t c memo 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 filed date 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 with respect to the partnership items reported by epic associates 83-xii referred to herein as ea 83-xii disallow interest and point amortization deductions disallow depreciation_deductions disallow claimed net investment loss disallow qualified_investment_income disallow qualified_investment_expenses disallow excess expenses from net_lease_property disallow investment_interest income disallow net_investment_income disallow investment_income dollar_figure big_number big_number _o- _o- big_number dollar_figure big_number _o- big_number dollar_figure big_number big_number big_number 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 disallow interest and point amortization deductions disallow depreciation_deductions disallow deductions in excess of income disallow claimed net investment loss disallow qualified_investment_income disallow qualified_investment_expenses disallow net_investment_income disallow investment_income dollar_figure big_number -o- big_number dollar_figure big_number - q- - q- big_number big_number --o- --o- dollar_figure big_number big_number q- big_number big_number -o- 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 sec_183 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 efa 83-xii and ba 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 income and expenses on a calendar_year basis and used the accrual_method of accounting ba 83-xii efa 83-xii was formed on date pursuant to the uniform_limited_partnership_act of the commonwealth of virginia for a 10-year term ending on date the amended and restated certificate and agreement of limited_partnership dated date referred to herein as the 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 and was reincorporated in maryland in epic's business involved the purchase lease and sale of residential houses and condominiums we discuss epic at greater length below the partnership_agreement provides that epic's interest shall be deemed to be a one-percent share in the partnership's capital contributions for which it shall contribute dollar_figure in addition the partnership_agreement authorizes two classes of limited_partnership interests class a unit and class b units the class a unit was sold to four investors for an aggregate sum of dollar_figure the purchasers of the class a unit made cash payments totaling dollar_figure and executed recourse promissory notes totaling dollar_figure that were payable to the partnership on date these investors were admitted to the partnership on date ba 83-xii also sold class b units of limited_partnership_interest for dollar_figure per unit or a total of dollar_figure approximately dollar_figure of the amount_paid for each class b unit was paid in cash and the balance of dollar_figure was paid in the form of a recourse promissory note payable to ex 83-xii in quarterly installments of dollar_figure each with the last payment due on date before selling the class b units in ea 83-xii epic circulated a confidential private_placement offering memorandum dated date referred to herein as the offering memorandum the offering memorandum states that persons who purchased class b units would be admitted to ea 83-xii as limited partners commencing date the offering memorandum states that the limited partners' contributions would be used primarily to fund operating deficits of the partnership the 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 dollar_figure dollar_figure proceeds from sale of class b units big_number dollar_figure capital_contribution of general_partner big_number dollar_figure first mortgage loans big_number dollar_figure builder rebate referred to herein big_number dollar_figure as rental deficit contribution big_number dollar_figure uses purchase_price of homes big_number dollar_figure sales commissions to broker dealers big_number dollar_figure of the price paid for each unit escrows and prepaid insurance big_number dollar_figure first mortgage loan origination fees big_number dollar_figure organization fee to general_partner big_number dollar_figure of the price paid for each unit estimated cash-flow deficits through date big_number dollar_figure available for cash-flow deficits big_number dollar_figure big_number dollar_figure note footnotes omitted ‘this amount is dollar_figure more than the actual purchase_price dollar_figure as set forth above it was anticipated that dollar_figure of the proceeds of the offering would be offset by cash-flow deficits through date and dollar_figure 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 offering memorandum show an annual operating deficit of dollar_figure calculated as follows percentage of projected annual income amount total income builder lease dollar_figure dollar_figure rental income less vacancy expense factor big_number dollar_figure total projected income big_number dollar_figure annual operating expenditures aggregate first mortgage principal interest dollar_figure dollar_figure real_estate_taxes big_number dollar_figure insurance homeowner's dues big_number dollar_figure audit expenses big_number dollar_figure property administration fee big_number dollar_figure allowance for maintenance repairs big_number dollar_figure total projected cash expenditures big_number dollar_figure projected operating deficit big_number dollar_figure the offering memorandum also includes a cash-flow analysis for ea 83-xii from inception to date as set forth in appendix a to this opinion in the offering memorandum it was contemplated that epic would finance the partnership's operating deficits by advancing funds to the partnership the partnership_agreement provides that ea 83-xii would pay interest on all unsecured advances of funds by the general_partner at the rate of percent per annum the 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 percent per annum the partnership_agreement provides that cash from operations is to be distributed in the following order of priority to epic to repay any unsecured advances made by epic to the partnership together with interest 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 egual the partners' cumulative cash capital contributions percent to epic and percent to the limited partners holding the class a and class b units the partnership_agreement further provides that cash from sales and from financings is to be distributed in the following order of priority to repay partner- ship debt secured_by the property sold or refinanced and to pay the expenses of selling each property to repay any unsecured advances made by epic to the partnership together with interest to pay epic a disposition fee equal to 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 percent of any remaining amount to epic and 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 of limited partners capital_contribution upon admission to the partnership or a maximum total_payment of dollar_figure 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 dollar_figure for each partnership property -- - 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 disposi- tion fee on all resale of partnership properties except in connection with an exchange with a builder for like_kind property 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 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 dollar_figure 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 date under which it agreed to purchase five houses located in carrollton texas from raldon corp raldon for dollar_figure and to lease the houses back to raldon for use as model houses for an initial term of 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 dollar_figure to dollar_figure 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 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 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 we refer to the amount payable under the above provision as the builder fee 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 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 raldon corp builder lease payments tax ins hoa reimburse tenant rental rental deficit contribution interest_income total revenue first trust interest tax ins hoa expense repairs maintenance property management fee audit_fee interest on epic advances total expenses anticipated cash deficit as a percent of purchase_price according to the deficit from the above analysis year year year year total dollar_figure dollar_figure -q- --0- dollar_figure big_number big_number -o- -0- big_number -o- big_number dollar_figure dollar_figure big_number -0- -0- -0- -0- -0- -0- -0- -0- -0- -0- big_number big_number big_number big_number big_number -big_number -big_number -big_number -big_number -big_number -big_number -big_number -big_number -big_number -big_number -o- -big_number -big_number -big_number -big_number -big_number -big_number -big_number -big_number -big_number --607 --607 --607 --607 --big_number -big_number -big_number -big_number -big_number --big_number -big_number -big_number -big_number -big_number --big_number -big_number --big_number -big_number -big_number -big_number -3 -6 -9 -8 -28 epic projected a cash transaction at the end of the fourth year of dollar_figure or dollar_figure percent of the original purchase_price following appreciation rates would be required to recoup the investment in the properties after sales expenses of viz dollar_figure epic further projected that the percent and a disposition fee of percent to be paid to epic end of 2d year end of 3d year end of 4th year ' epic's projection by instrument dated december to bea 83-xii epic's right investment dollar_figure 'big_number big_number appreciation rate dollar_figure dollar_figure dollar_figure title and interest purchase and leaseback agreement with raldon as contained in the record is difficult to read and this amount may differ from the projection epic assigned in the on date ea 83-xii closed the purchase of each of the five model houses from raldon to finance its purchase of the subject houses ea xii borrowed approximately 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 dollar_figure payable to emi in monthly installments of interest only on the unpaid principal balance for years at the rate of percent the entire indebtedness under each note was due years after the date of the first payment of interest required under the note fach nonrecourse promissory note was secured_by a deed_of_trust bearing the date of closing and recorded on date in the land records of denton county texas a mortgage_insurance company ticor mortgage_insurance tmi issued a commitment and certificate of insurance dated date providing mortgage_insurance for 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 -- - 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 avignon dr dollar_figure dollar_figure dollar_figure dollar_figure avignon dr big_number dollar_figure big_number big_number avignon dr big_number dollar_figure big_number big_number avignon dr big_number dollar_figure big_number big_number avignon dr dollar_figure big_number big_number big_number dollar_figure big_number big_number 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 eba 83-xii set out below is a summary of the settlement statements showing that a total of dollar_figure was due to the buyer ea 83-xii at closing raldon corp buyer seller contract sales_price dollar_figure dollar_figure settlement charges to buyer dollar_figure -0- price adjustment dollar_figure dollar_figure gross amount due dollar_figure dollar_figure principal_amount of loans dollar_figure -o- builder fee dollar_figure dollar_figure rent advance dollar_figure dollar_figure rental deficit contribution -0- -0q- other credits dollar_figure dollar_figure settlement charges to seller -0- dollar_figure total credits dollar_figure dollar_figure amount due buyer dollar_figure -o- amount due seller --0- dollar_figure according to the settlement sheets the aggregate principal_amount of the loans dollar_figure was credited as follows buyer seller others total settlement charges to buyer -0- -0- dollar_figure dollar_figure amount due less loan s-dollar_figure -0- -o- --dollar_figure builder fee dollar_figure -0- -o- dollar_figure rent advance dollar_figure -0- -o- dollar_figure other credit dollar_figure -0- -o- dollar_figure settlement charges to seller -0- -0- dollar_figure dollar_figure amount due seller dollar_figure -o- dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure 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 date 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 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 date 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 dollar_figure the rental purchase agreement had originally called for the purchase of eight properties for a total of dollar_figure 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 -- - 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 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 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 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 dollar_figure to dollar_figure percent contribution the rental purchase agreement also provided condition to the purchaser's obligation to purchase the properties that the we refer to this payment as the rental deficit as a 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 of the transaction fox jacobs inc year year year year total builder lease payments --0- --0- -0- -o- --o- tax ins hoa reimburse -0- -0- -0q- --0- -0- tenant rental dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure rental deficit contribution big_number -0- -o- -0- big_number interest_income big_number big_number big_number -0-- big_number total revenue big_number big_number big_number big_number first trust interest -big_number -big_number -big_number -big_number -251 tax ins hoa expense -big_number -big_number -big_number -big_number -31 repairs maintenance -big_number -big_number -big_number -big_number -big_number property management fee -562 -562 -562 -562 -big_number audit_fee --big_number --big_number -big_number --big_number -big_number interest on epic advances --big_number --big_number --big_number --big_number -big_number total expenses -big_number -big_number --big_number -big_number --big_number anticipated cash deficit big_number -big_number -big_number -big_number -big_number as a percent of purchase dollar_figure -6 --6 -dollar_figure -dollar_figure price---check nos with fox jacobs following internal cash-flow analysis the above analysis is based upon the original plan to purchase eight houses for dollar_figure as shown above epic projected a cash deficit from that transaction at the end of the fourth year of dollar_figure or dollar_figure percent of the - - 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 percent and the disposition fee of percent to be paid to epic appreciation investment rates end of 2d year dollar_figure dollar_figure end of 3d year dollar_figure end of 4th year big_number dollar_figure 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 dollar_figure taking into account estimated monthly operating_expenses of dollar_figure tenant rentals of dollar_figure with a vacancy rate of percent and monthly contributions of investor capital of dollar_figure according to the analysis the present_value of the monthly deficit over months discounted pincite percent is dollar_figure the analysis which is reproduced below designates this amount as the rental deficit contribution operating_expenses per month dollar_figure tenant rental revenue -4 rent-up factor net tenant rental -big_number operating deficit big_number investor contribution purchase_price dollar_figure x -big_number net monthly deficit big_number present_value of deficit over mos pincite monthly deficit of big_number x dollar_figure big_number sic rental deficit contribution big_number as a percent of purchase_price the rental deficit contribution shown above was calculated using a net borrowing cost exclusive of servicing and private mortgage_insurance of dollar_figure percent the rental deficit contribution computed in the above analysis dollar_figure differs from the amount used in epic's cash-flow analysis for the project dollar_figure and differs from the rental deficit contribution finally negotiated with fox jacobs dollar_figure by instrument dated date epic assigned to ba 83-xii its entire right title and interest as purchaser and landlord in the rental purchase agree- ment dated date with fox jacobs on date ea 83-xii closed the purchase of each of the properties to finance its purchase of the subject properties ea 83-xii borrowed approximately percent of the purchase_price of each of the properties from emi on the closing date ea 83-xii executed seven nonrecourse promissory - notes in the aggregate principal_amount of dollar_figure payable to emi with monthly installments of interest only on the unpaid principal balance for years at the rate of percent thereafter the notes required ea 83-xii to pay monthly installments of principal and interest for years the principal_amount of each note was due at the end of years or date on date 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 full calendar months of the loan term shall be fourteen and 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 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 date and on the first day of each succeeding month through and including date 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 months of the loan term except that any remain-- ing indebtedness if not sooner paid shall be due and payable in full on date - - fach 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 date each deed_of_trust was amended on date to reflect the changes made by the allonge to note a mortgage_insurance company tmi issued a commitment and certificate of insurance dated date providing mortgage_insurance for 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 hemphill ave dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure w 17th st big_number dollar_figure big_number big_number big_number coronado ave big_number dollar_figure big_number big_number big_number coronado ave big_number dollar_figure big_number big_number big_number coronado ave big_number dollar_figure big_number big_number big_number linda ave big_number dollar_figure big_number big_number big_number hollywood dr big_number dollar_figure big_number big_number big_number subtotal big_number dollar_figure big_number big_number big_number a settlement statement was prepared for the sale of each property purchase_price as the in each case the statement shows the above contract sales_price of the -- - 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 efa 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 dollar_figure had been overpaid by or on behalf of the buyer ea 83-xii fox jacobs inc buyer seller contract sales_price dollar_figure dollar_figure settlement charges to buyer dollar_figure gross amount due dollar_figure dollar_figure principal_amount of loans dollar_figure builder fee dollar_figure dollar_figure rent advance dollar_figure dollar_figure rental deficit contribution dollar_figure dollar_figure other credits dollar_figure dollar_figure settlement charges to seller dollar_figure total credits dollar_figure dollar_figure amount due buyer dollar_figure amount due seller dollar_figure according to the settlement statements the aggregate principal_amount of the loans dollar_figure was credited as follows buyer seller others total settlement charges to buyer -0- --0- dollar_figure dollar_figure amount due less loans dollar_figure-dollar_figure --0- --0- --dollar_figure builder fee dollar_figure -0- -0- dollar_figure rent advance big_number --0- --0- dollar_figure rental deficit contribution dollar_figure --0- --0- dollar_figure other credits dollar_figure -0- -0- dollar_figure settlement charges to seller -0q- -0- dollar_figure dollar_figure amount due seller dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure 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 date 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 condominium units in paseos castellanos epic executed a residential rental purchase agreement rental purchase agreement dated date under which it agreed to purchase condominium units located in the paseos castellanos condominium complex in miami - - florida from babcock co babcock a subsidiary of weyerhaeuser for dollar_figure 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 it con- sists of eight two-story buildings with units in each building for a total of 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 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 bathrooms and square feet of living space are two-story units in the center of the building each with two bedrooms bathrooms and big_number square feet are two-story units in the center of the building each with three bedrooms bathrooms and big_number square feet and the remaining are one-story units on the ground level each with three bedrooms two bathrooms and big_number square feet -- p7 - 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 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 percent of the purchase_price of each property as a contribution towards rental deficits referred to as the rental deficit - - 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 of the transaction following internal cash-flow analysis with babcock paseos castellanos year year year year total builder lease payments -0- -0- -0- --o- --o- tax ins hoa reimburse -0q- -q- -q- -0- -0- tenant rental dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure rental deficit contribution big_number -0- -0- -o- big_number interest_income big_number big_number big_number -o- big_number total revenue big_number big_number big_number big_number big_number first trust interest -big_number -big_number -big_number -big_number -1 big_number tax ins hoa expense -big_number --big_number --big_number -big_number -big_number repairs maintenance -big_number -big_number -big_number -big_number -big_number property management fee --big_number --16 --16 -16 -big_number audit_fee -big_number -big_number -big_number -big_number -big_number interest on epic advances -big_number -big_number -big_number -big_number --big_number total expenses --big_number -big_number -big_number --big_number -big_number anticipated cash deficit big_number -big_number --big_number -282 -big_number as a percent of purchase dollar_figure -dollar_figure -dollar_figure --dollar_figure -dollar_figure price as shown above epic projected a cash deficit from the transaction at the end of the fourth year of dollar_figure or dollar_figure percent of the purchase_price viz dollar_figure epic further projected that the following appreciation - - rates would be required to recoup the investment in the properties after sales expenses of percent anda disposition fee of percent to be paid to epic investment appreciation rate end of 2d year dollar_figure end of 3d year dollar_figure end of 4th year dollar_figure epic's analysis of the transaction included a computation of the rental deficit contribution first epic personnel estimated the monthly deficit from the project dollar_figure taking into account estimated monthly operating_expenses of dollar_figure tenant rentals of dollar_figure with a vacancy rate of percent and a monthly contribution of investor capital of dollar_figure according to the analysis the present_value of the monthly deficit dollar_figure discounted over months pincite percent is dollar_figure the analysis which is reproduced below designates this amount as the rental deficit contribution operating_expenses per month dollar_figure tenant rental revenue -big_number rent-up factor net tenant rental -big_number operating deficit big_number investor contribution purchase_price dollar_figure x -big_number net monthly deficit big_number present_value of deficit over mos pincite monthly deficit of big_number x dollar_figure big_number sic rental deficit contribution big_number as a percent of purchase_price the rental deficit contribution shown above was calculated using a net borrowing cost exclusive of servicing and private mortgage_insurance of the rental deficit contribution computed in the above analysis differs from the amount finally negotiated with babcock dollar_figure by instrument dated date epic assigned to ba 83-xii all its right title and interest in the rental purchase agreement dated date with babcock thereafter ea 83-xii closed the sale of each of the condominium units as of date to finance its purchase of the condominium units in the paseos castellanos complex ea 83-xii borrowed from emi approximately percent of the purchase_price of each unit on or about the closing date ea 83-xii executed nonrecourse promissory notes in the aggregate principal_amount of dollar_figure payable to emi in monthly installments of interest only for years at the rate of percent - - thereafter the notes required ea 83-xii to pay monthly installments of interest and principal for years the notes required_payment in full on date ea 83-xii executed an allonge to note dated date for each of the 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 date ea 83-xii also executed a mortgage on the date of closing for each of the condominium units with fa 83-xii as the mortgagor and emi as the mortgagee the mortgages were modified on date to reflect that the maturity_date of the notes had changed from date to date set out below is a list of the 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 - - the babcock co contract builder rental deficit rent paseos castellanos price fee contribution advance loan h dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure h big_number dollar_figure big_number big_number big_number h big_number dollar_figure big_number big_number big_number h big_number dollar_figure big_number big_number big_number h big_number dollar_figure big_number big_number big_number h big_number dollar_figure big_number big_number big_number h big_number dollar_figure big_number big_number big_number b big_number dollar_figure big_number big_number big_number b big_number dollar_figure big_number big_number big_number d big_number dollar_figure big_number big_number big_number d big_number dollar_figure big_number big_number big_number d big_number dollar_figure big_number big_number big_number cc big_number dollar_figure big_number big_number big_number c big_number dollar_figure big_number big_number big_number cc big_number dollar_figure big_number big_number big_number c big_number dollar_figure big_number big_number big_number cc big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number g big_number dollar_figure big_number big_number big_number g big_number dollar_figure big_number big_number big_number g big_number dollar_figure big_number big_number big_number g big_number dollar_figure big_number big_number big_number g big_number dollar_figure big_number big_number big_number g big_number dollar_figure big_number big_number big_number g big_number dollar_figure big_number big_number big_number g big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number subtotal big_number dollar_figure big_number big_number 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 statement is the amount of the loan proceeds below is a summary of the settlement sheets for the set out purchase of the condominium units in paseos castellanos paseos castellanos contract sales_price price adjustment other charges gross amount due principal_amount of loans builder fee rent advance rental deficit contribution other credits amount due from buyer amount due to seller according to the settlement amount of the loans dollar_figure buyer dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure big_number dollar_figure -o- -o- -o- dollar_figure sheets seller dollar_figure big_number big_number big_number big_number dollar_figure big_number was credited as follows the aggregate principal buyer seller others total settlement charges -q- -0- dollar_figure dollar_figure builder fee dollar_figure -0- -0- dollar_figure rent advance dollar_figure -0- -0- dollar_figure rental deficit contribution dollar_figure -0- -0- dollar_figure other credits -0- -0- dollar_figure dollar_figure amount due from buyer -dollar_figure -0- -0- --dollar_figure amount due to seller -0- dollar_figure dollar_figure -0-- dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure tmi issued a commitment and certificate of insurance dated date under which it committed to issue mortgage_insurance for percent of the first loss amount with respect to the mortgage on each condominium unit subsequently mortgage dated date emi and csl executed an assignment of for each condominium unit transferring their interest in each note to the national - -- bank of washington thus shortly after ea 83-xii purchased the subject properties from babcock national bank of washington purchased the promissory notes that bfa 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 dollar_figure -0- dollar_figure fox jacob sec_394 dollar_figure big_number babcock big_number big_number big_number total big_number big_number big_number the offering memorandum states that investors would break even if the real properties acquired by ea 83-xii appreciated at the annual rate of dollar_figure 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 - b5 - beginning date and ending date 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 date and ending date are as follows to to to revenue rental income dollar_figure dollar_figure dollar_figure interest income---general partner dollar_figure -o- other income dollar_figure -0- total revenue dollar_figure big_number expenses interest on first mortgage dollar_figure big_number big_number additional mortgage interest -0- --o- -o- other interest_expense -0- -0- big_number real_estate_taxes insurance hoa dollar_figure big_number big_number audit_fee dollar_figure big_number big_number repairs and maintenance dollar_figure big_number big_number property administration fee dollar_figure big_number big_number interest expense--general partner --o- big_number big_number rental commission dollar_figure big_number big_number legal fees dollar_figure big_number other expenses dollar_figure total expenses dollar_figure big_number big_number net results of operations -dollar_figure -big_number -big_number taxable_income loss net results of operations -dollar_figure -big_number -big_number plus mortgage amortization -0- -0- --0- less depreciation dollar_figure big_number big_number amortization of loan fees dollar_figure big_number big_number amortization of refinancing costs -0- -0- --0- accrued mortgage interest -0- taxable_income loss --dollar_figure --607 --big_number the above amounts can be compared with the cash-flow projection that was set out in the 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 date and ending date is interest - - expense--general partner in the amount of zero during dollar_figure during and dollar_figure during 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 dollar_figure dollar_figure and zero respectively the record also contains audited financial statements of ex 83-xii for the years ended date and 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 revenues rental income_interest income other income expenses interest depreciation real_estate_taxes amortization repairs and maintenance property management fee rental commissions homeowner's association dues insurance professional fees other expenses net_loss partners’ capital deficit at beginning of year partners' contributions partners' distributions partners’ capital deficit at end of year year ended december dollar_figure -o- big_number big_number big_number big_number big_number big_number big_number big_number big_number --o- dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number -o- one of the notes accompanying the financial statements deals with related-party transactions and states as follows 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 dollar_figure of cost per -- - year to epic for these services during and 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 dollar_figure and earned dollar_figure of interest to from epic and affiliates during and 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 ea 83-xii rent income dollar_figure dollar_figure dollar_figure late charges -o- -o- interest_income big_number big_number miscellaneous -o0- -0- total gross_income big_number big_number interest noninvestment big_number big_number big_number commissions big_number big_number big_number insurance big_number big_number big_number legal and professional fee big_number repairs big_number big_number big_number taxes big_number big_number big_number utilitie sec_464 big_number homeowners dues big_number big_number audit_fee big_number big_number big_number points amortization big_number big_number big_number property management big_number big_number real_estate tax service big_number -0- -0- miscellaneou sec_107 -o- depreciation big_number big_number big_number bad_debts --o- big_number --o- amortization org expense -o0- big_number -0- recording fees -0- -o0- service fee-emi -0- big_number total expenses big_number big_number --big_number net rental income -big_number -big_number --big_number on its schedule k partner's share of income credits deductions etc for ea 83-xii reported an ordinary_loss of dollar_figure investment_interest expense of dollar_figure net_investment_income of dollar_figure and excess expenses from net_lease_property of dollar_figure and for purposes of allocating tax preference items to its partners ea 83-xii reported a net investment loss of dollar_figure on its schedules k for and ea 83-xii reported ordinary losses of dollar_figure and dollar_figure respectively and investment_income of dollar_figure and dollar_figure - - respectively and for purposes of allocating tax preference items to its partners ea 83-xii reported qualified_investment_income of dollar_figure and dollar_figure respectively and qualified_investment_expenses of dollar_figure and dollar_figure respectively for depreciation purposes ea 83-xii treated the aggregate contract_price of it sec_51 properties dollar_figure less the aggregate rental deficit contribution dollar_figure as its aggregate basis in the real_estate viz dollar_figure ea 83-xii allocated percent of that amount to land viz dollar_figure and percent to buildings viz dollar_figure ba 83-xii depreciated the latter amount on a straight-line basis over years and claimed depreciation of dollar_figure 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 dollar_figure at the annual rate of percent thus ea 83-xii was obligated to pay interest to emi in the aggregate amount of dollar_figure during each of the years in issue ie dollar_figure x percent ea 83-xii was also obligated under the partnership_agreement to pay interest at the annual rate of percent to compensate the general_partner for unsecured advances of funds to the partnership al the returns filed on behalf of ba 83-xii for the years in issue report the following liabilities to the general_partner on schedule l sheets year ended amount of advances balance accrued interest dollar_figure -0- big_number dollar_figure big_number big_number ea 83-xii reported the following interest_expense on its returns for the years in interest noninvestment investment_interest income total issue dollar_figure dollar_figure dollar_figure -oq- -o- big_number big_number big_number the difference between the above amounts and the interest_paid or incurred with respect to the partnership's first mortgage notes is as follows total interest_expense reported interest on first mortgage notes difference the record of this case does differences dollar_figure big_number dollar_figure big_number dollar_figure big_number big_number big_number not explain the above - ba 83-xii paid loan origination fees to emi in the aggregate amount of dollar_figure equal to percent of the principal_amount of the first mortgage loans ée dollar_figure x percent this amount was amortized over the life of the loans for each of the years in issue ba 83-xii reported points amortization expense of dollar_figure on each of the subject returns bfa 84-iit epic formed ea 84-iii on date pursuant to the uniform_limited_partnership_act of the commonwealth of virginia for a 10-year term ending on date 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 date which was recorded on date 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 date the second amended and restated certificate and agreement of limited_partnership partnership_agreement describes the business of ea 84-iii in the following terms -- - 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 partnership_agreement provides that epic's interest shall be deemed to be a one-percent share in the partnership's capital contributions for which it shall contribute dollar_figure in addition the 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 partnership_agreement states that one class a unit representing an aggregate capital_contribution of dollar_figure was sold to four investors one class b unit representing a capital_contribution of dollar_figure was sold to one investor and one class c unit representing an aggregate capital_contribution of dollar_figure was sold to three investors it also appears that thereafter two - investors made an aggregate capital_contribution of dollar_figure 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 date the agreement also states that the general_partner in its sole discretion may authorize future class units from date 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 offering memorandum dated date the 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 offering memo- randum contains a chart summarizing ea 84-iii's anticipated sources and uses of the proceeds of the offering as follows sources amount percent proceeds from sale of class a unit dollar_figure dollar_figure proceeds from sale of class b unit big_number dollar_figure proceeds from sale of class c unit big_number dollar_figure proceeds from sale of class d unit big_number dollar_figure proceeds from sale of class e unit big_number dollar_figure proceeds from sale of additional class es big_number dollar_figure capital contributions of general_partner big_number dollar_figure first mortgage loans big_number dollar_figure builder rebates big_number dollar_figure general_partner advances big_number dollar_figure total big_number dollar_figure uses purchase_price of homes big_number dollar_figure sales commissions to broker dealers big_number dollar_figure escrows and prepaid insurance big_number first mortgage loan origination fees big_number dollar_figure organizational fee to general_partner big_number dollar_figure estimated cash-flow deficits through date big_number dollar_figure available for cash-flow deficits big_number dollar_figure total big_number dollar_figure as set forth above it was anticipated that dollar_figure of the proceeds of the offering would be offset by cash-flow deficits through date and dollar_figure of the offering proceeds would be available for cash-flow deficits after that date the projected annual income and operating costs of efa 84-iii as set forth in the offering memorandum shows an annual operating deficit of dollar_figure calculated as follows percentage of projected annual income amount total income rental income less vacancy expense factor dollar_figure dollar_figure total projected income big_number dollar_figure annual operating expenditures aggregate first mortgage principal interest big_number dollar_figure real_estate_taxes big_number dollar_figure insurance homeowner's association dues big_number dollar_figure audit expenses big_number dollar_figure property administration fee big_number dollar_figure allowance for maintenance repairs big_number dollar_figure additional interest big_number dollar_figure total projected cash expenditure sec_662 sec_408 dollar_figure projected operating deficits big_number dollar_figure the offering memorandum also includes a cash-flow analysis for ea 84-iii from date through date as set forth in appendix b to this opinion in the offering memorandum it was contemplated that epic would finance the partnership's operating deficits by advancing funds to the partnership the partnership_agreement provides that ea 84-iii would pay interest on all unsecured advances of funds by the general_partner at the rate of percent per annum the partnership_agreement permits the partnership to advance to the general_partner any funds that were not distributed a7 - 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 percent per annum the partnership_agreement provides that cash from operations is to be distributed generally in the following order of priority to epic to repay any unsecured advances made by epic to the partnership together with interest 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 percent to epic and percent to the limited partners holding the class a b c d be 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 to repay the partnership debt secured_by the property sold or refinanced to repay general creditors of the partnership including epic any advances with interest i111 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 -- - contributions of the partners up to the amounts which equal the partners' cumulative cash capital contributions and v percent to epic and percent to the limited partners the 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 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 dollars dollar_figure 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 k the general_partner in its sole discretion shall receive up to seven percent 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 --- - 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 dollar_figure 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 on all advances of funds to the partnership made by the general_partner pursuant to section a xiv the general_partner shall be entitled to interest at the rate of fifteen percent per annum 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 -- - purchase of production houses in texas and arizona epic entered into a residential rental purchase agreement rental purchase agreement dated date under which it agreed to purchase residential properties from u s home corp u s home for an aggregate purchase_price of dollar_figure 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 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 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 we refer to this amount as the builder fee the rental purchase agreement also requires u s home to pay to the purchaser months' rent for each property under certain conditions that provision states as follows -- - on the closing date seller shall pay to purchaser a sum egqual to the total estimated rent for three 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 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 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 - - 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 of the properties to ea 84-iii on date efa 84-iii purchased the properties it had been assigned for an aggregate purchase_price of dollar_figure to finance its purchase of the properties ea iii borrowed dollar_figure approximately percent of the purchase_price from emi on the closing date ea 84-iii executed nonrecourse promissory notes in the aggregate principal_amount of dollar_figure payable to emi with monthly installments of interest only for years at the annual rate of percent thereafter the notes required ba 84-iii to pay monthly installments of principal and interest for years the full indebtedness was due and payable on date fach 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 percent of the first -- - loss amount