 2,211,700

March 43,725 20,274 23,451 2,188,249

April 43,725 20,059 23,666 2,164,583

May 43,725 19,842 23,883 2,140,700

June 43,725 19,623 24,102 2,116,598

July 43,725 19,402 24,323 2,092,275

August 43,725 19,179 24,546 2,067,729

September 43,725 18,954 24,771 2,042,958

October 43,725 18,727 24,998 2,017,960

November 43,725 18,498 25,227 1,992,733

December 43,725 18,267 25,458 1,967,275

1981 Total $524,700 $234,010 $290,690
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1982

January $ 43,725 $ 18,033 $ 25,692 $1,941,583

February 43,725 17,798 25,927 1,915,656

March 43,725 17,560 26,165 1,889,491

April 43,725 17,320 26,405 1,863,087

May 43,725 17,078 26,647 1,836,440

June 43,725 16,834 26,891 1,809,549

July 43,725 16,588 27,137 1,782,412

August 43,725 16,339 27,386 1,755,025

September 43,725 16,088 27,637 1,727,388

October 43,725 15,834 27,891 1,699,497

November 43,725 15,579 28,146 1,671,351

December 43,725 15,321 28,404 1,642,945

1982 Total $524,700 $200,372 $324,328

Portion of Portion of

 Monthly Monthly

Amount of Payment Payment Balance

 Monthly Allocated Allocated Due on

Payment For Payment to Interest to Principal Principal 

1983

January $ 43,725 $ 15,060 $ 28,665 $1,614,282

February 43,725 14,798 28,927 1,585,355

March 43,725 14,532 29,193 1,556,162

April 43,725 14,265 29,460 1,526,702

May 43,725 13,995 29,730 1,496,972

June 43,725 13,722 30,003 1,466,969

July 43,725 13,447 30,278 1,436,691

August 43,725 13,170 30,555 1,406,136

September 43,725 12,890 30,835 1,375,301

October 43,725 12,607 31,118 1,344,182

November 43,725 12,322 31,403 1,312,779

December 43,725 12,034 31,691 1,281,088

1983 Total $524,700 $162,842 $361,858

1984

January $ 43,725 $ 11,743 $ 31,982 $1,249,106

February 43,725 11,450 32,275 1,216,831

March 43,725 11,154 32,571 1,184,261

April 43,725 10,856 32,869 1,151,391

May 43,725 10,554 33,171 1,118,221

June 43,725 10,250 33,475 1,084,746

July 43,725 9,944 33,781 1,050,965

August 43,725 9,634 34,091 1,016,874

September 43,725 9,321 34,404 982,470

October 43,725 9,006 34,719 947,751

November 43,725 8,688 35,037 912,714

December 43,725 8,367 35,358 877,355

1984 Total $524,700 $120,967 $403,733
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1985

January $ 43,725 $ 8,042 $ 35,683 $841,673

February 43,725 7,715 36,010 805,663

March 43,725 7,385 36,340 769,323

April 43,725 7,052 36,673 732,650

May 43,725 6,716 37,009 695,641

June 43,725 6,377 37,348 658,293

July 43,725 6,035 37,691 620,602

August 43,725 5,689 38,036 582,566

September 43,725 5,340 38,385 544,181

October 43,725 4,988 38,737 505,445

November 43,725 4,633 39,092 466,353

December 43,725 4,275 39,450 426,903

1985 Total $524,700 $74,246 $450,454

A number of cases have held that even though an underlying

transaction or stated indebtedness is held to be a sham, devoid

of economic substance, and based on an inflated purchase price,

recourse indebtedness associated with the transaction may still

be regarded as genuine and related interest expense may still be

deductible. See, e.g., Rice’s Toyota World, Inc. v.

Commissioner, 752 F.2d 89, 95-96 (4th Cir. 1985), affg. in part,

revg. in part, and remanding 81 T.C. 184 (1983); Coleman v.

Commissioner, 87 T.C. 178, 213 (1986), affd. without published

opinion 833 F.2d 303 (3d Cir. 1987). Where, however, stated

indebtedness associated with such a sham transaction represents

nonrecourse indebtedness, the cases are consistent in disallowing

claimed interest deductions relating to the nonrecourse

indebtedness. See, e.g., Jacobson v. Commissioner, 915 F.2d 832

(2d Cir. 1990), affg. in part, revg. in part, and remanding in

part T.C. Memo. 1988-341; Polakof v. Commissioner, 820 F.2d 321,

324 (9th Cir. 1987), affg. per curiam T.C. Memo. 1985-197; Hulter
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v. Commissioner, 91 T.C. 371, 392 (1988); Coleman v.

Commissioner, supra at 209-210.

