                        T.C. Memo. 2002-166



                      UNITED STATES TAX COURT



                WAYNE A. MCFADDEN, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 11206-99.              Filed July 2, 2002.


     John M. Walker, for petitioner.

     H. Clifton Bonney, Jr., for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     BEGHE, Judge:   Respondent determined the following

deficiencies and accuracy-related penalties with respect to

petitioner’s Federal income tax:
                               - 2 -

                                       Accuracy-Related
                                           Penalty
         Year          Deficiency        Sec. 6662(a)
         1995           $39,052          $7,810.40
         1996            24,428             4,759.00

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years at issue, and

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

Procedure.

     After concessions, the issues for decision are whether

petitioner:   (1) Correctly computed his basis in a parcel of real

property he acquired and sold at a loss in 1995, or (2) in the

alternative, is entitled to a nonbusiness bad debt deduction in

1995 for a loan to petitioner’s daughter and her former

boyfriend.

     We hold: (1) Petitioner overstated his basis and the

resulting loss on the sale of the property that he computed on

his return, and (2) is entitled to a nonbusiness bad debt

deduction.

                         FINDINGS OF FACT

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

The stipulation of facts and attached exhibits are incorporated

by this reference.

     Petitioner resided in Foster City, California, when he filed

the petition in this case.
                                - 3 -

     Petitioner is an attorney licensed to practice law in the

State of California.    He maintains an office in San Mateo,

California, under the name Law Offices of Wayne A. McFadden.

Petitioner’s practice includes real estate law, family law, and

civil litigation.    Petitioner has two daughters, Stephanie and

Kari McFadden, and three sons, Johnathan, Rob, and Christian

McFadden.

     On January 1, 1986, petitioner established a profit-sharing

plan entitled The Law Offices of Wayne A. McFadden Profit Sharing

Plan (the profit-sharing plan or the plan).    Petitioner was the

fiduciary and sole beneficiary of the plan.    The record does not

indicate the times and amounts of petitioner’s contributions to

the plan.

     In 1988, petitioner caused the plan to make separate loans

to Stephanie and Johnathan (the 1988 loans) to enable each of

them to make a downpayment on a townhouse in Hercules,

California.    Each loan was for $30,000 with an interest rate of

12-1/2 percent.    Petitioner viewed the loans as business

transactions and required Stephanie and Johnathan each to execute

a note secured by a first deed of trust on the townhouse that she

or he purchased.    Stephanie and Johnathan made regular payments

on their loans.

     In 1989, Stephanie asked petitioner for another loan.     At

the time, she was dating David Payne (David), a plumber who lived
                                - 4 -

in Atascadero, California.   Atascadero is approximately 4 hours

south of Hercules.   Stephanie lived in Hercules while working as

an accountant for a construction company and would travel to

Atascadero on weekends to see David.

     Stephanie and David had become interested in purchasing a

particular residential property in Atascadero, but neither had

the financial ability to do so.   They wanted to live in the

house, refurbish it, and eventually resell it.     In addition to

his plumbing skills, David had experience framing houses.

Stephanie and David felt that with David’s craft skills and

experience they could make most of the desired improvements to

the house themselves.   Stephanie asked petitioner if he would

lend her and David the funds they needed to purchase and improve

the property.

     Petitioner, as the fiduciary of his profit-sharing plan, was

willing to lend funds from his plan to Stephanie and David.

Petitioner viewed the loan as an appropriate investment for his

profit-sharing plan and was diligent in reviewing the feasibility

of Stephanie and David’s proposal.      Petitioner inquired about the

location and condition of the property, and the nature and extent

of the proposed improvements.   Petitioner consulted real estate

agents to confirm the adequacy of the security of a potential

loan.   He believed that Stephanie had real estate talent, and

that David’s craft skills provided an opportunity to enhance the
                                - 5 -

value of the property at a minimal labor cost.   Stephanie and

David told petitioner that David would make approximately 80

percent of the improvements in exchange for $1,000 per month.

Petitioner concluded that the loan to Stephanie and David would

give the plan an opportunity to earn a 12-1/2 percent return.

     Petitioner agreed to lend Stephanie and David funds from his

profit-sharing plan for part of the purchase price and all the

subsequent improvements to the Atascadero property.

