                       T.C. Memo. 1998-134



                     UNITED STATES TAX COURT



           DAKOTAH HILLS OFFICES LIMITED PARTNERSHIP,
                  AN ARIZONA LIMITED PARTNERSHIP,
                WILLIAM M. AND DIANNE B. STEPHENS,
          TAX MATTERS PARTNER, ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     1
      Cases of the following petitioners are consolidated
herewith: Pavillion II Limited Partnership, An Arizona Limited
Partnership, William M. and Dianne B. Stephens, Tax Matters
Partner, docket No. 18956-93; Copper Crest I Limited Partnership,
An Arizona Limited Partnership, William M. and Dianne B.
Stephens, Tax Matters Partner, docket No. 18962-93; Dakotah Hills
Retail Limited Partnership, An Arizona Limited Partnership,
William M. and Dianne B. Stephens, Tax Matters Partner, docket
No. 18963-93; Club Carmel Limited Partnership, An Arizona Limited
Partnership, William M. and Dianne B. Stephens, Tax Matters
Partner, docket No. 18965-93; Pio Decimo II Limited Partnership,
An Arizona Limited Partnership, William M. and Dianne B.
Stephens, Tax Matters Partner, docket No. 18990-93; Ina
Thornydale Limited Partnership, An Arizona Limited Partnership,
William M. and Dianne B. Stephens, Tax Matters Partner, docket
No. 18992-93; Ironwood Manufacturing, Ltd., An Arizona Limited
Partnership, William M. and Dianne B. Stephens, Tax Matters
Partner, docket No. 18993-93; and Vail Commerce Center Limited
Partnership, An Arizona Limited Partnership, William M. and
Dianne B. Stephens, Tax Matters Partner, docket No. 19067-93.
                                  - 2 -

          Docket Nos. 18955-93,      18956-93,   Filed April 6, 1998.
                      18962-93,      18963-93,
                      18965-93,      18990-93,
                      18992-93,      18993-93,
                      19067-93.



William M. and Dianne B. Stephens, pro sese.2

James E. Archie, for respondent.


                           MEMORANDUM OPINION

     HAMBLEN, Judge:     Respondent issued a notice of final

partnership administrative adjustments (FPAA) to each partnership

involved in these cases.      The proposed adjustments determined by

respondent in each case for the 1989 taxable year are as follows:

          Partnership                            Adjustment

     Dakotah Hills Offices Ltd. Partnership       $385,519
     Pavilion II Ltd. Partnership                  432,084
     Copper Crest I Ltd. Partnership               181,371
     Dakotah Hills Retail Ltd. Partnership         972,812
     Club Carmel Ltd. Partnership                  234,902
     Pio Decimo II Ltd. Partnership              2,685,926
     Ina Thornydale Ltd. Partnership               480,813
     Ironwood Manufacturing Ltd. Partnership       918,765
     Vail Commerce Center Ltd. Partnership         417,156


After concessions, the principal issue for decision is whether

petitioners recognized income pursuant to a section 752(b) deemed

distribution.3


     2
      On Jan. 30, 1996, this Court granted George Tomas Rhodus'
petition to withdraw as counsel for petitioners.
     3
      All section references are to the Internal Revenue Code in
effect for the year at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
                                                   (continued...)
                                  - 3 -

                           FINDINGS OF FACTS

     This case was submitted on the basis of the entire record.

The stipulation of facts and the annexed exhibits are

incorporated herein and found accordingly.        The principal place

of business of the partnerships was located in Tucson, Arizona,

at the time the petitions were filed.        The partnerships were

formed on the following dates:

     Dakotah Hills Offices Limited                 October 25, 1984
     Pavilion II Limited Partnership               May 16, 1986
     Copper Crest I Limited Partnership            February 7, 1986
     Dakotah Hills Retail Limited Partnership      July 19, 1985
     Club Carmel Limited Partnership               August 22, 1985
     Pio Decimo II Limited Partnership             December 18, 1984
     Ina Thornydale Limited Partnership            April 9, 1985
     Ironwood Manufacturing Limited Partnership    December 3, 1985
     Vail Commerce Center Limited Partnership      December 3, 1985


     The Agreements and Certificates of Limited Partnership

(Agreements) designated, inter alia, D. Randall Jenkins, and the

JNC Companies, as the general partners for the partnerships.

