Court Opinion

ID: 4334665
Source: CourtListenerOpinion
Date Created: 2018-11-14 01:47:21.424642+00
Date Added: 2024-06-11T14:47:55.172818
License: Public Domain

121 T.C. No. 15

                UNITED STATES TAX COURT

FEDERAL HOME LOAN MORTGAGE CORPORATION, Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 3941-99, 15626-99.     Filed October 30, 2003.

     P was originally exempt from Federal income
taxation. However, on Jan. 1, 1985, P became subject
to taxation under the Deficit Reduction Act of 1984
(DEFRA), Pub. L. 98-369, sec. 177, 98 Stat. 709. P
adopted the accrual method of accounting for its first
taxable year commencing Jan. 1, 1985.   Before that
date, P acquired certain mortgages that were in
default. Interest accrued on each of those mortgages
from the date of acquisition up to Jan. 1, 1985. At
various points after Jan. 1, 1985, P foreclosed the
mortgages on the underlying real estate. In computing
its gain or loss from the foreclosures, P increased its
regular adjusted cost basis in the mortgages for unpaid
interest that had accrued before Jan. 1, 1985. R
argues that P is not entitled to increase its regular
adjusted cost basis on account of interest which
accrued before Jan. 1, 1985.

     Held: Sec. 166(a), I.R.C., provides a deduction
for bad debts. Sec. 1.166-6(a)(2), Income Tax Regs.,
provides: “Accrued interest may be included as part of
                               - 2 -

     the deduction allowable under this paragraph, but only
     if it has previously been returned as income.” P’s
     accrued interest, which was accrued when P was tax
     exempt and not required to file income tax returns, was
     not “returned as income” within the meaning of sec.
     1.166-6(a)(2), Income Tax Regs., and P is not entitled
     to increase its regular adjusted cost basis for these
     amounts.

     Robert A. Rudnick, Stephen J. Marzen, James F. Warren, and

Neil H. Koslowe, for petitioner.

     Gary D. Kallevang, for respondent.

                              OPINION

     RUWE, Judge:   Respondent determined deficiencies in

petitioner’s Federal income taxes in docket No. 3941-99 for 1985

and 1986, as follows:

          Year                             Deficiency

          1985                            $36,623,695
          1986                             40,111,127

Petitioner claims overpayments of $9,604,085 for 1985 and

$12,418,469 for 1986.

     Respondent determined deficiencies in petitioner’s Federal

income taxes in docket No. 15626-99 for 1987, 1988, 1989, and

1990, as follows:
                               - 3 -

          Year                            Deficiency

          1987                           $26,200,358
          1988                            13,827,654
          1989                             6,225,404
          1990                            23,466,338

Petitioner claims overpayments of $57,775,538 for 1987,

$28,434,990 for 1988, $32,577,346 for 1989, and $19,504,333 for

1990.

     Petitioner and respondent filed cross-motions for partial

summary judgment under Rule 1211 on the issue of whether, for

purposes of claiming a bad debt deduction under section 166,

petitioner is entitled to increase its regular adjusted cost

basis in certain mortgages acquired before January 1, 1985, for

unpaid interest which accrued during the period that petitioner

was tax exempt.

                            Background

     The facts have been stipulated and are so found.   The

stipulation of facts and the attached exhibits are incorporated

herein by this reference.   At the time of filing the petition,

petitioner’s principal office was located in McLean, Virginia.

At all relevant times, petitioner was a corporation managed by a

board of directors.

     1
      All Rule references are to the Tax Court Rules of Practice
and Procedure, and all section references are to the Internal
Revenue Code in effect for the taxable years in issue.
                               - 4 -

     Petitioner was chartered by Congress on July 24, 1970, by

the Emergency Home Financing Act of 1970, Pub. L. 91-351, title

III (Federal Home Loan Mortgage Corporation Act), 84 Stat. 450.

Petitioner was originally exempt from Federal income taxation.

However, Congress repealed petitioner’s Federal income tax

exemption status in the Deficit Reduction Act of 1984 (DEFRA),

Pub. L. 98-369, sec. 177, 98 Stat. 709.   Pursuant to this act,

petitioner became subject to Federal income taxation, effective

January 1, 1985.

     Petitioner held mortgages in its retained mortgage portfolio

or as collateral for issuances of collateralized mortgage

obligations (CMOs).   In other cases, petitioner, as guarantor of

participation certificates (PCs)2 it issued, would reacquire

mortgages placed in a PC pool that became delinquent.3

Petitioner routinely acquired real estate by foreclosure when

mortgages that it owned became delinquent.   In some cases,

mortgages that petitioner held, and had never sold, became

delinquent.