     In January 1990, petitioner, as the plan’s fiduciary, made

the first in a series of 33 loans totaling $160,701 to Stephanie

and David from his profit-sharing plan.    The purpose of the loans

was to make the downpayment on residential property in

Atascadero, California, and postacquisition improvements.    The

loans were made over an 18-month period beginning in January 1990

and ending in August 1991.   The amounts of the loans varied from

$500 to $23,000.    Petitioner believed that his only recourse in

the event of default would be to the Atascadero property.

     On February 14, 1990, Stephanie and David purchased a

single-family residence in Atascadero, California, for $225,000,

with Stephanie acquiring an 80-percent interest and David a 20-

percent interest.   The residence had two bedrooms, three

bathrooms, and was situated on 3.3 acres of land.   Stephanie and

David financed the purchase of the Atascadero property by

obtaining a $180,000 loan from the Great Western Bank (the Great
                               - 6 -

Western loan) in exchange for a note secured by a first deed of

trust to the Atascadero property.    The balance of the purchase

price was financed by the loans to Stephanie and David from

petitioner’s profit-sharing plan.

     David moved into the residence on the Atascadero property

shortly after the purchase and immediately began making

improvements.   Stephanie continued to work and live in Hercules

but traveled to Atascadero on the weekends to be with David and

to help him with the improvements.     When Stephanie and David

acquired the property, Stephanie intended to reside there full

time when her financial situation improved.     At no time did

Stephanie become a full-time resident of the Atascadero property.

     The improvements made by Stephanie and David included:

Paving the driveway; converting the existing carport to living

space; building a new carport, bathroom, jacuzzi, and master

bedroom with a full bath; and adding two fireplaces.     David was

paid $1,000 per month out of the funds borrowed from petitioner

and, as expected, made approximately 80 percent of the

improvements.   By all accounts, the craftsmanship on the

residence was well regarded.   The improvements were completed

after approximately 1 year, and the property was listed for sale

shortly thereafter in 1991.

     Stephanie and David first listed the Atascadero property for

sale with a real estate agent on April 19, 1991, at an asking
                                - 7 -

price of $449,500.    The asking price remained $449,500 for

approximately 3 months, but failed to generate any offers.

Stephanie and David reduced the price to $379,500 in

approximately July 1991.    Despite the reduction, the Atascadero

property still failed to generate any offers.    Stephanie and

David’s real estate agent attributed the lack of interest to a

“soft” market and was of the opinion that a further reduction, to

$350,000, would be necessary to generate any offers.    Stephanie

and David were unwilling to reduce the price further and took the

property off the market in August 1991 with the hope that market

conditions would improve.

     On August 30, 1991, Stephanie and David consolidated the 33

loans (hereinafter the Atascadero loan) by executing a “Note

Secured By Second Deed Of Trust” in favor of petitioner’s profit-

sharing plan.    The note states that Stephanie and David are

individually, jointly, and severally liable for the outstanding

balance of $166,029 plus 12-1/2 percent interest from August 30,

1991, until paid, compounded annually.    The note was due 24

months after the date of the note (August 30, 1991), or upon the

sale, transfer, conveyance, or encumbering of the property.      The

note recites that the holder may proceed against the makers

independently.    The note is secured by a second deed of trust and

assignment of rents to the Atascadero property.
                                - 8 -

     Stephanie and David made unsuccessful attempts to sell the

Atascadero property at different times over the next 2 years.

Stephanie and David leased the property to tenants during some

portions of the period that they owned the property.    David lived

on the Atascadero property during periods he and Stephanie could

not find tenants.    In 1993, Stephanie and David ended their

relationship.

     At some point during or before 1994, Stephanie sold her

townhouse in Hercules and built a home in Oakland, California, in

which she resided.    While Stephanie lived in Oakland, her mother

experienced health problems and moved in with her.

