Pleasant Summit Land Corporation v. Commissioner

863 F.2d 263 (3rd Cir. 1988)

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Nature of the Case

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Facts

P entered into an agreement to purchase the Summit House, a property containing two apartment buildings and a small separate resident manager's apartment for $4,200,000. P paid $250,000 in cash and delivered a $1,350,000 note secured by a purchase money mortgage, and by P taking title subject to a previously existing $2,600,000 nonrecourse mortgage. P then created a wholly-owned subsidiary, Mount Orange Realty Corp. (MORC), to which it then sold the Summit House buildings while retaining the land beneath them. The sale price to MORC was $5,200,000, consisting of $500,000 in cash which MORC borrowed or owed and a $4,700,000 nonrecourse mortgage which wrapped around and was subject to the prior two mortgages. This conveyance of the property placed the depreciable buildings in one entity while leaving the nondepreciable land in another. P then sold its MORC stock to the newly created PSA, which was organized to acquire the Summit House, for $2,559,200, paid in the form of a nonrecourse note secured by the MORC shares, for which a mortgage of Summit House to P was immediately substituted. PSA then dissolved MORC, took direct ownership of the Summit House buildings, and took over MORC's obligations including the $500,000 due on the purchase of the Summit House and the $4,700,000 nonrecourse wraparound mortgage. The cost to PSA for the acquisition of Summit House was the $2,559,200 indebtedness for the purchase of the MORC shares, assumption of MORC's $500,000 obligation, and assumption of MORC's $4,700,000 nonrecourse wraparound mortgage for a total of $7,759,200. These transactions left PSA with large debts with interest charges and a substantial depreciable asset, a situation setting up the possibility for it to claim large tax deductions. P leased the land under the buildings to PSA for $10,000 a year under an agreement allowing rent to be accumulated and deferred at a fixed rate of interest. This provision caused PSA to generate additional tax deductions for the interest which accrued on the unpaid rent. PSA then sold thirty limited partnership units to a group of investors including George Prussin for a total of $1,980,000 paid with down payments and subsequent installments. PSA reported losses on its income tax returns for 1978 and 1979, and later years, largely attributable to interest deductions and depreciation. They were passed through to the limited partners who used them to offset income on their individual tax returns. On December 19, 1985, an unrelated third party purchased the Summit House land from P and the buildings and lease from PSA for a total of $7,000,000. On its corporate income tax return for its taxable year ending May 31, 1979, P indicated that: (1) it had realized a gain of $3,742,704 on the sale of certain improvements to land in West Orange, New Jersey (Summit House); (2) it elected to use the cost recovery method for reporting this profit; and (3) under this method none of the gain was includable in its gross income for the taxable year covered by the return. D issued a deficiency notice to P. Prussin reported a loss of $417,012 from Prussin's distributive share of the 1978 losses of PSA on their joint federal income tax return for 1978 and a loss of $345,170 on their 1979 income tax return. D issued a deficiency notice to the Prussins entirely disallowing his share of the partnership losses on the ground that the Prussins had not established the amount and character of any of the partnership items on which their individual loss claims were based. P and the Prussins brought this action. D got the verdict and Ps appealed.