## Facts

- A California limited partnership, Twenty-Fourth Property Associates, with Charles T. Franklin and other physicians as limited partners, entered a 1968 transaction to “purchase” the Thunderbird Inn motel in Arizona from the Romneys.
- A recorded “Sales Agreement” stated a purchase price of $1,224,000, payable over roughly ten years with interest, including a $75,000 payment labeled “prepaid interest” and monthly payments nearly matched by amounts flowing back under related arrangements.
- The partnership’s obligation to the sellers was nonrecourse; upon default, the sellers’ remedy was limited to forfeiture of the partnership’s interest in the property.
- The transaction included a leaseback under which the sellers continued to operate the motel and cover operating expenses; payment streams were structured so that, apart from the initial $75,000, little net cash moved between the parties for many years.
- The stated purchase price and nonrecourse note substantially exceeded the motel’s fair market value, limiting the partnership’s economic incentive to satisfy the full stated obligation.
- The partnership claimed depreciation deductions on the motel and interest deductions on the nonrecourse obligation, generating pass-through losses to the limited partners.
- The Commissioner disallowed the deductions; the Tax Court upheld the disallowance, treating the arrangement as, in substance, an option to acquire the property later.
- The partners sought review in the Ninth Circuit.

## Issues

1. Whether the partnership obtained a present ownership interest and depreciable basis in the motel sufficient to support depreciation deductions.
2. Whether the partnership’s nonrecourse note constituted genuine “indebtedness” supporting interest deductions under I.R.C. § 163.
3. Whether a transaction using nonrecourse debt far exceeding the property’s value should be treated, for tax purposes, as lacking economic substance (or as an option-like arrangement) rather than a sale.

## Decision

- The Ninth Circuit affirmed the disallowance of the partnership’s depreciation and interest deductions.
- The court agreed the transaction did not produce a depreciable basis or deductible interest because the purported debt and ownership attributes lacked substantive economic reality.
- Although the Tax Court described the deal as an option exercisable in the future, the Ninth Circuit affirmed on the ground that the inflated nonrecourse obligation did not create a real investment or true indebtedness for the claimed deductions.

## Legal Principles

- For depreciation, a taxpayer must have a capital investment and an ownership-like interest bearing meaningful benefits and burdens; labels in transactional documents do not control over economic substance.
- A nonrecourse obligation that substantially exceeds the fair market value of the collateral may be disregarded, to that extent, in determining depreciable basis because the buyer lacks a realistic incentive to pay the inflated amount.
- Interest is deductible only on genuine indebtedness; “interest” payments tied to a nonrecourse obligation lacking substantive economic reality are not deductible under I.R.C. § 163.
- Sale-leaseback and circular-payment structures are evaluated for actual economic risk and investment; minimal net cash at risk and retention of operational control by the seller support denial of depreciation and interest deductions.

## Conclusion

The court sustained the Commissioner’s denial of depreciation and interest deductions because the partnership’s inflated nonrecourse “purchase” obligation did not reflect a real economic investment or genuine debt, so it did not create a depreciable basis or deductible interest for federal income tax purposes.


Estate of Franklin v. Comm’r, 544 F.2d 1045 (9th Cir. 1976)