                   T.C. Memo. 2003-225



                 UNITED STATES TAX COURT



     ROBERT K. AND DAWN E. LOWRY, Petitioners v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No.   11579-00.            Filed July 30, 2003.



     Ps realized a sec. 1231, I.R.C., gain when a
partnership of which P husband was a 50-percent owner
conveyed rental property to the holder of a security
deed on the property in satisfaction of the loan
obligation. Ps assert that the gain should be
recognized in 1993, because the lender issued a Form
1099-A indicating that the lender had acquired the
property on Dec. 15, 1993, the partnership executed a
grant deed, and the lender executed a covenant not to
sue, both dated Dec. 15, 1993. In the same month, the
partnership and the lender issued escrow instructions
to a title company, under which the grant deed and
covenant not to sue were delivered in escrow pending a
subsequent closing of title. Title closed in 1994. Ps
did not disclose the gain on either their 1993 or 1994
Federal income tax returns. Held: Ps’ sec. 1231,
I.R.C., gain must be recognized in 1994. Held,
further, Ps are liable for the sec. 6662(a),
                                - 2 -

     I.R.C., accuracy-related penalty on grounds of failure
     to prove that they acted with reasonable cause and good
     faith with respect to their substantial understatement
     of income tax for 1994 and 1995.



     Daniel C. Ertel, for petitioners.

     Lydia A. Branche, for respondent.



                         MEMORANDUM OPINION


     NIMS, Judge:    Respondent determined the following

deficiencies and penalties with respect to petitioners’ Federal

income taxes for the taxable years 1994 and 1995:

                 Year      Deficiency     Penalties
                                         Sec. 6662(a)

                 1994       $30,096           $6,019
                 1995       179,066           35,813

     Unless otherwise indicated, all section references are to

sections of the Internal Revenue Code in effect for the years in

issue.

     After concessions by petitioners the issues remaining for

decision are:

     (1)    Whether a section 1231 gain in the amount of $774,982

was realized and should be recognized, alternatively, in 1993 or

1994; and

     (2)    whether petitioners are liable for section 6662(a)

penalties in 1994 and 1995.
                               - 3 -

     The parties stipulated that respondent’s adjustments

resulted in passive activity losses in the amount of $614,164 and

capital losses of $48,244 being fully absorbed in 1994, and

therefore, those amounts that were carried forward to

petitioners’ 1995 tax return were adjusted and 1995 taxable

income and penalty were increased by $674,789 and $48,244,

respectively.

     The parties also stipulated that the period of limitations

for the assessment of a deficiency has expired for the 1993

taxable year pursuant to section 6501.

                            Background

     This case was submitted fully stipulated, and the facts are

so found.   The stipulations of the parties, with accompanying

exhibits, are incorporated herein by this reference.    Petitioners

resided in Santa Ana, California, when they filed their petition.

                  The Fitch Property Transaction

     At all relevant times petitioner Robert K. Lowry

(petitioner) was a 50-percent partner in Lowry Wells Investments

(the Partnership), which owned the Fitch Property, located in

Irvine, California.   The other 50-percent partner was George

Wells.
                               - 4 -

     The Fitch Property was encumbered by a Deed of Trust and

Security Agreement (Deed of Trust) dated January 23, 1987,

reflecting a loan made by Aid Association for Lutherans (AAL) to

the Partnership in the amount of $3.5 million.    The Deed of Trust

secured a Promissory Note (Note) signed by both Partnership

partners.   The loan under the Deed of Trust was recourse in that

it was personally guaranteed by George Wells and petitioner.    As

of June 29, 1993, the loan was in default, and AAL began the

process of foreclosure of the Deed of Trust.    On August 27, 1993,

AAL notified the Partnership that “All of the legal and equitable

interest in the rents, issues, and profits of the [Fitch]

Property is vested in * * * [AAL].     * * * [AAL] is exercising its

rights under the Deed of Trust.”