The issue presented to us in petitioner’s instant motion,

however, involves a slightly different issue -- namely, once

actual payments (or portions thereof) are disallowed as

“interest”, should such payments be treated as repayments of the

principal portion of the stated indebtedness that is to be

recognized for Federal income tax purposes and thereby reduce the

interest allowable in subsequent periods. 

We have found limited but helpful authority on this issue. 

In Bizub v. Commissioner, T.C. Memo. 1983-280, payments of

$58,500 designated as “prepaid” interest were made with respect

to stated principal on an inflated, nonrecourse indebtedness. 

Claimed interest deductions relating to payments of “prepaid”

interest were disallowed, and the payments were treated as

repayments of principal. See also Siegel v. Commissioner, 78

T.C. 659, 687 n.5 (1982).

In Prussin v. Commissioner, T.C. Memo. 1990-287, on remand

from the Third Circuit (Pleasant Summit Land Corp. v.

Commissioner, 863 F.2d 263 (3d Cir. 1988), affg. in part and

revg. in part T.C. Memo. 1987-469), nonrecourse indebtedness

associated with the purchase of an apartment building was treated

as genuine indebtedness to the extent only of the fair market

value of the building. The taxpayers therein argued that the

interest deduction that should be allowed should be calculated by
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applying to the amount of interest originally claimed the

percentage of the stated principal amount of the indebtedness

that was to be recognized for tax purposes. This is essentially

the same percentage-formula argument that petitioner herein makes

with regard to the calculation of the economic accrual of

interest on the principal portion of the Partnership’s

indebtedness that is to be recognized. 

In Prussin v. Commissioner, supra, we rejected the

taxpayers’ use of a simple percentage formula to calculate the

proper interest deduction on the portion of the taxpayers’

indebtedness that was to be recognized. Instead, disregarding

the terms of various loan documents, which required lump-sum

payments of interest only, we looked to the economic reality of

the transaction and applied an “effective economic interest rate”

of 9 percent. 

Having considered the arguments of the parties and the above

authorities, we agree with respondent. The schedule in Levy v.

Commissioner, 92 T.C. at 1360, setting forth the economic accrual

of interest was intended as illustrative and was based on the

total stated purchase price for the buildings involved in this

case and the $4,770,000 total stated principal indebtedness on

the Partnership’s promissory note. That opinion only involved

the use of the Rule-of-78's method of accruing interest versus

the economic accrual method of accruing interest on long-term

indebtedness. The value of the buildings and the genuineness of
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the Partnership’s indebtedness were not involved in that opinion. 

Petitioner’s reliance on the schedule set forth in Levy v.

Commissioner, 92 T.C. at 1365, is misplaced.

As a result of the reduction to $2,370,000 of the portion of

the Partnership’s total stated indebtedness that is to be

recognized for Federal income tax purposes (see Levy v.

Commissioner, T.C. Memo. 1991-646), the Partnership’s monthly

payments of $43,725 exceeded the allowable monthly interest

expense, and a considerable portion or excess of each monthly

payment remained to reduce principal. We believe that, for

Federal income tax purposes, those excess funds cannot be

ignored. They were paid by the Partnership, and they must be

considered as either interest or as repayments of principal. 

Under the economic accrual method of calculating interest

expense, the interest attributable to the use of money for a

period between payments is determined by applying the effective

rate of interest on the loan to the "unpaid balance" of the loan

for that period. See Rev. Rul. 83-84, 1983-1 C.B. 97, 98. 

Because the Partnership's monthly payments exceeded the allowable

interest expense, the excess of each payment properly is to be

regarded as a repayment of a portion of the principal.

Accordingly, the portion of each monthly $43,725 payment in

excess of allowable interest (calculated under the economic

accrual method and on only the $2,370,000 portion of the

Partnership’s stated indebtedness that is to be recognized) must
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be treated as a repayment of principal and applied, for Federal

income tax purposes, to reduce the $2,370,000 outstanding

principal balance on the Partnership’s indebtedness. Any

contrary treatment of the portion of each monthly $43,725 payment

in excess of allowable interest would produce a result contrary

to the economic substance of the indebtedness before us.

In our prior memorandum opinion in Levy v. Commissioner,

T.C. Memo. 1991-646, we disregarded the express terms of the

promissory note, and we based our decision on what constituted

the economic substance and reality of the transaction. We see no

reason to depart from that approach at this time. The

Partnership made monthly $43,725 payments to the creditor, only a

portion of which represents properly accrued interest expense. 

The excess of the monthly $43,725 payments by the Partnership to

the creditor should be applied to the $2,370,000 principal

portion of the Partnership's stated indebtedness that is to be

recognized for Federal income tax purposes, and such $2,370,000

is to be treated as amortized until paid off. 

For the reasons stated, we shall deny petitioner’s motion to

vacate decision.

An appropriate order

will be issued.