with respect to the mortgage on each of the properties set out below is a list of the 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 heronwood dr dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure heronwood dr big_number dollar_figure big_number big_number big_number tower hill lane big_number dollar_figure big_number big_number big_number northcliff manor dr big_number dollar_figure big_number big_number big_number clarewood dr big_number dollar_figure big_number big_number big_number s briar bayou dr big_number dollar_figure big_number big_number big_number kingslake forest dr big_number dollar_figure big_number big_number big_number kingslake forest dr dollar_figure big_number big_number big_number kingslake forest dr dollar_figure big_number big_number big_number kingslake forest dr big_number dollar_figure big_number big_number carola forest dr big_number dollar_figure big_number big_number big_number west ferret dr big_number dollar_figure big_number big_number big_number medical dr condo big_number dollar_figure big_number big_number earlywood dr big_number dollar_figure big_number big_number ridgecreek dr big_number dollar_figure big_number big_number total big_number dollar_figure big_number big_number big_number 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 of approximately dollar_figure had been overpaid of the buyer u s home corp contract sales_price settlement charges to buyer price adjustment principal_amount of loans builder fee rent advance rental deficit contribution other credits settlement charges to seller amount due to buyer amount due to seller ba 84-iii buyer dollar_figure by or behalf seller dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure -o- dollar_figure big_number big_number big_number big_number big_number dollar_figure big_number dollar_figure dollar_figure the record does not contain of the settlement statements and some amounts composing this total were estimated according to the settlement statements principal_amount of the loans follows u s home corp settlement charges to buyer amount due less loan builder fee rent advance rental deficit contribution other credits settlement charges to seller amount due seller in passing u s heronwood drive buyer dollar_figure-big_number big_number big_number big_number big_number --0- --0- big_number and the four houses pincite3 and kingslake forest drive these six the aggregate total dollar_figure -64 dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure was credited as seller others -0- dollar_figure --0o- -o- --0o- -o- --0o- -o- --0o- -o- --0o- -o- -0- dollar_figure dollar_figure -0- dollar_figure dollar_figure dollar_figure we note that the parties stipulated that home sold to ea 84-iii the two houses pincite and properties are listed among the properties covered by the - -- residential rental purchase agreement dated date 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 kingslake forest drive at trial respondent introduced warranty deeds that show that on or about date the two properties on heronwood drive were transferred by u s home to tanmis models inc and on or about date were transferred by tanmis models inc to ea 84-iili respondent also introduced warranty deeds that show that on or about date the four properties on kingslake forest drive were transferred by u s home to dyblof models inc and on or about date 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 -- - issued by eba 84-iii in connection with its purchase of the properties from u s home emi made the assignment in documents entitled assignment of deed_of_trust that are dated date 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 properties as general_partner of ea 84-iii epic executed promissory notes dated date each of the notes was payable to csl in the principal_amount of dollar_figure a total of dollar_figure under each of the promissory notes bea 84-iii promised to pay monthly installments of interest only on the unpaid principal balance at the annual rate of percent with the principal due and payable on date fifteen of the promissory notes were secured_by deeds of trust on the 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 -- - the 16th promissory note and the related deed_of_trust are similar to the others except they refer to unit of the reflections condominium complex described below purchase of condominiums units in the reflections epic executed a residential rental purchase agreement rental purchase agreement dated date 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 dollar_figure 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 the complex is composed of seven buildings with a total of dollar_figure square feet of net rentable living area located on acres the units have fireplaces parking spaces big_number 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 -- - under the rental purchase agreement pitman japhet agreed as a condition to closing to pay to epic 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 egqual 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 dollar_figure percent to dollar_figure 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 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 --- - 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 date with pitman japhet the record does not contain an instrument of assignment in any event on date ea 84-iii purchased the condominium units at the reflections to finance its purchase of the condominiums ea 84-iii borrowed dollar_figure approximately percent of the aggregate purchase_price from emi ea 84-iii executed nonrecourse promissory notes in the aggregate principal_amount of dollar_figure that were each payable to emi with monthly installments of interest at the annual rate of percent the record does not contain any of the promissory notes but their terms are summarized in the offering memorandum as follows -- - 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 fach 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 deeds of trust to philadelphia savings fund of philadelphia set out below is a list of the condominiums that ea 84-iii purchased together with the purchase_price rental deficit contribution rent advance and loan amount -- - rental purchase builder deficit rent unit price fee contrib advance loan a dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure a big_number dollar_figure big_number big_number big_number a big_number dollar_figure big_number big_number big_number a big_number dollar_figure big_number big_number big_number b big_number dollar_figure big_number big_number big_number b big_number dollar_figure big_number big_number big_number b big_number dollar_figure big_number big_number big_number b big_number dollar_figure big_number big_number big_number c big_number dollar_figure big_number big_number big_number c big_number dollar_figure big_number big_number big_number c big_number dollar_figure big_number big_number big_number c big_number dollar_figure big_number big_number big_number d big_number dollar_figure big_number big_number big_number d big_number dollar_figure big_number big_number big_number d big_number dollar_figure big_number big_number big_number d big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number e big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number f big_number dollar_figure big_number big_number big_number g big_number dollar_figure big_number big_number big_number g big_number dollar_figure big_number big_number big_number g big_number dollar_figure big_number big_number big_number g big_number dollar_figure big_number big_number big_number total big_number dollar_figure big_number big_number big_number 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 eba 84-tiii set out below is a summary of the -- settlement statements showing that the aggregate amounts paid_by or on behalf aggregate amount due pitman japhet properties contract sales_price settlement charges to buyer principal_amount of loans builder fee rent advance rental deficit contribution adjustments other credits payoff loans settlement charges to seller amount due buyer amount due seller according to the settlement statements principal_amount of the loans follows pitman japhet properties settlement charges to buyer amount due less loans builder fee rent advance rental deficit contribution adjustments other credits payoff loans settlement charges to seller amount due seller of the buyer ea 84-iii from the buyer by dollar_figure buyer dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number --0o- --0o- big_number big_number dollar_figure seller dollar_figure --0o- dollar_figure --0o- dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure big_number dollar_figure dollar_figure dollar_figure dollar_figure the aggregate buyer seller others -o- -0- dollar_figure s-dollar_figure -0- -0q- dollar_figure -0- -0q- dollar_figure -0- -0q- dollar_figure -0- -0q- dollar_figure -0- -0q- dollar_figure -0- -0q- -0- -0- dollar_figure -0- -0- dollar_figure -0- dollar_figure -o- dollar_figure dollar_figure dollar_figure exceeded the was credited as total dollar_figure -dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure big_number dollar_figure dollar_figure dollar_figure dollar_figure -- - 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 dollar_figure dollar_figure dollar_figure pitman japhet big_number big_number big_number total big_number big_number big_number the offering memorandum states that investors would break even if the real properties acquired by ea 84-iii appreciated at the annual rate of dollar_figure percent over the 4-year period that the partnership planned to hold the properties financial statements for ba 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 date and ending date 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 - - period beginning date and ending date are as follows ea 84-iit to to to revenue rental income dollar_figure dollar_figure dollar_figure interest income--general partner dollar_figure -0- --0- other income big_number total revenue dollar_figure big_number big_number expenses interest on first mortgage dollar_figure big_number big_number additional mortgage interest -0- --o- -o- other interest_expense -0- -0- big_number real_estate_taxes insurance hoa dollar_figure big_number big_number audit_fee dollar_figure big_number big_number repairs and maintenance dollar_figure big_number big_number property administration fee dollar_figure big_number big_number interest expense--general partner -0- big_number big_number rental commission dollar_figure big_number big_number legal fees dollar_figure other expenses dollar_figure total expenses dollar_figure big_number big_number net results of operations --dollar_figure ---big_number --big_number taxable_income loss net results of operations --dollar_figure ---big_number --big_number plus mortgage amortization -0- -0- --0- less depreciation dollar_figure big_number big_number amortization of loan fees dollar_figure big_number big_number amortization of refinancing costs -0- --o- -o- accrued mortgage interest -0- -0- -o- misc expenses -0- taxable_income loss --136 dollar_figure -753 --big_number the above amounts can be compared with the cash-flow projection that was set out in the 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 date and ending date is interest expense--general partner of zero during three of dollar_figure during and dollar_figure during -- - 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 dollar_figure during the record contains audited financial statements of efa 84-iii for the period beginning september inception to date that were prepared by a firm of certified public accountants included therein is the following statement of operations and changes in partners' capital revenues rental income dollar_figure interest_income big_number big_number expenses interest big_number depreciation big_number real_estate_taxes big_number amortization big_number property management fee big_number rental commission big_number insurance big_number repairs and maintenance big_number other big_number loss from operations big_number partners' capital contributions big_number partners' capital at end of year big_number one of the accompanying notes deals with related-party transactions and states as follows 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 dollar_figure of cost to epic for these services during in addition the partnership paid organization fees to epic of dollar_figure 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 -- - dollar_figure of interest net from epic during 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 dollar_figure 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 and paid_or_incurred interest_expense on unsecured advances from epic in and in the following amounts interest income--general partner dollar_figure -o- -o- interest expense--general partner dollar_figure dollar_figure dollar_figure big_number federal_income_tax returns filed on behalf of eba 84-tiii for federal_income_tax purposes ea 84-iii reported the following income and expenses for the years in issue ea 84-iil rent income_interest total gross_income interest noninvestment commissions insurance legal and professional fee repairs taxes utilities homeowners dues property management fee points amortization miscellaneous audit_fee service fee depreciation total expenses net rental income dollar_figure --0o- big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number -big_number on its schedule k partner's share of income credits deductions etc for dollar_figure dollar_figure -0- big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number -o0- big_number big_number big_number big_number big_number -big_number -774 ea 84-iii reported an ordinary_loss of dollar_figure a net investment loss of dollar_figure for purposes of allocating tax preference items to its partners and net_investment_income of dollar_figure for purposes of computing investment_interest schedules k for and losses of dollar_figure and dollar_figure investment_income of zero and dollar_figure respectively on its respectively purposes of allocating tax preference items to its and ba 84-iii reported ordinary and for partners ea 84-iii reported qualified_investment_income - - of dollar_figure and dollar_figure respectively and qualified_investment_expenses of dollar_figure and dollar_figure respectively for depreciation purposes ea 84-iii treated the aggregate contract_price of it sec_55 properties dollar_figure less the aggregate rental deficit contributions dollar_figure as its aggregate basis in the real_estate viz dollar_figure bfa 84-iii allocated percent of that amount to land viz dollar_figure and percent to buildings viz dollar_figure ba 84-iii depreciated the later amount on a straight-line basis over years and claimed deprecation at the annual rate of dollar_figure in each of the years in issue ea 84-iii claimed a depreciation allowance for months on its return dollar_figure and a depreciation allowance for months on its and 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 dollar_figure ea 84-iii was obligated to pay interest at the annual rate of percent on the notes issued to purchase the properties from u s home and was obligated to pay interest at the annual rate of percent on the notes issued to purchase the condominium units from pitman japhet thus ea 84-iii was obligated -- jo - to pay interest to emi in the total amount of dollar_figure during each of the years and computed as follows loan rate annual interest u s home properties dollar_figure dollar_figure pitman japhet properties big_number dollar_figure total big_number dollar_figure ba 84-iii was also obligated under the partnership_agreement to pay interest at the annual rate of percent to compensate the general_partner for unsecured advances of funds to the partnership the returns filed on behalf of ba 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 -o- --o- dollar_figure dollar_figure big_number big_number ba 84-iii reported noninvestment interest_expense on its returns for the years in issue of dollar_figure dollar_figure and dollar_figure respectively the difference between these amounts and the interest_paid or incurred with respect to the partnership's first mortgage notes is as follows total interest_expense reported dollar_figure dollar_figure dollar_figure interest on first mortgage notes big_number big_number big_number difference big_number big_number big_number ‘four months of interest the record of this case does not fully explain the above differences ba 84-iii paid loan origination fees to emi in the aggregate amount of dollar_figure equal to percent of the principal_amount of the first mortgage loans ée dollar_figure x percent on the subject returns ea 84-iii claimed a deduction for amount of points of dollar_figure dollar_figure and dollar_figure respectively as mentioned above epic the general_partner of ba 83-xii and ea 84-iii was incorporated in 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 and epic formed approximately limited_partnerships with more than big_number limited partners epic was the general_partner of each limited_partnership these partnerships owned approximately big_number residential dwelling units located - throughout the united_states and issued approximately big_number mortgages totaling approximately dollar_figure 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 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 or 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 to 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 -- - 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 as shown in exhibits to the and offering memoranda reveal high annual appreciation during 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 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 -- down that business when interest rates increased in 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 - - of its mortgages to 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 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 percent in the case of a 90-percent loan a secondary lender would require mortgage_insurance of at least 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 i1 e a 2-to-l1 ratio the new partnerships were known internally to epic's management as tax partnerships to distinguish them from the earlier income partnerships -- - during the period after 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 or 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 ina 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 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 - 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 date when all of the limited_partnerships sought protection under the bankruptcy laws --- - 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 dollar_figure of the dollar_figure it received for managing each property another affiliate erni acted as a real_estate broker to sell properties generally erni received a real_estate - jq - commission of 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 date 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 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 -- - 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 date 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 or 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' sec_25 spot checks there is over- valuing by epic that has resulted in inflated property values and properties with loan to value ratios in excess of up to a we can only speculate at the reason for the overvaluing because epic mortgage utilizes independent fee appraisers the appraisers -- - 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 on 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 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 date before agreeing to insure any mortgage loans to an epic partnership - - 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 date 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 - - 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 ie whether or not the property investors are acquiring the property at a - -- bargain price or whether epic is overcharging the investors in a later memorandum dated date 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 ina letter dated date cmac ended its business relationship with epic epic's financial statements the record contains epic's financial statements for and these statements show the following revenue and expenses revenues builder fees interest_income and loan service fees rental income_property management fees partnership organization fees loan origination fees other income total revenue costs and expenses interest_expense payroll fringe_benefits commissions partnership rental expenses other operating_expenses total expenses income from operations ba 83-xiit and ba 84-tii's - - year ended dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number bankruptcy in state's savings and loan system big_number big_number big_number big_number big_number big_number big_number big_number dollar_figure big_number -0- big_number big_number big_number big_number big_number big_number big_number big_number -o- big_number big_number big_number the governor of maryland shut down the 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 loan savings loan insurance corp in date fslic a nonfederally insured maryland savings and applied for deposit insurance issued by the federal 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 - - ea 84-iii and ba 83-xii could no longer use csl as a source of funds necessary for their operations by date ea 83-xii and ea 84-iii defaulted on their respective obligations under the mortgages and deeds of ba 83-xii and trust on the properties shortly thereafter bfa 84-iii filed petitions in the u s bankruptcy court for the ehastern district of virginia notices of fpaa issued to ea 83-xii in the notices of fpaa issued to ea 83-xii for and respondent adjusted