     At some point, AAL and the Partnership negotiated a

settlement agreement (which is not in the record) in lieu of

foreclosure whereby the Partnership would convey the Fitch

Property to AAL in full settlement of the outstanding

indebtedness.

     On December 9, 1993, escrow instructions “on behalf of

* * * [AAL] and * * * [the Partnership]” were issued to First

American Title Insurance Company (the Title Company).    The escrow

instructions include the following provisions:

     Borrower has tendered to you in escrow the Grant Deed
     (the “Deed”) from Borrower to Lender. Your acceptance
     of these escrow instructions constitutes your
     acknowledgment that (i) you have received and reviewed
                               - 5 -

     an executed copy of the Settlement Agreement and the
     documents executed by the parties thereto pursuant to
     the terms thereof; (ii) all requirements precedent to
     issuance of the pro forma owner’s title policy (the
     “Owner’s Policy”) attached hereto have been satisfied
     and that you are prepared to issue the Owner’s Policy;
     (iii) you have confirmed that the Deed has been
     properly executed and witnessed; (iv) the Deed is in
     proper recordable form; and (v) the correct property
     description has been appended.

                  *   *   *    *       *   *    *

                          CONSENTED TO:
                          LOWRY & WELLS INVESTMENTS,
                           a California partnership

                                       By: George H. Wells
                                       Name:
                                       General Partner

     On December 15, 1993, the partners executed a Grant Deed

which would convey the Fitch Property to AAL.       The Grant Deed

provided, among other things, that

          It is the intention of the Grantor and the Grantee
     that the lien created by the Deed of Trust will not
     merge into the fee title acquired by the Grantee
     pursuant to this Grant Deed. No such merger will occur
     until such time as the Grantee executes a written
     instrument specifically effecting such merger and duly
     records the same.

     Also on December 15, 1993, AAL executed a “Covenant Not to

Sue” the Partnership and its general and limited partners as to

any matter arising from the loans made by AAL to the Partnership

and secured by the Deed of Trust.    The Covenant was conditioned

upon a release by the Partnership to AAL, the conveyance of the

Fitch Property to AAL, and “other good and valuable

consideration.”
                                 - 6 -

     Necessary steps continued until May 21, 1994, so that the

Title Company could remove certain exceptions raised by the title

report and provide title insurance as required by the escrow

instructions.    As of May 27, 1994, the Title Company had

determined that it could issue the title policy without the

exceptions, so the escrow closed and the Grant Deed was recorded

on that date.

     At some point, AAL issued to the Partnership a 1993 Form

1099-A (undated), Acquisition or Abandonment of Secured Property,

indicating that the Partnership had an outstanding debt in the

amount of $3,218,046.06 secured by the Fitch Property, that the

date of acquisition or abandonment was December 15, 1993, and

that the Fitch Property had an appraised value of $1,915,000.

     On October 14, 1994, the Partnership filed an Amended Form

1065 U.S. Partnership Return of Income for taxable year 1993

which included the following:

                STATEMENT REGARDING ERRONEOUS REPORTING
                     OF ABANDONED SECURED PROPERTY

          The Partnership, Lowry Wells Investments, received
     a form 1099-A for 1993, indicating an abandonment of
     real property on December 15, 1993. This reporting is
     wholly inaccurate. A deed in lieu of foreclosure was
     delivered on May 27, 1994. The lender, Aid Association
     for Lutherans, erred in reporting the transaction[s] in
     1993. A copy of an escrow statement issued by First
     American Title Insurance Company has been attached
     which indicates the transfer of title factually
     occurred on May 27, 1994.
                               - 7 -

          The subject property has previously been
     transferred to Lowry Wells Limited Liability Company
     pursuant to a tax-free partnership division under IRC
     §708(b)(2)(B).

          Lowry Wells Limited Liability Company will
     correctly report this 1994 event on a 1994 return and
     realize and recognize any gains (or losses) as is
     appropriate in that filing.

