T.C. Memo. 1996-53

UNITED STATES TAX COURT

MAURICE E. HODGKINS AND BARBARA J. HODGKINS, Petitioners

v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 20551-93. Filed February 14, 1996.

Held: petitioners' rental losses redetermined; held,

further, gain from sale of real property redetermined; held,

further, petitioners are liable for additions to tax under

sec. 6653(a), I.R.C., for 1988, under sec. 6661, I.R.C., for

1988, and for an accuracy-related penalty under sec.

6662(a), I.R.C., for 1989.

Maurice E. Hodgkins and Barbara J. Hodgkins, pro se.

Daniel J. Parent, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION

NIMS, Judge: Respondent determined the following

deficiencies, additions to tax, and penalty in respect of

petitioners' Federal income taxes: 

 Additions to Tax Penalty 

Taxable Sec. Sec. Sec.

Year Deficiency 6653(a) 6661 6662(a) 

1988 $17,219.00 $860.95 $4,304.75 --

1989 2,152.00 -- -- $430.00

Unless otherwise indicated, all section references are to

sections of the Internal Revenue Code in effect for the years at

issue, and all Rule references are to Tax Court Rules of Practice

and Procedure. 

After concessions, the issues for decision are:

(1) How much are petitioners entitled to deduct as Schedule

E expenses for real property located at 7786 Chancery Court,

Citrus Heights, California, in 1988? 

(2) How much are petitioners entitled to deduct as Schedule

E expenses for real property located at 7933 Sawgrass Circle,

Citrus Heights, California, for 1988, and how much gain did

petitioners realize from its sale?

(3) Must petitioners increase their gain from the sale of

real property located at 9266 Madison Avenue, Orangevale,

California, by depreciation in the amount of $819 allowable in an

earlier year, but not taken in that year?
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(4) How much gain did petitioners realize from the sale of

real property located at 400 Crow Canyon Drive, Folsom,

California?

(5) Are petitioners liable for the addition to tax for

negligence under Section 6653(a)(1) for 1988?

(6) Are petitioners liable for the addition to tax for

substantial understatement of tax liability under section 6661

for 1988?

(7) Are petitioners liable for the accuracy-related penalty

under section 6662(a) because of negligence or substantial

understatement of income tax for 1989?

Some of the facts have been stipulated and are found

accordingly. The stipulation of facts and attached exhibits are

incorporated herein by this reference. Petitioners, Maurice E.

Hodgkins and Barbara J. Hodgkins, resided in Sacramento,

California, at the time they filed their petition. For

convenience we have divided this case by issues.

1. Chancery Court

FINDINGS OF FACT

While petitioners' names are on the marquee, the leading

role in this case was played by petitioner husband's brother,

John Hodgkins (John). They trusted John, and he directed them in

their financial affairs, told them which documents to sign, kept

their books, and supplied the figures for their tax returns. And
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when they were audited, John dealt with their examination. He

told them when to buy, sell, borrow against, and repair property. 

At John's direction, money went from petitioners to him and back

again from him to them. But petitioners understood none of this.

From May 1986 until February 1988, when John was convicted

for falsifying documents, he was licensed by California to sell

realty. He involved petitioners in his real estate deals. At

John's instigation, they purchased a house located at 7786

Chancery Court, Citrus Heights, California (Chancery Court) from

William Paxton on December 23, 1986. They paid $67,000 for the

house, and Mr. Paxton financed $17,000 of the cost. The record

does not disclose how petitioners financed or otherwise obtained

the remaining $50,000.

On February 19, 1987, petitioners borrowed $50,000 from the

Jack Rice Revocable Trust (Jack Rice), using a mortgage on

Chancery Court as security, which Jack Rice subsequently

recorded. The note secured by the mortgage contained an

acceleration clause under which, if petitioners were to sell,

convey, or otherwise alienate Chancery Court, the loan would

become immediately due and payable at the option of the holder. 