Most of the Agreements provided that the partnerships were to be

capitalized by promissory notes (investor notes) which were

executed and delivered by the limited partners to the

partnerships as consideration for the acquisition of their

partnership interests, i.e., "partnership units".         In most

instances, the Agreements provided:

          2.10 First Promissory Note(s): Shall mean the
     Demand Promissory Note(s) executed by the Limited
     Partners as payment for each Limited Partnership


     3
      (...continued)
indicated.
                               - 4 -

     Unit(s) being purchased, and shall be in an amount
     equal to [dollar amounts] per unit which shall be
     secured by the Limited Partner's unit(s) being
     purchased and which is intended to be converted into an
     installment promissory note(s) (the "Second Promissory
     Note") when the Partnership obtains a financial
     commitment from a bank, savings and loan association or
     other financial institution.

               *    *     *    *       *   *   *

          2.18 Partnership Unit: Partnership unit is the
     quantitative term of measurement used to measure one
     (1) Limited Partner's interest in the Limited
     Partnership as compared with other Limited Partners and
     the entire Partnership. * * *

               *    *     *    *       *   *   *

          2.21 Second Promissory Note(s): Shall mean the
     Second Promissory Note(s) shall be executed by the
     Limited Partners as a modification of and in
     satisfaction of the First Promissory Note(s) and shall
     be prepared so as to satisfy the requirements of the
     bank, savings and loan association or other financial
     institution that has given the Partnership a loan
     commitment.


Similarly, the remaining Agreements stipulated that the investor

notes would be utilized to acquire partnership interests in the

limited partnerships.   Furthermore, the Agreements required each

investor to execute a security agreement which conveyed to the

partnership a security interest in his or her partnership
                                 - 5 -

interest.4   This requirement was imposed, in part, to secure

payment of the investor notes.

     In accordance with the aforementioned security agreements,

the partnerships negotiated, pledged, and assigned all of the

investor notes as collateral for loans to the partnerships from

financial institutions.   In turn, the partnerships acquired a

number of real properties with the loan proceeds.   The notes

issued to the lenders by the partnerships were nonrecourse to the

general partners, but through various additional agreements, the

general partners were rendered liable with respect to the

partnership indebtedness.   These notes were not, by their terms,

recourse to the limited partners.5




     4
      As an example, on Oct. 12, 1984, William M. and Dianne B.
Stephens, as investors, signed a Security Agreement, in which
they:
     [acknowledged] that the investor note and this
     agreement, which stands as collateral therefore [sic],
     will be assigned by the partnership as collateral for a
     loan to a lender, and [the Stephens] hereby expressly
     waives every defense, counterclaim or set-off which
     [the Stephens] or any of [the other investors] may now
     have or hereinafter may have to any action by such
     lender or the lender's assignee.

This Security Agreement designates "Dakotah Hills Offices Limited
Partnership" as the "Secured Party".
     5
      For purposes of this opinion, the term, "recourse
indebtedness" means that the debtor's assets may be reached by
creditors if the debt is not paid. Conversely, "nonrecourse
indebtedness" means that a creditor's remedies are limited to a
particular collateral for the debt. Raphan v. United States, 759
F.2d 879 (Fed. Cir. 1985).
                               - 6 -

     As an additional inducement for the lenders to accept the

investor notes from the partnerships as collateral, the

partnerships negotiated and purchased financial guaranty bonds

from Admiral Insurance Co. (Admiral).   The bonds provided that in

the event any limited partner defaulted on his or her obligations

under the investor notes, Admiral agreed to pay to the lender(s)

the amount due under the investor notes.   The terms of the

financial guaranty bonds provided that upon the satisfaction of

the bond, the lenders were required to transfer the investor

notes as well as the security agreements to Admiral.