     There is nothing in the record to indicate that any property

was ever transferred to Lowry Wells Limited Liability Company

(LLC).

     Petitioners were advised by Rob Lambert in a Memorandum

dated August 29, 1994, to file the 1993 Amended tax return with

the expectation that the LLC would “hopefully” be treated as

having corporate entity characteristics, but would preserve the

passthrough attributes of a traditional partnership.   This was

based on the assumption that at the time of delivery of the deed

by the LLC, the LLC would be insolvent for purposes of section

108, so that most of the gain realized on the Fitch Property

transaction would be treated as cancellation of indebtedness

income and therefore not taxable.   At the time this advice was

given, the Fitch Property transaction had already closed (on May

27, 1994), and the Certificate of Limited Liability Company for

LLC had yet to be filed, which in fact took place on September

19, 1994.   The Fitch Property was conveyed to AAL by the

Partnership, not by the LLC.
                               - 8 -

      Petitioners did not report the section 1231 gain on their

1994 tax return.   The record does not contain their 1993 tax

return.

      By letter dated December 28, 1993, Bruce Stuart, Lowry

Wells’s attorney, with the consent of David Crist, attorney for

AAL, requested that the Grant Deed in escrow be recorded on or

after January 3, 1994, so that the closing would occur in tax

year 1994.

      The Partnership realized a section 1231 gain of $1,549,963

on the conveyance of the Fitch Property to AAL.   Petitioners’

proportionate share of the gain is $774,982.

                            Discussion

I.   Year of Recognition of Gain Under Section 1231

      Petitioners contend that the Partnership conveyance of the

Fitch Property to AAL, and the cancellation of the Partnership

indebtedness, occurred on December 15, 1993.

      Respondent contends that the conveyance of the Fitch

Property by the Partnership to AAL occurred in 1994, and that

petitioners were required to recognize section 1231 gains in that

year.

      Since we agree with respondent that the section 1231 gain

must be recognized in 1994, we need not address his additional
                               - 9 -

argument that petitioners are estopped by the rule of consistency

from claiming that the section 1231 gain should be recognized for

tax purposes in 1993.

     Petitioners essentially base their argument on (1) the fact

that the Grant Deed and the Covenant Not to Sue agreement are

dated December 15, 1993, and (2) the fact that AAL issued a 1993

Form 1099-A, showing the “date of lender’s acquisition” of the

Fitch Property to be “12-15-93”.   Petitioners argue that all

subsequent actions were for the benefit of AAL, and of no further

concern to the Partnership.

     Past decisions of this Court and California law, as applied

to the facts of this case, do not support petitioners’ argument

that the transaction was completed in 1993.   The escrow

instructions, dated December 9, 1993, recite that they were being

issued to the Title Company on behalf of AAL and the Partnership.

The instructions were consented to by George H. Wells, signing as

a general partner of “Lowry & Wells Investments, a California

partnership.”   Also, as noted above, the Grant Deed recited that

the Grantor and Grantee intend that the lien created by the Deed

of Trust would not merge into the fee title being acquired by the

Grantee.   The Grant Deed further recites that no merger will

occur until the Grantee executes and records a separate

instrument specifically effecting such merger.   These facts alone

repudiate petitioners’ contention that “The subsequent actions by
                              - 10 -

AAL in obtaining a title policy and recording the deed through

‘their’ escrow agent are not relevant to the question of the date

when transfer of ownership was complete.”    In fact, subsequent

steps taken by all concerned in 1993 and 1994, and not by AAL

alone, are very relevant to that question.

     A transfer of property by deed in lieu of foreclosure

constitutes a “sale or exchange” for Federal income tax purposes.

Allan v. Commissioner, 86 T.C. 655, 659 (1986), affd. 856 F.2d

1169, 1172 (8th Cir. 1988).   In a given case, the test to be

applied to determine whether a transaction is a closed one is a

practical test, and the transaction should be regarded in its

entirety.   Clodfelter v. Commissioner, 426 F.2d 1391 (9th Cir.

