                       T.C. Memo. 1998-150



                     UNITED STATES TAX COURT



    RONALD R. ARMACOST AND CATHY L. ARMACOST, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 19616-96.                    Filed April 27, 1998.



     Richard P. Algeo, for petitioners.

     Julie L. Payne, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     DEAN, Special Trial Judge:   This case was heard pursuant to

section 7443A(b)(3) and Rules 180, 181, and 182.1   Respondent

determined a deficiency in Ronald and Cathy Armacost's Federal

income taxes for the taxable year 1992 in the amount of $5,470.


     1
      Section references are to the Internal Revenue Code in
effect for the year at issue. Rule references are to the Tax
Court Rules of Practice and Procedure.
                               - 2 -


The sole issue for decision is whether interest payments on a

promissory note made by Ronald Armacost (petitioner) to his ex-

wife are deductible.

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

The stipulation of facts and the attached exhibits are

incorporated herein by reference.   Petitioners resided in Liberty

Lake, Washington, at the time their petition was filed.

                         FINDINGS OF FACT

     Petitioner married Linda L. Armacost in 1963.   During their

marriage, petitioner and Linda Armacost accumulated numerous

assets, including stocks, bonds, a personal residence, vacation

properties, and other liquid assets.   They also acquired several

commercial properties on which they developed, constructed, and

operated gas stations and convenience stores.

     Petitioner and Linda Armacost resided only in the community

property States of Washington or Idaho during their marriage;

therefore most of their assets were owned in undivided one-half

interests.

     In January 1985, petitioner and Linda Armacost legally

separated.   They agreed to divide their property equally and

executed a Separation Agreement designating which property would

be allocated to whom.   All their property, along with its "value

at date of dissolution", was divided as follows:
                               - 3 -


                           Ronald Armacost
1.    Lake home at Priest Lake, Idaho ($50,000);
2.    All boats, boat motors and trailers, and motorcycles plus
      household furnishings ($25,000);
3     Hawaiian condominium at Kihei, Maui ($61,000); and
4.    Debt on family home (-$49,000).
5     All capital stock in Budget Oil Co., Inc. ($101,000);
6.    One-half of all investment stocks ($0);
7.    One-half of all royalty rights in Procto-Therm ($0);
8.    One-half of all limited partnership interests in oil well,
      rotator, and handlebar ($0);
9.    One-half of existing partnership interests in Cable Marque
      and Dinestalon ($0);
10.   Individual retirement accounts ($4,800);
11.   One-half interest in Ronald Armacost's Budget Oil Co., Inc.
      pension and profit sharing plan ($40,000);
12.   Commercial property located at N. 7902 Division (-$38,000);
13.   Commercial property located at Division and Augusta
      ($128,000);
14.   Commercial property located at University City ($195,000);
15.   Commercial property located on Pines Road ($400,000);
16.   Commercial property located in Moscow, Idaho ($145,000);
17.   Building at Third and Maple ($50,000);
18.   Commercial property located at Liberty Lake ($247,000); and
19.   Bank Note - McDonald's Property (-$135,000).
20.   Ranch Land located in Adams County, Idaho ($20,000).

      Total Assets                          $1,244,800

                           Linda Armacost
1.    Family Home ($70,000);
2.    Vehicles and household furnishings ($25,000);      and
3.    Account balances ($4,000).
4.    McDonald's property ($580,000);
5.    Miller real estate contract ($16,000);
6.    Lang real estate contract ($5,000);
7.    One-half of all investment stocks ($0);
8.    One-half royalty rights in Procto-Therm ($0);
9.    One-half partnership interest in Cable Marque      and Dinestalon
      ($0);
10.   One-half of all limited partnership interests      in oil well,
      rotator, and handlebar ($0);
11.   One-half interest in Ronald Armacost's Budget      Oil Co., Inc.
      pension and profit-sharing plan ($40,000).

      Total Assets                     $740,000
                                - 4 -


     Petitioner received more property upon dissolution of the

marriage than did Linda Armacost, so he signed a promissory note

in the amount of $250,000 payable to Linda Armacost to equalize

the distribution of assets.    The note was payable for 20 years,

at 10 percent interest.    Linda Armacost also was granted a

security interest in the properties transferred to petitioner.

     Petitioner made payments to Linda Armacost under the note,

and deducted the interest paid on his Federal income tax return

for taxable year 1992.    Respondent disallowed the deduction on

the ground that the interest was nondeductible personal interest

under section 163(h)(2).

                               OPINION

     Respondent contends that the interest on the note was

incurred for purposes of dividing community property incident to

divorce.   Section 1041 provides that no gain or loss shall be

recognized on the transfer of property incident to divorce, and

the property is treated as having passed to the transferee by

gift.   Respondent argues that the interest here is nondeductible

because the underlying debt is traced back to the divorce, a

personal purpose.   This is essentially the same argument

respondent made in Seymour v. Commissioner, 109 T.C. 279 (1997).