     In a number of cases, the ownership of mortgages, which were

in default, was transferred to petitioner before January 1, 1985.

     2
      PCs are securities representing beneficial ownership of the
principal and interest payments on a pool of mortgages.
     3
      Regardless of the manner in which petitioner acquired the
delinquent mortgages, all real estate that petitioner acquired
through foreclosure of delinquent mortgages is known as “real
estate owned”.
                                - 5 -

At various points in the taxable years 1985 and 1986, petitioner

foreclosed on these mortgages and obtained freehold title to the

underlying real estate.    Petitioner was required to demonstrate

its gain or loss on the foreclosures.

     For the taxable years 1985 through 1990, petitioner

consistently accrued into income stated interest on all single-

family mortgages that it owned, whether or not that interest was

received.   If such a mortgage was or became delinquent,

petitioner nonetheless continued to accrue the interest through

the date of foreclosure.   Petitioner accrued into income interest

from the date of acquisition through the date of foreclosure in

respect of all mortgages acquired before January 1, 1985, that

were subject to foreclosure after that date.4

     As part of the legislation in which petitioner became

subject to Federal income taxation, Congress enacted transition

rules for determining petitioner’s adjusted basis in assets that

it held on January 1, 1985.   Those rules are contained in DEFRA

section 177(d), 98 Stat. 711, which provides:

     (2) Adjusted basis of assets.--

          (A) In general.--Except as otherwise provided in
     subparagraph (B), the adjusted basis of any asset of
     the Federal Home Loan Mortgage Corporation held on
     January 1, 1985, shall--

     4
      Petitioner’s treatment of interest accrued after Jan. 1,
1985, is not in dispute.
                                   - 6 -

          (i) for purposes of determining any loss, be equal
     to the lesser of the adjusted basis of such asset or
     the fair market value of such asset as of such date,
     and

          (ii) for purposes of determining any gain, be
     equal to the higher of the adjusted basis of such asset
     or the fair market value of such asset as of such date.

               *     *      *      *       *   *    *

          (5) Adjusted basis.--For purposes of this
     subsection, the adjusted basis of any asset shall be
     determined under part II of subchapter O of the
     Internal Revenue Code of 1954.

     In computing the gain or loss from its foreclosure sales,

petitioner determined its adjusted basis pursuant to DEFRA

section 177(d)(2) for mortgages acquired before, and held on,

January 1, 1985.   In determining its adjusted basis under these

transition rules, petitioner included in its regular adjusted

cost basis the amounts of unpaid interest which it had accrued

from the date of acquisition of each mortgage to the date of

foreclosure on the underlying real estate.         These amounts of

accrued interest included certain interest which had accrued

before January 1, 1985.

     Petitioner used its regular adjusted cost basis in

determining the amount of any gain realized, or loss incurred, on

the foreclosure of real estate securing mortgages that petitioner

owned on January 1, 1985.       During the taxable year 1985,

petitioner foreclosed on 2,735 mortgages which it had held on

January 1, 1985, and petitioner included in its adjusted cost
                                - 7 -

basis $3,050,459 of unpaid interest accrued as of December 31,

1984.    During the taxable year 1986, petitioner foreclosed on 747

mortgages held on January 1, 1985, and it included in its

adjusted cost basis $675,988 of unpaid interest accrued as of

December 31, 1984.

                             Discussion

     The parties filed cross-motions for partial summary judgment

on the question of whether, for purposes of claiming a bad debt

deduction under section 166, petitioner is entitled to increase

its regular adjusted cost basis in certain mortgages acquired

before January 1, 1985, for unpaid interest which accrued before

January 1, 1985, when it was tax exempt.

     Summary judgment is intended to expedite litigation and

avoid unnecessary and expensive trials.     FPL Group, Inc. v.

Commissioner, 116 T.C. 73, 74 (2001).     Either party may move for

summary judgment upon all or any part of the legal issues in

controversy.    Rule 121(a); FPL Group, Inc. v. Commissioner, supra

at 74.    A decision will be rendered on a motion for partial

summary judgment if the pleadings, answers to interrogatories,

depositions, admissions, and other acceptable materials, together

with the affidavits, if any, show that there is no genuine issue

as to any material fact and that a decision may be rendered as a

matter of law.    Rule 121(b); Elec. Arts, Inc. v. Commissioner,

118 T.C. 226, 238 (2002).    The moving party has the burden of
                               - 8 -

proving that no genuine issue of material fact exists, and the

moving party is entitled to judgment as a matter of law.

