                             T.C. Memo. 1996-393



                         UNITED STATES TAX COURT



SHERBURNE M. EDMONDSON, JR. AND DIANE L. EDMONDSON, Petitioners
         v. COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 22405-93.                         Filed August 22, 1996.



      Sherburne M. Edmondson, Jr., and Diane L. Edmondson, pro

sese.

      Matthew R. Kretzer, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


      JACOBS, Judge:     Respondent determined a $9,629 deficiency in

petitioners' 1988 Federal income tax, and additions to tax pursuant

to sections 6651(a)(1), 6653(a), and 6661 in the respective amounts

of   $1,802,   $653,   and   $2,407.   Pursuant    to   an   amended   answer,
                                       -2-

respondent increased the deficiency to $19,269, and the additions

to tax pursuant to sections 6651(a)(1), 6653(a), and 6661 to

$4,212, $1,135, and $4,817, respectively.

      Respondent and Sherburne M. Edmondson, Jr. (Mr. Edmondson),

entered into a Stipulation of Settled Issues (the settlement

stipulation) resolving all items in dispute except whether Diane L.

Edmondson (Ms. Edmondson), Mr. Edmondson's ex-wife, qualifies for

tax relief as an innocent spouse pursuant to section 6013(e).                 Ms.

Edmondson did not contest any of the compromised items, which would

have resulted in a deficiency in tax, including additions to tax,

being assessed jointly against her and Mr. Edmondson (but for

innocent spouse relief), but she refused to sign the settlement

stipulation because she felt "uncomfortable" doing so. In response

to the Court's inquiry, respondent's counsel agreed that should the

Court deny innocent spouse relief to Ms. Edmondson, respondent

would seek against her only the amount of taxes and additions to

tax   computed    under   the   settlement      stipulation    signed    by   Mr.

Edmondson and respondent.

      In general, respondent's determinations are presumed correct.

Thus, except for a matter pleaded in respondent's amended answer

(discussed below), Ms. Edmondson bears the burden of proving

respondent's determinations erroneous.                Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933). Since Ms. Edmondson failed to

introduce   any    evidence     with   regard    to   any   item   in   dispute,

respondent's determinations with respect to those items where Ms.
                                  -3-

Edmondson bears the burden of proof are sustained.         Thus, the

principal issue to be resolved is whether Diane L. Edmondson

qualifies for tax relief as an innocent spouse.

     We also must consider an issue raised by respondent's amended

answer, even though the matter was covered by the settlement

stipulation.    The issue so presented is whether gain from the sale

of a house in Seattle, Washington, which was owned by Mr. Edmondson

and his first wife, qualifies for deferred recognition pursuant to

section 1034.

     All section references are to the Internal Revenue Code for

the year in issue; all Rule references are to the Tax Court Rules

of Practice and Procedure.

                           FINDINGS OF FACT

Background

     At the time they filed their petition, Sherburne M. Edmondson,

Jr., and Diane L. Edmondson (hereinafter sometimes referred to as

the Edmondsons) resided in Sunnyvale, California.      Ms. Edmondson

(hereinafter referred to as petitioner) filed an amendment to

petition on April 12, 1995, asserting that she is an innocent

spouse.   Petitioner and Mr. Edmondson untimely filed their 1988

joint Federal income tax return on February 11, 1991.

The Edmondsons' Marriage

      Petitioner and Mr. Edmondson met in Seattle in 1981.       The

next year they married.    At that time, petitioner was 21 years old,

and Mr. Edmondson was approximately 10 years older.    Mr. Edmondson
                                      -4-

has   a   medical   technology   degree     and   worked   in   the   research

department of the University of Washington, performing medical

research on cardiovascular disease.          Petitioner failed to complete

high school and was not employed at that time.          Both petitioner and

Mr. Edmondson had children from previous marriages.

      Shortly after they married, the Edmondsons moved to San Diego.

Mr.   Edmondson     began   working   at    Scripps   Clinic    and   Research

Foundation.    In 1983, he acquired Glass Onion Records, a San Diego

record store.1      Petitioner worked in the store but was not paid.