     In 1994, respondent examined petitioner’s profit-sharing

plan and trust.   Respondent determined that the 1988 loans to

Stephanie and Johnathan and the Atascadero loan to Stephanie and

David were prohibited transactions under section 4975(c) because

they were made to disqualified persons as defined by section

4975(e)(2).   Respondent required Stephanie and Johnathan to

correct the prohibited 1988 loans by returning the outstanding

loan balances to the plan by December 31, 1994, and that they

each pay a 5-percent excise tax and interest.    Johnathan and

Stephanie repaid the outstanding balances of their 1988 loans by

December 31, 1994.

     With respect to the Atascadero loan, respondent offered to

allow the transaction to be corrected in either of two ways.
                                - 9 -

First, the outstanding loan principal could be returned to the

plan, plus the interest the plan would have earned in all of 1994

and the first day of 1995.    Respondent determined that the

interest should be 6 percent, the rate historically earned by the

plan.    Respondent calculated the outstanding principal plus

interest on the Atascadero loan to be $176,276.    Respondent

computed this figure by adding the principal of the Atascadero

loan, $160,701, to the $5,570 outstanding balance of Stephanie’s

1988 loan.    The interest on the outstanding amount, as determined

by respondent, was $10,005.    The total amount required to be

returned to the plan on January 1, 1995, for correction was

$176,276.

     In the alternative, respondent offered to allow petitioner

to take an early deemed distribution of Stephanie and David’s

note on January 1, 1995, and agree to pay a 10-percent additional

tax for an early distribution prior to age 59-1/2 under section

72(t).    Respondent determined that the amount of the distribution

should be $176,276, which would have to be reported as income on

petitioner’s 1995 Federal income tax return.    The record does not

indicate how respondent calculated the value of the note secured

by the second deed of trust.    In exchange for petitioner’s taking

the deemed distribution of the note and paying the section 72(t)

additional tax, respondent agreed that petitioner would not be

liable for any other taxes, interest, or penalties with respect
                               - 10 -

to the loan to Stephanie and David.     Stephanie would be required

to pay a 5-percent excise tax and interest totaling $14,381.

     Respondent informed petitioner that no closing agreement

would be executed if he accepted the terms of either offer.

According to the examining agent, it was not the practice of

respondent to use closing agreements to resolve profit-sharing

plan disputes, except in cases of fraud and when a case is

selected for review.   A closing agreement would not be used to

resolve the dispute with petitioner because it did not fall

within either exception.   The dispute would be resolved when

petitioner performed according to the terms of the agreement.

     Petitioner agreed to a deemed distribution pursuant to the

terms offered by respondent.   On January 1, 1995, as the profit-

sharing plan’s fiduciary, petitioner assigned Stephanie and

David’s note, secured by the second deed of trust to the

Atascadero property, to himself as beneficiary of the plan.

Petitioner was 58 years old at the time of the distribution.

     In the beginning of 1995, Stephanie accepted a job in

Dallas, Texas.   Stephanie lived in a rented apartment in Texas

for more than half of 1995, continued to make the mortgage

payments on her home in Oakland where her mother resided, and

made payments on the Great Western loan on the Atascadero

property.   The monthly payments on the Great Western loan were
                               - 11 -

$1,214.   David did not make any payments on the Great Western

loan.

     On July 7, 1995 petitioner’s accountant notified him the

amount of the deemed distribution was incorrect because Stephanie

had repaid the outstanding balance on her 1988 loans prior to

December 31, 1994.   According to petitioner’s accountant, the

amount of the distribution should have been reduced by $5,905,

from $176,276 to $170,371.    Respondent agreed with this

reduction.

     By summer 1995, Stephanie was experiencing financial

difficulties from having to make 3 monthly payments.    Stephanie

informed petitioner that she could no longer continue making

payments on the Great Western loan and was going to default.

Petitioner became concerned that he would lose his security

interest in the Atascadero property if Great Western foreclosed

on the first deed of trust.    Petitioner’s fears were aggravated

when he discovered a State tax lien on the Atascadero property.

When he asked Stephanie about her other assets out of which his

note could be satisfied, Stephanie told him she had “nothing”.

Petitioner suggested to Stephanie that she was morally obligated

to sell the Oakland home to satisfy his note.    During their

conversations, petitioner learned that Stephanie was

contemplating filing for bankruptcy protection.    Petitioner

consulted a bankruptcy lawyer who advised that any gain from a
                               - 12 -

sale of the Oakland home would be exempt from Stephanie’s

creditors.   Petitioner also had conversations with David about

the debt.    Petitioner felt that David honestly wanted the loan to

be paid but concluded that David was not in a position to make

payments.