the ordinary_income reported by the partnership as shown below in the second column for each year ea 83-xii rent income dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure late charges -0- -0- --0- -0- interest_income big_number big_number big_number big_number miscellaneous -0- -0- -0- --q- total gross_income big_number big_number big_number big_number interest noninvestment big_number -o- big_number -0- big_number -o- commissions big_number big_number big_number big_number big_number big_number insurance big_number big_number big_number big_number big_number big_number legal and professional fee big_number big_number repairs big_number big_number big_number big_number big_number big_number taxes big_number big_number big_number big_number big_number big_number utilitie sec_464 big_number big_number homeowner dues big_number big_number big_number big_number big_number big_number audit_fee big_number big_number big_number big_number big_number big_number points amortization big_number -0- big_number -0- big_number --0- property management big_number big_number big_number big_number big_number real_estate tax service big_number big_number -o- -0- --0- --0- miscellaneou sec_107 -0q- -q- depreciation big_number -0- big_number -0- big_number -0- bad_debts -o- -0- big_number big_number -0- -0- amortization organization expense -o- -0- big_number big_number --0- --0- recording fees --o- -0- --o- -0- service fee-emi -o- -0-- -o- -0-- big_number big_number total expenses big_number big_number big_number big_number big_number big_number total rent income --big_number big_number --big_number big_number -big_number big_number - - respondent also disallowed the investment_interest expense of dollar_figure claimed on the return the explanation of items attached to the notice of fpaa for 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 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 -- - 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 and this activity was not engaged in for profit and only the following deductions are allowable the deductions which would be allowable for the taxable_year without regard to whether or not such activity is engaged in for profit and a deduction egqual 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 above the notices of fpaa for and are virtually identical respondent made other adjustments to ea 83-xii's returns for and for taxable_year respondent disallowed the net investment loss of dollar_figure reported for purposes of allocating tax preference items to its partners and respondent disallowed the excess expenses from net_lease_property of dollar_figure and the investment_interest income of dollar_figure for taxable years and respondent disallowed the qualified_investment_income of dollar_figure and dollar_figure respectively the qualified - - investment_expenses of dollar_figure and dollar_figure respectively and the investment_interest income of dollar_figure and dollar_figure respectively in support of these other adjustments the notices of fpaa issued to eba 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 and 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 and respondent adjusted the ordinary_income reported by the partnership as shown below in the second column for each year -- - ea 84-iii rent income dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure interest -q- -q- -0- -q- total gross_income big_number big_number big_number big_number big_number interest noninvestment big_number -0- big_number -0- big_number commissions big_number big_number big_number big_number big_number insurance big_number big_number big_number legal professional fee big_number big_number big_number repairs big_number big_number big_number big_number big_number taxes big_number big_number big_number big_number big_number utilities big_number big_number big_number big_number big_number homeowner dues big_number big_number big_number property management fee big_number big_number big_number big_number big_number points amortization big_number -0- big_number -0- big_number miscellaneou sec_141 audit_fee -0- -0- big_number big_number big_number service fee -q- -q- -0- -q- big_number depreciation -0-- big_number -0-- big_number total expenses big_number big_number big_number big_number big_number net rental income -big_number big_number --big_number big_number --big_number the explanation of the above adjustments is virtually identical to the explanation in the notices of fpaa issued to bea 83-iii quoted above respondent made a number of other adjustments to bfa 84-iii's returns for and respondent disallowed the net investment loss of dollar_figure and investment_interest income of dollar_figure claimed in respondent disallowed qualified_investment_income of dollar_figure and qualified_investment_expenses of dollar_figure claimed in respondent disallowed qualified_investment_income of dollar_figure qualified_investment_expenses of dollar_figure and investment_interest income of dollar_figure claimed in in support of these other adjustments the notices of fpaa state that it has not dollar_figure big_number -o- big_number big_number big_number big_number big_number big_number big_number big_number -o- big_number big_number -o- -big_number - - 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 eba 84-iii for and 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 and according to the notices of fpaa the interest deductions are disallowed because it has not been established that the amounts were for interest ona bonafide sic debt similarly according to the notices of fpaa the depreciation_deductions are disallowed because it has not been established that a bona_fide investment in depreciable_property was made the interest deductions at issue consist principally but not entirely of amounts paid_or_accrued with respect to the nonrecourse promissory notes issued by each partnership for the purchase of the residential properties described above we sometimes refer to the subject promissory notices as first mortgage notes the - -- depreciation_deductions are based entirely on the portion of the subject promissory notes that each partnership claims as a basis in the residential properties purchased with the notes if none of the promissory notes constitutes a bona_fide debt as determined by the notices of fpaa it follows as discussed below that no amount_paid or accrued with respect to any of the notes is deductible as interest under sec_163 furthermore if none of the promissory notes constitutes a bona_fide debt it also follows that neither partnership incurred a cost in issuing the notes and neither partnership obtained a basis in any of the properties for depreciation purposes thus the first issue for decision in these cases is whether any of the nonrecourse promissory notes issued by either partnership constitutes a bona_fide debt a portion of the interest deducted by both partner- ships was for points amortization these deductions are based upon the loan origination fees paid_by both partnerships to emi the partnerships treated these fees as additional interest on the first mortgage notes and amortized them over the life of the loans the second issue for decision in these cases is whether the - - partnerships are entitled to these deductions for points amortization the notices of fpaa also take the position that the activity of each partnership for each of the tax years in issue and is an activity_not_engaged_in_for_profit within the meaning of sec_183 the notices of fpaa state the allowability of interest_expenses incurred is limited to the investment_income of the taxpayer for the taxable_year thus according to the notices of fpaa if sec_183 applies then the interest_expenses of each partnership must be treated as investment_interest subject_to limitation under sec_163 on that basis the adjustments to the subject returns would be similar in amount to the adjustments determined under the theory described above that neither partnership had entered into a bona_fide indebtedness during any of the years in issue the application of sec_183 is not just an alternative theory the notice of fpaa issued to ba 84-iii for relies on sec_183 to disallow net operating_expenses of dollar_figure this is the amount by which the deductions claimed by ea 84-iii exceed the partnership's gross_income after the deductions for interest and depreciation are disallowed under the non-bona -- - fide indebtedness theory described above thus we must consider the application of sec_183 no matter how we decide the other issues this is the third issue for decision in these cases it appears that each partnership also deducted as interest amounts paid_or_accrued during the years in issue with respect to certain funds advanced to it by epic as general_partner by implication the notices of fpaa take the position that any such unsecured advance made by epic to either partnership did not create a bona_fide indebtedness of the partnership to epic and any amount_paid or accrued with respect to any such advance is not deductible under sec_163 this is the fourth issue for decision in these cases it also appears that ea 84-iii deducted as interest amounts paid_or_accrued during with respect to promissory notes issued to csl each of those promissory notes was secured_by a deed_of_trust on one of the properties that had been purchased by ea 84-iii in as mentioned above the notices of fpaa disallow all of the interest deductions claimed by the partnerships on the ground that the amounts deducted were not shown to have been paid as interest on a bona_fide debt thus the fifth issue for decision in these cases is whether any of the -- - promissory notes issued by ea 84-iii to csl constitutes a bona_fide debt nonrecourse promissory notes generally a taxpayer is allowed to deduct an amount as interest under sec_163 if the amount was paid_or_incurred during the taxable_year with respect to genuine indebtedness see eg 364_us_361 945_f2d_92 5th cir affg tcmemo_1990_87 80_tc_972 affd sub nom 731_f2d_230 4th cir 76_tc_759 similarly a taxpayer is allowed to include purchase money indebted- ness in the basis of an asset for purposes of computing the allowance for depreciation under sec_167 if the indebtedness is genuine indebtedness and represents an actual investment in property see eg 722_f2d_695 11th cir affg 78_tc_471 78_tc_659 indebtedness is not considered genuine that is a true loan if the facts show that the parties to the loan did not intend the principal_amount of the indebtedness to -- - be repaid in full see eg siegel v commissioner supra pincite in the case of nonrecourse indebtedness such as that involved in the instant cases the indebtedness is a lien that the debtor must satisfy according to its terms in order to retain possession and use of the encumbered property but there is no fixed unconditional obligation of the debtor to pay see eg 86_tc_848 affd 841_f2d_264 9th cir however the lack of personal liability of the debtor by itself does not mean that nonrecourse indebtedness will not be repaid nor does it disqualify the nonrecourse indebtedness from being considered genuine see eg hager v commissioner supra pincite 47_tc_340 a nonrecourse mortgage can be found to be genuine indebtedness for tax purposes on the assumption that the mortgage will be repaid in full 461_us_300 we have previously summarized the approaches taken by the courts in determining whether a purported nonrecourse_liability is to be treated as true debt for federal tax purposes see eg waddell v commissioner supra pincite fox v commissioner supra pincite1 in fox - - v commissioner supra pincite1 we described these approaches as follows there are various approaches which may be taken in establishing whether a purchaser may treat a nonrecourse_liability as a bona_fide debt one originating in 544_f2d_1045 9th cir affg 64_tc_752 indicates that when the amount of the aggregate purchase_price unreasonably exceeds the value of the property securing the note or when the principal_amount of the note unreasonably exceeds the value of the property securing the note the debt will not be recognized in such instance the purchaser acquires no equity in the property by making payments and therefore would have no economic incentive to pay off the note estate of franklin v commissioner supra pincite9 the estate of franklin analysis comparing the purchase_price and size of the note to the fair_market_value of the property at the time of purchase originated in real_estate transactions see estate of franklin v commissioner supra 75_tc_53 affd per curiam 670_f2d_855 9th cir 74_tc_1534 affd 678_f2d_818 9th cir but has also been applied to the purchase of cattle see hager v commissioner supra and more recently to movies see wildman v commissioner supra siegel v commissioner supra brannen v commissioner supra another line of cases in many ways compli- mentary to the above more closely addresses the problem of bona_fide loans where the sole security for such loans is a speculative asset with an undeterminable value at the time of purchase this line of decisions holds that highly contingent or speculative obligations are not recognized for tax purposes until the uncertainty surrounding them is resolved 693_f2d_281 3d cir -- -- revg and remanding on other grounds 73_tc_491 692_f2d_152 1st cir vacating and remanding on other grounds 73_tc_491 637_f2d_1041 5th cir 505_f2d_1266 52_tc_367 affd on another issue 451_f2d_173 9th cir 43_tc_270 40_tc_831 affd per curiam 333_f2d_653 2d cir for example in lemery v commissioner supra we held that an obligation to pay dollar_figure of the dollar_figure stated purchase_price of a business only out of future net profits was too contingent to be included in the purchaser’s amortizable_basis fn refs omitted respondent takes the position in the instant cases that none of the first mortgage notes issued by ea 83-xii or eba 84-iii is a bona_fide debt because the aggregate principal_amount of the notes issued by each partnership exceeds the aggregate fair_market_value of the property securing the notes and for that reason neither partnership had an incentive to repay the notes see eg 544_f2d_1045 9th cir affg 64_tc_752 respondent does not rely on a disparity between the purchase_price of the properties and their value and neither respondent nor petitioners address the question whether the value comparison required under the estate of franklin line - - of cases should be based upon the purchase prices of the properties as opposed to the principal amounts of the notes see brannen v commissioner f 2d pincite chabot j concurring therefore as framed by the parties the first issue in these cases is whether the principal_amount of the first mortgage notes issued by each partnership unreasonably exceeds the value of the properties securing the notes petitioners argue that the fair_market_value of the properties purchased by each partnership was at least egual to the amount of the debt at the time it was incurred they argue that the fair_market_value of each of the subject properties is its contract_price as established by a contemporaneous appraisal that was made by an independent unrelated appraiser the appraisals reflect the sale of each property to an individual buyer rather than the bulk_sale of all of the properties to a single buyer petitioners argue that the promissory note issued to purchase each of the properties based upon to percent of the contract_price is bona_fide indebtedness petitioners emphasize that each of the nonrecourse mortgages in the partnerships was insured by an unrelated mortgage_insurance company and was purchased by an unrelated lender shortly after the loan was funded according to petitioners the unrelated mortgage insurers and the lenders who acquired the loans in the secondary market each had the incentive to ascertain that the value of the properties was at least equal to the debt and the fact that they undertook to participate in the transactions is evidence that the fair_market_value of the properties was at least equal to the amount of the debt at the time it was incurred petitioners argue that the unrelated lenders and insurers did due diligence and in fact would have exercised special caution with respect to such loans because of the unusual nature of the loans they further argue that the facts show that there was no attempt by epic to conceal the facts petitioners acknowledge that the partnerships purchased the properties with substantial discounts and that the partnerships did not pay the contract_price for any of the properties purchased as stated in their posttrial brief common sense suggests that a large and astute investor such as epic would demand price concessions thus petitioners acknowledge that the prices paid_by each partnership reflected the discounts or price concessions that a large buyer would expect when buying in bulk in fact as discussed above epic negotiated with the sellers of the properties various discounts in the aggregate amount of approximately percent of the contract_price of the properties furthermore the tax returns filed on behalf of each partnership compute the partnership's cost_basis for each property under sec_1012 as the contract_price of the property less the rental deficit contribution for that property and claim depreciation on the portion of the cost that was allocated to the improvements petitioners argue that the value of each of the subject properties is equal to the contract_price notwithstanding the fact that each partnership paid a price that reflected discounts from the contract_price petitioners argue that such discounts do not reduce the underlying value of any one item purchased finally petitioners argue that respondent's evidence relating to the fair_market_value of the properties is rife with errors in assumptions and or judgement and or application of concepts petitioners ask the court to conclude that respondent's evidence is biased and not worthy of consideration respondent argues that the promissory notes issued by eba 83-xii and ea 84-iii should be disregarded for tax purposes because the debt substantially exceeded the fair_market_value of the underlying property and lacked economic_substance according to respondent's posttrial brief respondent's appraisals reflect that the nonrecourse debt by emi exceeds the actual values of ea83-xii's properties by and the actual values of ea84-iii's properties by and that ba83-xii and ea84-iii overmortgaged the properties to support nominal purchase prices that permitted epic to receive substantial builder fees rental deficit contributions and rental advances respondent explains the computation of the above percentages as follows respondent's appraisals reflecting values totalling dollar_figure for the properties acquired by ea83-xii demonstrate that the nonrecourse debt totalling dollar_figure originated by emi exceeds the actual values by dollar_figure or respondent's appraisals reflecting values totalling dollar_figure for the properties acquired by ba84-iii demonstrate that the nonrecourse debt totalling dollar_figure originated by emi exceeds the actual values by dollar_figure or according to respondent ea 83-xii and ea 84-iii overmortgaged the properties in order to generate substantial builder fees rental deficit contributions and rental advances necessary to feed epic'ss ravenous appetite for fees to enlarge and maintain epic's real_estate empire as an essential element of the scheme respondent alleges that epic secured inflated faulty appraisals to support the nonrecourse debt originated by emi to acguire the properties in this connection respondent asserts that epic through cag encouraged outside appraisers to inflate values on properties acquired by the partnerships such as by requesting appraisers to value multiple properties purchased in bulk sales as if purchased separately by different individuals asa result respondent argues the nonrecourse debt issued by efa 83-xii and ba 84-iii to acquire the properties exceeded the value of the properties thus respondent asserts there was no incentive to repay the debt and the debt lacked economic_substance respondent also argues that the instant transactions did not involve unrelated parties and independent appraisers establishing purchase prices respondent argues that the transactions involved related parties and notes that epic acting through its subsidiary emi originated serviced each nonrecourse loan and was primarily responsible for any due diligence related to the loans respondent claims that for at least six properties acquired by ea 84-xii epic through two subsidiaries was both the seller and purchaser respondent argues that the outside appraisers were not independent because epic influenced their appraisals with guidelines and requests that precluded the use of bulk_sale methods in purchases of multiple units according to respondent epic through cag influenced the inflated appraisals related to the properties and determined the stated purchase_price respondent also argues that the participation of secondary lenders and mortgage insurers does not establish that the value of the properties approximated the debt because there is no evidence that they engaged in due diligence according to respondent the lack of due diligence by secondary lenders and mortgage insurers demonstrates that the lenders ignored or did not understand the realities of the epic transactions at the same time respondent notes the fact that some mortgage insurers refused to insure newly-created debt on epic properties the following is a list of the properties purchased by eba 83-xii viz single-family residences and condominium units together with the amount of each loan the value of each property as determined by respondent's appraisers and the loan to value ratio for each property computed using respondent's value ea 83-xii respondent's address loan amount value loan value hemphill ave dollar_figure dollar_figure dollar_figure west 17th st big_number big_number dollar_figure coronado ave big_number big_number