CITE AS: Chase v. Commissioner, 92 T.C. 874
DELWIN G. CHASE AND GAIL J. CHASE, PETITIONERS v. COMMISSIONER OF
INTERNAL REVENUE, RESPONDENT
Docket No. 7562-86. Filed April 24, 1989.
In substance, the partnership in which petitioners were partners,
disposed of the entire interest in an apartment building. Held, this
disposition by the partnership did not involve an exchange of like-kind
property under sec. 1031. Held, further, petitioners are not entitled to
elect installment sale treatment under sec. 453. Held, further, petitioner
Delwin Chase failed to liquidate his entire interest in a partnership and
is not entitled to capital loss treatment under sec. 731(a). Held,
further, only petitioner Gail Chase has satisfied the requirements of sec.
731(a).
Neil F. Horton, James G. Roberts, for the petitioners.
Rebecca T. Hill, Susan J. Adler, and Bryce A. Kranzthor, for the
respondent.
FAY, Judge: Respondent determined a deficiency in petitioners' Federal
income tax for the 1980 taxable year in the amount of $1,074,874. After
concessions, the following issues are presented for decision:
(1) Did petitioners satisfy section 1031 <> on the
disposition of the John Muir Apartments?
(2) Are petitioners entitled to a short-term capital loss of $783,762,
under section 731(a)(2), with respect to the receipt of $929,582 in
complete liquidation of a limited partnership interest held by both
petitioners?
We hold that, applying the substance over form doctrine, the John Muir
Investors, a partnership, rather than petitioners disposed of the John
Muir Apartments. Further, we hold that petitioners, as partners of John
Muir Investors, are not entitled to the benefits of section 1031
nonrecognition. Further, we hold that petitioners' entitlement to
installment sales treatment under section 453 is an untimely raised issue.
Finally, we hold that petitioner Gail Chase is entitled to recognize a
short-term capital loss in 1980 in connection with her complete
liquidation of her entire interest in John Muir Apartments.
FINDINGS OF FACT
Some of the facts have been stipulated. The stipulated facts and
attached exhibits are incorporated herein by this reference.
Petitioners Delwin G. Chase (Mr. Chase) and Gail J. Chase (Mrs. Chase),
resided in Alamo, California, at the time their petition herein was filed.
Petitioners filed a joint Federal income tax return for the year at issue.
DISPOSITION OF THE JOHN MUIR APARTMENTS
On January 26, 1978, Mr. Chase formed John Muir Investors (JMI), a
California limited partnership. JMI was formed for the purpose of
purchasing, operating and holding the John Muir Apartments, an apartment
building located in San Francisco, California (hereinafter referred to as
the Apartments), which were purchased by JMI on March 31, 1978, for
$19,041,024. Subsequently, Triton Financial Corp. (Triton) was added as a
general partner of JMI. Triton was a corporation in which petitioner held
a substantial interest. Mr. Chase and Triton were general partners who had
the exclusive right to manage JMI.
Pursuant to JMI's limited partnership agreement, once limited partners
made contributions to JMI, they were prohibited from receiving
distributions of property, other than cash, in liquidation of their
capital contributions to JMI. A section of the JMI limited partnership
agreement entitled "status of limited partners" provided as follows:
No limited partner shall have the right to withdraw or reduce his
invested capital except as a result of the termination of the partnership
or as otherwise provided by law. No limited partner shall have the right
to bring an action for partition against the partnership. No limited
partner shall have the right to demand or receive property other than cash
in return for his contribution, and no limited partner shall have priority
over any other limited partner either as to the return of his invested
capital or as to profit, losses or distribution.
After JMI held the Apartments for approximately 1 year, there developed
a high level of speculative interest in San Francisco in purchasing
apartment buildings for conversion to condominium units for sale to
individuals. This speculative interest caused the value of real estate
capable of being converted to condominium units, such as the Apartments,
to appreciate. By mid 1979, JMI was attempting to find a buyer for the
Apartments.
