T.C. Memo. 2006-176

UNITED STATES TAX COURT

THOMAS R. JONES, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 14608-04. Filed August 22, 2006.

Thomas R. Jones, pro se.

Susan S. Hu and Edwin A. Herrera, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

SWIFT, Judge: Respondent determined a deficiency in

petitioner’s 2000 Federal income tax and additions to tax as

follows: 

 Additions to Tax 

Deficiency Sec. 6651(a)(1) Sec. 6654(a)

 $2,726 $682 $146
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Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

The issues for decision are whether petitioner may deduct as

mortgage interest and real property taxes amounts petitioner paid

under a real property lease-option agreement and whether

petitioner is liable for additions to tax under sections

6651(a)(1) and 6654(a).

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

At the time the petition was filed, petitioner resided in

Highland, California. 

Prior to 2000, petitioner was employed by Union Pacific

Railroad. 

In February of 1995, petitioner moved to a house in

Highland, California (the property), renting the property under a

written rental agreement from Robert Peterson (Peterson) for $850

per month. Petitioner’s first check to Peterson, written on

February 14, 1995, was for $2,100 and included rent for the first

and last unspecified month of the rental period and a $400

security deposit. 

In mid-August of 1996, petitioner and Peterson modified

their rental agreement with respect to the property, converting
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the agreement to a lease-option agreement (the agreement). It is

not clear whether the agreement was formalized in a written

document, and many of its terms are not clear. 

Under the agreement, petitioner was to pay Peterson $5,000

for an option to purchase the property at any time prior to

August of 2002. Also under the agreement, petitioner’s monthly

rental payments increased from $850 to $1,051 per month. The

$1,051 was equivalent to the amount Peterson paid to his mortgage

lender each month on the mortgage on the property. In written

correspondence to petitioner, Peterson informed petitioner that

“about $990 [of the $1,051] is the deductible interest,” but

Peterson did not specify by whom he intended the interest to be

deductible. 

Under the agreement, it was understood that petitioner was

to pay the real property taxes on the property, and Peterson

apparently told petitioner that for Federal income tax purposes

petitioner could deduct the property taxes. 

Peterson agreed to continue to pay fire insurance on the

property for at least 1 additional year in exchange for

petitioner’s agreeing to repair the roof. 

According to the agreement, to exercise the purchase option

any time before August of 2002, petitioner was to pay Peterson a

second $5,000 and to pay off the outstanding balance of the
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mortgage on the property, which balance was $106,000 at the time

the agreement was entered into. 

In September of 1996, petitioner paid Peterson the $5,000

for the option to purchase the property. Beginning in September

of 1996 and continuing through 2000, petitioner also paid

Peterson $1,051 per month.

In a December 2, 1998, letter to petitioner, Peterson

referred to the property as “my property” and acknowledged that

he, Peterson, was still using the property as his address for the

purpose of receiving mail. Peterson consistently referred to the

agreement as an “option” agreement, and in September of 2001

Peterson wrote a letter to petitioner in which Peterson made it

clear that he understood that petitioner was not yet bound under

the agreement to purchase the property. 

In 1999, Peterson considered refinancing the mortgage on the

property and so informed petitioner, telling petitioner that this

would “actually [result] in a savings to * * * [petitioner]

during * * * [the] option period.” Petitioner apparently wanted

to participate in the refinancing of the property. Petitioner,

however, did not respond when Peterson mailed to petitioner bank

disclosure documents, and the refinancing of the mortgage on the

property was never completed. 

In connection with his efforts to refinance, Peterson

queried petitioner about the condition of the property and
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informed petitioner that petitioner was responsible for repairing

damage to the garage door, replacing a wooden barrier that

blocked access to a building on the property, and removing

clutter from the yard. Throughout the term of the agreement,

petitioner complied with these and other maintenance requests

from Peterson. 

From 1996 through 2000, petitioner continued to live on the

property, repaired the roof of the property, and paid real

property taxes on the property, including $806 in 2000. The real

property taxes were assessed to Peterson, and Peterson apparently

paid the fire insurance relating to the property. 

In 1999, petitioner was diagnosed with an illness which

involved mental distress, and through 2000 petitioner did not

work. 

On petitioner’s 1999 individual Federal income tax return,

prepared by a tax return preparer, petitioner reported zero tax

liability. 