Despite this acceleration clause, John secured another loan using

Chancery Court as security, as described below. 
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In August of 1987, John decided to combine two parcels of

property and develop them as a 32-lot subdivision called

"Westlake". John had already acquired an option to buy one of

the parcels, but he needed capital to option the remaining parcel

and develop Westlake. He took Larry Hashigami (Larry), an

alleged drug king, as his first partner.

Larry agreed to fund 50 percent of Westlake. But, since

John's three previous deals had failed, and since John intended

to option both parcels in his own name, Larry demanded and got

Chancery Court as security. 

Pledging the house to Larry would have triggered the

acceleration clause in Jack Rice's mortgage. So John

orchestrated an hypothecation to keep Jack Rice unaware of John's

machinations. John bought the house from petitioners, got them

to execute a grant deed, and swore every one involved to silence. 

He gave the grant deed to Larry, but he made him promise not to

record it. The deed purportedly granted title to William S.

Hashigami, Larry's brother Sid, rather than to Larry himself. 

 John "purchased" Chancery Court from petitioners on August

25, 1987. The purchase was evidenced by a document entitled

"Exchange Agreement", which provided that "This agreement shall

be a complete and full satisfaction by virtue of the debt

satisfied for the equity and ownership of the property Chancery

Court." Petitioners agreed to deed Chancery Court to whomever
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John requested, whenever he requested it. In exchange, John

agreed to pay Jack Rice's mortgage and the past due property

taxes. He also forgave a $9,340 debt of petitioners. An

addendum to the Exchange Agreement, which is inconsistent with

the Exchange Agreement itself, provided that petitioners were to

continue indefinitely to be the vested owners, to collect the

rent, and to take the tax benefits of Chancery Court.

Although the addendum gave the rents to petitioners, John

had already promised the rents to Larry in the Westlake

Agreement. The agreement gave Larry possession of Chancery Court

as of September 1, 1987. As part of his duties, he was to

collect the rents and from them recoup his investment in

Westlake. Notwithstanding the addendum, which was fabricated by

John, petitioners had no interest in the rents after August 25,

1987. Petitioners reported no rent from Chancery Court on their

1988 income tax return. 

Not only was the "Exchange Agreement" a sale of Chancery

Court to John, but he also subsequently treated it as his own,

arranging for its title to be recorded under another's name as

collateral, and afterward, having that title holder deed it

directly back to him rather than to petitioners. This deeding

and redeeding took place as the Westlake deal evolved. 

After John arranged for Larry's security and successfully

evaded Jack Rice's acceleration clause, he took other partners
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into the deal. One of the new partners, John S. Foggy, deceived

John by purchasing the remaining unoptioned property. To fight

this deception, on December 15, 1988, John bought out Larry. 

Larry agreed to give up his interest in Westlake, and as

consideration John guaranteed Larry the return of his capital and

a $50,000 profit, a total of $61,000. John secured his guarantee

by deeding Chancery Court to Sid, Larry's brother. This time the

agreement did not prevent the recording of the deed, and Larry

recorded it on December 22, 1988. Larry promised to have Sid

redeed the property to John as soon as Larry received his money. 

The Westlake Agreement explains that Sid's name was used on

the Chancery Court deed because Larry was experiencing palimony

problems. But another possible reason for this action appeared

on January 31, 1991, when the State of California brought a

complaint for forfeiture in rem against Chancery Court. 

California alleged that Larry was a drug king and that Larry's

agents sold drugs at Chancery Court. The State further alleged

that Larry owned Chancery Court, as well as other property, and

that the owners of record were mere straw men. 

The titles to two properties, including Chancery Court, that

Larry allegedly owned listed Sid as the owner. Sid, however, did

not know why his name appeared on either one of the deeds, and he

officially disclaimed any right to Chancery Court on February 4,
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1991. John, meanwhile, asserted ownership. He asked Sid to

return the property to him.

