Rev. Rul. 84-5

1984-1 C.B. 32.

                       Internal Revenue Service
                                 Revenue Ruling

                 INTEREST;  DEDUCTION;  NONRECOURSE OBLIGATION

                           Published: January 9, 1984

SECTION. - -INTEREST, 26 CFR 1.163-1: Interest deduction in general

(Also Section 461; 1.461-1.)

  Interest;  deduction;  nonrecourse obligation.  A partnership that purchases timeshare units in a vacation home with a nonrecourse obligation calling for a large balloon payment of interest and principal in 30 years is not allowed a deduction for the interest purportedly accrued on the obligation because the obligation does not constitute a valid indebtedness.

ISSUE

  Under the circumstances described below, can a partnership deduct interest with respect to a nonrecourse note under section 163 of the Internal Revenue Code?

FACTS

  X, a corporation, was engaged in the construction of vacation homes and the marketing of "timeshare units" therein.  Each timeshare unit consisted of a 1/350 th undivided interest in a specific vacation home.  Fifteen days during the year were reserved for maintenance and repairs.  Purchasers held title as tenants in common with each owner having the exclusive right to possess the property one day per year for each timeshare unit purchased.

  X also offered to finance a portion of the purchase price of the timeshare units.  The finance agreement called for "add-on interest," whereby the entire amount of interest due on the 30-year obligation is calculated based on the sum of the outstanding principal balance and unpaid interest.  The total amount of interest is then added to the original principal amount.  The finance agreement also provided that the purchaser could retire the outstanding indebtedness on December 3 of any year.  A purchaser who prepays the entire obligation will be entitled to a rebate of interest in accordance with Rule of 78's method.  For example, using the Rule of 78's method, the amount that would be required to retire the loan at the end of the first year would be the principal amount plus 30/465 ths of the total interest of the 30-year obligation. (The 30 numerator is the number of years of the loan remaining at the time the calculation is made, and the 465 denominator is the sum of the years digits for 30 years.)  In its promotional materials, X represented that a taxpayer who uses the accrual method of accounting would be entitled to deduct interest allocated according to the Rule of 78's method.

  At the suggestion of X's sales agent, individuals A and B organized a general partnership, P, to acquire 7 timeshare units in a vacation home.  P adopted the accrual method of accounting.  A and B each contributed 2,500 dollars to P in exchange for a one-half interest therein.

  On January 2, 1980, P entered into an installment contract with X for the purchase of the 7 timeshare units for a total purchase price of 14,000 dollars, the actual fair market value of the units. On January 3, 1980, P made a cash downpayment of 2,000 dollars and entered into a finance agreement with X for the 12,000 dollar balance of the purchase price.  On the same day X conveyed a 7/350 th interest in the vacation home to P, as a tenant in common.

  Under the terms of the finance agreement, the total amount of finance charge over the 30-year period was calculated to be 318,500 dollars.  P had a recourse obligation to make annual "interest" payments to X of 2,800 dollars on December 31 of each of the first 10 years.  No additional payments were due until the 30th year, when P must pay X the principal balance, 12,000 dollars, and all accrued and unpaid interest, 290,500 dollars, for a total payment of 302,500 dollars.  The obligation of 302,500 dollars was entirely nonrecourse with respect to P, A, and B and was secured only by the 7 timeshare units in the vacation home.

  If P wanted to retire the debt on December 31, 1980, P would be required to pay the principal amount of 12,000 dollars plus interest of approximately 20,548 dollars ( 30/465 times 318,500), for a total of 32,548 dollars.  Of this total amount, P would have been required to make the annual payment of 2,800 dollars even if P did not want to retire the entire obligation.

  On December 31, 1980, P paid 2,800 dollars to X.  P accrued and deducted an interest expense of 20,548 dollars for the 1980 tax year.  P realized 848 dollars of rental income from the leasing of the 7 timeshare units to an unrelated party during 1980 and incurred incidental expenses of 80 dollars with respect to the leasing activity.  P's partnership return for 1980 showed an ordinary loss of 20,500 dollars, the calculation of which included a depreciation allowance of 720 dollars.  A and B each claimed a deduction of 10,250 dollars on their 1980 individual income tax returns as their allocable share of P's losses.

LAW AND ANALYSIS

  Section 163(a) of the Code allows a deduction for all interest paid or accrued within the taxable year on indebtedness.  In order for interest to be deductible under section 163(a), there must be a valid indebtedness to pay a principal sum and the interest thereon. With regard to debt incurred on the purchase of property, in the absence of personal liability, a debt will have substance and genuine existence, for federal tax purposes, only if the value of the underlying security bears a reasonable relationship to the amount of the indebtedness.  Estate of Franklin v. Commissioner, 544 F.2d 1045, 1048 (9th Cir.1976), aff'g. 64 T.C. 752 (1975);  Rev. Rul. 77-110, 1977-1 C.B. 58.

  In Estate of Franklin the court stated:

  For the 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.

  It is not reasonable, at the time of purchase, to assume that P will ever pay any of the nonrecourse amounts.  Even if P wanted to retire the debt on December 31 of the first year, the amount of the required payment would exceed twice the initial value of the 7 timeshare units.  Because of the method used for allocating and accruing interest, there is no reasonable relationship at the outset between the obligation and the value of the property offered as security therefor.  Further, P has not shown that the value of the property will ever equal the amount of the nonrecourse obligation, which will reach 302,500 dollars at the end of 30 years. Consequently, the nonrecourse obligation does not constitute a valid indebtedness for federal income tax purposes, and P cannot accrue any interest expense or cost with respect to the purported interest and principal evidenced by the nonrecourse obligation.

  Under the terms of the contract, however, P has a recourse obligation to make annual prepayments of "interest" to X of 2,800 dollars for each of the first 10 years.  Because it can be concluded that the nonrecourse indebtedness is to be disregarded, it may be assumed that these recourse payments represent the remaining purchase price of P's interest in the property.  Furthermore, when discounted at 19.36 percent, an interest rate within the limits charged on installment sales of similar real property, the payments of 2,800 dollars for each of the first 10 years reduce to a present value of 12,000 dollars, the balance of the purchase price remaining unpaid at the time of the sale.  The 16,000 dollar difference between the total recourse payments (28,000 dollars) and the unpaid balance of the purchase price as stated in the contract (12,000 dollars) is interest that, in effect, has been agreed to by the parties.  The ten recourse payments of 2,800 dollars each are self-amortizing level payments, and the amount of interest allocated to each payment is computed by applying the effective rate of interest (19.36 percent) to the unpaid balance of the 12,000 dollar obligation.  See Rev. Rul. 83-84, 1983-1 C.B. 97.

HOLDING

  P may not accrue any amount of interest attributable to the 302,500 dollar nonrecourse obligation.  An interest deduction is allowed in 1980 for the portion of the 2,800 dollar payment that represents interest computed by applying the effective rate of interest to the unpaid balance of the 12,000 dollar obligation.

Rev. Rul. 84-5, 1984-1 C.B. 32.