On January 20, 1980, JMI accepted an offer (first offer) to purchase
the Apartments from an unrelated individual for $28,421,000. Subsequent to
JMI's acceptance of the first offer, but prior to the scheduled closing
date, petitioners attempted to structure the sale of the Apartments in
such a way that they would not have to recognize any taxable gain. To
accomplish this, Mr. Chase caused JMI to distribute to himself and his
wife a deed to an undivided 46.3527 percent interest in the Apartments in
liquidation of petitioners' 46.3527 percent limited partnership interest
in JMI. Petitioners attempted to structure the subsequent disposition of
the Apartments pursuant to the first offer so that, as to them, such
disposition would be treated for Federal tax purposes as a nontaxable
nonsimultaneous exchange of real property for other real property.
On February 5, 1980, the first offer expired due to the failure of the
buyer to deposit funds into escrow by such date as required by the escrow
agreement. However, there was a second offer for the purchase of the
Apartments on March 21, 1980, at which time an agent of RWT Enterprises,
Inc. (RWT), wrote a letter of intent to Triton, one of JMI'S two managing
general partners, to purchase the Apartments for $26,500,000 (second
offer). This letter further stated that any broker's commissions would be
paid by Triton. This letter did not indicate that RWT believed, or had
been informed, that petitioners, individually, had any ownership interest
in the Apartments.
In connection with the second offer, on March 26, 1980, an officer of
Triton wrote a letter on behalf of JMI, in Triton's role as a managing
general partner of JMI, to a brokerage company. This letter stated that
JMI agreed to pay a real estate brokerage commission of $250,000 as a
result of the sale to RWT and that this commission was the total
commission due. Triton did not mention petitioners' undivided ownership
interest in the Apartments, or of any duty by petitioners to pay a pro
rata portion of such commission.
In preparing to close the sale, an escrow agreement was executed. Under
the heading "seller," the escrow agreement was signed, on behalf of JMI,
by Mr. Chase. The escrow agreement was not signed by petitioners on behalf
of themselves as individual owners of the Apartments.
On June 12, 1980, when Mr. Chase was certain that the sale to RWT was
going to close, he recorded the deed from JMI, executed in January 1980,
for petitioners' undivided interest in the Apartments.
Petitioners, as with the first offer, attempted to structure the
Apartments' disposition so that it would not be taxable to them. To this
end, on June 13, 1980, petitioners entered into a Real Property Exchange
Trust Agreement (exchange agreement) with RWT and Dudley Ellis (Mr.
Ellis). Mr. Ellis was a former employee of Mr. Chase who agreed to serve
as trustee of a trust (the Ellis Trust), created under the exchange
agreement. The exchange agreement was executed in anticipation of the sale
of the Apartments to RWT, and provided that RWT, as purchaser of the
Apartments, would transfer to the Ellis Trust petitioners' share of the
proceeds. Pursuant to the exchange agreement, Mr. Ellis, in his capacity
as trustee of the Ellis Trust, agreed to transfer to petitioners
"like-kind real property" which Mr. Ellis was to purchase with such
proceeds. Specifically, the exchange agreement provided that petitioners
would locate and negotiate the terms for the purchase of properties to be
"exchanged." Petitioners then instructed Marilyn Lamonte, the escrow
officer handling the sale, to pay 46.3527 percent of the "net proceeds"
from the sale to Mr. Ellis as trustee under the exchange agreement.
On July 7, 1980, the John Muir Apartments were sold to Traweek
Investment Fund No. 10, Ltd. (Traweek), an entity related to, and
substituted as buyer by, RWT. The net proceeds of $9,210,876 received from
the sale to Traweek were allocated by Lamonte between the Ellis Trust and
JMI. The actual payments out of escrow were a check for $3,799,653 to
Ellis in his capacity as trustee under the Ellis Trust, and a check for
$4,811,223 paid directly to JMI.
Petitioners' instructions to Lamonte, to the effect that Ellis, as
trustee, was to be the recipient of 46.3527 percent of "net proceeds" from
the sale, were not followed. Rather, the portion of the proceeds
distributed to Ellis in trust for petitioners represented an allocation of
a distributive share of total net proceeds to petitioners in their
capacity as limited partners of JMI in accordance with the terms of the
JMI limited partnership agreement and not as a straight allocation of
46.3527 percent of "net proceeds."