     In August 1995, after consulting with a real estate agent

about the value of the Atascadero property, petitioner accepted a

deed in lieu of foreclosure to the Atascadero property from David

and Stephanie to avoid losing his security interest.    The deed

states that it is in full satisfaction of the obligations secured

by the first deed of trust in favor of Great Western.    The deed

was executed by David on August 11, 1995, and by Stephanie on

August 21, 1995.   The fair market value of the Atascadero

property was $207,500 at the time the deed was executed.     The

outstanding balances on the loans from Great Western and

petitioner’s profit-sharing plan were $168,957 and $170,371,

respectively.   At the time the deed was conveyed to petitioner,

neither Stephanie nor David had made any principal payments on

the Atascadero loan.   Petitioner did not pursue a judgment in the

California courts for the balance of the loan because he believed

that California’s antideficiency statute, section 580b of the

California Civil Procedure Code (2002), precluded any recovery.

     Petitioner made the monthly payments on the Great Western

loan from September 1995 through December 1995.   Petitioner paid
                              - 13 -

the earthquake and homeowner’s insurance and the property taxes

on the Atascadero property in November 1995.   On December 29,

1995, petitioner sold the Atascadero property to Bryan Dunnivan

for $200,286.   Mr. Dunnivan took the property subject to the

Great Western first deed of trust and gave petitioner a note for

$32,000 secured by a deed of trust to the Atascadero property.

     On December 29, 1995, Stephanie sold her Oakland home.     In

1995, Stephanie also purchased a house in Dallas, Texas, which

she sold in 1996 for a gain of $45,401.   Stephanie earned $87,148

and $100,744 in 1995 and 1996, respectively.

     On his 1995 Federal income tax return, petitioner reported

the $170,371 early distribution in gross income and calculated a

tax of $17,037 for an early distribution under section 72(t).

Petitioner claimed a $136,331 short-term capital loss from the

sale of the Atascadero property.   Petitioner calculated a

$336,331 basis in the property, consisting of $170,371, the

amount owed him by Stephanie and David when he took the deed in

lieu of foreclosure, plus $168,957, the amount outstanding on the

note held by Great Western.   Petitioner acknowledges but does not

explain the $2,997 difference between the basis he claimed on his

return, $336,331, and the sum of the two amounts he used to

calculate the basis, $339,328 ($170,371 + $168,957).

     Petitioner did not claim any deduction for a worthless debt

on his 1995 return.   In response to respondent’s denial of the
                               - 14 -

capital loss on the sale of the Atascadero property claimed by

petitioner in his 1995 return, petitioner in his petition claimed

a capital loss deduction for the debt in the amount outstanding

on the Atascadero loan.

                               OPINION

     The issues for decision are whether petitioner:

(1) Correctly calculated his basis in computing a loss on the

sale of the Atascadero property, or (2) in the alternative, is

entitled to a deduction under section 166 for a worthless

nonbusiness debt.

     Respondent’s determination in the notice of deficiency is

presumed correct, and petitioner bears the burden of proving it

is incorrect.   Rule 142(a);1 Welch v. Helvering, 290 U.S. 111,

115 (1993). We hold that petitioner incorrectly calculated his

basis in the Atascadero property.   Petitioner’s basis in the

Atascadero property was $207,500, which entitles petitioner to a

$7,214 loss on the December 29, 1995, sale of the property to

Bryan Dunnivan for $200,286.   Additionally, we hold that

petitioner is entitled to a $131,828 deduction for a nonbusiness

bad debt under section 166 for 1995.


     1
      Sec. 7491, which is effective for Court proceedings that
arise in connection with examinations commenced after July 22,
1998, places the burden on the Commissioner in certain
circumstances. However, petitioner has not contended, nor is
there evidence, that the examination of his 1995 return commenced
after July 22, 1998, or that sec. 7491 applies.
                                - 15 -



Petitioner’s Basis in the Atascadero Property

     Petitioner contends that his basis in the Atascadero

property, for the purpose of computing his loss on its sale to

Bryan Dunnivan was $339,328; this is the sum of the outstanding

balances of the two notes secured by the property, the $168,957

note held by Great Western and the $170,371 note received by

petitioner as a distribution from his profit-sharing plan.