At first Sid refused to deed the property back to John. 

Larry had not explained to Sid either the Westlake Agreement or

the buy-out arrangement, and furthermore Sid's attorney advised

him against deeding the property to John since both the I.R.S.

and the Sacramento Sheriff's Office were making inquiries. But

then John wrote Sid a letter on September 27, 1991, the pertinent

part of which provides:

Your Brother and I were involved in a 32 lot

subdivision. He was asked to sign a Recession Contract

eliminating him from the limited partnership. He

wanted some temporary collat[e]ral to guarantee his

purported, Westlake Venture capital and profit. He

agreed upon 7786 Chancery Court. However, because of

his "[e]stranged situation", with Patty Buchannon and

possible "palimony" problem, I refused to deed it to

him, so we agreed to deed it to you Sid. Sid, it's

time to deed it back." * * *

The letter further explains that John had made the mortgage

payments for 5 years. Shortly thereafter, on October 17, 1991,

Sid deeded the property to John. John's efforts, however, proved

futile. Jack Rice foreclosed on Chancery Court and sold it for

$78,000 on November 21, 1991. 

John's desire to avoid the acceleration clause in the Jack

Rice mortgage produced evidence that petitioners continued to be

owners of Chancery Court after they executed the Exchange

Agreement. Jack Rice issued a Form 1098 listing petitioner
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husband as the payor of mortgage interest. Petitioners

correspondingly deducted this interest on their tax return. The

fire insurance policy for Chancery Court lists petitioners, along

with Jack Rice, as the insureds. Under petitioners' names a

further $5,000 was borrowed from Jack Rice against the property

before the deed listing Sid as the owner was recorded. 

On the other hand, when Jack Rice was not involved,

petitioners failed to treat themselves as the owners of Chancery

Court. For example, petitioners filed for bankruptcy, the timing

of which coincided with the recording of the deed naming Sid as

the nominal owner of Chancery Court. Petitioners failed to list

Chancery Court or the encumbering mortgage on their bankruptcy

petition. They also failed to list Chancery Court under property

transferred within the past year.

OPINION

Respondent determined that petitioners did not own Chancery

Court during 1988, that they did not use it for the production of

income in that year, and that they did not pay any related

expenses. Respondent therefore disallowed petitioners' claimed

$14,904 loss from Chancery Court in 1988. This disallowance

consisted of $11,369 in mortgage interest and $3,535 in

depreciation. 

We do not believe petitioners paid the mortgage. There is

no reliable evidence that petitioners paid it, and most of the
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evidence indicates that John paid it. He was contractually

obligated to do so and, furthermore, he states that he paid the

mortgage interest in his letter to Sid asking for the return of

the property. Consequently, petitioners are not entitled to

deduct $11,369 of mortgage interest on their 1988 return. 

A taxpayer with bare legal title to property, but no capital

investment or economic interest in it, cannot claim depreciation. 

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

affg. 64 T.C. 752 (1975); Helvering v. F&R Lazarus & Co., 308

U.S. 252 (1939). The taxpayer entitled to the depreciation

deduction is the one who suffers the economic loss of his

investment by virtue of the wear and tear or exhaustion of the

property--the one who has the economic benefits and burdens of

ownership. Frank Lyon Co. v. United States, 435 U.S. 561 (1978);

Leahy v. Commissioner, 87 T.C. 56 (1986).

The Exchange Agreement between petitioners and John

transferred the benefits and burdens of ownership to John. 

Petitioners received the full fair market value for the property

from John. He agreed to pay back taxes, forgave a $9,340 debt

that petitioners owed him, and assumed the mortgage. True,

petitioners remained liable on the Jack Rice mortgage, but John

promised them that he would repay it. Only if John failed would

petitioners be forced to pay. Hence, petitioners' position

became tantamount to that of a guarantor rather than primary
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obligor. The risk of a decline in value rested on John, not

petitioners. 