     In the Seymour case, the taxpayer incurred indebtedness to

his ex-spouse upon his divorce.    Respondent disallowed his

interest deduction on the ground that section 1041 characterized
                                - 5 -


the taxpayer's interest as personal interest under section

163(h).    In that case, the taxpayer prevailed because we

concluded that section 1041 does not require indebtedness to a

former spouse incident to divorce to be characterized as personal

interest for purposes of section 163(h)(1).     Seymour v.

Commissioner, supra at 286.    If the taxpayer can satisfy the

requirements of section 163(h)(2)(A) through (E), the interest

will be properly deductible under section 163(a).     Id.

     Generally, section 163 provides that interest on

indebtedness is deductible by the taxpayer in the year it is

paid.   Sec. 163(a).   However, substantial limitations are placed

on this general rule which may limit or prohibit the taxpayer

from deducting indebtedness interest at all.

     Section 163(h) provides that for an individual taxpayer,

personal interest is nondeductible.     Personal interest is defined

in section 163(h)(2) as the residual of what remains after

considering five enumerated exceptions.    These exceptions are as

follows:

          (A) interest paid or accrued on indebtedness
     properly allocable to a trade or business (other than
     the trade or business of performing services as an
     employee),

          (B) any investment interest (within the meaning
     of subsection (d)),

          (C) any interest which is taken into account
     under section 469 in computing income or loss from a
     passive activity of the taxpayer,
                                 - 6 -


          (D) any qualified residence interest (within the
     meaning of paragraph (3)), and

          (E) any interest payable under section 6601 on
     any unpaid portion of the tax imposed by section 2001
     for the period during which an extension of time for
     payment of such tax is in effect under section 6163 or
     6166 or under section 6166A (as in effect before its
     repeal by the Economic Recovery Tax Act of 1981).

Sec. 163(h)(2).   The exception relating to investment interest is

the basis for petitioner's claim.

     Interest on indebtedness must be allocated in the same

manner as its underlying debt.    Sec. 1.163-8T, Temporary Income

Tax Regs., 52 Fed. Reg. 24999 (July 2, 1987).    Underlying debt is

allocated by tracing specific disbursements of the proceeds to

specific expenditures.   Id.    If the underlying debt is incurred

as a personal expenditure, the interest on that debt may not be

deducted under section 163 except to the extent such interest is

qualified residence interest.    Sec. 1.163-8T(a)(4)(ii), Example

(1), Temporary Income Tax Regs., 52 Fed. Reg. 25000 (July 2,

1987).

     But if the underlying debt is incurred to acquire investment

property, the interest on that debt is deductible under section

163 as investment interest.    Sec. 163(h)(2)(B).   Investment

interest is defined as any interest paid on indebtedness properly

allocable to investment property.    Sec. 163(d).   Investment

property includes property producing gross income from interest,

dividends, annuities or royalties not derived in the taxpayer's
                                 - 7 -


trade or business, or property held in the course of the

taxpayer's trade or business which is neither a passive activity

nor an activity in which the taxpayer materially participates.

Sec. 163(d)(5)(A), 469(e)(1).

     To determine whether the promissory note signed by

petitioner is indebtedness traceable to investment property, we

look at the nature of the underlying assets acquired by

petitioner as a result of the divorce.   To the extent the note

was made to acquire Linda Armacost's community interest in their

investment property, the interest paid on that note will be

properly characterized as investment interest and will be

deductible under section 163.    To the extent, however, the note

was made to acquire her interest in noninvestment property, the

interest will not be deductible as investment interest under

section 163.   Respondent's determinations are presumed correct,

and petitioner has the burden of proving them erroneous.    Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

     The Separation Agreement is silent as to which properties

received by petitioner are attributable to the $250,000 note.

But the lack of such designation in the Settlement Agreement does

not affect the underlying character of the assets.   The value

differential between what petitioner received and what Linda

Armacost received may appear to be equal to the total property

distribution upon the divorce.    However, examination of the total
                               - 8 -


property values is not the end of our analysis.    Based on the

record, we are able to classify each property as either

investment property or noninvestment property.

     Petitioner received personal property, a condominium in

Maui, and a lake house in Idaho.   He also assumed the outstanding

debt on the family home.   Petitioner testified that these assets

are noninvestment properties, and the record supports such a

finding.

     The evidence also shows that petitioner's stock, partnership

interests and royalty rights, IRA, pension and profit plan and

commercial real estate are investment property.2

     Linda Armacost received the family home, cash, and personal

property, which we find is noninvestment property.    For her share

of investment property, Linda Armacost kept the McDonald's

property, two land sale contracts, her interest in investment

stocks and partnership interests, and one-half of their pension

and profit sharing plan.   The character of these assets is

reflected in the record, and the parties do not dispute such a

designation.