Rauenhorst v. Commissioner, 119 T.C. 157, 162 (2002).

     Section 166(a) allows a deduction for bad debts.5    The basis

for determining the amount of the deduction for any bad debt is

the adjusted basis provided in section 1011 for determining the

loss from the sale or other disposition of property.     Sec.

166(b).6   Section 1.166-6, Income Tax Regs., provides specific

rules for bad debts which are attributable to mortgaged or

pledged property.   Section 1.166-6, Income Tax Regs., provides:

          (a) Deficiency deductible as bad debts--(1)
     Principal amount. If mortgaged or pledged property is
     lawfully sold (whether to the creditor or another
     purchaser) for less than the amount of the debt, and
     the portion of the indebtedness remaining unsatisfied

     5
      Sec. 166(a) provides:

     SEC. 166(a).   General Rule.--

          (1) Wholly worthless debts.--There shall be
     allowed as a deduction any debt which becomes worthless
     within the taxable year.

          (2) Partially worthless debts.--When satisfied
     that a debt is recoverable only in part, the Secretary
     may allow such debt, in an amount not in excess of the
     part charged off within the taxable year, as a
     deduction.
     6
      Sec. 166(b) then provides:

          SEC. 166(b). Amount of Deduction.--For purposes
     of subsection (a), the basis for determining the amount
     of the deduction for any bad debt shall be the adjusted
     basis provided in section 1011 for determining the loss
     from the sale or other disposition of property.
                               - 9 -

     after the sale is wholly or partially uncollectible,
     the mortgagee or pledgee may deduct such amount under
     section 166(a) (to the extent that it constitutes
     capital or represents an item the income from which has
     been returned by him) as a bad debt for the taxable
     year in which it becomes wholly worthless or is charged
     off as partially worthless. See § 1.166-3.

          (2) Accrued interest. Accrued interest may be
     included as part of the deduction allowable under this
     paragraph, but only if it has previously been returned
     as income.

          (b) Realization of gain or loss--(1) Determination
     of amount. If, in the case of a sale described in
     paragraph (a) of this section, the creditor buys in the
     mortgaged or pledged property, loss or gain is also
     realized, measured by the difference between the amount
     of those obligations of the debtor which are applied to
     the purchase or bid price of the property (to the
     extent that such obligations constitute capital or
     represent an item the income from which has been
     returned by the creditor) and the fair market value of
     the property.

          (2) Fair market value defined. The fair market
     value of the property for this purpose shall, in the
     absence of clear and convincing proof to the contrary,
     be presumed to be the amount for which it is bid in by
     the taxpayer.

     Petitioner argues that it is entitled to increase its

regular adjusted cost basis in its mortgages to account for

unpaid interest which accrued during the period in which it was

tax exempt.   Respondent argues that section 1.166-6(a)(2), Income

Tax Regs., requires as a condition precedent to such a basis

increase that petitioner “returned as income”, i.e., reported as

taxable income, its accrued interest.   Since petitioner was tax

exempt when the interest at issue accrued, respondent contends

that petitioner has not met the requirements for deductibility
                              - 10 -

under section 1.166-6(a)(2), Income Tax Regs.   We agree with

respondent.

     Section 1.166-6(a)(2), Income Tax Regs., allows a bad debt

deduction on account of accrued interest only if that accrued

interest has previously been “returned as income.”   We construe

this language to require the accrued, but unpaid, interest to

have previously been reported by the taxpayer as taxable income

on a Federal income tax return.   This is, in our view, consistent

with the purpose of providing a bad debt deduction which is to

account for:   (1) The taxpayer’s unrecovered cost or capital

investment, and (2) amounts reported as income but ultimately not

collected because they became worthless.   Citizens’ Acceptance

Corp. v. United States, 462 F.2d 751, 756 (3d Cir. 1972).7   We

     7
      See also Dist. Bond Co. v. Commissioner, 39 B.T.A. 739, 746
(1939), affd. in part on this issue, revd. in part on different
grounds 113 F.2d 347 (9th Cir. 1940), a case involving a claimed
bad debt deduction for accrued tax-exempt interest, wherein the
Board of Tax Appeals observed:

          Petitioner insists that the deduction should be
     allowed in the instant case, notwithstanding the rule
     above referred to, for the reason that the amount in
     controversy was accrued by petitioner on its books and,
     it is argued, thus passed through the “tax mill.” We
     can not agree with this argument. So far as concerns
     tax liability, a taxpayer on an accrual basis who
     accrues an income item on his books but does not
     include the amount in taxable income is in no different
     position than the taxpayer on a cash basis who does not
     include a similar item in income because it has not
     been received. To allow the deduction in either of
     such events would result in reducing the amount of the
     taxable income received or accrued from other sources
     by an amount representing not a loss of capital or of
                               - 11 -

cannot construe the language in the regulation to include

interest which the taxpayer has “accrued” for financial purposes

but has not taken into account for tax purposes.

     In cases interpreting the statutory requirements for

allowance of a bad debt deduction for accrued, but unpaid,

interest, the Board of Tax Appeals construed the provision of a

deduction for “Debts ascertained to be worthless and charged off

within the taxable year”, which appeared in prior versions of

section 166, to include a requirement that the item be previously

“charged on”.   See, e.g., Collin v. Commissioner, 1 B.T.A. 305

(1925).8   The Board of Tax Appeals determined that for interest

to be “charged on” for purposes of a bad debt deduction, it must

have been accrued as income, it must have been returned as income

for taxation, and a tax must have been paid thereon.   See, e.g.,

id. at 310.   Thus, interest which had accrued, but which remained

unpaid, could not be the subject of a bad debt deduction, since

the taxpayer was on the cash receipts and disbursements method of

accounting.   See id.   Further, an accrual basis taxpayer that had

accrued tax-exempt bond interest on its books, but did not report

     actual income, but merely a loss of anticipated
     earnings. * * *

See also Beekman v. Commissioner, 17 B.T.A. 643, 648 (1929).
     8
      The statute under construction in Collin v. Commissioner, 1
B.T.A. 305 (1925), was sec. 214(a)(7) of the Revenue Act of 1918,
ch. 18, 40 Stat. 1067.
                                 - 12 -

such interest for tax purposes, could not claim a bad debt

deduction for the accrued interest.       See Dist. Bond Co. v.

Commissioner, 39 B.T.A. 739, 746 (1939), affd. in part on this

issue, revd. in part on different grounds 113 F.2d 347 (9th Cir.

1940).      We believe these same principles apply for purposes of

applying section 1.166-6(a)(2), Income Tax Regs.      Indeed, section

1.166-6(a)(2), Income Tax Regs., appears to have incorporated the

principles articulated in this prior caselaw.      Accordingly, we

hold that the language “returned as income”, as used in section

1.166-6(a)(2), Income Tax Regs., refers to interest that has been

properly accrued for tax purposes and has been reported as

taxable income on a return.

        It follows from our interpretation of section 1.166-6(a)(2),

Income Tax Regs., and the precedents cited above, that petitioner

cannot claim a bad debt deduction for interest, which accrued

during a period in which petitioner was tax exempt, which it did

not report as taxable income, and on which it was not subject to

tax.9

        Petitioner argues that the regulation is inapplicable to its

situation because it adopted the accrual method of accounting for

        9
      Petitioner does not allege that it filed a “return” in
which it reported its accrued interest as taxable income for the
periods before Jan. 1, 1985. The argument that petitioner makes
is that consistency in accounting requires it to increase its
regular adjusted cost basis in its mortgages for the interest
that accrued on those mortgages before Jan. 1, 1985.
                              - 13 -

its first taxable year commencing January 1, 1985, and that

thereafter it consistently accounted for its accrued interest

from the date of the acquisition of the mortgages until the

foreclosures on the underlying real estate.   Petitioner argues:

          It is long established law that when an entity
     becomes taxable for the first time, its adjusted cost
     basis in its assets, as of the date on which it becomes
     subject to federal income tax must be determined by
     reference to events that occurred during the pre-
     taxable period, using consistently the tax accounting
     method adopted by the taxpayer. * * *