In 2000, petitioner received $19,500 in Social Security

benefits from the Railroad Retirement Board (RRB) and $22,324 in

disability payments from Union Central Life Insurance (UCLI)

relating to his mental distress. 

For 2000, RRB submitted to respondent a Form 1099-R,

Distributions From Pensions, Annuities, Retirement or ProfitSharing Plans, etc., with regard to the $19,500 paid to
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petitioner, but it is not clear whether petitioner received a

copy of this Form 1099. 

Also for 2000, UCLI submitted to respondent a Wage and Tax

Statement, Form W-2, Wage and Tax Statement, with regard to the

$22,230 paid to petitioner, and petitioner received a copy of

this W-2. 

Without consulting a tax professional and apparently under

the impression that the disability benefits he received in 2000

did not constitute taxable income, petitioner did not file a

Federal income tax return for 2000. 

On his 2000 individual Federal income tax return, Peterson

claimed an interest deduction in the amount of the total monthly

mortgage payments that were made on the property in 2000. 

In May of 2002, petitioner obtained a $100,000 mortgage on

the property, and Peterson’s mortgage was paid off. Petitioner

exercised the option to purchase the property and paid Peterson

the required $5,000 exercise price. The legal title to the

property was then transferred from Peterson to petitioner. 

Upon audit, respondent determined that petitioner’s 1999

Federal income tax liability was $13,236. Petitioner remitted

this amount to respondent plus penalties and interest. 

At respondent’s request, on October 9, 2002, petitioner

filed his 2000 individual Federal income tax return, upon which

he reported zero taxable income.
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On May 3, 2004, respondent mailed to petitioner a notice of

deficiency in the amount of $2,726 with regard to petitioner’s

2000 Federal income tax return in which respondent determined

that $3,127 of the $19,500 petitioner received from RRB and the

$22,230 received from UCLI constituted taxable income to

petitioner. Respondent also determined that petitioner was

liable for a section 6651(a)(1) failure to file addition to tax

and a section 6654(a) addition to tax for failure to make

estimated tax payments.

For 2000, petitioner does not dispute the income adjustments

relating to the funds received from RRB and UCLI. Petitioner,

however, argues that he should be able to deduct as mortgage

interest and as real property taxes a portion of the payments he

made in 2000 relating to the property. 

OPINION

Interest and Property Tax Payments

Under section 163, interest paid on a mortgage relating to a

qualified residence generally is deductible. Sec. 163(h)(2) and

(3). For the mortgage interest to be deductible by a particular

taxpayer, the mortgage must be the obligation of the taxpayer

claiming the deduction, not the obligation of another. Golder v.

Commissioner, 604 F.2d 34, 35 (9th Cir. 1979), affg. T.C. Memo.

1976-150. However, under section 1.163-1(b), Income Tax Regs.,

even though property may not be in a taxpayer’s name, as long as
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the taxpayer is the legal or equitable owner thereof and is at

least indirectly liable on the mortgage, the taxpayer may deduct

mortgage interest he or she pays relating to the property. 

Under section 164, real property taxes paid by a taxpayer

may be deductible by the person upon whom the taxes are imposed. 

Sec. 1.164-1(a), Income Tax Regs.; see Magruder v. Supplee, 316

U.S. 394, 396 (1942). The equitable or beneficial owner of real

property who pays taxes assessed against the property to protect

his or her interest therein may deduct the taxes he or she paid

even though legal title to the property may be held by another

person. Estate of Movius v. Commissioner, 22 T.C. 391, 394

(1954).

Generally, taxpayers bear the burden of proving that they

are entitled to deductions claimed. See Rule 142(a); New

Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Hradesky

v. Commissioner, 65 T.C. 87, 90 (1975), affd. per curiam 540 F.2d

821 (5th Cir. 1976). 

For Federal income tax purposes, a sale occurs upon the

earlier of transfer of legal title or the practical assumption of

the benefits and burdens of ownership. Keith v. Commissioner,

115 T.C. 605, 611 (2000); Baird v. Commissioner, 68 T.C. 115, 124

(1977). In deciding whether transfer of either legal title or

the benefits and burdens has occurred, we look to State law. 