Petitioner is mistaken.

     Section 1012 sets forth the fundamental proposition that

“the basis of property shall be the cost of such property”.        It

is well settled that the cost of property to a mortgagee who

receives a voluntary conveyance on account of a debt is the

property’s fair market value.    See Commissioner v. Spreckels, 120

F.2d 517, 520 (9th Cir. 1941); Kohn v. Commissioner, 16 T.C. 960,

962 (1951), affd. 197 F.2d 480 (2d Cir. 1952); Sargent v.

Commissioner, T.C. Memo. 1970-214.       It is as if the debtor had

sold the property to an outsider for cash, and then used the cash

to reduce the debt.   Commissioner v. Spreckels, supra.      Any

portion of the debt not satisfied by the conveyance may be

deducted under section 166 to the extent the taxpayer can prove

worthlessness.   Id.; Kohn v. Commissioner, supra.

     The case at hand differs slightly from the cited cases

because it involves a junior lienholder’s acquiring property
                               - 16 -

encumbered with a senior lien.    Like the cited cases,

petitioner’s basis in the Atascadero property is its fair market

value, but the existence of the Great Western mortgage requires

additional explanation as to how we arrive at the fair market

value basis.

     In the case at hand, petitioner’s recourse debt, owed him by

Stephanie and David on the Atascadero loan, was satisfied to the

extent of $38,543, the amount by which the property’s fair market

value--$207,500--exceeded the Great Western note secured by the

first deed of trust--$168,957--and is a “cost” of the property to

petitioner.

     In addition, petitioner took the property subject to the

Great Western note secured by the first deed of trust, which had

an outstanding balance of $168,957 on the date petitioner

acquired the property.    A purchaser’s basis under section 1012

includes genuine indebtedness to which the property is subject.

Estate of Franklin v. Commissioner, 544 F.2d 1045, 1049 (9th Cir.

1976), affg. 64 T.C. 752 (1975); Bertoli v. Commissioner, 103

T.C. 501, 515 (1994).    The genuine nature of the Great Western

loan is not in dispute; petitioner respected the debt to which

the property was subject and made payments on the Great Western

loan to protect his interest in the Atascadero property.    The

outstanding balance on the Great Western loan–-$168,957–-is

included in petitioner’s cost basis.
                               - 17 -

       Petitioner’s basis in the Atascadero property is $207,500,

which is the fair market value as stipulated by the parties on

the date he acquired the property and is also the sum of the

extent to which his debt was satisfied--$38,543--and the balance

of the Great Western loan to which the property was subject--

$168,957.

       On December 29, 1995, petitioner sold the Atascadero

property to Bryan Dunnivan for $200,286.    Respondent has not

argued that the December 29, 1995, sale was not at arm’s length.

We hold that petitioner is allowed a $7,214 short-term capital

loss for 1995 on the sale of the property to Mr. Dunnivan.

Section 166 Deduction

       When a creditor receives property on account of a recourse

debt, the debt is considered satisfied to the extent of the value

of the property acquired.    Commissioner v. Spreckels, supra at

520.    The unpaid balance of the debt may be deducted under

section 166 if and to the extent that the taxpayer can establish

its worthlessness.    Id.; Kohn v. Commissioner, supra; Litzenberg

v. Commissioner, T.C. Memo. 1988-482; Shaheen v. Commissioner,

T.C. Memo. 1982-445; Sargent v. Commissioner, supra; see also

sec. 1.166-6, Income Tax Regs.

       In the case at hand, when petitioner accepted the deed in

lieu of foreclosure, the Atascadero loan, the balance of which

was $170,371, was satisfied to the extent of $38,543, the amount
                              - 18 -

Stephanie would have received had she sold the property for cash

subject to the Great Western first deed of trust and paid the

cash to petitioner.   As discussed below, petitioner is entitled

to treat the excess of the Atascadero loan, $131,828, as a

worthless nonbusiness debt under section 166.