The business failed sometime before 1988.

      During the year in issue, petitioner attended the Fashion

Institute of Design and Merchandising, where she took an accounting

course.

      Mr. Edmondson provided all monetary support for the family,

and was responsible for the household finances and payment of all

expenses. Although Mr. Edmondson did not hide any assets or income

from petitioner, petitioner did not attempt to ascertain the

details of their finances. The Edmondsons maintained joint bank

accounts. Toward the end of their marriage, petitioner maintained

a separate bank account.

      Throughout    their   marriage,      the   Edmondsons'    lifestyle   was

modest. They did, however, fly to Mexico during the year in issue



      1
          Petitioner believes that she owned Glass Onion Records
jointly with Mr. Edmondson.
                                        -5-

to   explore   the     possibility   of   investing    in   an     import/export

business.

      On February 11, 1991, Mr. Edmondson asked petitioner to sign

a joint 1988 tax return.             She signed the return voluntarily,

without any force or threat from Mr. Edmondson.                     Because she

trusted Mr. Edmondson to prepare the return            correctly, she signed

the return without reviewing it.           Indeed, throughout petitioner's

marriage to Mr. Edmondson, she consistently signed joint tax

returns without reviewing them.

      In April 1992, petitioner and Mr. Edmondson separated.                   Mr.

Edmondson agreed to give petitioner $500 a month for 36 months and

took responsibility to repay one of her two student loans. The

Edmondsons divorced in November 1993.

      On October 25, 1994, Mr. Edmondson signed a notarized document

(an indemnity), whereby he agreed to be solely responsible for the

payment of all taxes incurred during his marriage with petitioner.

Seattle House

      Prior to marrying petitioner, Mr. Edmondson owned a house in

Seattle with his first wife.2 Mr. Edmondson lived in the house

through 1981.        Thereafter, the house was rented until its sale on

July 29, 1988.         The sale resulted in a $30,948.64 gain to Mr.

Edmondson.     The    proceeds   from   the   sale   were   used    to   pay   the

Edmondsons' living expenses as well as debts of their failed record

      2
          Petitioner was aware that Mr. Edmondson had owned the
Seattle house.
                                    -6-

business. Neither petitioner nor Mr. Edmondson purchased a house

within 2 years after the date of sale.

Floyd Avenue House

     Sometime in 1988, Mr. Edmondson entered into an oral "equity

share" agreement with Wieland and Helen Emery von Behrens (friends

of the Edmondsons).     Pursuant to that agreement, the von Behrenses

purchased a house at 1393 Floyd Avenue, in Sunnyvale, California

(the Floyd Avenue house).         The von Behrenses held title to the

house, and were the only borrowers on a deed of trust.                Mr.

Edmondson agreed to renovate the house in exchange for an eventual

equity interest in the property.3          This arrangement was made

because Mr. Edmondson could not qualify for a mortgage. Petitioner,

Mr. Edmondson, and their respective children lived in the house

during the year in issue.

Petitioner's Present Circumstances

     At the time of trial, petitioner supported herself and her

daughter,     working   as   an    administrative   assistant   for    a

semiconductor firm.     She earned approximately $35,000 a year, and

paid yearly tuition of $5,000 for her daughter to attend private

school.     Petitioner also attended night school.

The Edmondsons' 1988 Federal Income Tax Return

     The Edmondsons reported an adjusted gross income of $37,611.70

on their 1988 Federal income tax return. Two Schedules C were

     3
          There is no additional evidence in the record regarding
this arrangement.
                                   -7-

attached to the return, one listing petitioner as the proprietor of

Glass Onion Records ("Businesswoman, Retail Sales, Marketing"), and

the other listing Mr. Edmondson as proprietor of S.M.E. Contracting

Co.4 ("General Contractor"). On the Schedule C relating to Glass

Onion Records, $18,188.01 of expenses was claimed; among other

things, the expenses were with respect to:            Debts of Glass Onion

Records   prior   to   its   failure;    a   1988    trip   to   Mexico;    and

petitioner's education. On the Schedule C relating to S.M.E.

