                          T.C. Memo. 1998-406



                      UNITED STATES TAX COURT



     PHILLIP LEE ALLEN AND CAROLYN F. ALLEN, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 243-97.                   Filed November 13, 1998.



     Joseph E. Mudd and Jeri L. Gartside, for petitioners.

     Andrew H. Lee, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     GERBER, Judge:   Respondent determined a deficiency in

petitioners’ Federal income tax for 1991 of $39,697 and an

accuracy penalty in the amount of $7,939.

     The issues for our consideration are:      (1) Whether

petitioners are entitled to nonrecognition treatment on the

$130,000 settlement payment received from Allstate Insurance Co.
                                - 2 -


under section 1033;1 and (2) whether petitioners are liable for

an accuracy-related penalty pursuant to section 6662(a).

     Petitioners contend that the $130,000 settlement payment was

for damage to petitioners’ home, was used for repairs, and

therefore should not be recognized as income in accord with the

section 1033(a) involuntary conversion rules.    Respondent

counters that section 1033 is inapplicable because the gain

realized by petitioners was not the result of an involuntary

conversion.2

                         FINDINGS OF FACT

     The stipulation of facts and the exhibits attached thereto

are incorporated herein by this reference.

     Phillip and Carolyn Allen, petitioners, have resided, at all

pertinent times, in Orange, California.     In 1987, the beginning

of what would become extensive damage in petitioners’ home

occurred.   The first indication of the problem was that the

sliding glass doors would no longer close.    Then the cupboard

doors were difficult to open.   The kitchen cabinets started to

     1
        Unless otherwise stated, all section references are to
the Internal Revenue Code in effect for the taxable year in
issue.
     2
        Respondent also advanced arguments concerning sec. 104
because of petitioners’ references to that section in their
briefs. Petitioners’ reference to the income exclusion principle
of sec. 104 was merely by way of an analogy as a means to test
the nature of the payment in order to show compliance with a sec.
1033 requirement. For this reason, we address only the parties’
sec. 1033 arguments.
                                 - 3 -


show separation, and the kitchen tiles cracked.    The putty

holding the large living room windows began to ooze out around

the glass as if being compressed.    Tile in other areas of the

home cracked, as did the shower.    The drywall nails popped out

from the hallway wall.    Concrete in other areas of the property

also cracked and separated, including the garage floor, driveway,

patios, and walkways.    The garage door would no longer close

properly.   The fence, which had already been realigned once,

began leaning and separating, and the gate could no longer close

or open properly.

     Feeling that the floor inside the home was also

"separating", petitioners pulled the carpet back and revealed

deep cracks in the foundation.    The slab had cracked due to a 3-

inch vertical shift in the foundation.    Because the cracking of

the slab foundation had damaged the radiant heating pipes laid

within, petitioners’ heating system no longer functioned and

needed complete replacement.    The damage to the foundation was so

severe that the house had to be lifted and placed on Perma-jacks

to stabilize it.    When this was done, the kitchen walls,

countertops, and flooring were crushed by the movement and had to

be rebuilt.

     Petitioners’ neighbor, John Lane (Lane), had caused the

damage when he removed a lateral support berm between the

properties.   Petitioners discussed the damage with an engineer,
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then contacted their homeowners’ insurance company, Allstate

Insurance Co. (Allstate), to make a claim for coverage.    Allstate

advised petitioners that they were covered for property damage

caused by a third party.

     The first repair estimate was approximately $102,000 to

$104,000.   The repair costs, however, increased as further damage

occurred and was discovered.   Due to disagreements with Allstate

regarding the repair cost estimates and Allstate’s alleged delay,

petitioners hired an attorney to aid in further negotiations with

Allstate.

     In July 1988, petitioners filed suit against Allstate for

damages, including punitive damages, for Allstate’s alleged

breach of contract and breach of the statutory duty of good faith

and fair dealing under the California Insurance Code.    The

parties then agreed to go through the arbitration process

provided for in the homeowners’ policy.    In September 1990, the

arbitrator submitted an interim award.    At that time, the

arbitrator ruled that petitioners’ home’s replacement cost value

was $128,084.   He ordered Allstate to pay that amount minus the

cash discount and credit for payments previously made.    He also

found that neither Allstate nor its employees had acted in bad

faith and ordered that further litigation on this matter should

cease.   By stipulation, the parties agreed that no final award

would be entered at that time.    Allstate proceeded to pay
                                - 5 -


petitioners approximately $102,000 of the interim award.    Before

final judgment had been entered, petitioners filed a petition to

vacate the interim award and requested a rehearing on the matter.