     We might agree that petitioner’s argument is correct in

certain specific circumstances;10 however, we cannot agree that

petitioner’s supposition merits recognition as a rule of general

application.   In the instant cases, we are dealing with a

regulatory provision which requires that accrued, but unpaid,

interest be returned as income as a condition precedent to the

inclusion of that interest amount in the taxpayer’s regular

adjusted cost basis.   Petitioner has not returned its accrued

interest as income for taxable years before January 1, 1985; it

does not meet the requirement stated in section 1.166-6(a)(2),

     10
      See, e.g., sec. 1016(a)(3) (providing an adjustment for
previously tax-exempt individuals or organizations for
exhaustion, wear and tear, obsolescence, amortization, and
depletion, to the extent sustained for any period in which such
individuals or organizations were not subject to taxation); Fed.
Home Loan Mortgage Corp. v. Commissioner, 121 T.C. 128 (Sept. 4,
2003). Sec. 1.166-6(a)(2), Income Tax Regs., provides no
comparable adjustment to regular adjusted cost basis for interest
which accrued during a period in which a taxpayer was tax exempt.
                              - 14 -

Income Tax Regs.; and any general theory of consistent

accountancy does not assist petitioner.

     Petitioner’s position disregards the fact that it was tax

exempt for periods before January 1, 1985, and any interest which

might have been accrued on its books and records did not accrue

as taxable income.   Petitioner was not required to file an income

tax return for years before 1985.   See secs. 6011(a), 6012(a),

6072(b).   Thus, petitioner’s interest accruals for the periods

before January 1, 1985, could not have been “returned as income”.

Petitioner cites no authority which supports its contention that

previously tax-exempt taxpayers which become taxable must, as a

general rule, adjust their regular adjusted cost basis upward to

account for items of interest that would have been accrued as

taxable income if those taxpayers had previously been taxable.

Nothing in section 166, the regulations interpreting that

section, or, more specifically, the transition rules of DEFRA

section 177(d) supports petitioner’s position.

     Petitioner relies upon Rev. Rul. 55-437, 1955-2 C.B. 548,

and argues that under this ruling, adjustments to basis must be

made as if the taxpayer, in fact, had been subject to tax and

that these adjustments must be made according to the accounting

method that the taxpayer adopts in its first taxable year.   We do

not read Rev. Rul. 55-437, supra, this broadly.
                                - 15 -

     In Rev. Rul. 55-437, supra, a building and loan association

became subject to Federal income taxation on January 1, 1952,

having been previously tax exempt.       For its first taxable year,

beginning after December 31, 1951, the association adopted the

accrual method of accounting.    As of January 1, 1952, the

association had outstanding balances of installment accounts

receivable of 500x dollars of which 200x dollars represented

unrealized profit with respect to such contracts.      Rev. Rul. 55-

437, 1955-2 C.B. at 549-551, states:

     the only election of accounting method binding upon the
     association is that made in the return filed by it for
     its first taxable year beginning after December 31,
     1951. * * *

          Accordingly, if the association selects the
     accrual method of accounting in the return for its
     first taxable year beginning after December 31, 1951,
     the 200x dollars of unrealized profit received in such
     and subsequent taxable years under the installment
     contracts which were entered into in taxable years
     beginning prior to January 1, 1952, would not
     constitute taxable income insofar as the right to
     receive such installment payments accrued during a
     taxable year in which the association was exempt from
     Federal income taxation. However, if the taxpayer
     selects the cash or installment method of accounting in
     such return, the payments received, to the extent of
     the previously unrealized profits included therein,
     would constitute taxable income in the year received.

     Rev. Rul. 55-437, supra, does not support petitioner’s

position with respect to its pre-1985 interest accruals.       Rev.

Rul. 55-437, supra, deals with the timing of income recognition.

The revenue ruling has nothing to do with the determination of

basis for purposes of a foreclosure-related bad debt deduction
                              - 16 -

and clearly does not purport to replace the long standing rules

concerning bad debt deductions.11

     Petitioner also relies on certain statements that the Court

of Appeals for the Fifth Circuit made in W.L. Moody Cotton Co. v.

Commissioner, 143 F.2d 712, 714 (5th Cir. 1944), affg. 2 T.C. 347

(1943).   In W.L. Moody Cotton Co., the taxpayer kept its books

and filed its Federal income tax returns on a cash receipt and

disbursements basis.   However, from 1927 through 1935, it accrued

and reported as gross income in its returns for those years

interest on certain collateralized accounts and notes receivable.

In 1937, it charged off on its books of account and deducted in

its income tax return the interest that it previously accrued and

reported.   This Court upheld the Commissioner’s disallowance of

the taxpayer’s deduction for its accrued, but unpaid, interest.