dollar_figure linda ave big_number big_number dollar_figure coronado ave big_number big_number dollar_figure hollywood dr big_number big_number dollar_figure coronado ave big_number big_number dollar_figure avignon dr big_number big_number dollar_figure avignon dr big_number big_number dollar_figure avignon dr big_number big_number dollar_figure avignon dr big_number big_number dollar_figure avignon dr big_number big_number dollar_figure paseos castellanos big_number big_number dollar_figure units total big_number big_number dollar_figure ' at trial respondent's appraiser conceded that this value should equal the contract_price of the property dollar_figure this is the aggregate amount for all condominium units respondent's position is that the promissory notes issued by ea 83-xii comprising of the notes mentioned above should be disregarded for tax purposes because the aggregate nonrecourse debt represented by those notes exceeds the value of the properties by dollar_figure percent similarly the following is a list of the properties purchased by ea 84-iii viz single-family residences and condominium units together with the amount of each loan the value of each property as determined by respondent's appraisers and the loan to value ratio for each property computed using respondent's value ea 84-iii respondent's address loan amount value loan value heronwood dr dollar_figure dollar_figure dollar_figure heronwood dr big_number big_number dollar_figure tower hill la big_number big_number dollar_figure northcliffe manor dr big_number big_number dollar_figure clarewood dr big_number big_number dollar_figure s briar bayou dr big_number big_number dollar_figure kingslake forest dr big_number big_number dollar_figure kingslake forest dr big_number big_number dollar_figure kingslake forest dr big_number big_number dollar_figure kingslake forest dr big_number dollar_figure carola forest dr big_number big_number dollar_figure w ferret big_number big_number dollar_figure medical dr condo big_number big_number dollar_figure earlywood dr big_number dollar_figure ridgecreek dr big_number dollar_figure reflections condos big_number big_number dollar_figure units total big_number big_number ' this is the aggregate amount for all condominium units in the reflections respondent's position is that the promissory notes issued by ea 84-iii comprising of the notes mentioned above should be disregarded for tax purposes because the aggregate nonrecourse debt represented by those notes exceeds the value of the properties by dollar_figure percent the above schedules show that respondent tests whether the principal_amount of the indebtedness exceeds the value of the property securing it in the aggregate rather than loan by loan if the value comparison were made loan by loan most of the loans issued with respect to the single-family residences would approximate the value of the property securing the loan even using respondent's values for example in the case of the single-family residences acquired by ea 83-xii as shown in the schedule above none of the loans issued by the partnership materially exceeds the value of the related property as determined by respondent's appraisers similarly in the case of the properties acquired by ea 84-iii other than the reflections condominium units of the loans issued by the partnership are percent or less of the value of the related property as determined by respondent's appraisers nevertheless respondent determined that all of the loans issued by both partner- ships are not bona_fide because the aggregate principal_amount of the loans issued by each partnership exceeds the aggregate value of the properties by percent in the case of ea 83-xii and dollar_figure percent in the case of ea iii petitioners do not take issue with this aspect of respondent's approach and the parties do not address the issue whether the value comparison should be made in the aggregate or loan by loan in these cases we must determine whether the fair_market_value of the properties acquired by each partner- ship is more or less than the principal_amount of the debt that was incurred by the partnership in purchasing the properties for purposes of making this comparison we must determine the fair_market_value of the properties as of the time they were acquired by each partnership see eg 993_f2d_288 2d cir affg tcmemo_1992_72 917_f2d_1314 2d cir revg and remanding tcmemo_1989_178 in the case of ea 83-xii we must determine the fair market values of the properties as of date and in the case of eka 84-iii we must determined the fair market values of the properties as of date the fair_market_value of an item of property is the price at which the property would change hands between a willing buyer and a willing seller neither being under any compulsion to buy or to sell and both having reason- able knowledge of relevant facts e g 411_us_546 75_tc_53 affd per curiam 670_f2d_855 9th cir 71_tc_998 see sec_1_170a-1 income_tax regs sec_20_2031-1 estate_tax regs sec_25 gift_tax regs this is a question of fact to be determined from an examination of the entire record see eg 85_tc_56 affd sub nom 813_f2d_837 7th cir mcshain v commissioner supra pincite the fair_market_value of real_property is based on the highest_and_best_use to which the property could be put on the date of valuation see eg 98_tc_554 87_tc_892 87_tc_389 generally the highest_and_best_use of a parcel of property is the reasonable and probable use of the property that supports the highest present_value see frazee v commissioner supra pincite symington v commissioner supra pincite in determining the highest_and_best_use of the property it is necessary to consider the realistic objective potential uses for which the property is adaptable and needed or likely to be needed in the foreseeable future see stanley works v commissioner supra pincite see generally 292_us_246 in the process of establishing the fair_market_value of an item of property on the basis of its highest_and_best_use it 1s sometimes necessary to consider the most appropriate market through which the property would change hands from a willing seller to a willing buyer see eg 799_f2d_243 6th cir affg tcmemo_1984_490 757_f2d_1208 11th cir affg 80_tc_872 cf united_states v cartwright supra pincite in identifying what market to use in estimating the value of an item of property we have looked to the regulations promulgated under the estate_and_gift_taxes see sec_20_2031-1 estate_tax regs sec_25_2512-1 gift_tax regs which provide that the fair_market_value of an item of property is the sales_price of the item in the market in which such item is most commonly sold to the public see eg 89_tc_535 lio v commissioner supra pincite 813_f2d_837 7th cir 84_tc_285 anselmo v commissioner t c pincite in applying the estate and gift_tax regulations to ascertain the fair_market_value of an item of property for purposes of computing the amount of a charitable_contribution_deduction the court_of_appeals in anselmo v commissioner f 2d pincite noted the following rules governing valuations for charitable_contributions of property are distinguishable from valuations in the estate and gift context because the taxpayer has the opposite incentives in the two situations the taxpayer wants to reduce the value of property for estate and gift_tax purposes but as here the taxpayer wishes to inflate the value of property for charitable donation purposes the estate and gift_tax regulations are aimed at preventing abusive undervaluation of property the regulations governing charitable_contributions are not in the usual case however there should be no distinction between the measure of fair_market_value for estate and gift_tax and charitable_contribution purposes cf 303_f2d_887 5th cir thus the court_of_appeals noted that the estate and gift_tax regulations were not a perfect fit in considering the charitable deduction in that case because the taxpayers had an incentive to inflate the value of the property whereas the estate and gift_tax regulations are aimed at preventing abusive undervaluation of property id the same is true in the instant cases nevertheless we also agree with the court_of_appeals that there should be no distinction between the measure of fair_market_value id see also 376_f2d_402 5th cir skripak v commissioner supra pincite n finally we agree with the court_of_appeals that selection of the proper market for valuation purposes is a guestion of fact see anselmo v commissioner f 2d pincite a sale to the public is a sale to the ultimate consumer of the property that is a sale to one of a group of persons who do not purchase the item for resale see eg goldstein v commissioner supra pincite lio v commissioner supra pincite in the normal situation a sale to the ultimate consumer is a sale to a retail customer see lio v commissioner t c pincite anselmo v commissioner t c pincite this is not invariably the case however because the term public refers to the customary purchasers of an item of property and not necessarily to individual consumers anselmo v commissioner f 2d pincite in anselmo the court_of_appeals noted for example that the buying public for live cattle comprises primarily slaughterhouses rather than individual consumers see id therefore in anselmo the court_of_appeals agreed with the finding of this court that the market for low quality unmounted gems was the market in which jewelry manufacturers and jewelry stores purchase stones to create jewelry items rather than the retail market in which individual purchasers buy finished jewelry similarly in akers v commissioner supra pincite the court found that the market for a tract of land containing approximately big_number acres was the market for large tracts of over big_number acres and not the market for properties averaging less than a tenth that size the court noted that the ultimate consumer of a 50-acre lot does not normally have the time inclination expertise or capital to buy a tract of land or times as big as the one he wants with a view to subdivision and sale of the excess id the above cases may be contrasted with 388_f2d_476 6th cir affg 46_tc_136 in which the fair_market_value of bound volumes of medical journals that had been contributed to a hospital was at issue the court held that the fair_market_value should be computed on the price an ultimate consumer would pay ie valued at retail and further held that what might be paid_by a dealer buying to resell is not a proper consideration id pincite in akers v commissioner f 2d pincite the court reconciled that case with the others by noting that unlike the unmounted gems in anselmo and unlike the undivided land in akers the medical journals in goldman had already been 'subdivided ' in effect and were ready for immediate sale in the retail market and were not so expensive as to suggest that no retail buyer for them could have been found the appropriate market for estimating the value of an item of property may sometimes be the market in which the taxpayer purchased the property for example in 85_tc_56 the taxpayers purchased large quantities of lithographs and donated them to a -- - charitable_organization months later claiming a charitable deduction of approximately three times the amount_paid and in 89_tc_535 the taxpayers purchased posters and other art and donated them to a charitable_organization days later claiming a charitable deduction of approximately twice the present_value of the consideration paid the taxpayers in each case asked us to value the property by looking to the prices charged by galleries and dealers to their retail customers in defining the appropriate market and the ultimate consumer for the property in those cases we gave particular attention to three factors whether the buyers purchased the item of property for resale whether the buyers received special discounts in the purchase_price and whether the sellers made substantial sales of the same type of property see id pincite we found that the taxpayers had not purchased the property for resale they had received no special discounts and they had purchased from dealers who were responsible for a substantial portion of the total retail sales of the property thus contrary to the taxpayers' position we found that the appropriate market for valuing the property at issue in both cases was the market in which the taxpayers had purchased the property and that the taxpayers were the ultimate consumers of the property accordingly we looked to the price paid_by the taxpayers as the fair_market_value of the property see also klaven v commissioner tcmemo_1993_299 weiss v commis-- sioner tcmemo_1993_228 rhode v commissioner tcmemo_1990_656 weintrob v commissioner tcmemo_1990_ opinion modified tcmemo_1991_67 affd and remanded without published opinion sub nom waqner v commissioner 31_f3d_1175 3d cir broad v commissioner tcmemo_1986_340 at the outset of our consideration of the instant cases it is helpful to note several points about the positions of the parties first respondent's appraisers valued the single-family houses and one condominium unit on a different basis than they used to value the other condominium units according to respondent's brief respondent's appraisers valued the single-family houses acquired by each partnership and one of the condominium units purchased by ea 83-iii on a retail basis that is as if the properties were purchased separately by individuals respondent's brief describes the appraisals of of the single-family houses and the condominium unit pincite medical drive as follows respondent's appraisals which were performed to years after ha83-xii and ea84-iii acquired the properties reflect retail values of the houses pincite and avignon drive in carrollton the seven houses in odessa viz hemphill avenue west 17th street coronado avenue linda avenue coronado avenue hollywood drive and coronado avenue the two houses pincite and heronwood drive in humble the condominium pincite medical drive in san antonio the house pincite w ferret drive in tucson as _ if the properties were purchased separately by individuals emphasis supplied similarly respondent's brief describes the appraisals of the other single-family houses as follows respondent's appraisals which were performed to years after ha83-xii and ea84-iii acquired the properties reflect retail values for the residences pincite avignon in carrollton brarlywood drive and ridgecreek drive in san antonio and tower hill lane northcliffe manor drive clarewood drive s briar bayou carola forest drive and and kingslake forest drive in houston as if purchased separately by individuals emphasis supplied on the other hand respondent's appraisers valued the condominium units acquired by each partnership other than the condominium unit pincite medical drive ona wholesale basis that is as if the purchase consisted of multiple properties purchased in bulk sales from the same builder respondent's brief states as follows respondent's appraisals of the units in miami and 40-unit complex in san antonio which were performed to years after ea83-xii and fa84-iii acquired the properties reflect the wholesale value of multiple properties purchased in bulk sales from the same builder emphasis supplied second according to respondent's brief the difference between the retail value of each single-family property as determined by respondent's appraisers and the wholesale value of that property is the amount of the rental deficit contribution respondent's brief states as follows because each of the single family properties was purchased by epic in purchases involving multiple houses from the same builder a discount in the amount of the rental deficit contribution of approximately to the retail value is appropriate to arrive at the wholesale value of each property the above statement echoes the opinion of respondent's appraisers messrs dalton and ramos who valued the reflections condominium complex that was purchased by ea 84-iii in a memorandum that accompanied their appraisal messrs dalton and ramos describe the difference between the wholesale and retail values of the properties as the amount of the rental deficit contribution the memorandum states as follows another way to view the rdc 1ie rental deficit contribution is as the difference between the properties sic retail price over its wholesale price as discussed above the sum of the parts is much greater than the whole by selling the properties individually the owner receives the greater retail price while he would get only a wholesale price if he sold all of the properties to a single investor in one transaction that is multiple purchases from the same builder demand a wholesale price the discount would be in the range of the rdc or a -25 reduction of the retail price of each unit if sold separately the percentage reduction is supported in the 40-unit condominium complex appraisal tab c the indicated wholesale value was estimated at dollar_figure epic financed the property based on a projected retail_sale of the property of dollar_figure the wholesale value i sec_30 lower than epic’s projected retail value the 40-unit condominium complex tab c was valued at wholesale as this was the market for these types of properties the values obtained for the single-family houses in tab's a and b of this report reflect the retail fair_market_value of the properties multiple sales of single-family houses were not plentiful at the date of value and at the present date they are very obscure a discount in the approximate amount of the rdc for each single-family property is required if these house were sold wholesale i1 e grouped with a multitude of other houses in one transaction to a single investor the rdc was chosen as a discount from retail to wholesale based on the discussion presented in above significantly respondent does not appear to take the position that the builder fees and rent advances are additional discounts that must be applied to the retail value of the property in computing its wholesale value in this connection we note the fact that the builder fees were treated as having been paid_by the seller to epic as opposed to the partnership and were reported as income by epic and the fact that the rent advances were treated as rents and were included in the gross_income of each partnership in summary respondent's position is that valuing the subject properties as if sold to separate individuals yields the retail value of the properties whereas valuing them as if purchased ina bulk_sale yields the wholesale value of the properties furthermore according to respondent the difference between the retail value and the wholesale value of a particular property is the discount that epic negotiated with each of the sellers referred to as the rental deficit contribution both of these positions are set forth in the memorandum written by messrs dalton and ramos the relevant portion of which is quoted above third the appraisals that were obtained pursuant to epic's contracts with the sellers at the time ea 83-xii and efa 84-iii purchased the subject properties referred to herein as the contemporaneous appraisals valued all of the properties without discount as if each property were sold separately to an individual purchaser to use respondent's terminology all of the contemporaneous appraisals valued the properties both single-family houses and condominiums on a retail basis they did not value the subject properties on a wholesale basis that is as if purchased in bulk by a single_person thus in valuing the single-family homes and the condominium unit pincite medical drive all of the appraisers used the retail market in valuing the other condominiums on the other hand respondent's appraisers used the wholesale market and the contemporaneous appraisals used the retail market fourth in valuing the subject properties none of the parties relies upon the values that were established in the contracts between epic and the sellers of the properties petitioners argue that the transactions were arm's-length transactions between unrelated parties but they take the position that the value of each property is its contract_price rather than the discounted price that the partnership actually paid for the property on the other hand respondent argues that the value of each property is a discounted price as determined in respondent's appraisals but not the discounted price that the partnership actually paid for the property epic negotiated the purchase of the subject properties on behalf of ea 83-xii and ea 84-iii from five developers fox jacobs raldon babcock u s home and pitman japhet the contracts between epic and each of the sellers followed a similar pattern each contract set forth a purchase_price for each property referred to herein as the contract_price that was based on the prices that the seller had received from sales of similar properties to individual retail purchasers the contract provided that the seller would pay an amount negotiated between epic and the seller called the rental deficit contribution the seller agreed to pay this amount to the purchaser the limited_partnership the contract further provided that the seller would pay to epic a commission of percent of the contract_price and under certain conditions would prepay rent to the purchaser in negotiating these contracts with epic each seller was principally interested in the amount that it would net after the above discounts and fees a representative of one seller babcock testified that his concern was the bottom line or minimum number and that he permitted epic to structure the discounts and fees -- - there is nothing in the record of either of the subject cases to suggest that the business interests of epic and both limited_partnerships were not adverse to the business interests of each of the five developers nor is there anything to suggest that epic and the partnerships did not deal with those companies at arm's length respondent does not suggest otherwise in asserting that the transactions involved related parties respondent focuses on emi the company