The rewards of ownership were also transferred to John by

the Exchange Agreement. Any increase in value thereafter was

his. Even though petitioners did not transfer legal title to

John when they signed the Exchange Agreement, they agreed to

transfer title at John's request.

The parties also behaved as if John owned the property after

the Exchange Agreement. John used the property as collateral on

one of his personal obligations and assigned the rents to

guarantee repayment of this loan. Moreover, when ownership of

the property became confused, he fought for and got title

transferred back into his name rather than into petitioners'.

We agree with respondent that petitioners are not entitled

to deduct depreciation from Chancery Court for 1988. All the

credible evidence indicates that petitioners transferred the

benefits and burdens of ownership to John on August 25, 1987,

when they signed the Exchange Agreement.

2. Sawgrass

 John also involved petitioners in the purchase and resale

of 7933 Sawgrass Circle, Citrus Heights, California (Sawgrass). 

Petitioners purchased the house from Sharon Benvenuti, obtaining

a grant deed from her on March 28, 1988, but not recording it

until August 16, 1988. The house stood empty during petitioners'
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ownership. On September 2, 1988, a few weeks after petitioners

recorded their deed, they sold the house to Inderjit and Bharati

Dutt. 

The gain that petitioners showed on their return and the

gain that respondent determined are as follows:

Per Return Per Exam Adjustment

Sales price $127,500 $127,500 $-0-

Purchase price, (119,560) (114,905) 4,655

 improvements, and

 expenses of resale 

Gain 7,940 12,595 4,655

The parties' post-determination maneuvering adds complexity

to their disagreement. They stipulate or claim that some of what

was capitalized should now be deducted and some of what was

deducted should now be capitalized. First, the parties 

stipulated that $1,837 previously capitalized should be deducted

as an investment interest expense. Second, petitioners assert

that $9,851 previously deducted as a rental loss should now be

capitalized. In 1988 petitioners deducted a $9,851 rental loss,

which respondent disallowed on the grounds that the property was

unproductive, and for lack of substantiation. Petitioners now

concede that they did not use the property to produce income and

that therefore they should not have taken the rental loss in

1988. They now insist, however, that the expenditures entitle

them to adjust their basis upwards.
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Petitioners have failed to prove that their gain on Sawgrass

was less than respondent determined. They offered as evidence a

document entitled "Sellers Instructions", marked "Estimated". 

They also submitted a handwritten itemized summary of their

calculation of gain, but did not substantiate most of the items

listed. The items that they did substantiate--a $6,663 payment

to make the mortgage current, $93,948 to repay the mortgage, and

$7,957 to pay the cost of selling--do not exceed respondent's

calculation. As for the expenses previously deducted as a rental

loss, nothing in evidence substantiates them. Petitioners have

the burden of proof, Rule 142(a), and they have failed to carry

it.

3. Madison Avenue

FINDINGS OF FACT

In 1987 petitioners purchased property located at 9266

Madison Avenue, Orangevale, California (Madison Avenue). John

maintained an office there. During 1988, petitioners incurred a

rental loss on the property and sold it in June of that year. 

Respondent's Notice of Deficiency disagreed with both the claimed

rental loss and the amount of gain shown on petitioners' return. 

After concessions, the only disputed issue is a $819 depreciation

deduction.
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Madison Avenue generated the deduction in 1987 and

petitioners could have taken it then. But, according to

petitioners, they "goof[ed] up" and failed to deduct it. 

Respondent reduced the basis of Madison Avenue by $819, thereby

increasing petitioners' gain.

OPINION

Section 1016(a)(2) provides that an adjustment to basis

shall in all cases be made for exhaustion, wear and tear,

obsolescence, amortization, and depletion, to the extent of the

amount allowed, but not less than the amount allowable. 

Petitioners cannot defer the deduction putatively allowable in

1987 to the current year. Virginian Hotel Corp. v. Helvering,

319 U.S. 523 (1943). And they cannot include the previously

allowable depreciation deduction in their basis because they

failed to take the deduction in a prior year. United States v.

