A shared-appreciation loan was a pure loan and did not make the lender a partner with the borrower, the US Tax Court said.
The lender also shared in net cash flow.
The US Tax Court said the borrower could deduct as interest both the share of net cash flow and the share of appreciation in the underlying property that the borrower paid to the lender.
The government lawyers had trouble arguing the arrangement created a partnership between the lender and borrower after agreeing in a court filing at the start of the case that the deal documents created a loan.
Two individuals formed a partnership in 2006 to buy a building on 6.85 acres in Rome, Georgia with the aim of doing some renovations and then leasing the building to business tenants. Home Depot and Ferguson Plumbing already had short-term leases. The local hospital was looking for space to offer physical therapy to hospital patients.
The partnership borrowed the amount needed for the project from Protective Life Insurance Co. The insurance company offered the partnership a choice of two loans: a conventional loan with a floating interest rate or a “participating loan” with a lower interest rate of 6.25% but that required signing a separate agreement called an “additional interest agreement” under which the borrower promised to pay 50% of net cash flow during the loan term and 50% of appreciation in the value of the building on the maturity date for the loan or, if earlier, when the property was sold or the loan was refinanced, the property condemned, the loan defaulted or subordinated financing was arranged with another lender.
The lender used the same loan documentation — a note and security agreement — for both types of loans, except the participating loan also required signing the additional interest agreement.
The partnership borrowed $4.4 million in total to cover not only the acquisition cost but also the renovations. The loan covered the entire $2.2 million acquisition price plus another $250,000 in transaction costs. The partnership put down a $50,000 earnest money deposit, but got it back at closing.
The partnership made monthly payments under the loan. The payments were treated as base interest (6.25%) first, then repayment of principal, and then payment of the additional interest.
It sold the building in 2014 for $6.3 million.
The IRS argued that the 50% share of appreciation could not be deducted as interest on grounds that it was paid to the lender in its capacity as a partner. It said either the payment was a return on equity investment by the lender or a “guaranteed payment” not tied to partnership income to the lender in its capacity as a partner.
The court rejected the IRS position. It said the lender did not become a partner.
It said the lender could not be a partner unless it contributed part of the capital or provided services for the project. The court said the government would have had to argue that part of the “loan” was really an equity investment. Instead, the government stipulated at the start of the case that the entire $4.4 million was a loan.
In a 1960 court decision called Farley Realty, a US appeals court found that a shared-appreciation loan gave the lender an equity interest, but in that case, there was no fixed maturity date by when the lender had to be paid a share of the appreciation. In this case, the share had to be paid no later than when the loan principal came due.
The court said another factor weighing toward treatment of the appreciation share as interest was that the lender had no real exposure to losses in the supposed partnership. A partner’s return rides up and down with how well the business performs.
The court granted the government the fact that the loan was the sole source of capital to undertake the project — the two partners put in only $5 each — cut in favor of treating the lender as a partner, but said it was not enough by itself to reach that conclusion, especially given the government stipulation at the outset that the entire $4.4 million was a loan.
The case is Deitch v. Commissioner. The court released the decision in late August.