     Section 166 allows a deduction for any debt that becomes

worthless within the taxable year.     Sec. 166(a)(1).   The parties

agree that the Atascadero loan was a nonbusiness debt.     A

nonbusiness debt is any debt that is not created or acquired in

connection with a trade or business of the taxpayer.     Sec.

166(d)(2)(A).   In the case of nonbusiness debt, the deduction is

treated as a loss from the sale or exchange of a capital asset

held for not more than 1 year.   Sec. 166(d)(1)(B).

     Taxpayers seeking to avail themselves of the so-called bad

debt deduction must prove the existence of a bona fide debt, as

defined by section 1.166-1(c), Income Tax Regs., and that the

debt became wholly worthless during the tax year in which it was

deducted, sec. 1.166-5(a)(2), Income Tax Regs.

     On reply brief, respondent insinuates that the loan payments

from petitioner’s profit-sharing plan to Stephanie and David were

gifts rather than bona fide debt.    This position is diametrically

opposed to the characterization respondent has given the payments

since 1994.   Throughout the course of the examination of the

profit-sharing plan and trust, the settlement discussions
                               - 19 -

regarding the prohibited transactions, and the trial and

subsequent briefs in the case at hand, respondent has repeatedly

referred to the funds advanced to Stephanie and David as “loans”

and “debt”.   Respondent has clearly had ample opportunity to take

the position that the funds were in reality gifts but waited

until the final installment of the briefing schedule.    Respondent

cannot unbake the cake by springing this argument on petitioner

and the Court this late in the game.

     For completeness, we shall discuss whether the Atascadero

loan was bona fide debt.    Bona fide debt is debt that arises from

a debtor-creditor relationship based upon a legally valid and

enforceable obligation to pay a fixed or determinable sum of

money.   See sec. 1.166-1(c), Income Tax Regs.   Whether a debtor-

creditor relationship exists depends on all the facts and

circumstances, and generally no one fact is determinative.    An

essential question is whether there is a good-faith intent on the

part of the recipient of the funds to make repayment, and a good-

faith intent of the person advancing the funds to enforce

repayment.    In determining whether such intent exists, we

consider all the evidence, and we evaluate whether there was a

reasonable expectation of repayment in light of the economic

realities at the time the funds were advanced.   See Fisher v.

Commissioner, 54 T.C 905, 909-910 (1970).

     Intrafamily transfers are subject to close scrutiny and may
                               - 20 -

be presumed to be gifts.   The presumption may be rebutted by an

affirmative showing that, at the time of the transaction, there

was a real expectation of repayment and a real intent to enforce

the collection of the asserted debt.    See Estate of Van Anda v.

Commissioner, 12 T.C. 1158 (1949), affd. per curiam 192 F.2d 391

(2d Cir. 1951).

     Some of the factors we consider when determining whether

there is a debtor-creditor relationship with a reasonable

expectation of repayment are whether:   (1) There is a note or

other evidence of indebtedness; (2) interest is charged; (3)

there is a fixed schedule for repayment; (4) security or

collateral is requested; (5) there is any written loan agreement;

(6) a demand for repayment has been made; (7) the parties’

records reflect the transaction as a loan; (8) repayments have

been made; and (9) the borrower was solvent at the time of the

loan.    See Hunt v. Commissioner, T.C. Memo. 1989-335.

     The case at hand presents enough of the above indicia to

satisfy us that there was a debtor-creditor relationship.    The

Atascadero loan is evidenced by a note executed by Stephanie and

David in favor of petitioner; the note was secured by a second

deed of trust to the Atascadero property; and interest was

charged at a rate well above the applicable Federal rate.2   See

     2
      In January 1990, when Stephanie and David received the
first disbursement of funds, the applicable Federal rate was 7.90
percent for short-term loans with an annual period of
                                                   (continued...)
                               - 21 -

sec. 7872.    In addition, petitioner testified that he viewed the

Atascadero loan as an investment for his profit-sharing plan.

Stephanie testified that the funds were loans, and that she had

always intended to repay the amounts borrowed.    We found

petitioner and Stephanie to be credible, forthright, and

believable in all respects.    The advances from petitioner’s

profit-sharing plan to Stephanie and David were bona fide debt.