Contracting Co., $19,406.13 of expenses was claimed; among other

things, the expenses were with respect to renovations to the Floyd

Avenue house.

     Attached to the Edmondsons' 1988 return was a Form 2119 (Sale

of Principal Residence), wherein $30,948.64 of gain from the sale

of Mr. Edmondson's Seattle house was deferred.

Notice of Deficiency and Amended Answer

     Respondent   disallowed    all     deductions    claimed    on   the   two

Schedules C on the basis that the Edmondsons failed to establish

that the expenses were deductible under section 162(a).                In the

amended answer, respondent asserted that the deferral of the

$30,948.64 gain from the sale of Mr. Edmondson's Seattle house was

erroneous.




     4
          Except for the 1988 tax return, there is no evidence in
the record with regard to S.M.E. Contracting Co.
                                       -8-

                                     OPINION

Issue 1.     Innocent Spouse

     Spouses who file a joint income tax return generally are

jointly and severally liable for its accuracy and the tax due,

including any additional taxes, interest, or penalties determined

on audit of the return.         Sec. 6013(d)(3); Ness v. Commissioner, 954

F.2d 1495, 1497 (9th Cir. 1992), revg. 94 T.C. 784 (1990); Guth v.

Commissioner, 897 F.2d 441, 442 (9th Cir. 1990), affg. T.C. Memo.

1987-522; Price v. Commissioner, 887 F.2d 959, 961 n.3 (9th Cir.

1989), revg. an Oral Opinion of this Court.            However, pursuant to

section 6013(e), a spouse (commonly referred to as an innocent

spouse) can be relieved of tax liability if that spouse proves: (1)

A joint return was filed; (2) the return contained a substantial

understatement of tax attributable to grossly erroneous items of

the other spouse; (3) in signing the return, the spouse seeking

relief did not know, and had no reason to know, of the substantial

understatement; and (4) it would be inequitable to hold the spouse

seeking relief liable for the understatement.              Sec. 6013(e)(1);

Guth v. Commissioner, supra at 443; Price v. Commissioner, supra at

961-962.     The spouse seeking relief bears the burden of proving

that each     of   the   four    section   6013(e)   requirements   has   been

satisfied.     Purcell v. Commissioner, 826 F.2d 470, 473 (6th Cir.

1987), affg. 86 T.C. 228 (1986). Failure to meet any one of the

statutory requirements will disqualify an individual from innocent
                                -9-

spouse relief. Bokum v. Commissioner, 94 T.C. 126, 138-139 (1990),

affd. 992 F.2d 1132 (11th Cir. 1993).

     In the case before us, respondent concedes that the Edmondsons

filed a 1988 joint income tax return and that a substantial

understatement of tax exists.   As a result, the controversy herein

focuses   on   the   aforementioned   second,   third,   and   fourth

requirements, namely:   Whether the substantial understatement was

attributable to Mr. Edmondson's grossly erroneous items; whether

petitioner did not know,     and had no reason to know, of the

substantial understatement; and whether it would be inequitable to

hold petitioner liable for the income tax deficiency attributable

to such substantial understatement.

     A.   Grossly Erroneous Items of the Other Spouse

     The phrase "grossly erroneous items" statutorily is defined to

mean with respect to any spouse (a) any item of gross income

attributable to that spouse which is omitted from gross income, and

(b) any claim of a deduction, credit, or basis by that spouse in an
                                      -10-

amount   for   which   there   is    no   basis   in   fact   or   law.5     Sec.

6013(e)(2).

     To prove that the disallowed deductions have no basis in fact

or law, an individual seeking innocent spouse status is not entitled

to rely on the Commissioner's disallowance of deductions contained

in the notice of deficiency, without introducing further evidence

to establish that a deduction has no basis in fact or law.                 Douglas

v. Commissioner, 86 T.C. 758, 762-763 (1986).

     Petitioner    presented    no    evidence    to   show   that   the     items

disallowed by respondent            were grossly erroneous or that the

deduction claimed for those items had no basis in fact or law. See,

e.g., Douglas v. Commissioner, supra; Neary v. Commissioner, T.C.