     Concomitantly with the purchase of the bonds, the

partnerships entered into indemnity agreements in which the

partnerships agreed to indemnify Admiral against any loss on the

bonds.   In most instances, the partnerships' obligation under the

indemnity agreements was secured by liens on real estate

properties owned by the partnerships.

     Sometime in 1987 and 1988, the partnerships initiated

bankruptcy proceedings and terminated payments on the partnership

notes held by the financial lenders.    Consequently, the lenders

made demand on the limited partners who had contributed the

investor notes, to the extent stipulated in the financial

guaranty bonds.   The limited partners, however, refused to honor

the outstanding investor notes.   The lenders, therefore, demanded

and received a settlement from Admiral pursuant to the terms of

the bonds.
                               - 7 -

     Subsequently, within and without the bankruptcy proceedings,

the parties engaged in prolonged and lengthy litigation.    In

particular, Admiral sued the limited partners who had defaulted

on the outstanding investor notes, contending that it had become

the holder of the aforementioned notes.    The limited partners, in

turn, countersued Admiral, alleging that they had been

fraudulently induced to enter the partnerships and that Admiral

had been party to the fraud.

     On November 10, 1989, Admiral and the representatives of the

limited partners, executed a Settlement Agreement.    The preamble

to the Settlement Agreement states that Admiral and the investors

were "parties to certain lawsuits" which, at the time of the

agreement, were "pending in the United States District Court for

the District of Arizona and/or the Arizona Superior Court in

which Admiral has asserted claims against Investors and Investors

have asserted claims against Admiral."6     Under the terms of the

Settlement Agreement, an investor was given until December 31,

1989, to elect one of two options.     The first option was as

follows:

          Commencing on the later of (i) January 1, 1990, or
     (ii) the effective date of any enacted statutory
     provisions amending the Internal Revenue Code to
     provide for preferential treatment with respect to the

     6
      It appears that at least some of the limited partners in
the various partnerships were parties to a suit against Admiral,
but the record does not disclose whether all of the limited
partners involved in this proceeding were parties to such
lawsuit.
                                 - 8 -

     gain arising from the sale or exchange of a capital
     asset, the Investors shall abandon their interests in
     the JNC Partnerships by conveying them to the Trustee,
     and thereafter, the Investors' promissory notes that
     are the subject of claims by Admiral against the
     Investors or are otherwise held by Admiral shall be
     returned to the Investors. The return of the
     Investors' promissory notes is intended as a purchase
     price reduction within the meaning of I.R.C. Section
     108(e)(5). * * *


The second option provided as follows:

          Immediately after the conclusion of the bankruptcy
     proceedings, the Investors shall convey their interests
     in the JNC Partnerships to the Trustee; and all
     promissory notes executed by the Investors that are the
     subject of claims by Admiral against the Investors or
     are otherwise held by Admiral shall be returned to the
     Investors. The return of the Investors' promissory
     notes is intended as a purchase price reduction within
     the meaning of I.R.C. Section 108(e)(5).


In sum, under the Settlement Agreement, an investor could

"abandon" his or her interest or interests in the partnership "by

conveying them to the Trustee", or the investor could elect to

"convey" his or her interest or interests in the partnership to

the trustee.   In either event, the investor notes were to be

returned.   Moreover, under the Settlement Agreement, the

investors assigned to Admiral:

     all of their right, title and interest in and to (i)
     any claim or cause of action against any and all Third
     Parties * * * and (ii) any claim, or cause of action
     which was, could have been, could be or might be
     asserted arising out of or in any manner related to the
     bankruptcy of JNC, the JNC Partnerships or the
     principals, general partners or affiliates thereof
     * * *
                               - 9 -

In turn, Admiral agreed not to pursue the investors' claims

against specific individuals enumerated in the document, but

reserved the right to "pursue any of the assigned claims against

any other person, or any of its own claims against any person."

The investors, however, retained the right to pursue other

specific, enumerated individuals at their own individual expense

and, through counsel of their own choosing.     Next, Admiral agreed

to "indemnify, defend and hold harmless the Investors" against

claims by third parties relating to the investor notes.     Finally,

on December 29, 1989, the Settlement Agreement was approved by

the bankruptcy court.7

     In April 1993, respondent mailed the FPAA's, to petitioners,

which proposed adjustments on the premise that "the discharge of

liability on the partners' capital contribution notes in 1989

resulted in a partnership distribution pursuant to * * * section

752(b)."