     In April 1991, petitioners and Allstate entered into a

general release and settlement agreement, which provided that, as

settlement for the action filed by petitioners, Allstate would

pay petitioners an additional $130,000.    In return, petitioners

agreed to release Allstate and its related entities from all

claims and liabilities “including claims for bad faith breach of

contract or statutory violations under law.”    Petitioners also

agreed to pay Allstate any moneys received under any other claim

of loss for this damage, up to $128,084.

     At the settlement conference preceding the agreement, the

parties discussed the revised estimate of repair costs, but did

not discuss punitive damages other than petitioners’ agreement to

forgo punitive damages if the settlement amount was close to the

actual cost of repairs.   The repair estimate at that time was

$236,000, though the actual cost was greater.

     While petitioners were pursuing their claim against

Allstate, they also filed a complaint against Lane for the damage

he caused by removing the berm.   In order to protect its

subrogation rights, Allstate filed a lien against any possible

award in the Lane litigation.   The lien amount was approximately

$85,000, though Allstate later accepted $75,000 in satisfaction
                               - 6 -


of the lien.   Out of the $112,000 eventually awarded in the Lane

litigation, petitioners received the net amount of $37,000.

     In 1991, petitioners reported the casualty loss they

suffered through the damage to their property and the

reimbursement they received for repairs.   Petitioners reported

that they received a total of $269,467.20, for which they claimed

nonrecognition treatment under section 1033.   This figure

included the $102,467.20 received from Allstate before the

settlement, the $130,000 settlement payment and $18,500 from each

of Lane’s insurers, State Farm, and coincidentally, Allstate.

Respondent sent petitioners a notice of deficiency, stating that

the $130,000 settlement payment was taxable.   Respondent also

determined that the income increase caused purely mathematical

adjustments to deductions and exemptions taken by petitioners.

Respondent determined petitioners also owed a $7,939 accuracy-

related penalty under section 6662(a) for their failure to

include the $130,000 payment in income.    Petitioners dispute the

income tax deficiency and penalty.

                              OPINION

      The sole adjustment under consideration involves the

question of whether petitioners are entitled to use the

nonrecognition provisions of section 1033.   All other adjustments

and our consideration of the penalty depend on the outcome of

this primary issue.
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     Gain or loss realized on the disposition of property

generally must be recognized as taxable under section 1001(c).

Disposition of property includes the involuntary conversion of

property through condemnation and damage.   Rosenthal v.

Commissioner, 416 F.2d 491, 498 (2d Cir. 1969), affg. 48 T.C. 515

(1967).   Section 1033 provides an exception, allowing

nonrecognition of gain realized under specific circumstances.

     To qualify for the section 1033 nonrecognition, the gain

realized must have been:   (1) Compensation for the involuntary

conversion of the taxpayer’s property and (2) expended within a

specified period of time for the replacement of the converted

property with similar property.   Sec. 1033(a)(2)(A) and (B).

     Here, the parties disagree about the $130,000 received in

settlement of petitioners’ claim against Allstate.   Petitioners

argue that the settlement proceeds were compensation for the

involuntary conversion of their property and that the

compensation was expended for repairs to restore the house to its

original condition.   Respondent argues that the payment cannot

qualify for section 1033 treatment because it was not

compensation for a property loss nor was it used solely to

replace the involuntarily converted property.    If the payment was

to satisfy a claim for punitive damages, that portion would not

be “compensation” as required by section 1033.   See Lukhard v.

Reed, 481 U.S. 368, 389 (1987) (“Punitive damages * * * are a
                                 - 8 -


windfall * * * rather than compensation.”).     Because the amount

paid was in settlement of multiple claims, we must first

determine the character or nature of the settlement.