From January 1980, until the date of the sale was closed, the expenses
of operating the Apartments were paid with funds that were in JMI'S
operating bank account. Petitioners did not pay, with their own money, any
of the expenses from January 1980, when they received a deed to the
Apartments through July 7, 1980, the date of sale. Petitioners also did
not receive any of the rental income earned during this period, such rent
continued to be paid to JMI.
Petitioners' relationship with respect to the Apartments, after they
were deeded an undivided interest in such, was in all respects unchanged
in relation to their relationship to the Apartments as limited partners of
JMI.
On June 30, 1981, Ellis, as trustee of the Ellis Trust, assigned to
Creston Corp. (Creston), as successor trustee of the Ellis Trust,
petitioners' share of the proceeds from the sale. Creston was, at the time
of such assignment, a corporation wholly owned by Ellis.
By July 23, 1982, Triton, as general partner of entities controlled by
petitioner, completed the acquisition of the following three properties
which were later acquired from Creston by petitioners: (1) The Snug Harbor
Apartments in Dallas, Texas (the Snug Harbor property); (2) a ground lease
to commercial real property in Orange County, California (the Irvine
property); and, (3) certain commercial real estate in Santa Ana,
California (the Woodbridge property).
Creston, as trustee under the Ellis Trust, acquired, and immediately
transferred to petitioners, the Snug Harbor property on or about October
27, 1982. Petitioners held the Snug Harbor property for 7 months. Creston
acquired and then transferred to petitioners, the Irvine property on
October 29, 1982. Petitioners, in turn, disposed of the Irvine property on
the same date. On October 29, 1982, Creston acquired, and then transferred
the Woodbridge property to petitioners, who disposed of the property on
the same date. In addition to the above properties, Creston, as trustee
under the Ellis Trust, also purchased for petitioners three other
properties located in the State of Kentucky.
LIQUIDATION OF THE LOCKWOOD INTEREST
On March 5, 1980, petitioners purchased a 2.92-percent limited
partnership interest in JMI from Albert and Hazel Lockwood for $230,000
and a 8.78-percent limited partnership interest from Todd and Karen Sue
Lockwood for $690,000 (hereinafter referred to collectively as the
Lockwood interest). The Lockwood interest was a limited partnership
interest in addition to the 46.3527-percent interest previously acquired.
On July 9, 1980, 2 days after the disposition of the Apartments,
petitioners received $929,582 in complete liquidation of their
11.72-percent Lockwood interest. Petitioners reported a short-term capital
loss of $783,762 on their 1980 Federal income tax return as a result of
this distribution. Petitioners computed their adjusted basis and loss as
follows:
Cost of Lockwood interest $920,000
Distributive share of long-term
capital gain reported from the
sale of the John Muir Apartments 850,189
Distributive share of operating
loss reported (59,845)
----------
Adjusted basis 1,710,344
Amount realized 926,582
Less adjusted basis 1,710,344
---------
Claimed loss (783,762)
The $929,582 cash distribution from the liquidation of this
11.72-percent interest liquidated petitioners' entire limited partnership
interest in JMI held as of this date. Petitioner, however, continued
thereafter to hold an interest in JMI as a general partner. After this
liquidation of the 11.72-percent interest, JMI continued operating as a
partnership for the purpose of investing in other real property.
On December 31, 1980, petitioners acquired a 1.31-percent limited
partnership interest in JMI from Anthony and Carole Cline.
OPINION
The first issue is whether petitioners met the requirements of section
1031. Section 1031(a) provides that no gain or loss is recognized if
property held for productive use in a trade or business or for investment
(excluding certain types of property not involved herein) is exchanged
solely for property of like-kind. Since the distinction between "trade or
business" and "investment" in section 1031(a) is immaterial for our
purposes, for convenience, we will use the term "held for
investment."Based on a number of theories, respondent contends that
petitioners are not entitled to nonrecognition under section 1031(a) or,
in the alternative, that petitioners must recognize gain under section
1031(b) to the extent that certain of the property ultimately received by
petitioners was not held for investment.
Respondent contends that section 1031(a) is inapplicable because the
disposition of the Apartments was, in substance, a sale by JMI, and not an
exchange by petitioners of like-kind property. Petitioners contend that we
must respect the form in which they structured the disposition of the
Apartments, and that such form satisfied the requirements of section
1031(a).