1970), affg. 48 T.C. 694 (1967).   Although other factors may be

considered, passage of title is usually conclusive.     Id.   An

exception is illustrated by our decision in Keith v.

Commissioner, 115 T.C. 605 (2000), discussed infra pp. 14-15.

     It seems beyond dispute that the title to the Fitch Property

passed on May 27, 1994, when the Title Company was ready to issue

a title policy acceptable to AAL and could file the deed for

recordation, which it did on that date.   Previously, AAL and the

Partnership had negotiated a settlement agreement in lieu of

foreclosure whereby the Partnership would convey the Fitch

Property to AAL as full settlement of the outstanding
                               - 11 -

indebtedness.    Before the settlement agreement had been

negotiated, AAL had begun the process of foreclosure on the Deed

of Trust.

       At the time AAL agreed to accept a deed to the Fitch

Property in lieu of foreclosure, the balance due on the secured

Note substantially exceeded the fair market value of the Fitch

Property, so that if foreclosure had proceeded, AAL could have

pursued a deficiency judgment of a substantial amount against the

partners, who were personally liable on the Note.    See Ghirardo

v. Antonioli, 924 P.2d 996 (Cal. 1996).    Thus, to protect

themselves against the possibility of a deficiency judgment, the

partners required the Covenant Not to Sue.    Notwithstanding

petitioners’ assertion that the Covenant Not to Sue became

immediately effective on December 15, 1993, the day it was

signed, by its terms the Covenant Not to Sue was conditioned

upon, among other things, the conveyance of the Fitch Property to

AAL.    This could only take place upon satisfaction of the terms

of the escrow.

       The escrow instructions, dated December 9, 1993, refer,

among other things, to a Settlement Agreement dated November 30,

1993, and the fact that “Borrower [the Partnership] has tendered

to you [the Title Company] in escrow the Grant Deed (the ‘Deed’)

from Borrower to Lender.”    (Emphasis added.)   Reference is also

made to the delivery to the Title Company of “an executed copy of
                              - 12 -

the Settlement Agreement and the documents executed by the

parties thereto.”   Under California law, “An escrow involves the

deposit of documents and/or money with a third party to be

delivered on the occurrence of some condition.”   Summit Fin.

Holdings, Ltd. v. Contl. Lawyers Title Co., 41 P.3d 548, 551

(Cal. 2002) (quoting 3 Miller & Starr, Cal. Real Estate, sec.

6:1, pp. 2-3 (rev. 2000)).

     In short, all of the documents signed in 1993, and upon

which petitioners predicate their alleged 1993 fait accompli, are

actually documents essential to a closing of title when all

conditions precedent thereto had been satisfied, and the escrow

could be closed.

     On December 28, 1993, Bruce Stuart (Mr. Stuart), one of the

Partnership’s attorneys, wrote Ms. Darlene Longoria of the Title

Company as follows:

     Dear Ms. Longoria:

          This letter is to advise you that with the consent
     of David Crist as attorney for the Aid Association for
     Lutherans, we request that the recordation of the Deed
     in the above-referenced escrow occur on or after
     January 3, 1994 so that the closing will occur in tax
     year 1994. Should you have any questions, please feel
     free to contact me.


     In a letter dated September 1, 1994, to William Holt from

Mr. Stuart, the latter recapitulated the Fitch Property

transaction as follows:
                              - 13 -

     Dear Bill:

          This letter is to review the recent transaction
     between Lowry & Wells Investments and the Aids
     Association for Lutherans (“AAL”). AAL was the holder
     of a Promissory Note Secured by Deed of Trust on the
     Fitch Street Property owned by Lowry & Wells
     Investments (“L & W”). In late 1993 a settlement was
     negotiated between AAL and L & W whereby L & W would
     convey the property to AAL, together with all leases
     and tangible personal property, in return for which AAL
     would agree to accept such conveyance as a full
     settlement of the then outstanding indebtedness.
     Through joint instructions to escrow, the parties
     agreed that the closing would occur subsequent to
     December 31, 1993, and in fact the Deed conveying title
     to the property was recorded May 27, 1994.