Keith v. Commissioner, supra at 611. 
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In the instant case, the August 1996 agreement between

petitioner and Peterson was not accompanied by a transfer of

legal title, so we must decide whether the agreement included

terms that were sufficient to transfer to petitioner the benefits

and burdens of ownership of the property. 

As we observed in Keith v. Commissioner, supra, factors

frequently cited by this and other courts as indicative of the

benefits and burdens of property ownership include: 

A right to possession; an obligation to pay taxes,

assessments, and charges against the property; a

responsibility for insuring the property; a duty to

maintain the property; a right to improve the property

without the seller’s consent; a bearing of the risk of

loss; and a right to obtain legal title at any time by

paying the balance of the full purchase price. [Id. at

611-612.] 

The key question before us is whether the agreement between

petitioner and Peterson constituted a mere option or an actual

purchase of the property by petitioner. If the agreement

constituted a mere option and not a purchase, then under

California law the agreement would vest in petitioner no

ownership interest in the property. See Staudigl v. Harper, 173

P.2d 343, 347 (Cal. Dist. Ct. App. 1946). 

The test of whether the agreement constituted an option or a

purchase by petitioner is whether petitioner was obligated to

purchase the property. See Allen v. Smith, 114 Cal. Rptr. 2d

898, 905 (Ct. App. 2002) (written contract treated as purchase
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and sale, not as an option, where buyer was obligated to proceed

with the purchase after inspection contingency was satisfied);

Welk v. Fainbarg, 63 Cal. Rptr. 127, 132-133 (Ct. App. 1967) 

In the instant case, the bulk of the evidence establishes

that Peterson had no legal authority to require specific

performance by petitioner. Petitioner was not obligated to

exercise the option or otherwise liable to pay the purchase price

to Peterson if petitioner decided not to exercise the option. In

the communications between petitioner and Peterson, Peterson

referred to the exercise of the option contract as something

petitioner could exercise or not as he chose. The communications

between petitioner and Peterson referred to Peterson as the

owner. 

Although we conclude that the agreement constituted only an

option and not a purchase or sale of the property itself, we

consider petitioner’s claim that he held an equitable ownership

interest in the property.

 Petitioner argues that under California law he should be

considered to beneficially own the property. However, under

California law beneficial ownership contrary to legal title may

be established only by clear and convincing proof. Cal. Evid.

Code sec. 662 (West 1995); see Pac. Sw. Realty Co. v. County of

Los Angeles, 820 P.2d 1046, 1052 (Cal. 1991). 
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Beneficial ownership has been characterized as when “the

buyer has the possession and use of the property to the complete

exclusion of the seller, subject only to the seller’s remedies in

case of default.” County of San Diego v. Davis, 33 P.2d 827, 828

(Cal. 1934). 

Petitioner argues that under the terms of the agreement,

beginning in September of 1996 petitioner acquired equitable

ownership of the property. Petitioner points out that he

possessed the property, that after entering into the agreement he

began making larger payments to Peterson, and that he paid $5,000

to Peterson as well as property taxes on the property. 

We agree with respondent that the evidence does not

establish that during 2000 petitioner was the equitable owner of

the property. 

Various benefits and burdens were retained by Peterson. 

Peterson continued to pay insurance on the property and to pay

other liabilities as owner of the property. Peterson made

decisions relating to improvements on the property.

We are sympathetic to petitioner, as the agreement did

convey to petitioner some benefits and burdens of ownership. 

However, given the facts before us, California courts would

construe the agreement at issue as an option contract, not as a

purchase and sale contract. 
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Petitioner has not met his burden of proving either that

petitioner and Peterson in fact had an agreement for the purchase

and sale of the property (as opposed to an option agreement) or

that in 2000 petitioner had acquired sufficient benefits and

burdens relating to the property to be deemed the equitable owner

of the property.

For 2000, petitioner is not entitled to deduct as mortgage

interest or as real property taxes the payments he made on the

property. 

Additions to Tax

Under section 7491(c), the Commissioner has the burden of

production with respect to additions to tax. Once the

Commissioner meets that burden, the burden of proof shifts back

to the taxpayer with regard to additions to tax. Rule 142(a);

Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Respondent has

established petitioner’s tax liability and therefore has

satisfied his burden of production under section 7491(c). 