     Petitioners filed a petition with this Court contesting

respondent's proposed adjustments.     Thereafter, we granted

petitioners' motion to consolidate all of the cases, pursuant to

Rule 141.   Petitioners filed a motion for summary judgment, on

the ground that the adjustments in the FPAA's were not




     7
      The record indicates, however, that the Settlement
Agreement did not encompass all of the investors involved in the
partnerships.
                                - 10 -

"partnership items" for purposes of section 6231.8   Subsequently,

the case was submitted on the basis of the record.   Petitioners

did not file a brief, but respondent filed a brief within the

time designated by the Court.

                                OPINION

     In the instant case, the fundamental issue is whether there

was a section 752(b) distribution adjustment by any of the

partnerships to those limited partners who accepted the

settlement with Admiral and the partnerships.   Specifically, the

parties diverge on the legal substance and effect of the

Settlement Agreement.   Respondent asserts that the financial

arrangements embodied in the Settlement Agreement resulted in a

section 752(b) distribution to petitioners.   Conversely,

petitioners contend that none of the partnerships made such a

distribution to them.

     Section 61 requires that certain amounts be included in

gross income.   Section 61(a)(13) provides, in part, that gross

income means all income from whatever source derived, including,

inter alia, distributive shares of a partnership's gross income.

     Section 701 provides that a partnership is not liable for

Federal income taxes; instead, persons carrying on business as

partners are liable in their separate or individual capacities

for the income taxes arising from partnership operations.    In

     8
      The motion was denied. Dakotah Hills Offices Ltd.
Partnership v. Commissioner, T.C. Memo. 1996-35.
                               - 11 -

determining his or her income tax, a partner must take into

account his "distributive share" of each item of partnership

income, gain, loss, deduction, and credit.     Sec. 702.   Each

partner is taxed on his distributive share of partnership income

without regard to whether the income is actually distributed to

him.    Sec. 1.702-1(a), Income Tax Regs.   Section 722 provides

that the basis of a partnership interest acquired by contribution

of money or other property to a partnership is the amount of such

money, and the adjusted basis of such property, increased by any

gain recognized under section 721(b) to the contributing partner

at such time.

       A partner's basis of his partnership interest is subject to

adjustments.    In particular, a partner's share of liabilities of

the partnership are included in computing the partner's tax basis

of his partnership interest.    Cf. Crane v. Commissioner, 331 U.S.

1 (1947).

       Section 752(a) provides that any increase in a partner's

share of the liabilities of a partnership, or any increase in a

partner's individual liability by reason of the assumption by

such partner of partnership liabilities, shall be considered a

contribution of money by such partner to the partnership.      This

contribution results in an increase in the partner's basis of his

partnership interest.    Sec. 722.

       Section 752(b) provides that any decrease in a partner's

share of the liabilities of a partnership, or any decrease in a
                              - 12 -

partner's individual liabilities by reason of the assumption by

the partnership of such individual liabilities, shall be

considered as a distribution of money to the partner by the

partnership.   Likewise, such a decrease in a partner's share of

the liabilities of a partnership results in a reduction in a

partner's tax basis in his partnership interest.     Sec. 722.

     A partner's contribution of a promissory note to a

partnership will not, in and of itself, establish basis since the

note is not deemed to be cash, and is not property in which the

partner possesses a basis.   Sec. 722; Gemini Twin Fund III v.