(Mr. Holt is identified in a document stipulated by the parties

as “the predecessor accountant”.)

     Petitioners quote sections 1055 and 1056 of the California

Civil Code (West 1982) in support of their position that title to

the Fitch Property passed on December 9, 1993, when the partners

executed the warranty deed:

     SEC. 1055.   Presumption as to date of delivery

          DATE. A grant duly executed is presumed to have been
     delivered at its date.

     SEC. 1056.   Delivery necessarily absolute

          DELIVERY TO GRANTEE IS NECESSARILY ABSOLUTE. A
     grant cannot be delivered to the grantee conditionally.
     Delivery to him, or to his agent as such, is
     necessarily absolute, and the instrument takes effect
     thereupon, discharged of any condition on which the
     delivery was made.


     In quoting the above sections, petitioners overlooked Cal.

Civ. Code sec. 1057 (West 1982), which provides:
                              - 14 -

     SEC. 1057.   Delivery in escrow

          DELIVERY IN ESCROW. A grant may be deposited by
     the grantor with a third person, to be delivered on
     performance of a condition, and, on delivery by the
     depositary, it will take effect. While in the
     possession of the third person, and subject to
     condition, it is called an escrow.

     In this case, the Grant Deed was jointly delivered by the

Partnership and AAL to the Title Company with the escrow

instructions, so under section 1057 of the California Civil Code

and California case law, title to the Fitch Property did not pass

to AAL until performance of the conditions in the escrow

instructions had been achieved.    It has long been held in

California, as elsewhere, that delivery of an instrument in

escrow conveys no title.   In re Chrisman, 35 F. Supp. 282 (S.D.

Cal. 1940).   Consequently, the warranty deed was delivered to AAL

in 1994 when the terms of the escrow were satisfied, and the deed

was duly recorded, and not before.

     Petitioners seek to bring their facts within those of Keith

v. Commissioner, 115 T.C. 605 (2000), to show that a title

closing is not necessary to establish a closed transaction.   The

facts of Keith, however, are specifically relevant to a form of

transaction under Georgia law known as a “contract for deed”.

Georgia law normally construes a contract for deed as a device

for passing equitable ownership, leaving the seller with

essentially a security interest.     Id. at 614.
                              - 15 -

      Under a contract for deed in Georgia, the buyer obtains a

right to possession; an obligation to pay taxes, assessments, and

charges against the property; a responsibility for insuring the

property; a duty to maintain the property; a right to improve the

property without the seller’s consent; a bearing of the risk of

loss; and a right to obtain legal title at any time by paying the

balance of the full purchase price.    All of these elements, short

of transfer of title, were held in Keith to be sufficient for

obtaining equitable ownership.   The facts in the case before us

do not establish that AAL obtained equitable ownership before

title to the Fitch Property passed in 1994 by virtue of the

recordation of the Grant Deed upon satisfaction of the escrow

instructions.

      For the foregoing reasons, we hold for respondent on this

issue.

II.   Section 6662 Accuracy-Related Penalty

      In determining that petitioners are liable for the section

6662 accuracy-related penalty, respondent determined that all of

the underpayment of tax for 1994 and 1995 is due to negligence or

disregard of rules or regulations, and that petitioners have not

established that such underpayment was due to reasonable cause.

Since the IRS examination in this case commenced before July 22,

1998, section 7491, relating to burdens of proof and production,
                                - 16 -

is not applicable, and petitioners bear the burdens of proof and

production with respect to the penalty.    Bixby v. Commissioner,

58 T.C. 757, 791-792 (1972).

     Section 6662(b) imposes an accuracy-related penalty in the

amount of 20 percent of any underpayment that is attributable to

one or more of the following:    (1) Negligence or disregard of

rules or regulations; (2) any substantial understatement of

income tax; (3) any substantial valuation misstatement.    Section

6662(d)(1) defines substantial understatement as an amount that

exceeds the greater of 10 percent of the tax required to be shown

on the return for the taxable year or $5,000.

