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Petitioners spent approximately 1 year looking for real
property to acquire in northern California. On July 25, 1979,
they purchased an 80-acre ranch in Pescadero (hereinafter
Pescadero property or ranch) for $275,876.80. An artificial
8-acre pond, which also served as a reservoir, was located on the
ranch. As part of a larger tract of land, the Pescadero property
had formerly been operated as a dairy farm. The ranch had two
residences and several large barns and equipment sheds. There
also was a granary that had been used as a cheese house.
When petitioners acquired the Pescadero property, they had
no prior experience as farmers. Petitioner husband, at the time
of trial, owned a subchapter S corporation, Energy Design
Engineering Corp. (Energy Design), which provided consulting
services to the electric utility industry. Energy Design was
intermittently profitable. Petitioner husband also was part
owner of Cogeneration Acquisition & Development Corp.
(Cogeneration), which furnished consulting services to the
development of cogeneration projects as well as electric power
projects in the United States. Cogeneration was regularly
profitable but eventually ceased business.
The Pescadero property was in a severely neglected condition
when petitioners purchased it. Over a period of several years,
petitioner husband made substantial improvements to at least one
of the residences, such as installing a heating system and
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