     When an amount is paid in settlement of litigation, we must

ascertain the specific claims, if any, for which the settlement

was paid.   Bagley v. Commissioner, 105 T.C. 396, 406 (1995),

affd. 121 F.3d 393 (8th Cir. 1997).      Where the settlement

language does not delineate which claims are being settled, the

most important factor in determining the nature of a settlement

payment is the payor’s intent in making the payment.      Knuckles v.

Commissioner, 349 F.2d 610, 613 (10th Cir. 1965), affg. T.C.

Memo. 1964-33.   If a payor’s intent cannot be discerned from the

settlement agreement, all the facts and circumstances surrounding

the case should be considered.     Robinson v. Commissioner, 102

T.C. 116, 127 (1994), affd. in part, revd. in part and remanded

70 F.3d 34 (5th Cir. 1995).   Specific factors to consider include

the details of the underlying proceeding and the allegations,

responses, and arguments contained in the pleadings of that

proceeding.   Id.

     Petitioners testified that the primary discussion at

conference was about the cost to repair the property, not about

the possibility of punitive damages.     Petitioners’ counsel in the

Allstate insurance controversy testified that the only reference

to punitive damages made in settlement negotiations was
                               - 9 -


petitioners’ willingness to give up any claim for such in return

for settlement close to the amount of actual damages.    At that

time, actual damages were estimated at $236,000,3 and the amount

to be paid to petitioners, including the $102,000 paid pursuant

to the earlier arbitration and the proposed $130,000 settlement,

was $232,000.   Allstate’s counsel corroborated that testimony by

stating that the money was paid to settle the claim for the cost

to repair the property and that no amount was paid to settle any

punitive damage claim.   For this reason, we find that Allstate

paid petitioners with the intent to compensate them, under their

homeowners’ policy, for actual damages incurred in the

involuntary conversion of their property.

     The second prong of nonrecognition of gain under section

1033 is that the money must be spent to replace the converted

property with similar property.    Sec. 1033(a)(2)(A).   The funds

may also be used to restore a converted property “so that it

could be used in the same manner as it was used prior to the

* * * [involuntary conversion].”    Rev. Rul. 67-254, 1967-2 C.B.

269, 270 (approving of the use of conversion compensation to

rearrange existing facilities and build a new building on the

remaining property after conversion); see also Rentz v.


     3
        The actual cost of repairs was more than the $269,467.20
petitioners eventually received in connection with this loss.
Respondent never questioned petitioners’ treatment of the
additional $37,000 payment from the Lane litigation.
                                - 10 -


Commissioner, T.C. Memo. 1977-13 (citing Rev. Rul. 67-254, supra,

with approval and allowing section 1033 treatment of conversion

compensation funds used to construct a property similar to the

converted property).

     Respondent has attempted to attack petitioners’ use of the

funds received from Allstate by arguing that petitioners made

improvements rather than replacements.       Respondent first pointed

out that petitioners replaced their Formica countertops with

Corian, a more expensive material.       However, petitioners

explained that they were able to buy the Corian at cost so that

it was less expensive than Formica.       Respondent then alleged that

petitioners had unnecessarily replaced trees on their property

with the settlement proceeds.    Petitioners countered, showing

that the trees had to be moved due to the placement of the new

retaining wall.   Respondent then attempted to show that

petitioners used the proceeds to replace clear glass with

colored, but petitioners paid the $300 to color the glass out of

their own pockets.   Finally, respondent argued that petitioners

had introduced air conditioning to the house though it had not

previously been air conditioned.    There is no cost breakdown of

the $4,156.75 paid to replace the entire heating system and to

add air conditioning.   However, even if we were to assume that

half of that amount was attributed to adding air conditioning, it

would be less than 1 percent of the total estimated repair cost.
                             - 11 -


Petitioners have shown that the funds received from Allstate were

used, in substantial part, to restore their property to the

original condition and though some enhancements were made, in a

relative sense, they were de minimis.   Petitioners’ actions

fulfill the use of funds requirement of section 1033.   See Davis

v. United States, 589 F.2d 446 (9th Cir. 1979).

     Because petitioners have met both requirements of section

1033 and have chosen not to recognize the $130,000 payment

received from Allstate in settlement of their homeowners’

insurance claim as taxable income, we hold for petitioners.    Due

to our holding on the income tax deficiency, the penalty is not

applicable.

     In light of the foregoing,


                                   Decision will be entered for

                              petitioners.
