                        T.C. Memo. 1998-432



                      UNITED STATES TAX COURT



            JUNG SIK LIM & BOK S. LIM, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 17433-97.                  Filed December 10, 1998.



     Matthew J. McCann, for petitioners.

     Wendy L. Wojewodski, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     GERBER, Judge:   Respondent determined a deficiency in

petitioners’ 1993 Federal income tax of $8,909.   Petitioners

claim an overpayment of their 1993 Federal income tax in the

amount of $4,172.   Respondent has conceded all adjustments

determined in the notice of deficiency, and the remaining issue

concerns petitioners’ claim for an overpayment.   In order to
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address petitioners’ claim for an overpayment, the parties have

asked us to decide whether the interest paid by petitioners is

deductible as business interest.    If the interest is deductible

as business interest, petitioners would be entitled to certain

deductions that were not originally claimed, and, in turn, they

would be entitled to an overpayment.

     Unless otherwise indicated, section references are to the

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

references are to the Tax Court Rules of Practice and Procedure.

                          FINDINGS OF FACT1

     At the time their petition was filed, petitioners resided in

Temple Hills, Maryland.   During August 1992, petitioners and

petitioner husband’s sister-in-law purchased real property

located at 3302 Branch Avenue, Temple Hills, Maryland (Branch

property).   Although the sister-in-law was a named purchaser, she

was only nominally involved in the real estate acquisition.     The

improvements on the property were a two-story building (Branch

building) and a parking lot.   Concurrent with the Branch property

purchase, the shares of stock of Volm’s Enterprise Corp. (Volm’s)

were purchased from the seller of the real estate.   Volm’s, a

subchapter C corporation, operated a liquor store on the first

floor of the Branch building under the name “Branch Avenue


     1
       The stipulations of fact and attached exhibits are
incorporated herein by this reference.
                                - 3 -


Liquors”.    Petitioners acquired 75 percent and the sister-in-law

the remaining 25 percent of Volm’s shares of stock.

     After the purchases of the realty and corporate stock,

Volm’s continued to use the ground floor of the Branch building

to operate a liquor store.    Petitioners, in addition to being the

majority owners of the liquor business, devoted the majority of

their time to the operation of the Branch building liquor store

business.    Petitioners and the sister-in-law used part of the

second floor of the Branch building as their personal residence.

The first floor of the Branch building, which is 2,640 square

feet, is slightly larger than the second floor, which is 2,160

square feet.    Volm’s also used a 286-square-foot office on the

second floor of the building.    Overall, 61 percent of the Branch

building is used by Volm’s to operate the liquor store, and 39

percent is used by petitioners and relatives as their personal

residence.

     During 1993, the liquor store business did not make rental

payments directly to petitioners for the business' use of the

Branch property.    Although there was no written lease, the liquor

store business paid certain expenses incurred in connection with

the Branch property in exchange for its use of the building.

Volm’s paid the real estate taxes on the Branch property of

$4,384.45 during 1993.    Volm’s also paid all of the utilities,

including the electric, gas, and sanitation costs, incurred for
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the Branch property.   The utility payments included the portion

used by petitioners and others as a personal residence.

Petitioners did not report as rental income on their 1993 Federal

tax return Volm’s payments of utility expenses or the real estate

taxes.   Petitioners, likewise, did not claim the interest or

depreciation paid or incurred in connection with the liquor store

business' rental of the Branch property.

     Other than the payment of utilities and taxes by Volm’s,

rent payments were not made during the 1992 or 1993 tax years

because of Volm’s startup cash-flow problems.    Beginning in 1994,

Volm’s began paying $3,000 monthly rent payments to petitioners.

      The purchase price of the Branch property was $700,000, and

petitioners incurred settlement costs of over $60,000.    The

purchase price of the property was allocated 57 percent to the

land and 43 percent to the building.    Petitioners obtained an

$800,000 Small Business Administration loan (SBA loan) to

purchase the Branch property.   The seller of the Branch property

retained a security interest in the property to secure seller-

financed debt of $280,000.   Although the sister-in-law was

designated as a purchaser, she did not contribute any money

toward the purchase of the Branch property and did not make any

mortgage payments on the loans secured by the property.    During

1993, petitioners made interest payments of $69,193.40 and

$21,163.68 on the SBA and seller-financed loans, respectively.
                                - 5 -


                               OPINION

     Petitioners did not report income from rent or claim

deductions for interest or depreciation in connection with Volm’s

use of the first floor and part of the second floor of the Branch

property.2   Petitioners claim an overpayment of the tax paid for

1993 based on the excess of deductions over the income that they

did not report or claim.    With respect to the deficiency

determined, respondent concedes that petitioners would owe no

additional tax for 1993, even if their overpayment was not

allowed.