Ludey, 274 U.S. 295 (1927); Collins v. Commissioner, 18 T.C. 99

(1952), affd. 203 F.2d 565 (6th Cir. 1953); sec. 1.1016-

3(a)(1)(ii), Income Tax Regs. Therefore, petitioners' basis is

reduced by the $819 depreciation deduction that they could have

taken in 1987.
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4. Crow Canyon

Petitioners took out a $155,000 mortgage to purchase 400

Crow Canyon Drive, Folsom, California, (Crow Canyon) from

Fireman's Fund Insurance Company (Fireman's Fund) on December 18,

1986. Petitioners also made a $5,000 cash deposit in escrow. Of

the total $160,000 available by reason of the purchase money

mortgage and the cash in escrow, $139,000 was applied to the

purchase price of the property, and the balance to closing costs. 

On January 6, 1988, the mortgagee foreclosed. On disposition of

Crow Canyon, petitioners received forgiveness of their $155,000

mortgage indebtedness.

Petitioners reported a net loss of $23,000 on the

disposition of Crow Canyon. Respondent, however, determined an

$18,826 gain. Respondent disallowed the following amounts, which

petitioners claim as part of their basis: 

Item Amount

1986-1987 property taxes $964

Commission 23,000

Lost escrow deposit 5,000

Improvements 9,191

Interest paid in escrow 3,670

Total adjustment 41,825
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a. 1986-1987 Property Taxes

The parties now concur that petitioners' basis in Crow

Canyon includes the property taxes that accrued prior to their

ownership. 

b. Commission

Petitioners claim that they paid a $23,000 commission to

John when they bought Crow Canyon. This commission was not

substantiated.

The purchase agreement provided:

Buyer and Seller acknowledge, understand and agree that

neither Buyer nor Seller are obligated for any

commission whatsoever in connection with the sale of

the Property, including Joe Mefford Realty. 

The so-called commission of $23,000 is 16.55 percent of the

$139,000 purchase price. Furthermore, this commission was

payable, if at all, to John. While an unusually large commission

paid to a relative might, in some situations, be justifiable, the

facts in this case do not support such a conclusion.

Petitioners offer as proof only self-serving documents

prepared by John. There is no reliable evidence that petitioners

actually incurred the cost of the commission. They claim that
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they forgave a $23,000 debt, which John owed them, but presented

no trustworthy evidence of this indebtedness. We do not believe

that petitioners paid the commission, and we therefore disallow

the inclusion of this amount in petitioners' Crow Canyon basis.

c. Lost Escrow Deposit

While respondent included in the basis of Crow Canyon $5,000

of earnest money, which was deposited in escrow and then used to

purchase the property on December 18, 1986, petitioners assert

that they are entitled to an additional $5,000. Petitioners

contend that they fumbled an earlier attempt to purchase Crow

Canyon and, consequently, on that deal they lost their $5,000 of

earnest money, also held in escrow. They now seek to add this

allegedly lost escrow deposit to their basis in Crow Canyon.

While we believe that petitioners previously deposited

$5,000 into escrow and that this deposit was earnest money for an

earlier agreement, we are unpersuaded that petitioners lost the

money. There is no document in evidence that describes the final

disposition of the escrow account. The documents submitted

merely evidence an ongoing negotiation--signed by one party or
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the other, but never by both. Petitioners failed to prove that

they lost their deposit. 

d. Improvements

Respondent disallowed $9,191 of improvements that

petitioners had included in basis. Respondent determined that

the improvements were either unsubstantiated or previously

deducted as repairs. Crow Canyon needed work when petitioners

purchased it. They deducted $2,739 for repairs in 1986 and

$5,500 in 1987. Petitioners also included in basis an additional

$9,191 as improvements. Petitioners' sole substantiation for

these repairs and improvements was a few receipts from 1986

totaling $1,763.31. Petitioners failed to distinguish these

items from those amounts already deducted as repairs. We

therefore deny petitioners' increase in basis for improvements.

e. Interest Paid in Escrow

Respondent also determined that the first mortgage interest

payment of $3,670 did not belong in the basis of Crow Canyon. 

