Deductibility of fees paid to postpone property settlement.

What is the proper treatment of a fee paid to postpone a property closing? Must the fee be capitalized as a cost of acquiring the property or may it be currently expensed? In some circumstances, it is possible to deduct the payments made to defer a property's closing as interest, rather than capitalize them, according to Halle, 4th Cir., 1996, rev'g and rem'g TC Memo 1994-630.

Halle, a developer, found a tract of land he wanted to purchase, and negotiated an acceptable price. He formed Kingstowne, L.P. (KLP) to buy the property. The land was owned by, and the sole asset of, Greendale Development Company, Inc. (Greendale), which was owned by four shareholders. On Mar. 8,1985, KLP agreed to purchase Greendale stock for $29 million. The purchase agreement required a $3 million deposit, with the balance due on the settlement date, Apr. 26, 1985. The agreement allowed KLP to defer settlement until Oct. 1, 1985, by paying the stockholders an additional $225,000 a month. If KLP defaulted on the settlement, it would forfeit the $3 million deposit and any monthly installments already made. KLP deferred the settlement for four months and paid an additional $900,000 to the Greendale stockholders.

Greendale had almost finished rezoning the property for higher density development. When the agreement was executed on Mar. 8, 1985, the continuing engineering, planning and development costs through Mar. 15, 1985 would be borne by Greendale and thereafter by KLP--which eventually paid $506,779 in such costs as they accrued.

Between the agreement's execution and settlement, KLP applied for and obtained $53 million in loan commitments to finance the property's purchase and development. It also began negotiations to sell portions of the land and exchanged preliminary drafts of joint development ventures, which could not be finalized until settlement. On its 1985 income tax return, KLP deducted the $900,000 as interest, which the IRS disallowed. The Tax Court denied a petition for readjustment of partnership items, holding that the monthly payments were not interest paid on indebtedness. Because there was a liquidated damages clause that would limit KLP's loss to the deposit plus monthly damages if it defaulted, the Tax Court viewed the $900,000 payments as resembling amounts paid to retain the"option to complete or not complete the transaction."

The Fourth Circuit discussed the usual criteria for determining whether interest exists. Was there an existing, unconditional and legally enforceable obligation to pay a principal sum? If an existing, legally enforceable obligation is materially conditional, it may still give rise to an indebtedness, if the contingency is beyond the control of the person seeking the deduction, the amount of the debt is fixed and the payor's liability to the payee is primary and direct. (See, e.g., Journal Co., 125 F2d 349, 350-351 (7th Cir. 1942).) Finally, indebtedness may be imposed on a property's purchaser when the benefits and burdens of ownership shift before payment (Nelson, TC Memo 1993-419).

The question addressed by the Fourth Circuit was whether KLP's situation involved a debt or merely an option. If KLP defaulted, it would have lost as much as $3.9 million in-liquidated damages (approximately 13% of the purchase price), which the court considered a significant consequence. Also, KLP assumed some burdens of ownership by paying engineering, planning and development costs of over $500,000 after Mar. 15, 1985, but before the settlement date.

The court stated: "One who invests significant, unrecoverable resources in property that he does not legally own. . . is less likely to hold merely an option in that property." In addition, KLP's activities did not indicate that it was looking at other properties for potential development and that it simply sought to hold open its choice to pursue development of Greendale's tract. KLP initiated and pursued negotiations to sell portions of that tract and to enter into: joint development ventures with respect to other portions. It spent time and money to obtain $53 million in financing before settlement. Further, there was no apparent motive for the parties to create an option.

The Service argued that no interest payments were set forth in the contract. However, the court held that the failure to label these payments as interest was immaterial, since they corresponded specifically to the contract purchase price, the prevailing interest rate and the time of deferral.

Under the appropriate circumstances, fees paid to postpone a property's closing may be deducted currently as interest on indebtedness. A purchase contract should disclose the parties' intent to treat such payments as interest both in form and substance.