     Respondent does not dispute the fact that petitioners paid

the interest totaling nearly $90,000.    We have found the

allocable percentages of business and personal use of the realty

and the allocable percentages of the purchase price attributable

to the land and building.    The parties have couched the issue for

our consideration solely in the context of whether petitioners

rented a portion of the Branch property to Volm’s.3   If we decide

     2
       In the context of the taxable year before the Court,
petitioners’ failure to report income attributable to Volm’s
payments of taxes, utilities, and expenses does not preclude the
possibility of an overpayment. That is so because petitioners
also failed to claim deductions in amounts far in excess of the
amount of any unreported income attributable to Volm’s payments.
Accordingly, unreported income would “wash” with the unclaimed
deductions, leaving sufficient amounts to generate the
overpayment sought by petitioners.
     3
       Although the fact pattern in this case could easily have
generated issues concerning investment interest, passive loss
                                                   (continued...)
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that there was a valid rental agreement between petitioners and

the liquor business, then respondent agrees that petitioners

would be entitled to interest and/or depreciation deductions on

Schedule E or Schedule A, as appropriate.   Petitioners concede

that they failed to report, as income, the payments made by the

liquor business on the real property and that they failed to

claim any interest (personal or business) or depreciation

deduction to which they may be entitled.    The parties agree that

if we decide that petitioners are entitled to deduct the business

interest, petitioners would be entitled to an overpayment to be

computed by the parties.4




     3
      (...continued)
activity, and related matters, the parties agreed that if we
decide that Volm’s and petitioners had a valid business rental
arrangement, then petitioners will be entitled to an overpayment
to be computed by the parties. If we decide otherwise,
petitioners will not be entitled to an overpayment or be liable
for a deficiency. Accordingly, the parties agreed at trial that
the sole determinant to deductibility lies in the answer to the
question of whether petitioners and the liquor business had a
landlord and tenant relationship and whether rent was paid.
     4
       We note that the parties’ arguments were cryptic and
difficult to follow. For example, even though respondent agreed
that the outcome of this case depended solely on the whether a
rental relationship existed between petitioners and the liquor
business, respondent argued that the limitations of sec. 163(d)
would apply to petitioners’ interest payments on the Branch
property. Because of the manner in which the issue was posed by
the parties and the limited scope of our inquiry, we must assume
that respondent agrees that sec. 163 would not limit petitioners’
deduction if we decide the issue, as framed, in petitioners’
favor.
                                - 7 -


     Respondent argues that the absence of a rental agreement

between petitioners and the corporation is a factor that supports

a finding that the property at issue did not produce rental

income.5   Petitioners counter that rent payments were not made by

the corporation for use of the Branch property initially because

of a lack of cash-flow.    Instead of making rental payments to

petitioners, the corporation paid the utilities and other

expenses incurred in operating the building.    Separate corporate

income tax returns were filed by Volm’s in which its income and

expenses were reported.    By the third year after the purchase

(the year following the one in issue), the corporation was able

to, and did, pay a $3,000 monthly rental to petitioners.

Initially, rent was paid for use of the building in the form of

the payment of expenses.    Although petitioners did not report

Volm’s payments of utilities and other expenses as rent, they

also did not claim the corresponding deductions for interest and

depreciation attributable to Volm’s usage of the Branch property.

     Generally, for purposes of deductibility, a taxpayer may

deduct reasonable rents paid for property used in a trade or


     5
       Respondent also referenced subsecs. 1.469-1T(e)(3)(ii),
(vi), and (vii), Temporary Income Tax Regs., 53 Fed. Reg. 5702,
5703 (Feb. 26, 1988), for his argument that Volm’s and
petitioners were in some type of joint venture, under which
Volm’s was allowed to operate the liquor business in the Branch
property. Because we find that there was a rental agreement
between petitioners and the liquor business, it is not necessary
to further address this aspect.
                               - 8 -


business.   Sec. 162(a)(3); Limericks, Inc. v. Commissioner, 165

F.2d 483, 484 (5th Cir. 1948), affg. 7 T.C. 1129 (1946).      A

taxpayer may rent property from a related person or entity, but

the deduction is limited to an amount that would have been paid

if the parties had dealt at arm’s length.     Sparks Nugget, Inc. v.

Commissioner, 458 F.2d 631, 635 (9th Cir. 1972), affg. T.C. Memo.

1970-74; Levenson & Klein, Inc. v. Commissioner, 67 T.C. 694, 715

(1977); Coe Lab., Inc. v. Commissioner, 34 T.C. 549, 585-586

(1960).   Here, however, the amount of rent paid by Volm’s, in the

form of the payment of expenses on the Branch property, was less

than the $3,000 monthly rent that was paid when Volm’s became

liquid.

     An oral lease between related parties has sufficed as the

basis for rental deductions.   E.g., Wy’East Color, Inc. v.

Commissioner, T.C. Memo. 1996-136.     Here, an established

corporate entity was using petitioners’ real property for

business purposes.

     Our holding in response to the limited question posed by the

parties is that a business rental relationship existed between

petitioners and the liquor business (Volm’s).    Accordingly,

petitioners are entitled to deduct business interest in an amount

attributable to the portion of the property used for the liquor

business.   To the extent that the interest is attributable to
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petitioners’ personal residential use of the property, it would

be deductible, subject to the appropriate limitations.

     To reflect the foregoing,

                                         Decision will be entered under

                                 Rule 155.