affiliated with epic that originated the loans and on cag the affiliated appraisal company that obtained contemporaneous appraisals in many cases the activities of those companies however did not establish the prices of the properties that was done through negotiation between epic the willing buyer and each of the five developers the willing seller generally where there is evidence that parties having adverse economic interests have dealt at arm's length and have assigned a value to certain property that evidence is viewed as the most reliable basis for a determination of fair_market_value of the property see eg siegel v commissioner t c pincite narver v commissioner t c pincite mcshain v commissioner t c pincite 50_tc_236 affd 406_f2d_288 2d cir in the instant cases the values assigned to the properties at issue under epic's contracts with the sellers are the discounted purchase prices paid for the properties to use respondent's terminology these values are the wholesale values of the properties the following schedule shows the aggregate contract prices of the properties purchased by each partnership less the aggregate rental deficit contributions the aggregate builder fees and the aggregate rent advances and compares the net amount to respondent's valuation single ea 83-xii properties family condos total aggregate contract prices dollar_figure dollar_figure dollar_figure less aggregate rental deficit contribution sec_67 sec_643 big_number big_number less aggregate builder fees big_number big_number big_number less aggregate rent advances contract prices less discounts fees big_number big_number ___ big_number advances big_number big_number big_number respondent's valuation big_number big_number big_number single ea 84-xii properties family’ condos total aggregate contract prices big_number big_number big_number less aggregate rental deficit contributions big_number big_number big_number less aggregate builder fees big_number big_number big_number less aggregate rent advances big_number big_number contract prices less discounts fees advances big_number big_number big_number respondent's valuation big_number big_number big_number includes the condominium pincite medical drive in san antonia texas single-family houses and the condominium pincite medical drive as discussed above respondent's all of the appraisals including valued the single-family houses and the -- - condominium unit pincite medical drive on a retail basis the reason for this in the case of the single-family houses was suggested in the memorandum of respondent's appraisers messrs dalton and ramos quoted above when they stated multiple sales of single-family houses were not plentiful at the date of value and at the present date they are very obscure in effect it appears that there was not a market for multiple sales of single-family houses in and when the properties were purchased furthermore respondent used the retail value of the single-family houses and the condominium unit pincite medical drive in computing the percentages and arguing that the aggregate nonrecourse debt exceeded the value of the properties by dollar_figure percent in the case of ea 83-xii and dollar_figure percent in the case of ea 84-iii respondent does not argue that the single-family houses and the condominium unit pincite medical drive should be valued on a wholesale basis thus it appears that respondent agrees with petitioners that these properties should be valued on a retail basis accordingly we shall review the evidence in the record to determine the retail value of the single- family houses and the condominium pincite medical drive the partnerships purchased a total of single-family houses and the condominium unit pincite medical drive as to of these properties the difference between the principal_amount of the debt and the fair_market_value determined by respondent's appraisers is not material this is certainly true in the case of the single-family properties purchased by ea 83-xii according to respondent's appraisers the aggregate value of the properties is dollar_figure or dollar_figure more than the aggregate principal_amount of the loans dollar_figure similarly according to respondent's appraisers the difference between the value of of the single-family properties and the condominium unit pincite medical drive purchased by eba 84-iii and the principal_amount of the loan is less than percent as to these properties therefore there is no appreciable difference in the result of the value comparison depending on whether we use respondent's valuation or the contract prices of the properties the single-family residences as to which according to respondent's appraisers there is a material difference between the value of the property and the principal_amount of the debt are the following ea 84-iii respondent's property loan value loan value tower hill ln dollar_figure dollar_figure dollar_figure northcliff manor big_number big_number dollar_figure clarewood dr big_number big_number dollar_figure s briar bayou dr big_number big_number dollar_figure kingslake forest big_number big_number dollar_figure kingslake forest big_number big_number dollar_figure kingslake forest big_number big_number dollar_figure kingslake forest big_number big_number dollar_figure petitioners’ evidence regarding the above eight properties includes contemporaneous appraisals of the properties and testimony of the appraiser mr paul lang regarding the general nature of his appraisals for epic mr lang is a licensed real_estate appraiser in the state of texas and a senior resident associate sra of the appraisal institute he appraised each of the subject eight properties at the time ea 84-iii purchased it in mr lang's appraisals of the above single-family properties were made on fhlmc fnma forms as required by epic's contract with the seller u s home those forms state as follows this appraisal is based upon the market_value definition stated in fhlmc form_439 rev and fnma form 1004b rev that definition of market_value is as follows definition of market_value the highest price in terms of money which a property will bring ina competitive and open market under all conditions requisite to a fair sale the buyer and seller each acting prudently knowledgeably and assuming the price is not affected by undue stimulus implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby buyer and seller are typically motivated both parties are well informed or well advised and each acting in what he considers his own best interest a reasonable_time is allowed for exposure in the open market payment is made in cash or its equivalent financing if any is on terms generally available in the community at the specified date and typical for the property type in its locale the price represents a normal consideration for the property sold unaffected by special financing amounts and or terms services fees costs or credits incurred in the transaction real_estate appraisal terminology published mr lang used both the sales comparison and the cost approach in valuing the subject properties in the case of each of the properties mr lang concluded that the market_value of the property was egual to its contract_price at trial mr lang testified that his appraisals were independent and objective and that he had inspected each of the properties at the time of the appraisal the appraisal forms provide support for this testimony mr lang made notations on the appraisal forms describing specific work on certain of the properties that had to be completed for the valuation to be accurate mr lang testified that the copies of his appraisals which are in -- - evidence are incomplete in that there is no map showing the comparable sales used in his analysis the addresses and sale prices for the properties that he used as comparables appear on the forms respondent's appraiser mr charles brown a valuation engineer employed by the internal_revenue_service appraised a number of single-family properties purchased by ba 84-iii including the eight properties listed above at the time of his testimony mr brown had applied for but had not received the appraisal institute's designation as sra and he was not licensed as a real_estate appraiser in texas the definition of fair_market_value used by mr brown is the following the most probable price as of a specified date in cash in terms equivalent to cash or in other precisely revealed terms for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite to a fair sale with the buyer and seller acting prudently knowledgeably and for self-interest and assuming that neither is under undue duress thus mr lang's appraisals are based upon a definition of market_value formulated in terms of the highest price as contained on the fhlmc fnma forms and mr brown's appraisals are based upon a definition of market_value formulated in terms of the most probable price we note that the definition of market_value of real_property formulated in terms of the most probable price as contained on the fhlmc fnma forms was not used in fhlmc fnma forms until announcement made by fnma on date describes the new wording of the definition effective for appraisals completed on and after date as follows it also defines the market_value as the most probable price which a property should bring x as opposed to the highest price which a property will bring in the old version this change recognizes that the market_value of a property usually falls within a range and that the indicated value is an estimate which should not necessarily be at the highest portion of that range emphasis supplied mr brown's report states generally that the value of single-family residences in the houston texas area decreased significantly after his report states as follows these homes closely followed the prevalent houston area real_estate trends during the early 1980's values increased dramatically until when values declined sharply for the next to years mr brown appraised the houses in years after the sales at issue using both the comparable sales and cost methods mr brown testified that he inspected the exterior of each house appraised and that he reviewed the records at the harris county appraisal district and at baca landata a company located in houston texas which assists taxpayers in dealing with the harris county appraisal district mr brown's approach is illustrated by his appraisal of the property pincite tower hill lane that property is located on a cul-de-sac in the northcliffe manor subdivision approximately miles northwest of downtown houston it consists of a big_number ssquare-foot house and garage built in on a big_number square-foot lot mr brown employed the comparable sales approach and the cost approach to value this property he identified four comparable sales two sales of comparable houses in and two sales in he then used a comparable sales adjustment grid to adjust the sale price of each of the comparables to account for differences in the date of sale location lot size size of the improvements and year built after determining the adjusted fair_market_value of each of the comparables mr brown divided the adjusted_value of each property by the square footage of the improvements to arrive at the fair_market_value per square foot of the comparable for example mr brown determined that the fair market values per square foot of the two comparable sales in were dollar_figure and dollar_figure he found that the fair market values per square foot of the two comparable sales in were dollar_figure and dollar_figure mr brown then chose the relatively low value of dollar_figure per square foot as the market_value in of the subject house referred to in the appraisal report as tract i mr brown's report explains his choice as follows after the adjustments are made the fair_market_value of tract i falls in the range of dollar_figure to dollar_figure per sguare foot in since tract i is one of the largest homes in the subdivision it shall command a loan value per square foot say dollar_figure we note that the size of the improvements was already taken into account in the comparable sales adjustment grid mr brown multiplies this value by the square footage of the improvements on tract i and estimates that the fair_market_value of the property on the basis of the sales comparison approach is dollar_figure after further adjusting the value by his estimate of the cost to reproduce the house mr brown's final estimate of the fair_market_value of the property is dollar_figure it appears that mr brown's appraisal is too low one of the comparable sales in is a house located on the same cul-de-sac as the subject property tower hill lane that property wa sec_116 square feet smaller and was sold for dollar_figure dollar_figure per square foot to an unrelated buyer in the same month that the partnership purchased the subject property this is dollar_figure more than mr brown's appraised value of its larger neighbor similarly a second comparable that wa sec_173 square feet smaller than the subject property sold in date for dollar_figure in valuing the properties that are the subject of his report mr brown used a total of comparable sales from from and from in applying the comparable sales approach mr brown followed the same approach in valuing the properties as to each of the properties he reviewed three to five of the comparables he adjusted the sales prices of the comparables for age location and size as described above and computed an adjusted fair_market_value per square foot of the comparable he then selected a value per square foot that represented his opinion of the fair_market_value of the subject property set out below is a summary for each of the subject properties of the fair market values per square foot of the comparables that were sold in or the fair market values per square foot of the comparables that were sold in and the fair_market_value per square foot that was selected by mr brown as the value of the subject property adjusted fmv per sq ft of adjusted fmv per sq ft subject property ea 84-iii properties tract comparable sales in of comparable sales in fmv per sq ft tower hill ln i dollar_figure dollar_figure -0- dollar_figure dollar_figure dollar_figure northcliff manor dr ii dollar_figure dollar_figure -0- dollar_figure dollar_figure clarewood dr iii dollar_figure dollar_figure -0- dollar_figure -0- s briar bayou dr iv dollar_figure dollar_figure -0- dollar_figure -0- carola forest dr vv dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure kings lake forest dr vi dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure kings lake forest dr vii dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure kings lake forest dr viii dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure kings lake forest dr ix dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure heronwood dr xx dollar_figure dollar_figure -0- dollar_figure -0- heronwood dr xi dollar_figure dollar_figure -0- dollar_figure -0- it is readily apparent that in every case mr brown selected a fair_market_value per square foot that is roughly equivalent to the value of the comparable sales in and is substantially below the value of the comparable sales in and in doing so we believe that mr brown gave undue weight to the comparable sales in that took place after the value of the subject properties had declined sharply for the above reasons in comparing the fair_market_value of the property and the principal_amount of the debt we will treat the amount set forth in the contemporaneous appraisal of the property made by mr lang as the fair_market_value of each of the eight properties as of date condominiums unlike the single-family residences it appears that there was both a retail market and a wholesale market for condominiums at the time the partnerships purchased the condominium units at issue in these cases respondent's principal expert witness dr richard hewitt iii wrote an article in in which he described a double-tiered market for condominiums hewitt condominium developed lot discounting concepts again real_estate appraiser and analyst jan --date dr hewitt noted that in valuing condominiums some persons advocated using the gross sellout amount the sum of the retail_sale prices of the condominiums as the market_value while others advocated using a discounted or wholesale value see id according to dr hewitt both are correct under certain circumstances id dr hewitt wrote the following numerous questions continue to arise relative to what exactly is market_value for condominium developed lots certain advocates promote the idea that gross sellout summation of retail sales prices constitutes market_value whereas others have advocated the use of discounted value or wholesale value actually both are correct under certain circumstances due to what can best be described as a double-tiered market phenomenon the two-tier participants consist of end-product users final condominium unit owners or final single family dwelling purchasers and interim purchasers it is the basic purchase motivation and investment goal differentials between these two tiers that result in dramatically different actual price hence value levels the general misunderstanding of these differentials also serves as a major stumbling block to the proper appraisal of and underwriting of loans for such projects in view of this the estimate of market_value first requires a clear recognition of value to whom id petitioners take the position that the fair_market_value of the condominium units purchased by each partnership is equal to the sum of the contract prices of the units as determined by the contemporaneous appraisals as discussed above the contemporaneous appraisals valued each condominium unit individually principally using the comparable sales approach thus using the terminology suggested by respondent and messrs dalton and ramos as discussed above the contemporaneous appraisals valued the condominium units purchased by ea 83-xii and ea 84-iii in the retail market adding together the contract prices of the individual units to derive the value of the condominium complex is the gross sellout approach referred to in the portion of dr hewitt's article quoted above on that basis the fair_market_value of the units in paseos castellanos that were purchased by eba 83-xii in date is dollar_figure or dollar_figure more than the aggregate principal_amount of the promissory notes issued by ea xii to purchase those properties similarly on that basis the fair_market_value of the units composing the reflections condominium complex that were purchased by ea 84-iii in date is dollar_figure or dollar_figure more than the aggregate principal_amount of the promissory notes issued by ea 84-iii to purchase those units respondent contends that the condominium units purchased by each partnership should be valued on a discounted or wholesale basis on that basis respondent contends the aggregate fair_market_value of the units in paseos castellanos purchased by ea 83-xii is dollar_figure or dollar_figure less than the aggregate principal_amount of the promissory notes issued by ea 83-xii in support thereof respondent relies on the appraisal report prepared by mr harold mogul mr mogul's report states that the highest_and_best_use of the condominium units is the use for which the complex was originally designed and constructed residential condominium development the report begins by determining the total retail sales potential of the units mr mogul did this by looking to the prices received for units in the same condominium complex that were sold to buyers other than epic treating these retail sales as comparables mr mogul determined the retail sales potential of the subject condominium units to be dollar_figure from the total retail sales potential mr mogul deducted anticipated expenses over a 30-month absorption period in the aggregate amount of dollar_figure and he discounted the annual net_income to arrive at a wholesale value of the subject condominium units of dollar_figure respondent acknowledges on brief that mr mogul doubled real_estate_taxes and association fees in his computations and that using the correct amounts would increase the present worth of the condominium units under mr mogul's discounted cash-flow analysis to dollar_figure in passing we note that a representative of babcock co testified at trial that the contract prices of the subject units in paseos castellanos were based upon the prices of actual sales of similar units to members of the public mr mogul's appraisal tends to support that testimony the total retail sales potential of the units as determined by mr mogul dollar_figure differs from the aggregate contract prices of the units dollar_figure by dollar_figure or less than percent respondent contends that on a discounted or wholesale basis the aggregate fair_market_value of the units of the reflections condominium complex that were purchased by ba 84-iii is dollar_figure or dollar_figure less than the aggregate principal_amount of the promissory notes issued by ea tit in support thereof respondent relies on the appraisal report prepared by mr david b dalton an appraiser employed by the internal_revenue_service and by mr mark d ramos an internal_revenue_service engineer messrs dalton and ramos considered the highest_and_best_use of the condominium units in the long term to be the possible sale of the units individually or as a whole they considered the short-term highest_and_best_use of the condominium units to be as apartment units to exploit a possible cash-flow from the residential rental income of the forty units in their appraisal messrs dalton and ramos used the comparable sales approach to arrive at the wholesale value of the units dollar_figure based upon the sale of one apartment building with units this is an entirely different method than the discounted retail sales_method used by mr mogul in applying the sales comparison approach to the subject property messrs dalton and ramos reviewed four buildings in the same general area that were sold in three of the