Commissioner, T.C. Memo. 1991-315, affd. without published

opinion 8 F.3d 26 (9th Cir. 1993).     However, in order for a

limited partner to acquire basis in his or her partnership

interest with respect to the contribution of a promissory note,

the rules of section 752(a) apply.     Accordingly, if the limited

partner's share of the partnership's liabilities is increased

upon the contribution of a promissory note, the increase will be

treated as a contribution of money, and will, therefore, increase

basis pursuant to section 722.   Sec. 1.752-1(e), Income Tax

Regs.9

     The aforementioned provisions' requirement that the limited

partner is obligated to make an additional contribution is

satisfied if the limited partner has an unconditional, ultimate

     9
      Applicable to partnership liabilities incurred or assumed
before Jan. 30, 1989.
                               - 13 -

liability to contribute certain amounts toward the partnership's

recourse liabilities in the event the partnership's assets are

insufficient to satisfy the outstanding liabilities, and if the

limited partner has no right of reimbursement if constrained to

make up the difference.    Gefen v. Commissioner, 87 T.C. 1471

(1986); Abramson v. Commissioner, 86 T.C. 360 (1986); Smith v.

Commissioner, 84 T.C. 889 (1985), affd. without published opinion

805 F.2d 1073 (D.C. Cir. 1986).

     Accordingly, our determination in this instance concerns the

limited partners' personal liability with respect to the payment

of partnership recourse liabilities derived from the investor

notes that were contributed to the partnerships.    Respondent

contends that the limited partners became obligated to Admiral

due to the partnerships' failure to meet the terms of the various

loans from the lenders.    In turn, the limited partners were

either unable or refused to meet their obligations as delineated

in the investor notes.    Therefore, respondent argues that, in

1989, constructive distributions occurred as a result of the

Settlement Agreement between the limited partners, the

partnerships, and Admiral.    In particular, respondent cites the

language of the Settlement Agreement which provided that the

investor notes contributed by the limited partners would be

returned to the investors and never be enforced against the

limited partners themselves.    On the other hand, petitioners

argue that the investor notes were not liabilities, but, rather,
                              - 14 -

assets of the partnerships.   In essence, petitioners contend that

the investor notes did not result in an increase, pursuant to

section 752(a), in the basis of their partnership interests.

Additionally, petitioners evidently assert that Admiral was the

"equitable owner" of the investor notes, and that, the

partnerships were the owners de jure of the aforementioned notes.

In other words, petitioners argue that Admiral was not the

ultimate creditor.   Also, petitioners argue that since there was

no actual distribution of money, there was no section 752(b)

distribution.   We agree with respondent.

     The financing arrangements in the instant case rendered each

limited partner liable with respect to the recourse liabilities

of the partnerships up to and including the amount of that

limited partner's note in the event of default by the partnership

on such liabilities.   Moreover, at the inception of the

partnerships, the limited partners were aware that their investor

notes (held by the partnerships as assets) would be converted

into and applied as collateral by the partnerships.

Specifically, the limited partners executed security agreements

which conveyed to the respective partnerships security interests

in the investor notes.

     As noted, the partnerships held the investor notes as assets

which were utilized as collateral for loans in connection with

real estate acquisitions.   In particular, the partnerships

assigned their security interests in the investor notes to the
                               - 15 -

lenders.   Also, to obtain loans from the lenders, the

partnerships made financial arrangements with Admiral in which it

guaranteed the performance of the limited partners.    In that

regard, the partnerships executed an agreement to indemnify

Admiral against losses on the financial guaranty bonds in the

event that the insurance company was obligated to reimburse the

lenders on all outstanding loans.    In connection with the

foregoing transactions, Admiral possessed security interests in

the investor notes.   The partnerships, however, were unable to

discharge the indebtedness to the lenders.    Furthermore, upon

notice and demand from the lenders, the limited partners did not

meet their obligations under the outstanding investor notes.

Consequently, Admiral, as the guarantor, was obligated to pay the

lenders on the bonds.    Subsequently, there was a settlement in

which both Admiral and the partnerships released the limited

partners from all obligations on the investor notes, and, in

turn, the limited partners agreed to surrender and convey their

partnership interests back to the partnerships.    Moreover,

Admiral agreed to indemnify the limited partners against claims

by third parties in connection with the investor notes.

     The sum and substance of the foregoing transactions reflect

that the limited partners did not unilaterally possess rights of

reimbursement from the partnerships or the general partners for

amounts owed by the limited partners to the lenders with respect

to the investor notes.   At the time those notes were pledged as
                                - 16 -

collateral for the partnerships' liabilities, the limited

partners, accordingly, secured, pursuant to section 752(a), an

increase in the basis of their interests in the partnerships

equal to the amounts of those notes.