Memo. 1985-261.

     Further, the items disallowed were not solely attributable to

Mr. Edmondson.     Some relate primarily to Glass Onion Records, a

business in which petitioner participated with Mr. Edmondson.


     5
           The phrase "no basis in fact or law," is not defined in
sec. 6013. The courts, however, have held that a deduction has
no basis in fact when the expense for which the deduction is
claimed was never made, and a deduction has no basis in law when
the expense, even if made, does not qualify as a deductible
expense under well-settled legal principles or when no
substantial legal argument can be made to support its
deductibility. Ness v. Commissioner, 954 F.2d 1495, 1498 (9th
Cir. 1992), revg. 94 T.C. 784 (1990); Douglas v. Commissioner, 86
T.C. 758, 762 (1986). "Ordinarily, a deduction having no basis
in fact or in law can be described as frivolous, fraudulent, or,
* * * phony." Douglas v. Commissioner, supra at 763. A portion
of a deduction may be "grossly erroneous" even if another portion
of the same deduction is allowed. Ness v. Commissioner, supra at
1498-1499.
                                      -11-

Moreover,   some    of   the   disallowed    items   are     attributable   to

petitioner.

     We have observed that respondent's agreement to a compromise

settlement may suggest that the deductions claimed on a return were

less than grossly erroneous. See, e.g., Crowley v. Commissioner,

T.C. Memo. 1993-503; Anthony v. Commissioner, T.C. Memo. 1992-133;

Neary v. Commissioner, supra.           Here, respondent agreed in the

settlement stipulation to allow a portion of the Edmondsons' 1988

Schedule    C   deductions.       Further,      respondent     conceded     the

inapplicability of the section 6653(a)(1) addition to tax, and

although the settlement stipulation denies the deferral of gain on

the sale of the Seattle house in its entirety, we do not believe the

mischaracterization of this item constitutes a grossly erroneous

item within the purview of section 6013(e)(2). See Winnett v.

Commissioner,      96   T.C.   802,   810-811   (1991).    Thus,   we   reject

petitioner's argument that the substantial understatement of tax was

attributable solely to Mr. Edmondson's grossly erroneous items.

     Petitioner did not satisfy this second requirement.

     B.    Knowledge of the Substantial Understatement

     Assuming however, arguendo, that petitioner satisfied the

second requirement, she still is not entitled to innocent spouse

status because she failed to prove that she did not know, and had

no reason to know, of the substantial understatement of tax.

     Whether a spouse knew or had reason to know of a substantial

understatement depends on whether "a reasonably prudent taxpayer
                                        -12-

under the circumstances of the spouse [here, petitioner] at the time

of signing the return could be expected to know that the tax

liability stated was erroneous or that further investigation was

warranted." Stevens v. Commissioner, 872 F.2d 1499, 1505 (11th Cir.

1989), affg. T.C. Memo. 1988-63; see Bokum v. Commissioner, 94 T.C.

at 148; Griner v. Commissioner, T.C. Memo. 1990-301, affd. without

published opinion 951 F.2d 360 (9th Cir. 1991).

       The test for constructive knowledge of an understatement is a

subjective one, focusing on the following factors: (1) The spouse's

level of education; (2) the spouse's involvement in the business and

financial affairs of the marriage and in the transactions that gave

rise to the understatement; (3) the presence of expenditures that

appear lavish or unusual when compared to the taxpayers' accustomed

standard of living and spending patterns; and (4) the culpable

spouse's evasiveness and deceit concerning family finances.                    Price

v. Commissioner, 887 F.2d at 965.

       Petitioner had little knowledge of financial matters and was

only   tangentially     involved       in    family     finances.    However,   Mr.