We go on to examine whether the debt became worthless in 1995.

     The worthlessness requirement for nonbusiness debts is

interpreted strictly:    The deduction is unavailable if even a

modest fraction of the debt can be recovered.    Bodzy v.

Commissioner, 321 F.2d 331, 335 (5th Cir. 1963) (“last vestige of

value” must have “disappeared”), affg. T.C. Memo. 1962-40;

Clanton v. Commissioner, T.C. Memo. 1995-416 (“partial

worthlessness is insufficient”); sec. 1.166-5(a)(2), Income Tax

Regs.    This “hard line” approach is taken because the parties to

nonbusiness debts are typically members of the same family.     The

requirement of total worthlessness minimizes the opportunities

for taxpayers to claim deductions for gifts to family members.

Buchanan v. United States, 87 F.3d 197, 199 (7th Cir. 1996).

     To prove the worthlessness of a nonbusiness debt, a taxpayer

must be able to point to some particular event or group of facts



     2
      (...continued)
compounding. In August 1991, when the loans were consolidated,
the rate was 6.81 percent. See Rev. Rul. 90-1, 1990-1 C.B. 155;
Rev. Rul. 91-41, 1991-2 C.B. 352.
                                - 22 -

that proves worthlessness.     Coborn v. Commissioner, T.C. Memo.

1998-377 (citing     Am. Offshore, Inc. v. Commissioner, 97 T.C.

579, 593-594 (1991)), affd. 205 F.3d 1345 (8th Cir. 1999).

Petitioner must establish sufficient objective facts from which

worthlessness could be determined.       Fox v. Commissioner, 50 T.C.

813, 822-823 (1968), affd. per curiam 25 AFTR 2d 70-891, 70-1

USTC par. 9373 (9th Cir. 1970).    A debt is considered worthless

when there are reasonable grounds for abandoning hope that the

debt will be repaid.    The decision must be made in the exercise

of sound business judgment.     Andrew v. Commissioner, 54 T.C. 239,

248 (1970).   Legal action is not required to enforce payment

where the surrounding facts and circumstances indicate that, in

all probability, the action would not result in an enforceable

judgment in favor of the lender.    Sec. 1.166-2(b), Income Tax

Regs.   The determination by the trier of fact that a debt has

become worthless requires an examination of all the facts and

circumstances.     Boehm v. Commissioner, 326 U.S. 287, 293 (1945);

Dallmeyer v. Commissioner, 14 T.C. 1282, 1291 (1950).

     Petitioner contends he had two grounds for concluding the

Atascadero loan was worthless in 1995.      First, he argues that

Stephanie’s financial condition in 1995 had deteriorated to the

point where he would have been unable to recover any of the

outstanding balance from her.    Second, petitioner contends that
                             - 23 -

section 580b of the California Code of Civil Procedure (section

580b) prevented him from obtaining a deficiency judgment against

either Stephanie or David for the balance of the debt, in effect

rendering worthless the balance of the note.

     Respondent contends that petitioner either made a gift to

Stephanie and David when he did not take collection action, or

that he failed to prove the debt was worthless.   Respondent

emphasizes that Stephanie earned $87,148 and $100,744 in 1995 and

1996, respectively, and sold houses in both of those years.

Respondent also disputes the application of section 580b.

     Petitioner’s decision to take a deed in lieu of foreclosure

to the Atascadero property and conclude that the outstanding

balance of the Atascadero loan was worthless in 1995 under

section 166 reflected an exercise of sound business judgment.

     Petitioner’s inquiries into the ways in which Stephanie

might satisfy the debt refute respondent’s argument that

petitioner made gifts to Stephanie and David and support the

conclusion that the debt was worthless.   In 1995, Stephanie was

in dire economic straits from having to service both the Great

Western loan and the loan on her home in Oakland, as well as pay

rent on an apartment in Texas.   Stephanie informed petitioner

that she had to keep her apartment in Texas where she lived and

worked, and that she was unwilling to evict her mother to sell
                               - 24 -

the Oakland home.    Her only option was to cease making payments

on the Great Western loan.    Great Western would then have

foreclosed on its first deed of trust, which would have resulted

in petitioner’s second deed of trust being forfeited to the

senior lienholder.    Nevertheless, petitioner inquired into the

value of Stephanie’s home in Oakland with the view to convincing

her to sell the home and use the proceeds to satisfy her debt to

petitioner.    However, Stephanie’s financial condition had

deteriorated to the point where she was contemplating filing for

bankruptcy.    A bankruptcy attorney advised petitioner that the

gain from any sale of the Oakland home would be exempt from

creditors.    After his discussions with Stephanie, in which she

informed him that she had “nothing”, petitioner concluded that

the only asset out of which she could satisfy her debt was the

Atascadero property.