Petitioners concede that they deducted $612 of the interest

payment in 1986 and are therefore not entitled to include that

amount in basis. The lender also charged petitioners a $50 fee
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for obtaining a credit report. Petitioners failed to argue their

entitlement to this amount. We therefore deem it conceded; 

$3,008 remains in dispute.

According to the Firemen's Fund Mortgage note, the first

mortgage payment was for interest only and was payable in

advance. It was withheld from the loan proceeds at the close of

escrow. The payment covered the period from December 3, 1986, to

February 1, 1987. This period began 15 days before petitioners

purchased Crow Canyon. They claim that this prior-to-ownership

interest was a loan fee, part of the lender's consideration, and

that they therefore are entitled to include it in basis.

Interest is any amount paid for the use, forbearance, or

detention of money. Old Colony R. Co. v. Commissioner, 284 U.S.

552 (1932). Interest, subject to numerous rules, is usually

deductible rather than capitalized. Petitioners have cited no

section of the Code that would entitle them to capitalize this

preownership interest, and we know of none.

As for the part of the first mortgage payment relating to

the postacquisition period, petitioners claim that the property

was under repair and unproductive. They therefore also
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capitalized this part of the interest payment. Because

petitioners acquired Crow Canyon on December 18, 1986, and the

first payment covered the period ending on February 1, 1987, the

interest capitalization rules for both 1986 and 1987 apply.

Under section 266, section 263A(f), and section 189

(repealed for years after December 31, 1986), mortgage interest

on improved real property is only capitalized during a period of

construction or further improvement. Sec. 189(e)(2)(A) (repealed

for years after December 31, 1986); sec. 1.266-1(b)(ii), Income

Tax Regs.; sec. 1.263A-8(d)(3), Income Tax Regs. Petitioners

failed to prove that Crow Canyon underwent a period of

improvement. As already explained, petitioners substantiated

only $1,763.31 of repairs on Crow Canyon. Because we do not

believe there was a period of improvement petitioners are not

entitled to increase their basis by the amount of interest paid.

5. Additions to Tax and Penalties

Respondent determined additions to tax for negligence under

section 6653(a)(1) for 1988 and an accuracy-related penalty under

section 6662 for 1989. Section 6662(a) imposes a 20-percent

accuracy-related penalty to any portion of an underpayment of tax
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required to be shown on a return if, as provided in section

6662(b), the underpayment is attributable, among other things, to

negligence or disregard of rules or regulations, or any

substantial understatement of income tax. Section 6662(c)

includes in the definition of "negligence" any failure to make a

reasonable attempt to comply with the Internal Revenue title, and

defines "disregard" as including "careless, reckless, or

intentional disregard". We need not extend this opinion by

rehashing the many instances in each of the years in issue in

which petitioner carelessly, recklessly, or intentionally claimed

erroneous deductions or additions to basis. They either knew or

should have known of these errors. We therefore sustain

respondent's determination.
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Respondent also determined an addition to tax for

substantial understatement of tax liability under section 6661

for 1988. Petitioners have not shown that any of the exceptions

contained in section 6661(b) apply. The amount of any addition

to tax pursuant to section 6661 will be computed under Rule 155. 

Petitioners have the burden of proof on the additions to tax

and penalty issues, which they have failed to carry. Bixby v.

Commissioner, 58 T.C. 757 (1972); see Grzegorzewski v.

Commissioner, T.C. Memo. 1995-49. Respondent's determinations of

the additions to tax and penalty issues are therefore sustained.

To reflect the above,

Decision will be entered

under Rule 155.