     In the Settlement Agreement, the investors were, in essence,

relieved of personal liability with respect to their interests in

the partnerships and in the investor notes.   When Admiral

satisfied the partnerships' obligations to the lenders, the

partnerships were under obligation to Admiral.   Correspondingly,

Admiral acquired all interest in the investor notes, and, for all

practical purposes, became the holder in due course of the

investor notes.   Admiral, therefore, became a creditor of the

partnerships, and an asset of the partnership (the investor

notes) was acquired by Admiral as collateral for the

partnerships' indebtedness to Admiral.

     Petitioners contend that, subsequent to the Settlement

Agreement, the partnerships still possessed "legal muniment of

title" in the investor notes.    In that vein, petitioners assert

that Admiral was simply the "equitable owner" of the investor

notes.   Petitioners argue, in essence, that while the Settlement

Agreement may have extinguished Admiral's security interest in

the investor notes, the partnerships still retained and held

interest in the investor notes as assets.

     The partnerships, however, did not possess any rights with

respect to the outstanding investor notes.    Petitioners disregard
                                - 17 -

the indisputable fact that the partnerships assigned the investor

notes to the lenders in return for real estate loans.    Once the

partnerships defaulted on the aforementioned loans, all title and

interest passed to the lenders.    In due course, Admiral,

therefore, possessed the right to hold the limited partners

liable on the investor notes.    Indeed, petitioners evidently

concede as much.    In that regard, the Settlement Agreement

divested the limited partners of liability for the outstanding

investor notes.    Also, in the event that the investors were still

held liable by third parties for the investor notes contributed

to the partnerships, Admiral agreed to compensate or save

harmless the aforementioned investors.    Accordingly, the

investors' execution of the Settlement Agreement resulted in

distributions to them under section 752(b).

     We reject, likewise, petitioners' contention that they are

not liable for a section 752(b) deemed distribution because there

was no actual cash distribution.    Although there was no such

distribution, petitioners are, pursuant to section 752(b),

considered to have received a deemed or constructive distribution

when they were relieved of their share of the partnerships'

debts.   O'Brien v. Commissioner, 77 T.C. 113, 118 (1981).

Specifically, O'Brien v. Commissioner, supra, involved a

partner's abandonment of his interest in a real estate

partnership.   The partnership held real estate subject to

nonrecourse debt.    The taxpayer sent a letter to the partnership
                              - 18 -

abandoning his interest and walked away from the venture.     The

partnership continued in business.     We held that a partner's

     abandonment of his partnership interest resulted in a
     decrease in his share of the partnership liabilities
     within the meaning of section 752(b), not because he
     ever had personal liability under State law, but
     because he is no longer considered under the applicable
     Code provisions as sharing in the nonrecourse
     liabilities of the partnership.


O'Brien v. Commissioner, Id. at 118.     Thus, the taxpayer was held

to have been relieved of his share of partnership liabilities

upon the abandonment of his interest, causing a constructive cash

distribution under section 752(b).     Moreover, this constructive

distribution was held to be in liquidation of the partner's

interest; it occurred upon termination of his partnership

interest by abandonment.   See also White v. Commissioner, 991

F.2d 657, 661 (10th Cir. 1993), affg. T.C. Memo. 1991-552

("reduction in partner's liabilities by reason of a partnership's

assumption of those liabilities is a cash distribution" citing

sec. 752(b)).

     As noted, in the Settlement Agreement, petitioners'

respective shares of the partnerships' recourse liabilities were

decreased.   Accordingly, under section 752(b), petitioners are

considered to have received constructive distributions through

the abandonment of their partnership interests and the

forgiveness of the outstanding investor notes by Admiral and the

partnerships.   White v. Commissioner, supra.
                              - 19 -

     Accordingly, we hold that petitioners realized distributions

pursuant to section 752(b).   Due to concessions,

                                         Decisions will be entered

                                    under Rule 155.