buildings were substantially larger than the reflections both in the number of units and in square footage and the appraisers chose not to use those sales because the size differences would require a large upward adjustment to bring them comparable to the subject the fourth comparable the one on which they based their appraisal involved the sale of an apartment with units that was purchased for conversion to condominiums and as of date of the units had been converted the sale price of the apartment building dollar_figure divided by the number of apartments works out to a price per unit of approximately dollar_figure respondent's appraisers note that the reflections has a more desirable setting with a view of a lake than the comparable and has approximately three-fourths of an acre more land accordingly the appraisers increased the price per unit to dollar_figure an increase of dollar_figure per unit to account for these differences their report however does not explain how this adjustment was determined respondent's appraisers made no adjustment for the fact that the comparable was approximately years old at the time of the time of the sale whereas the reflections had just been built in passing we note that their appraisal of the units of the reflections condominium complex is accompanied by a memorandum discussed above in which messrs dalton and ramos point out that this wholesale value i sec_30 percent lower than epic's projected retail value of the condominiums dollar_figure and they suggest that the two values are within the range of what would be expected messrs dalton and ramos also state that epic over- leveraged the condominiums by financing the properties at their retail price and they note that epic financed the condo’s at dollar_figure thus their memorandum implies that the sum of the retail values of the condominium units is dollar_figure or dollar_figure less than the sum of the contract prices of the condominiums dollar_figure tt is evident from the above that the threshold guestion in these cases is whether the condominiums should be valued on a retail basis or on a wholesale basis if we decide that the condominiums should be valued in the retail market then it appears that the fair_market_value of the condominiums exceeds the amount of debt this is true whether we base the retail values of the properties on the contract prices as argued by petitioners or the retail prices implied in the reports of respondent's appraisers on the other hand if we decide that the condominiums should be valued in the wholesale market then it appears that the fair_market_value of the condominiums is less than the amount of debt this is true whether we base the wholesale values on the amounts set forth in respondent's appraisals or the prices that each partnership actually paid for the condominiums as the court noted in anselmo v commissioner f 2d pincite the selection of the relevant market at a given time for appraisal purposes is tantamount to selecting the price that is certainly true in this case none of the appraisers who testified in these cases considered this issue mr seph pomerantz who prepared the contemporaneous appraisals of the units in paseos castellanos testified that his firm was asked to appraise the units individually and not in bulk he further testified that he would not have completed his appraisals in the same fashion if he had been asked for a bulk appraisal similarly mr mogul's letter transmitting his appraisal report to respondent's counsel states that the report was made for the purpose of estimating the fair_market_value of the condominium units in paseos castellanos as of date assuming sale of thirty-nine units to a single purchaser thus as he further stated during his testimony mr mogul appraised the condominium units as property to be held by a single investor or entrepreneur finally mr dalton who appraised the units of the reflections testified at trial that his assignment from respondent was how much should epic have paid for this property in the memorandum attached to their appraisal messrs dalton and ramos make the following statement the fair_market_value of the properties acquired by epic associates 84-iii is based on the market place in which they were acquired the wholesale market as such the fair_market_value is the price paid_by epic associates 84-iii to the seller without regard to any rdc rental deficit contribution or other supposed builder rebate they do not explain why the fair_market_value of the properties acquired by ea 84-iii must be determined in the market place in which they were acquired the wholesale market when as they also recognize ea 84-iii purchased the properties for resale and received special discounts in the purchase_price from the sellers the report of respondent's principal expert witness dr richard hewitt iii does not explicitly discuss the appropriate market for determining the value of the subject properties dr hewitt's report does suggest that the value of the subject properties must be based upon the bulk purchase_price the wholesale price rather than the value of each single unit because the potential market risk to each partnership is actually related to multiple units and not a single unit as would be unrealistically reflected by the epic cag approach of solely obtaining individual unit appraisals in his testimony dr hewitt elaborated on that concept as follows what i was illustrating in the report is that if you look at the way epic appraised the properties they specifically by the directive of their captive appraisal group dictated that the appraisals be done on an individual basis despite the reality that their purchases were done in bulk and what i am saying is is sic that discount was represented because of the fact that they in fact had a risk exposure relating to a bulk purchase so they paid a fair price for buying or they may have-and i am trying to illustrate which is really the difficult concept in this whole epic matter--is there is a significant difference between the one-house-at--a-time appraisal versus the risk the portfolio risk of having having having on the basis of that statement respondent asks the court to make the following finding of fact because market risk for ea83-xii and ea84-iii related to multiple units acquired in bulk sales and not single units acquired in separate transactions and the appraisals obtained by epic for the properties were only on an individual basis using market and cost approaches the separate appraisals for each property did not realistically reflect the market risk or value to ea83-xii and 84-iili emphasis supplied we agree with dr hewitt that each partnership made bulk purchases of the properties and received special discounts from the sellers and that each partnership undoubtedly paid a fair price for the properties that it purchased we agree with dr hewitt that each partnership purchased the properties for resale as dr hewitt stated someone buying in the case of epic homes at a pop obviously is not going to live in those homes the intent from a typical market purchaser's standpoint if you were to buy a hundred homes would be to resell those we further agree with dr hewitt that the contemporaneous appraisals valuing each property individually do not reflect the bulk purchases made by each partnership the question that we must decide however is whether for purposes of determining the bona fides of the subject indebtedness the fair_market_value of the properties must be determined in the wholesale market the market in which the partnerships purchased the properties or the retail market the market in which the partnerships planned to resell the properties the thrust of respondent's position is that the fair_market_value of the properties as stated by messrs dalton and ramos is based on the marketplace in which they were acquired the wholesale market neither respondent nor respondent's witnesses provide a reason why this must be the case during his testimony dr hewitt touched on the appropriate market for valuing property and contrary to respondent's position his testimony suggests that the subject properties should be valued in the retail market on cross-examination dr hewitt answered a number of questions from petitioners' representative about the value of a bag of peanuts as purchased by an individual on the one hand or the value of the same bag of peanuts as purchased by a bulk purchaser such as an airline on the other hand on redirect the following exchange took place between dr hewitt and respondent's attorney q mr hewitt you and mr griffith talked about buying peanuts where he could go buy one bag of peanuts and delta could go buy another bag of peanuts let's do this example you could go to the grocery store where a bottle of coca-cola sells for cents a bottle and you can buy a six-pack for dollar_figure you bought a six-pack do you value your acquisition at dollar_figure or dollar_figure a of course not you would value it based on what you paid for it because it takes into account the discount the only way you could achieve the higher number would be to go into the soda-dispensing business and sell out individual cokes to individual users of one coke after another dr hewitt's response suggests that the purchaser must value the property on the basis of the amount_paid unless the purchaser is a person who is in the business of reselling the property like each of the subject partnerships and receives a discount from the seller in such a case the purchaser is entitled to value the property at the resale value ie dollar_figure in the hypothetical example posited by respondent's counsel or dollar_figure more than the buyer paid for the property dr hewitt's testimony on this point is consistent with the cases discussed above involving the determination of the appropriate market to use in estimating the value of an item of property see eg goldstein v commissioner t c pincite lio v commissioner t c pincite anselmo v commissioner t c pincite under those cases the fair_market_value of an item of property is its sale price in the market in -- - which it is most commonly sold to the public in the sense of the customary purchasers of the property anselmo v commissioner f 2d pincite4 it is evident that the subject condominium units were ready for immediate sale to individual purchasers and that individual purchasers were among the customary purchasers of condominiums it is also evident that neither partnership was the ultimate consumer of the condominiums the partnerships purchased the condominiums in bulk purchases and received substantial discounts from the sellers the developers of the properties the partnerships purchased the condominiums for the purpose of reselling them to owner occupants after leasing them for a period of time see goldstein v commissioner supra pincite therefore on the basis of the facts of the instant cases we find that the retail market was the appropriate market to use in estimating the fair_market_value of the condominiums furthermore in the instant cases retail valuation of the condominium units appears to have been approved by the marketplace as discussed in the findings_of_fact the specific loans at issue were initially made by emi which originated the loans and continued to service them but the loans were insured by private mortgage_insurance companies and were sold to unrelated lenders in the secondary mortgage market tricor and rmic are the private mortgage_insurance companies that issued mortgage_insurance covering the loans at issue in the instant cases the information submitted as part of dr hewitt's report confirms as one would suspect that the private mortgage insurers thoroughly investigated epic's business and were particularly careful to investigate the risks relating to the values of the properties that epic syndicated that information also shows that the private mortgage insurers had occasion to review appraisals submitted by epic in connection with its application_for mortgage_insurance and in some cases the private mortgage insurers ordered spot appraisals to compare with epic's appraisals it would be readily evident from reviewing the contemporaneous appraisals that epic had valued each of the condominiums and other residential properties purchased by its limited_partnerships on an individual or retail basis and not on a discounted or wholesale basis therefore the record suggests that the private mortgage insurers knew or had reason to know that epic valued the properties that it purchased on a retail rather than on a wholesale basis we do not mean to suggest that the private mortgage insurers gave advance approval to the specific loans at issue in these cases or to any other loans but only that the private mortgage insurers knew that epic valued the properties on a retail basis respondent argues that we should disregard the actions of the private mortgage insurers and secondary lenders on the ground that there is no evidence that the mortgage insurers and secondary lenders performed due diligence respondent argues that they ignored or did not understand the realities of the epic transactions we disagree while the record does not show what due diligence was conducted by or on behalf of the secondary lenders dr hewitt's testimony and the material submitted with dr hewitt's report confirm that the private mortgage insurers conducted due diligence with respect to the epic loans including risk assessments spot appraisals and other forms of due diligence and in fact two companies mgic and cmac ceased insuring epic loans after spot appraisals disclosed values that were lower than the values shown on the epic's appraisals retail valuation of the subject properties respondent's appraisers valued the single-family houses and the condominium unit pincite medical drive in the retail market as discussed above in the case of of these properties the difference between respondent's value and the contract_price of the property is not material as to those properties we have used respondent's values in comparing the aggregate fair_market_value of the properties to the aggregate principal_amount of the debt as to of these properties as discussed above we do not agree with respondent's appraisals and for purpose of making the value comparison required in these cases we accept the values established by the contemporaneous appraisals as to the units of paseos castellanos purchased by ba 83-xii and the units of the reflections purchased by fa 84-iii respondent's appraisers used the wholesale market rather than the retail market to value the units however the aggregate retail value of the units of paseos castellanos is implied in mr mogul's appraisal report when he finds that the total retail sales potential of the units is dollar_figure similarly the aggregate retail value of the units of the reflections is implied by messrs dalton and ramos in the memorandum that accompanied their appraisal report when they referred to dollar_figure as the retail price of the units in comparing the aggregate fair_market_value of the properties to the aggregate principal_amount of the debt we shall use the retail values of the condominiums implied in the reports of respondent's appraisers the following schedules show the aggregate retail value of the properties purchased by each partnership as compared to the aggregate debt ea 83-xii properties loan value loan value hemphill ave dollar_figure dollar_figure dollar_figure w 17th st big_number big_number dollar_figure coronado ave big_number big_number dollar_figure linda ave big_number big_number dollar_figure coronado ave big_number dollar_figure hollywood dr big_number big_number dollar_figure coronado ave big_number big_number dollar_figure avignon dr big_number big_number dollar_figure avignon dr big_number big_number dollar_figure avignon dr big_number big_number dollar_figure avignon dr big_number big_number dollar_figure avignon dr big_number big_number dollar_figure paseos castellanos big_number big_number dollar_figure total big_number big_number dollar_figure ea 84-xii properties loan value loan value heronwood dr dollar_figure dollar_figure dollar_figure heronwood dr big_number big_number dollar_figure tower hill lane big_number big_number dollar_figure northcliff manor dr big_number big_number dollar_figure clarewood dr big_number big_number dollar_figure s briar bayou dr big_number big_number dollar_figure kings lake forest dr big_number big_number dollar_figure kings lake forest dr big_number big_number dollar_figure kings lake forest dr big_number big_number dollar_figure kings lake forest dr big_number dollar_figure carola forest dr big_number big_number dollar_figure west ferret dr big_number big_number dollar_figure medical dr big_number big_number dollar_figure earlywood dr big_number dollar_figure ridgecreek dr big_number dollar_figure the reflections big_number big_number dollar_figure total big_number big_number dollar_figure as shown above on a retail basis the aggregate fair_market_value of the subject properties exceeds the aggregate amount of the debt accordingly on the basis of the record of these cases we find that the debt incurred by each partnership in purchasing the subject properties is bona_fide indebtedness points amortization both partnerships paid loan origination fees to emi equal to percent of the principal amounts of the first mortgage loans this amounted to dollar_figure in the case of fa 83-xii and dollar_figure in the case of ea 84-iii these fees were nonrefundable and were similar in amount to origination fees charged by other lenders as discussed above they were paid in connection with bona_fide indebtedness accordingly we agree with petitioners that these fees are deductible ratably over the life of the first mortgage loans see von muff v commissioner tcmemo_1983_514 profit_motive respondent determined in the subject notices of fpaa that the activity conducted by each partnership ea 83-xii and ea 84-iii during each of the years in issue was an activity_not_engaged_in_for_profit within the meaning of sec_183 thus in effect respondent determined that the activity of each partnership was an activity other than one with respect to which deductions are allowable for the taxable_year under sec_162 or under paragraph or of sec_212 sec_183 petitioners do not contend that the partnerships are entitled to deductions under sec_212 accordingly we must redetermine whether ea 83-xii and ea 84-iii are entitled to deductions under sec_162 during the taxable years in issue see brannen v commissioner f 2d pincite sec_162 provides for the deduction of all ordinary and necessary expenses paid_or_incurred during the taxable_year in carrying_on_a_trade_or_business see sec_162 it is settled that in order to constitute the carrying on of a trade_or_business under sec_162 the activity must be entered into in good_faith with the dominant hope and interest of realizing a profit see eg brannen v commissioner supra pincite siegel v commissioner t c pincite as we have noted in many cases the taxpayer must show that he or she had an actual and honest objective of making a profit e g 92_tc_958 91_tc_371 78_tc_642 affd without opinion 702_f2d_1205 d c cir for this purpose the term profit means economic profit independent of tax consequences e g 90_tc_74 85_tc_237 generally in the case of an activity to which sec_183 applies the deductions attributable to the activity are grouped into two categories those that would be allowable without regard to whether or not such activity is engaged in for profit and those that would be allowable only if such activity were engaged in for profit sec_183 paragraph of sec_183 allows a taxpayer to take the deductions in the first category without limit but paragraph of sec_183 limits the aggregate amount of the deductions in the second category i1 é deductions which are allowable only if the activity is engaged in for profit to the extent that the gross_income derived from such activity for the taxable_year exceeds the deductions allowable by reason of paragraph sec_183 b the depreciation_deductions claimed by each partnership under sec_167 are allowed only if the expenses were incurred in connection with an activity that constitutes a trade_or_business of the taxpayer see sec_167 thus if sec_183 applies to the activities of ea 83-xii and ea 84-iii the depreciation_deductions would be subject_to limitation under sec_183 b on the other hand the interest deductions claimed by each partnership under sec_163 are not subject_to the trade_or_business requirement however the notices of fpaa determined that the activity of neither partnership was engaged in for profit with the result that all interest_expenses relative to this activity are not allowable as deductions against ordinary_income but are separately_stated items subject_to the investment_interest limitations the notices of deficiency thus take the position that if sec_183 applies to the activities of each partnership then the interest_expense incurred with respect to the partnership's activities will be treated as interest on investment indebtedness and will be subject_to the rules prescribed by sec_163 limiting the allowable deduction before the limitation under sec_183 is computed see sec_1_183-1 income_tax regs in the case of a limited_partnership the profit_motive determination under sec_183 is made at the partnership level see eg 722_f2d_695 1llith cir 80_tc_972 feldman v commissioner tcmemo_1993_17 affd 20_f3d_1128 11th cir therefore in the instant cases we look to the actions of the general_partner epic to determine whether both of the partnerships are subject_to sec_183 the determination whether an activity is engaged in for profit is to be made by reference to objective standards taking into account all of the facts and circumstances of each case see sec_1_183-2 income_tax regs no one factor is determinative in making this determination see sec_1_183-2 income_tax regs greater weight is to be given to objective facts than to the taxpayer's statement of his or her interest