Edmondson   did   not   hide     any    assets    or    transactions    from    her;

petitioner refused to inquire into the details of the family's

finances and income taxes.         She neither reviewed the 1988 return,

took any steps to verify the accuracy of its contents, nor made any

inquiries about it. A taxpayer cannot simply turn a blind eye to

what is disclosed on the tax return.             The innocent spouse provision

is   "designed    to   protect    the       innocent,    not   the   intentionally
                                -13-

ignorant."    Cohen v. Commissioner, T.C. Memo. 1987-537.       Had

petitioner reviewed the return, she would have seen that it clearly

disclosed the deductions on the Schedules C and the deferment of

gain on Form 2119.6   Nearly half the deductions related to Glass

Onion Records, a business in which she participated.    These items

were of such magnitude compared to the Edmondsons' income that a

reasonable person of petitioner's educational level and background

would have been put on notice that further inquiry should have been

made.     See Stevens v. Commissioner, supra at 1507; Bokum      v.

Commissioner, 94 T.C. at 148.    Moreover, petitioner went on the

Mexican trip for which a deduction was taken. Thus, petitioner knew

or had reason to know of the substantial understatement on the

return. She therefore has not satisfied the third requirement (lack

of knowledge).

     C.   Inequity of Holding Petitioner Liable

     Again assuming, arguendo, that petitioner had satisfied the

knowledge requirement, she still is not entitled to innocent spouse

status because she failed to prove that it would be inequitable to

hold her liable (the fourth requirement).   This factor focuses on

whether petitioner benefited from the understatement of tax. Purcell

v. Commissioner, 86 T.C. at 242. "Normal support" is not considered

a significant benefit. Terzian v. Commissioner, 72 T.C. 1164, 1170-

     6
          The Form 2119 lists the $30,948.64 of deferred gain.
Petitioner was aware that Mr. Edmondson had sold the Seattle
house, and indeed she signed the Form 2119 on which the sale was
reported.
                                  -14-

1171 (1979).    Petitioner bears the burden of proving that she

received no significant benefit from the understatement other than

normal support, and this burden must be satisfied with specific

facts regarding lifestyle, expenditures, asset acquisitions, and the

disposition of the benefits of the understatement.           See Estate of

Krock v. Commissioner, 93 T.C. 672 (1989).

     It is also relevant to consider whether the spouse claiming

relief has been deserted, divorced, or separated.               Kistner v.

Commissioner, T.C. Memo. 1995-66; sec. 1.6013-5(b), Income Tax Regs.

We also examine the probable future hardships that would be imposed

on the spouse seeking relief, if such relief were denied. Sanders

v. United States, 509 F.2d 162, 171 (5th Cir. 1975).

     While petitioner's standard of living did not increase in 1988

in comparison to prior years, the Edmondsons continued living

together from 1988 until 1992. Thus, they shared equally in the tax

savings generated by the understatement.        In this regard, part of

the disallowed deductions (from which tax savings were derived)

related   to:   A   failed   business    that   both   Mr.   Edmondson   and

petitioner operated; the Floyd Avenue house in which they both

lived; and a Mexican trip that benefited petitioner as well as Mr.

Edmondson.

     The proceeds from the gain on the sale of the Seattle house

went to pay living expenses for the entire Edmondson household, as

well as the debts of the failed business. Moreover, Mr. Edmondson

gave petitioner $500 a month for 36 months following the end of
                                 -15-

their marriage.    In addition, Mr. Edmondson signed an indemnity

promising to pay all tax    liabilities resulting from the filing of

their joint tax returns.     The effect of such a promise has been

considered by this Court on several occasions with regard to

granting innocent spouse relief. See, e.g., Foley v. Commissioner,

T.C. Memo. 1995-16;    Buchine v. Commissioner, T.C. Memo. 1992-36,

affd. 20 F.3d 173 (5th Cir. 1994); Henninger v. Commissioner, T.C.

Memo. 1991-574.

     Considering    all the facts and circumstance involved herein,

we conclude that it would not be inequitable to hold petitioner

liable for the determined understatement.

     In sum, we hold that petitioner is not entitled to innocent

spouse relief.     She has failed to prove:    That the substantial

understatement was attributable to Mr. Edmondson's grossly erroneous

items; that she did not know or have reason to know of the

substantial understatement; or that it would be inequitable to hold

her liable for the deficiency as determined in the settlement

stipulation.

