Deductibility of fees paid to postpone property settlement.

• Author: Abramovitz, Michael S.

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...