     There is some dispute, however, as to the ranch located in

Adams County, Idaho, and a condominium unit located in Liberty

Lake, Washington.   Respondent contends that the ranch land

     2
      The value of petitioner's investment property is reduced by
his liability on the bank note on Linda Armacost's McDonald's
property.
                                 - 9 -


allocated to petitioner is noninvestment community property.

Petitioner, however, testified that he inherited the ranch from

his father.    In addition, section 7, paragraph 11 of the

Settlement Agreement states that the ranch land is the "sole and

separate property" of the petitioner.    Property acquired by

bequest or devise is ordinarily that spouse's separate property.

See In re Estate of Salvini, 397 P.2d 811 (Wash. 1964).

Therefore, the ranch is not community property, and Linda

Armacost had no right to receive payment for any interest in the

property.   See Poe v. Seaborn, 282 U.S. 101 (1930); Hansen v.

Blevins, 367 P.2d 758 (Idaho 1962); In re Estate of Salvini,

supra.   Because petitioner already owned the ranch in its

entirety, we find that no part of the $250,000 note is

attributable to the acquisition of this property.

     Next, we look at the condominium unit situated in Liberty

Lake.    Respondent argues that a condominium unit valued at

$247,000 was allocated to petitioner as noninvestment property.

Petitioner, however, contends that the property located in

Liberty Lake was not actually a condominium, but was one of his

commercial convenience stores.    After careful review of the

record, we agree with petitioner that the property the parties

valued at $247,000 is not a condominium unit and should be

characterized as commercial investment property.
                              - 10 -


     The parties submitted Joint Exhibit 4-D, Schedule of Assets

Received Upon Marital Dissolution (Schedule of Assets), which

refers to a commercial property in Liberty Lake valued at

$247,000.   The Schedule of Assets only refers to one property in

Liberty Lake.   The Separation Agreement, however, refers to two

properties in Liberty Lake.   A condominium is described in

section 7, paragraph 18 of the Separation Agreement, and

commercial real estate abutting Liberty Lake Road is found in

section 7, paragraph 20.

     For reasons unknown, a condominium in Liberty Lake is not

listed on the Schedule of Assets.   Petitioner testified, however,

that the only noninvestment property he received outside of the

personal property was the condominium in Maui and the house on

the lake in Idaho.   Everything else, petitioner claims, is

commercial investment property.   His testimony is supported by

the Schedule of Assets, which categorizes the Liberty Lake

property valued at $247,000 as commercial property.

     Respondent's argument that the Liberty Lake property valued

at $247,000 is a noninvestment property is unsupported by the

record.   We do not know the nature of the condominium in Liberty

Lake, but its character does not affect our finding that the

commercial property in Liberty Lake valued at $247,000 is

includable in petitioner's acquisition of investment property

from Linda Armacost.
                                 - 11 -


     Based on our findings above, we draw the following

conclusions regarding the value of properties distributed:

                    NonInvestment              Investment
                      1                        2
Ronald Armacost           $87,000                  $1,137,800
                          3                          4
Linda Armacost              99,000                     641,000

          1
           Includes lake home in Idaho ($50,000), personal
     property and household furnishings ($25,000),
     condominium in Maui ($61,000) and debt on the family
     home (-$49,000).
          2
           Includes all capital stock in Budget Oil Co.,
     Inc. ($101,000), one-half of all investment stocks,
     royalty rights, and partnership interests ($0), IRA
     ($4,800), one-half interest in pension and profit
     sharing plan ($40,000), commercial property located at
     N. 7902 Division (-$38,000), commercial property
     located at Division and Augusta ($128,000), commercial
     property located at University City ($195,000),
     commercial property located on Pines Road ($400,000),
     commercial property located in Moscow, Idaho
     ($145,000), commercial property located at Liberty Lake
     ($247,000), real estate at Third and Maple ($50,000),
     and a bank note on the McDonald's property (-$135,000).
          3
           Includes the family home ($70,000), vehicles and
     household furnishings ($25,000), and account balances
     ($4,000).
          4
           Includes McDonald's property ($580,000), Miller
     real estate contract ($16,000), Lang real estate
     contract ($5,000), one-half interest in investment
     stocks, royalty rights and partnership interests ($0),
     one-half interest in pension and profit sharing plan
     ($40,000).

     Petitioner received $12,000 less than Linda Armacost in

noninvestment property value, and $496,000 more than Linda

Armacost in investment property value.    This means that

petitioner is entitled to his one-half community interest of
                             - 12 -


$6,000 from Linda Armacost for noninvestment property, and Linda

Armacost is entitled to her one-half community interest of

$248,000 from petitioner for investment property.     Linda

Armacost's deficit in investment property nearly equals the

$250,000 promissory note signed by petitioner.      Thus we conclude

that the debt is attributable to the acquisition of Linda

Armacost's community share of investment property, and the

interest on that indebtedness is deductible pursuant to section

163(d).

     To reflect the foregoing,

                                      Decision will be entered

                                 for petitioners.