To qualify for nonrecognition, a taxpayer must satisfy each of the
specific requirements as well as the underlying purpose of section
1031(a). Bolker v. Commissioner, 760 F.2d 1039, 1044 (9th Cir. 1985),
affg. 81 T.C. 782 (1983). We must determine whether the "exchange"
requirement of that section was satisfied. Respondent argues that the
substance over form doctrine is applicable to impute the disposition of
the Apartments entirely to JMI and concludes that, in substance,
petitioners did not "exchange" any part of the Apartments.
The substance over form doctrine applies where the form chosen by the
parties is a fiction that fails to reflect the economic realities of the
transaction. Commissioner v. Court Holding Co., 324 U.S. 331 (1945);
United States v. Cumberland Public Service Co., 338 U.S. 451 (1950). In
determining substance, we must look beyond the "superficial formalities of
a transaction to determine the proper tax treatment." Blueberry Land Co.
v. Commissioner, 361 F.2d 93, 101 (5th Cir. 1966), affg. 42 T.C. 1137
(1964). "Transactions, which did not vary, control, or change the flow of
economic benefits, are dismissed from consideration." Higgins v. Smith,
308 U.S. 473, 476 (1940). We hold that the substance over form doctrine
applies and that, in substance, JMI disposed of the Apartments.
Although the general partners of JMI caused JMI to prepare a deed
conveying an undivided 46.3527-percent interest in the Apartments to
petitioners, at no time did petitioners act as owners except in their
roles as partners of JMI. Petitioners were deeded an undivided interest at
the time of the first offer because it appeared that a sale was imminent.
When this sale failed to close, however, petitioners' deed remained
unrecorded until shortly before the disposition in question. There is no
indication that any party to the sale believed that anyone other than JMI
held title at the time of RWT'S offer to purchase. Further, there is no
evidence of negotiations by petitioners on behalf of themselves concerning
the terms for the disposition of the Apartments. Also, petitioners never
paid any of the operating costs of the Apartments or their share of the
brokerage commission. Further, petitioners did not receive, or have
credited to them, any of the Apartment's rental income.
Equally important, in apportioning the net sale proceeds, all parties
ignored petitioners' purported interest as direct owners. Rather,
petitioners received only their distributive share of JMI's net proceeds
as limited partners. In addition, the JMI limited partnership agreement
provided that no limited partner could demand and receive property other
than cash from the partnership. Further, there is no evidence that
petitioners were otherwise authorized by the other limited partners to
receive a share of the Apartments as a partnership distribution or that
the other limited partners were even aware that such a distribution had
occurred. We can only conclude that petitioners' failure to respect the
form in which they cast this transaction by failing to receive their share
of proceeds as direct owners was caused by petitioners' realization that
they were not direct owners and could not be so by virtue of the
partnership agreement.
Petitioners final argument regarding the substance issue is that JMI's
general partners acted as petitioners' agents in negotiating the
disposition of the John Muir Apartments to Traweek. This, petitioners
argue, explains why they did not appear, individually, as parties in most
of the documents to this transaction. We find petitioners' argument, in
this regard, both self-serving and unsupported by the record.
Having determined that, in substance, JMI disposed of the Apartments,
we must determine whether petitioners are entitled to "exchange" treatment
under section 1031(a), which treatment would flow through JMI to all
partners in accordance with their distributive share of partnership gain.
Sec. 702(a). Petitioners are entitled to nonrecognition of gain under
section 1031(a), as a partner of JMI, if JMI has satisfied the
requirements of section 1031(a) in disposing of the Apartments.
Section 1031(a) requires that like-kind property be both given up and
received in the "exchange." Here, it is clear that JMI transferred
investment property but did not receive like-kind property in "exchange."
This is because JMI never held the properties that were ultimately
received by petitioners as part of the purported "exchange." Accordingly,
JMI never "exchanged" like-kind property.
Having concluded that JMI sold the entire interest in the Apartments,
and that JMI did not act as petitioner's agent with respect to an
undivided interest in such apartment, we hold that petitioners failed to
"exchange" like-kind property within the meaning of section 1031(a).