Issue 2.   Section 1034 Deferral

     A taxpayer must include in gross income gains derived from

dealings in property.      Sec. 61(a)(3).   A taxpayer is generally

required to recognize the entire amount of gain or loss realized on

the sale or exchange of property.   With respect to gain realized on
                               -16-

the sale of a principal residence,7 section 1034(a) provides the

following exception to that general rule:

          If property (in this section called "old
          residence") used by the taxpayer as his
          principal residence is sold by him, and, within
          a period beginning 2 years before the date of
          such sale and ending 2 years after such date,
          property   (in   this   section   called   "new
          residence") is purchased and used by the
          taxpayer as his principal residence, gain (if
          any) from such sale shall be recognized only to
          the extent that the taxpayer's adjusted sales
          price (as defined in subsection (b)) of the old
          residence exceeds the taxpayer's cost of
          purchasing the new residence.[8]

     Mr. Edmondson converted the Seattle house (old residence) to

a rental property in 1982 and never lived in it again.9     Although

     7
          The Internal Revenue Code does not define the phrase
"principal residence". Nevertheless, sec. 1.1034-1(c)(3), Income
Tax Regs., provides that the determination of whether or not
property is used by the taxpayer as his principal residence
"depends upon all the facts and circumstances in each case,
including the good faith of the taxpayer." For property to be
"used by the taxpayer as his principal residence" within the
meaning of sec. 1034(a), the taxpayer ordinarily must physically
occupy and live in the dwelling. Perry v. Commissioner,       F.3d
    (9th Cir., July 31, 1996), affg. T.C. Memo. 1994-247;
Houlette v. Commissioner, 48 T.C. 350 (1967); Stolk v.
Commissioner, 40 T.C. 345 (1963), affd. 326 F.2d 760 (2d Cir.
1964). Certain property has been considered as the principal
residence of taxpayers despite the fact that the taxpayers were
not living there at the time of its sale, e.g., where adverse
economic conditions required the taxpayers to lease the old
residence while trying to sell it. Bolaris v. Commissioner, 776
F.2d 1428, 1431 (9th Cir. 1985), affg. in part and revg. in part
81 T.C. 840 (1983); Clapham v. Commissioner, 63 T.C. 505, 509-512
(1975).
     8
          Any gain that is not recognized under sec. 1034 reduces
the taxpayer's basis in the "new residence". Sec. 1034(e).
     9
          We note that petitioner never lived in the Seattle
                                                    (continued...)
                                      -17-

the "temporary" rental of an old residence prior to its sale does

not preclude the nonrecognition of gain realized on the sale of the

old home, here the old residence ceased to be Mr. Edmondson's

principal residence well before it was sold in 1988.              See Perry v.

Commissioner,           F.3d        (9th Cir., July 31, 1996), affg. T.C.

Memo. 1994-247; Clapham v. Commissioner, 63 T.C. 505, 511-512 (1975)

(the       definition   of     "temporary"   depends   on   the    facts   and

circumstances of each case).

       Moreover, the Edmondsons never purchased a new principal

residence.      Mr. Edmondson entered into an oral agreement intended

to give him some type of an interest in the Floyd Avenue house.            The

exact details of such arrangement are not clear from the record.

What is clear, however, is that the Edmondsons never purchased the

Floyd Avenue house; the von Behrenses did.                  See Marcello   v.

Commissioner, 380       F.2d 499, 502 (5th Cir. 1967) ("If a third party

owns the residence, the purchase requirements are not met"), affg.

on this issue and remanding T.C. Memo. 1968-268.

       Based on the record before us, we conclude that Mr. Edmondson

did not purchase a new principal residence within the period

beginning 2 years before and ending 2 years after the sale of the

Seattle house. Thus, we sustain respondent's position that the gain

on the Seattle house does not qualify for deferred recognition

pursuant to section 1034.

       9
      (...continued)
house.
                              -18-

     To reflect concessions made by respondent in the settlement

stipulation,

                                     Decision will be entered

                             under Rule 155.
