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Purchasers of vacation home timeshares denied deductions.

In 1981, L and other individuals formed partnership U to purchase timeshare units in ski resort area vacation homes. Under the purchase arrangement, U made an $800 down payment for each unit; the partnership was then to pay $570 per unit annually for 10 years. No further payments were required until 30 years from the date of purchase, at which time U either forfeited its interest in the units (because the debt was non-recourse) or made a balloon payment of $86,700 per unit.

In 1981, L contributed his portion of the down payment (approximately $1,000). On his 1981 return, he claimed a $7,000 interest deduction, as his share of U's losses. The IRS completely disallowed the deduction. The Tax Court agreed with the Service, and the Court of Appeals (opinion King, J.) affirms.

Sec. 163(a) provides for the deduction of "all interest paid or accrued within the taxable year on indebtedness." It is well settled that interest is deductible only if paid with respect to genuine indebtedness. To justify a deduction the debt must exist; potential existence will not do. For debt to exist, the purchaser, in the absence of personal liability, must confront a situation in which it is presently reasonable from an economic point of view for him to make a capital investment in the amount of the unpaid purchase price.

In transactions in which the amount of nonrecourse debt bears no reasonable relationship to the value of the collateral securing repayment of the debt, it is very unlikely that the obligation will ever be paid. The debtor has no economic incentive to satisfy the obligation when the only consequence of his default is forfeiture of collateral worth far less than the amount of nonrecourse debt. Such indebtedness should not be recognized because of the unlikelihood of payment of the obligation.

L would have us follow the reasoning of Pleasant Summit Land Corp., 863 F2d 263 (3d Cir. 1988). The court in Pleasant Summit noted that while a taxpayer holding property subject to a non-recourse debt in excess of the market value of the property may have no incentive to pay off any portion of the debt, "it is equally logical to recognize that the creditor holding the debt has no incentive to take back the property if the taxpayer offers to pay the debt up to the value of the property."

Even if we were to accept the reasoning in Pleasant Summit, it would not help L. The timeshare units are of dubious utility. The inflated payments made by L purchased, in essence, an opportunity to take disproportionately large tax deductions. The analysis undertaken by the Third Circuit in Pleasant Summit is of doubtful relevance when dealing with collateral like that at issue here.

We therefore instead embrace the position of the Ninth Circuit in Est. of Franklin, 544 F2d 1045 (1976). The proper inquiry in this situation is not whether the seller/creditor has an incentive to settle the debt at the fair market value of the collateral, but whether it would be reasonable for the buyer/debtor to make a capital investment in the unpaid purchase price.

L had no incentive ever to pay the obligation. After the first year, L had already paid far more than his share of the fair market value of the units. The structuring of the financing effectively prohibited L from paying off his debt early. For him to have done so, he would have had to pay over $10,000 at the close of 1981 and over $16,000 at the close of 1982. This disparity between fair market value and the payoff amount would continue throughout the life of the loan; the partnership would always have negative equity because the payoff amount would always exceed the fair market value of the property. HOWARD I. LUKENS, 5th Cir., 10/7/91, aff'g TC Memo 1990-87

REFLECTIONS: THE IRS also assessed a Sec. 6621(c) interest penalty on L. Because the transaction was without economic substance and its primary factor was the "extravagant tax write-off," it was a tax-motivated transaction under Sec. 6621(c)(3)(A) and application of the increased interest rate was proper.
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Author:Fiore, Nicholas J.
Publication:The Tax Adviser
Date:Dec 1, 1991
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