The Court of Appeals for the Fifth Circuit affirmed, stating:

     11
      Petitioner also relies upon Rev. Rul. 55-434, 1955-2 C.B.
538, which it claims “further confirms the importance of
consistent application of Code § 166 to transactions straddling
an entity’s change in tax status.” Rev. Rul. 55-434, supra, did
not involve how to determine gain or loss upon foreclosure of a
mortgage. Rather it involved how to determine basis in real
property previously acquired in a foreclosure that occurred when
the taxpayer was tax exempt. The revenue ruling applied sec.
39.23(k)-3, Regs. 118, which provided that the unadjusted basis
of property acquired upon foreclosure is the fair market value of
the property at the date of the acquisition of the property. See
sec. 1.166-6(c), Income Tax Regs., which provides a similar rule.
The facts and legal question involved in that revenue ruling are
distinguishable, and petitioner’s reliance on that revenue ruling
is misplaced.
                              - 17 -

     A taxpayer on the cash basis is on that basis uniformly
     as to both receipts and deductions, and he cannot be
     permitted any irregular and sporadic variation from
     that basis. The accruing and returning as income of
     the interest, therefore, in the earlier years before it
     was actually received was not, in accordance with
     petitioner’s system of accounting, a charging of it on.
     Interest is charged on under the regulations and the
     decisions when the taxpayer is on a cash basis only
     when it is actually received. It is charged on when
     the taxpayer is on an accrual basis only when it is
     properly accrued. The conditions for a bad debt
     charge-off not being met here, the claim for it was
     properly disallowed. [Id. at 714.]

Petitioner relies on these statements and contends that “the

court’s decision in W.L. Moody Cotton Co. explicitly holds that a

taxpayer’s method of tax accounting must be consistently applied

for basis purposes.”   We might agree with petitioner’s contention

that W.L. Moody Cotton Co. requires consistency in accounting for

items of income and deduction.   However, we cannot agree that

W.L. Moody Cotton Co. supports increasing petitioner’s regular

adjusted cost basis for interest accrued when petitioner was tax

exempt.   Nothing in W.L. Moody Cotton Co. supports that position.

Indeed, the statements petitioner relies on were made in the

context of a broader discussion by the Court of Appeals of the

requirement that interest be properly “charged on” before it be

allowed as a bad debt deduction:

     As to the first question, the deduction for loss of
     interest as a bad debt loss, Art. 23(k)2 of Regulation
     94 provides in part: “Worthless debts arising from
     unpaid wages, salaries, rents and similar items of
     taxable income will not be allowed as a deduction
     unless the income such items represent has been
     included in the return of income for the year for which
                             - 18 -

     the deduction as a bad debt is sought to be made or for
     a previous year,” and it is settled law that interest
     cannot be charged off as a bad debt unless it has first
     been charged on. Petitioner concedes that this is so,
     but, argues that since it did in earlier years accrue
     the interest and return it as income, this fully
     satisfied the regulation and the decisions. It insists
     that the view of the commissioner and the Tax Court,
     that since taxpayer was not on the accrual but on the
     cash basis, there was no improper accruing of interest,
     adds to the law a provision which it does not contain,
     in effect, that for an interest item to be charged off
     as a bad debt, it must have been properly charged on.
     Agreement with petitioner’s contention would be to
     throw out of the window petitioner’s entire system of
     tax accounting, leaving to the varying caprices and
     whims of the taxpayer whether or not particular items
     should be deferred, advanced or returned. * * * [Id.]

We cannot agree that W.L. Moody Cotton Co. supports petitioner’s

position, and, indeed, it is contrary to that position to the

extent it holds that interest must first be properly included in

a return for tax purposes before it can be deductible as a bad

debt.

     Accounting methods are determinative of when an item of

income or deduction must be recognized but are not determinative

of whether the item meets the substantive requirements for being

an item of income or deduction.   Petitioner properly accounted

for its interest income using the accrual method of accounting.

Under this method of accounting, unpaid interest which accrued

before January 1, 1985, was properly assigned to that period.

However, since petitioner was tax exempt during this period, it

realized no tax consequences from its accrued interest.

Petitioner’s accrued interest was not taxable income, it was not
                             - 19 -

“returned as income”, and petitioner was not subject to tax on

account of the accrued interest.   It follows that under section

1.166-6(a)(2), Income Tax Regs., petitioner may not increase its

regular adjusted cost basis on account of interest which accrued

when it was tax exempt.

                                         An appropriate order

                                    will be issued.