Accordingly, petitioners are not entitled to the benefits of that section.
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Petitioners argue, alternatively, for the first time on brief, that if
section 1031(a) is inapplicable, they now be allowed to elect installment
sale treatment under section 453. Petitioners cite Bayley v. Commissioner,
35 T.C. 288 (1960), wherein we permitted a taxpayer to elect, in an
amended petition, the installment method under section 453, where the
issue of nonrecognition under section 1034 was decided adversely to the
taxpayer. Petitioners' argument fails for two reasons. First, petitioners
did not amend their pleadings or raise such issue at trial, but only
raised such issue on brief. See Seligman v. Commissioner, 84 T.C. 191
(1985) affd. 796 F.2d 116 (5th Cir. 1986); Markwardt v. Commissioner, 64
T.C. 989 (1975). Second, since we find that JMI disposed of the
Apartments, the election under section 453 can only be made by the
partnership. See sec. 703(b); Rothenberg v. Commissioner, 48 T.C. 369
(1967). Accordingly, we hold petitioners are not entitled to elect
installment sale treatment under section 453.
The final issue is whether petitioners are entitled to claim a
short-term capital loss of $783,762 under section 731(a)(2) in connection
with their receipt of $929,582 in complete liquidation of their Lockwood
limited partnership interest on July 9, 1980. This issue is raised because
petitioner held a general partnership interest in JMI throughout 1980 and
petitioners subsequently reacquired a limited partnership in JMI on
December 31, 1980. The general rule contained in section 731(a)(2) is that
a partner may not recognize a loss from a partnership distribution.
Section 731(a)(2) provides an exception to the general rule of
nonrecognition, however, if certain requirements are met. First, the
distribution must be "in liquidation of a partner's interest in a
partnership." Second, no property other than money, unrealized receivables
(as defined in section 751(c)), or inventory (as defined in section
751(d)(2)) must be received in the liquidating distribution. Third, a loss
must be realized. See sec. 731(a)(2).
With respect to the first requirement, both parties refer to section
761(d). That section defines, for purposes of subchapter K, the term
"liquidation of a partner's interest" as "the termination of a partner's
entire interest in a partnership by means of a distribution, or a series
of distributions, to the partner by the partnership." (Emphasis added.)
Respondent argues that under section 761(d), in order to terminate one's
"entire interest" in a partnership, one must terminate both his general
and limited partnership interests. Petitioners argue that section 761(d)
only requires the termination of either the entirety of one's limited
partnership interest or one's general partnership interest. Petitioners
further argue that the retention of one's general partnership interest
does not prevent, under section 731(a)(2), the recognition of a loss upon
the termination of one's entire limited partnership interest.
We find, however, that petitioners' argument ignores the plain meaning
of the statute which is unambiguous on its face. Section 761(d) provides
that the term "liquidation of a partner's interest" means the termination
of a partner's entire interest by means of a distribution, or a series of
distributions, to the partner by the partnership. When petitioners
liquidated their Lockwood interest, Mr. Chase still retained an interest
in JMI as a general partner and, therefore, he did not liquidate his
"entire interest" in JMI. As to Mrs. Chase, she no longer was a partner in
JMI after the distribution in liquidation of the Lockwood interest.
Although, as noted by respondent, she became a limited partner in JMI on
December 31, 1980, she no longer had any interest in JMI, as of July 9,
1980.
Respondent argues that no loss can be realized because petitioners
received nonqualifying property (46.3527-percent interest in the
Apartments), as opposed to money, unrealized receivables, or inventory, as
part of a series of liquidating distributions, and that petitioners are
thus disqualified from realizing a loss. It is unnecessary to reach this
argument since we previously held herein that the distribution to
petitioners of an interest in the Apartment was, for Federal tax purposes,
illusory. Accordingly, we hold that petitioner Gail Chase is entitled to a
short term capital loss.
To reflect the foregoing.
Decision will be entered under
Rule 155.
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1/ All section references are to the Internal Revenue Code of 1954 as
amended and in effect during the year in issue, and all Rule references
are to the Tax Court Rules of Practice and Procedure.
2/ We do not address respondent's alternative arguments, as those
arguments are moot.
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