see sec_1_183-2 income_tax regs as a preliminary matter we note that none of the parties to these cases contends that either partnership conducted more than one activity see generally sec_1_183-1 income_tax regs for example no party contends that the holding of the residential properties for appreciation and the renting of those properties by either partnership were separate activities for purposes of sec_183 the regulations list the following nine factors that should be taken into account in determining whether an activity was engaged in for profit the manner in which the taxpayer carries on the activity the expertise of the taxpayer or his advisers the time and effort expended by the taxpayer in carrying on the activity the expectations that assets used in the activity may appreciate in value the success of the taxpayer in carrying on other similar or dissimilar activities the taxpayer's history of income or losses with respect to the activity the amount of occasional profits if any which are earned the financial status of the taxpayer and any elements of personal pleasure or recreation see sec_1_183-2 income_tax regs the properties purchased by ea 83-xii and ea 84-iii were highly leveraged and produced operating losses the offering memorandum issued by each partnership disclosed the fact that the partnership would incur such operating losses and that the properties had to appreciate in value in order for an investor to realize a profit the offering memorandum issued for eba 83-xii projected a break-even appreciation rate of dollar_figure percent and the offering memo- randum for ea 84-iii projected a break-even appreciation rate of dollar_figure percent the appreciation rates required for a profit were high but there is nothing in the record of these cases to show that as of the initiation of either partnership such appreciation rates could not be achieved for example respondent's appraiser mr charles d brown testified that in houston texas property values increased during and even though interest rates were increasing he testified that if interest rates had dropped then the real_estate market in houston would have gone even more ballistic moreover in an internal memorandum prepared in late or early a member of epic'ss management noted that since mortgage rates have averaged above the inflation rate and appreciation rates have also averaged above the inflation rate on the basis of these relationships the memorandum concludes that epic's partnerships could be expected to generate positive economic benefits the memorandum also notes that there have been periods notably and when home price appreciation performed below average relative to inflation and interest rates respondent takes the position that neither epic nor any of its limited_partnerships including ea 83-xii and ea 84-iii ever intended to realize a profit respondent's position is that epic formed ea 83-xii and ea 84-iii and other limited_partnerships in order to satisfy its ravenous appetite for funds necessary to support its real_estate empire according to respondent the centerpiece of epic's scheme involved overmortgaging the properties purchased by each partnership by obtaining inflated defective appraisals to support nominal purchase prices that permitted epic to generate substantial builder fees rental deficit contributions and rental advances respondent also contends that epic's projected break-even appreciation rates of dollar_figure percent and dollar_figure percent were approximately twice as high as the actual appreciation rates from to and that epic failed to disclose its inability to sell the properties of older partnerships the adverse market conditions in the housing industry the re-syndications of properties from matured partnerships into new properties the use of defective appraisals to arrive at inflated values the purchase of properties for partnerships from epic subsidiaries the nature and use of the sweep account and the payment and appraisal fee for property not purchased by ea 83-xii we disagree under respondent's view of the facts epic was interested only in obtaining lump-sum payments from new property acquisitions and the fees attributable to those new properties respondent ignores the fact that epic's business of syndicating real_estate partnerships depended upon the perceived success of the limited_partnerships that it syndicated as a result epic advanced a high percentage of the lump-sum payments and fees that it realized from the acquisition of new properties to satisfy the obligations of older partnerships and thus to make sure that none of the partnerships defaulted on its obligations in choosing to make those advances and prevent any default the management of epic continued to believe that it could carry the properties until interest rates decreased and the real_estate market turned around respondent also ignores the fact that epic was entitled to percent of the net profits from the sale of properties so-called back-end appreciation mr clayton mcquistion an important member of epic's management referred to this as a gigantic profit opportunity based upon the record of these cases we find that epic acting as the general_partner of both ea 83-xii and ba 84-iii engaged in the activities of both partnerships with an actual and honest objective of making a profit bpic's advances to ea 83-xii and ea 84-iii as mentioned above respondent determined in the subject notices of fpaa that the deductions for interest claimed by each partnership with respect to the unsecured advances made by epic were not allowed on the ground that any such interest_expenses were not paid_or_accrued on bona_fide indebtedness respondent cites 43_tc_90 and invites the court to test whether the advances in this case are valid indebtedness in accordance with the holding of that case hambuechen involved an advance of money to a partnership by a limited_partner in that case we noted that the question whether a transaction created a debtor-creditor relationship for tax purposes is a question of fact see id pincite we applied the same factual analysis used to resolve debt-egquity issues in the context of a corporation and its stockholders and we held that the subject advance constituted a capital_contribution rather than a loan see 46_tc_147 petitioners argue that the advances in this case constitute bona_fide indebtedness rather than equity in support of that argument petitioners review each of the factors that were taken into account by the court in 464_f2d_394 5th cir in determining whether the advances in that case constituted debt or equity those factors are the following the names given to the certificates evidencing the indebtedness the presence or absence of a fixed maturity_date the source of payments the right to enforce payment of principal and interest participation in management flowing as a result the status of the contribution in relation to regular corporate creditors the intent of the parties thin or adequate capitalization identity of interest between creditor and stockholder source of interest payments the ability of the corporation to obtain loans from outside lending institutions the extent to which the advance was used to acquire capital assets and the failure of the debtor to repay on the due_date or to seek a postponement see also 730_f2d_634 11th cir affg tcmemo_1982_314 applying the same factors some of the above factors support respondent's position that the advances are equity for example there was no fixed maturity_date for repayment of the advances and the only realistic source of repayment was from gains from the sale of partnership properties furthermore it is unlikely that either partnership could have obtained credit on the same basis from outside sources other factors support petitioners' position that the advances are debt for example the partnership_agreement governing each partnership treats the unsecured advances as indebtedness establishes an interest rate and gives epic the right to collect payment of the advances from the partnership furthermore the advances were disproportionate to epic's interest in the partnership certain other factors do not clearly indicate that the advances were either debt or equity for example epic did not receive increased management control_over either partnership by reason of the advances but as general_partner epic already exercised full management control of both partnerships similarly it appears that the advances were used for all partnership needs we believe that the weight of the evidence tips in favor of finding that the subject unsecured advances are equity when we consider the intent of the parties in our view epic's management placed these funds at the risk of the business and had no reasonable expectation of repayment without regard to the success of all of the partnerships as discussed above epic'ss management anticipated that ea 83-xii and ea 84-iii would have surplus cash during their early lives but that each partnership eventually would incur operating deficits and would need to receive advances from epic in order to avoid defaults other than the sale of a partnership's properties a partnership had only four sources of cash to fund these operating deficits capital contributions by the limited partners partnership income consisting primarily of rental income builder rebates and general_partner advances epic's management realized that its ability to remain in business would be hurt if any of its limited_partnerships defaulted on an obligation epic's management recognized that epic had to advance funds to its partnerships epic's management also recognized that the advances would not realistically be repaid until and unless the properties were sold at a profit an internal memorandum prepared sometime after date states as follows to the extent anticipated operating deficits are greater than depreciation of purchase_price one half of this deficit must be funded by sources other than limited_partner contribu- tions to the extent we initially over-estimate partnership income in the offerings all of the increased operating deficit will come from the general_partner on the basis of the testimony at trial and the above we find that epic's advances to both partnerships were in the nature of equity rather than indebtedness accordingly any interest attributable to such advances claimed as a deduction by either partnership for any of the years in issue is not allowable under sec_163 sixteen promissory notes each in the principal_amount of dollar_figure as mentioned above ea 84-iii issued promissory notes payable to csl each in the principal_amount of dollar_figure and dated date each promissory note was secured_by a deed_of_trust also dated date in favor of csl eleven of the deeds of trust purport to have been filed on date with the county clerk of harris county texas five of the deeds of trust do not appear to have been filed in the bankruptcy filing that was made on behalf of ea 84-iii csl is listed as a secured creditor with respect to promissory notes in the aggregate amount of dollar_figure the filing also states that accrued interest in the amount of dollar_figure is payable to csl as a secured creditor at trial respondent introduced appraisals of the subject properties as of date and respondent argues on brief that the appraisals demonstrate that the value of the underlying properties declined or did not appreciate enough to support the new debt set out below is a list of the properties that shows the sum of the original purchase money indebtedness plus dollar_figure the value of each such property on date as determined by respondent's appraisers and the difference between those amounts fa properties loan dollar_figure value difference heronwood dr dollar_figure dollar_figure -dollar_figure heronwood dr big_number big_number -big_number tower hill lane big_number big_number -big_number northcliff manor dr big_number big_number -big_number clarewood dr big_number big_number -big_number s briar bayou dr big_number big_number -big_number kings lake forest dr big_number big_number -big_number kings lake forest dr big_number big_number -big_number kings lake forest dr big_number big_number -big_number kings lake forest dr big_number big_number -big_number carola forest dr big_number big_number -big_number west ferret dr big_number big_number big_number medical dr big_number big_number --big_number earlywood dr big_number big_number --big_number ridgecreek dr big_number big_number -big_number the reflections unit big_number big_number -big_number total big_number big_number -big_number in the case of the property pincite west ferret drive it appears according to respondent's evidence that the value of the property as of date dollar_figure exceeds the amount of the indebtedness dollar_figure accordingly it appears that respondent's evidence shows that the second trust note secured_by that property was valid indebtedness furthermore in the case of the properties pincite heronwood drive heronwood drive medical drive and harlywood drive the difference reflected in respondent's appraisals is not material petitioners presented no evidence to substantiate the fair_market_value of any of the subject properties as of date petitioners argue that the promissory notes are in fact unsecured debt and are bona_fide indebtedness without regard to the value of the property initially petitioners argued that the promissory notes were not recorded until after the bankruptcy filing and thus the notes had no substance in the eyes of the bankruptcy court on the basis of that premise petitioners argued respondent should not be allowed to rely upon defective documents to assert that those notes represented secured debt petitioners further argued that the notes should be treated as unsecured debt indistinguishable from the unsecured advances which they replaced in their reply brief petitioners withdrew the factual assertion that the promissory notes replaced unsecured advances made by epic they continue to take the position that the validity of the notes should be determined without regard to the value of the properties in for either of two reasons first petitioners argue that the notes were related to an dollar_figure line of credit from community that is described in respondent's brief as a nonrecourse line of credit with community csl totalling dollar_figure secured_by notes of limited partners and thus petitioners contend that the promissory notes were adequately secured without regard to the value of the real_estate second they argue that the real_estate was never legal security for the promissory notes therefore the value of the real_estate in is irrelevant we disagree fach of the promissory notes states that it is the note described in and secured_by a deed_of_trust dated date on property located in harris county state of texas and each note sets forth the address of the property each related deed_of_trust provides a legal description and an address of the property securing the note those documents are complete in and of themselves and make no reference to an dollar_figure line of credit from community in form each of the promissory notes purports to be secured_by one of the properties furthermore petitioners do not take issue with the premise of respondent's argument that each of the promissory notes that was issued by epic the general_partner of each partnership to csl an affiliated savings and loan associate is a nonrecourse obligation accordingly we agree with respondent that none of the promissory notes can be treated as bona_fide indebtedness unless petitioners prove that the amount of the debt does not unreasonably exceed the value of the property securing it see eg 722_f2d_695 1l1ith cir 544_f2d_1045 9th cir as mentioned above petitioners introduced no evidence of the value of any of the properties as of date there is no evidence to show that the fair market values of the properties on date exceed the aggregate indebtedness secured_by the property at that time except in the case of the property pincite west ferret drive as to which respondent's evidence shows that the fair_market_value exceeds the amount of the debt and except in the case of the properties pincite heronwood drive heronwood drive medical drive and karlywood drive as to which the discrepancies between the fair_market_value of the property and the amount of the debt are negligible accordingly we hereby sustain respondent's adjustment disallowing any interest_deduction claimed by ea 84-tiii on its return attributable to the remaining promissory notes payable to csl issued by ea 84-iii on date to reflect the foregoing decisions will be entered under rule appendix a epic associates 83-xii schedule d--pro forma cash-flow and taxable_income loss analysis through date application of funds total annual cash--flow rental income_interest income dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure interest_income dollar_figure dollar_figure dollar_figure -0- -0- dollar_figure less first mortgage payments dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure additional interest payments -0- --0- -o- dollar_figure dollar_figure dollar_figure taxes dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure insurance dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure audit fees dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure maintenance and repairs’ dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure property administration fee dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure net cash-flow from operations --226 dollar_figure --dollar_figure -dollar_figure -dollar_figure -dollar_figure -dollar_figure taxable_income loss analysis net cash-flow from operations --226 dollar_figure --dollar_figure -dollar_figure -dollar_figure -dollar_figure -dollar_figure plus mortgage amortization -o- --o- -0- -0- -0- -0- other income recognized --o- --o- -0- -0- -0- -0- less depreciation dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure amortization of mortgage loan fee dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure accrued mortgage interest --0- -0- -0- -0- --o- -o- net taxable_income -dollar_figure --dollar_figure --dollar_figure -dollar_figure -dollar_figure --dollar_figure ‘tt is assumed that the raldon corp leases will terminate date it is assumed that after builder lease terminations all properties will be rented out to individuals pincite-percent market_value in order to project the market of value the properties at the time they are rented out it is assumed they will appreciate percent per year for all rentals to individuals projected income is reduced by percent to allow for vacancies and rental commissions loan payments are not expected to increase within the period of these projections fifteen percent per year on net advances to the partnership the amount decreases at the beginning of each quarter by the amount of the quarterly investment minus the organization fee it increases during the year by the amount of the negative cash-flow to the extent epic owes the partnership money interest will be paid pincite percent per year while the houses are leased to the builder the builder is responsible for all maintenance and repairs thereafter it is assumed that these payments will amount of percent per year of the original purchase_price not applicable to this partnership appendix b epic associates 84-iii schedule d--pro forma cash-flow and taxable_income loss analysis date through date application of funds total annual cash-flow gross rental income from individuals dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure less rental commissions big_number big_number big_number big_number big_number big_number vacancy --0- big_number big_number big_number big_number big_number net rental income from individuals big_number big_number big_number big_number big_number big_number interest_income on partnership funds lent to epic big_number big_number -o0- -0- -0- big_number less first mortgage payments big_number big_number big_number big_number big_number big_number interest_expenses on funds lent by epic to the partnership -0- big_number big_number big_number big_number big_number taxes big_number big_number big_number big_number big_number big_number insurance big_number big_number big_number big_number big_number big_number home owner association due sec_333 big_number big_number big_number big_number big_number audit fees big_number big_number big_number big_number big_number big_number maintenance and repairs’ big_number big_number big_number big_number big_number big_number miscellaneous big_number -q- -q- -q- -q- big_number property administration fee big_number big_number big_number big_number big_number big_number net cash-flow from operations -big_number -big_number --big_number -big_number -big_number -1 big_number taxable_income loss analysis net cash-flow from operations -103 -big_number -big_number -big_number big_number -big_number less depreciation big_number big_number big_number big_number big_number big_number amortization of mortgage loan fee big_number big_number big_number big_number big_number big_number net taxable_income -big_number -660 -big_number --big_number -646 -big_number the year and the first three quarters of contain actual operating history thereafter it is assumed that the rent will increase percent per year during the period that the properties are assumed to be rented to individual tenants projected income is reduced by percent to allow for rental commissions and percent yearly to allow for vacancies loan payments are not expected to increase during this period fifteen percent per year on net advances by epic to the partnership the amount decreases at the beginning of each quarter by the amount of the quarterly investment minus the organization fee it increases during the year by the amount of the negative cash-flow to the extent epic owes the partnership money interest will be paid pincite percent per year it is assumed that these expenses will amount to percent per year of current property value