To defend against a section 6651 addition to tax for failure

timely to file a tax return, a taxpayer must establish both that

failure to timely file was not due to willful neglect and that it

was due to reasonable cause. United States v. Boyle, 469 U.S.

241, 245 (1985). 

Willful neglect means conscious, intentional failure or

reckless indifference. Id. A failure to file will be regarded
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as due to “reasonable cause” if the taxpayer exercised ordinary

business care and prudence and nevertheless was unable to file

his return by the due date. Crocker v. Commissioner, 92 T.C.

899, 913 (1989); sec. 301.6651-1(c)(1), Proced. & Admin. Regs.

In the absence of competent tax advice, a mistaken belief on

the part of a taxpayer that no tax return was required under the

statute generally will not support reasonable cause for not

filing a tax return. Shomaker v. Commissioner, 38 T.C. 192, 202

(1962); French v. Commissioner, T.C. Memo. 1991-196 (honest

belief that no tax was due does not constitute reasonable cause

where a taxpayer did not make good faith effort to ascertain

whether filing was necessary).

Where a taxpayer’s disability is raised as part of a

reasonable cause defense, we have looked to the severity of the

disability and the impact it had on the taxpayer’s life,

explaining that “significant psychiatric disorder and * * *

[mental incapacitation] during the period under consideration”,

Shaffer v. Commissioner, T.C. Memo. 1994-618, or confinement to

various hospitals for “severe mental illness,” Carnahan v.

Commissioner, T.C. Memo. 1994-163, affd. 70 F.3d 637 (D.C. Cir.

1995), may provide reasonable cause. But see Thomas v.

Commissioner, T.C. Memo. 2005-258 (taxpayer suffering from

bilateral tendinitis, carpal tunnel syndrome, and depression did
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not show reasonable cause when she was employed and running her

own business during the period in question). 

It is undisputed that petitioner herein failed to file a

2000 Federal income tax return within the prescribed deadline. 

Petitioner argues that he simply did not realize that disability

benefits were to be treated as taxable income. 

Especially, however, after receiving the UCLI W-2 form

showing the disability benefits as taxable, petitioner did not

seek the advice of a professional and did not exercise ordinary

care and prudence as to the taxability of the disability

payments. 

We conclude that neither petitioner’s lack of knowledge nor

his health problems constitute reasonable cause for his failure

to file his 2000 Federal income tax return. Petitioner is liable

for the section 6651(a)(1) addition to tax for failure to file a

return.

Section 6654(a) imposes an addition to tax on an

underpayment of estimated tax unless one of the statutory

exceptions applies. Niedringhaus v. Commissioner, 99 T.C. 202,

222 (1992). The enumerated exceptions provide that the addition

shall not be imposed: (1) If the tax is less than $1,000, or 

(2) where there was no tax liability for the preceding taxable

year. Sec. 6654(e)(1) and (2). For the latter purpose, we look

to the tax liability shown on the return for the previous year,
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rather than the tax liability ultimately assessed by the

Commissioner, even when income for the preceding year was

fraudulently understated on the return. Mendes v. Commissioner,

121 T.C. 308, 324 (2003). An invalid return, however, for the

previous year will not suffice for purposes of the safe harbor

under section 6654(e)(2). Mendes v. Commissioner, supra. 

If petitioner’s 1999 tax return is to be treated as a valid

tax return on which zero liability was reported, despite

respondent’s later deficiency assessment, petitioner might

qualify for the section 6654(e)(2) safe harbor for 2000. 

Because, however, the record herein does not include evidence as

to the validity of petitioner’s 1999 income tax return, this safe

harbor is not available to petitioner. 

Section 6654(e)(3)(B)(i) and (ii) also provides an exception

to this addition to tax where a taxpayer became disabled during

either the year the estimated tax payments were not made or the

preceding year, and where the tax underpayment is due to

reasonable cause and not due to willful neglect. See Thomas v.

Commissioner, T.C. Memo. 2005-258.

Petitioner was diagnosed with mental distress in 1999, the

year preceding the year in issue. Petitioner, however, has not

shown that his failure to pay estimated tax was due to reasonable

cause.
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For 2000, petitioner is liable for a section 6654 addition

to tax. 

To reflect the foregoing,

Decision will be entered

for respondent.