Valuing Interests in a Sham Real Estate Partnership

highriseAuthor: Staff

In a recent California appellate decision titled Ito v. Ito, the appellate court considered how to value two brothers’ respective interests in real estate they’d bought and sold. One of the brothers, a programmer, had gone into business with the other, a real estate investor, and then they fell out. The programmer sued the investor to wind things up. Ultimately, the real-estate investor appealed.

The main issues in the lawsuit were how to value each brother’s interest in real estate they’d bought and sold and how to treat their interests in a corporation they’d formed to make arrangements. The programmer testified that when they formed the corporation, he was making more than $300,000 a year as an independent contractor. His brother had no money, and the programmer agreed to do his business through a corporation and give his brother a 50% share of the business to take advantage of the brother’s tax losses. The brother got a salary under an employment contract with the corporation, but according to the programmer, he didn’t do anything for the corporation. In 2002, the brother forfeited his share of the business.

At trial, the court labeled the corporation an illegal scheme by the programmer to avoid paying income taxes and decided the brother had no interest from the beginning. The brothers had jointly bought about 39 properties and continued to own six of them through partnerships and limited liability companies at the time of trial. The investor argued that their interests should be determined by their capital accounts in the property, with the amount of the accounts fluctuating based on their contributions. He argued that the programmer’s capital accounts for the properties were zero because whatever he’d put in, he got back in the form of payments he’d received from the investor.

Among other things, the programmer countered his brother by providing expert testimony that the approach he used was one typically used in real estate partnerships, in which the partners split the capital accounts 50-50. The expert said that it was problematic to have an agreement in which the profit percentage changed each time a partner spent money on behalf of the partnership.

The court didn’t agree with the fluctuating capital accounts claim put forward by the investor because it ignored the written agreements that stated the brothers would be partners 50/50. A referee was then appointed to determine the balance of each brother’s capital account in different real estate and the amount of cash advance available as a loan without interest. The referee traced payments and found that the investor paid $288,960.67 more than the programmer toward the six properties, but the payments were from the corporation, so they were treated as loans from the programmer.

The report noted that the programmer reduced his taxes and reduced his brother’s taxes by having him report income that should have been taxable to him. The report suggested the $159,000 by which the programmer reduced his taxes should be treated as an offset to his total investment in all of the properties.

The real estate investor objected. The court dissolved the real estate partnership, and the referee was directed to liquidate partnership property or propose a division. The court determined that there was enough evidence that the properties had been structured to allocate profits and losses on a 50-50 basis.

On appeal, the investor made several arguments. Among other things, he argued that the court abused its discretion in determining the parties’ interests in the property and corporation. The appellate court explained the factual determinations were supported by substantial evidence. The programmer had testified that he lent the investor money to fund his capital contribution to the corporation and that the investor hadn’t performed services for the company, which was just a way to avoid taxes.

The investor argued that the court incorrectly found that certain properties were not effectively conveyed to the brothers’ parents. The appellate court explained that there was enough evidence to show that the parents received grant deeds to the properties and then gifted them back to the investor. Each property was in the investor’s name, but they were treated as partnership properties. The partnership owned all three properties, so each brother was owed half of the net proceeds.

The appellate court affirmed the judgment.

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