     We are unmoved by respondent’s argument that Stephanie’s

income in 1996 would have enabled her to make payments to

petitioner.    A taxpayer is not required to “‘wait until some turn

of the wheel of fortune may bring the debtor into affluence.’”

Andrew v. Commissioner, 54 T.C. 239, 249 (1970) (quoting

Minneapolis, St. Paul & Sault Ste. Marie R.R. Co. v. United

States, 164 Ct. Cl. 226, 241 (1964)).    Our concern is whether

petitioner exercised sound business judgment when he concluded

the debt was worthless in 1995.    Petitioner has established that
                              - 25 -

in 1995 he did not believe Stephanie would be able to make

payments on his debt, and that it was worthless.3

     Petitioner also had conversations with David about the debt.

Petitioner testified credibly that he believed that, even though

David was honest and wanted the debt paid, he did not have the

means to make payments.   Petitioner also consulted a real estate

broker concerning the value of the Atascadero property.

Petitioner took a deed in lieu of foreclosure to protect his

security interest and to salvage part of the debt he was owed.

     In addition to Stephanie’s and David’s inability to pay,

petitioner’s decision that the debt was worthless was based on

section 580b of the California Code of Civil Procedure.

Petitioner believed that section 580b barred him from pursuing an

action to recover the outstanding balance from either Stephanie

or David.   Section 580b provides that no deficiency judgment may

be obtained--

     after a sale of real property * * * for failure of the
     purchaser to complete his contract of sale, or under a
     deed of trust * * * or mortgage * * * given to the
     vendor to secure payment of the balance of the purchase
     price of that real property, * * * or under a deed of
     trust * * * or mortgage * * * on a dwelling for not
     more than four families given to a lender to secure


     3
      Petitioner did not claim a bad debt deduction on his 1995
return. Even though he believed the debt was worthless in 1995,
petitioner was under the mistaken impression that the proper tax
treatment of the worthless debt was to account for it as part of
his basis in the Atascadero property. Petitioner’s
misunderstanding of the proper tax treatment does not alter our
conclusion that he reasonably believed the debt was worthless in
1995.
                             - 26 -

     repayment of a loan which was in fact used to pay all
     or part of the purchase price of that dwelling
     occupied, entirely or in part, by the purchaser. [Cal.
     Civ. Proc. Code sec. 580b (West 2002).]

     While both petitioner and respondent devoted substantial

space in their briefs attempting to persuade the Court to adopt

their respective views of the proper construction of section

580b, we need not resolve this question.4   In the light of

Stephanie’s and David’s inability to pay, we view petitioner’s

conclusion that the unsatisfied portion of the Atascadero loan

was worthless as an exercise of sound business judgment.

     To give effect to the foregoing conclusions,


                                        Decision will be entered

                                   under Rule 155.




     4
      Although the application of Cal. Civ. Proc. Code sec. 580b
(West 2002) to petitioner’s loan is not clear, the policy behind
the statute and its liberal application by the California courts,
Roseleaf Corp. v. Chierighino, 378 P.2d 97, 101 (Cal. 1963)
(purpose of sec. 580b is to place the risk of inadequate security
on the lender); BMP Prop. Dev. v. Melvin, 198 Cal. App. 3d 526
(1988) (“purchase money” includes funds used to satisfy the
purchase price and funds used for other purposes that are an
integral part of the consummation of the transaction); Prunty v.
Bank of Am., 37 Cal. App. 3d 430 (1974) (courts have accorded
sec. 580b a reading that often goes beyond the bounds of the
statutory language), suggest that petitioner’s decision to avoid
the financial and time costs of risky litigation was reasonable.