     Section 6662(d)(2)(B) provides that an understatement does

not include any item on the taxpayer’s return if there existed

substantial authority for the taxpayer’s treatment of that item,

or if the relevant facts affecting the treatment of that item

were adequately disclosed on the taxpayer’s return or an attached

statement, and there was a reasonable basis for the taxpayer’s

treatment of that item.

     Section 6664(c) provides an exception to the accuracy-

related penalty if the taxpayer can show that there was

reasonable cause for the underpayment and that the taxpayer acted

in good faith with respect to the underpayment.    A taxpayer’s

good faith and reasonable reliance on the advice of an

independent professional as to the tax treatment of an item may
                               - 17 -

establish that the taxpayer was not negligent and may satisfy the

reasonable cause exception of section 6664(c).   Section 1.6662-

3(a), Income Tax Regs.

     Petitioners contend that the section 6662(a) penalty should

not be imposed: (1) Because they relied on professional advisers

for the preparation of their 1994 and 1995 returns; and (2)

because the test for adequate disclosure should properly be

applied to the Partnership’s return, and not to petitioners’

returns.   The latter argument was raised for the first time in

petitioners’ reply brief.

     Petitioners argue that they relied upon a C.P.A. for advice

as to how the Fitch Property transaction should be reported, and

that he was unaware of the existence of the Covenant Not to Sue

Agreement when he filed the partnership return for 1994.   All the

facts in the record lead to the conclusion that petitioners did

not report the transaction on their 1993 return, which is not in

the record.    Neither was the transaction reported on petitioners’

1994 return.

     Petitioners contend that the reporting requirement was

satisfied by the fact that the “reconveyance” was reported by the

LLC, “a related partnership”, as a sale or exchange of property
                               - 18 -

used in a trade or business.   However, since the LLC never owned

the Fitch Property, any reconveyance reported by the LLC was

wholly fictitious.

     As part of tax planning advice from Rob Lambert, petitioners

and the Partnership were advised to report the gain from the sale

of the Fitch Property as cancellation of indebtedness income on

their 1994 return, which is not recognized after the application

of section 108.   Petitioners simply failed to report the

transaction on any tax return.

     As noted previously, the Partnership filed an amended 1993

tax return in which it stated that a deed in lieu of foreclosure

was delivered on May 27, 1994, and that the Form 1099-A issued by

AAL showing that the transaction occurred in 1993 was “wholly

inaccurate” and that AAL erred in reporting the transaction in

1993.   It further alleged that the subject property had been

previously transferred to the LLC pursuant to a tax-free

partnership division and that the LLC would correctly report the

transaction.   In reliance on the advice received from Rob

Lambert, the LLC, on its Form 1065 for 1994, reported the section

1231 gain as cancellation of debt income excluded from gross

income pursuant to section 108(a)(1)(B) by applying the

insolvency test at the entity level; i.e., the LLC was insolvent
                                - 19 -

when the Fitch Property was conveyed, and therefore the gain

realized was not taxable.    Nothing in the record supports this

fabrication.

     The facts in this case show that the Fitch Property was

conveyed to AAL by the Partnership, not the LLC, and as noted

previously, the Certificate of Limited Liability Company of the

LLC was not even filed in the Office of the Secretary of State

(Delaware) until September 19, 1994, at least 4 months after the

Fitch Property had been conveyed by the Partnership to AAL.

     We conclude that petitioners have failed to meet their

burden of proving that they acted with reasonable cause and in

good faith.    Furthermore, based upon our holding on the first

issue in this case and concessions by petitioners, petitioners

owe taxes for 1994 and 1995 well in excess of the level

constituting a substantial understatement.    We therefore sustain

respondent’s determination that petitioners are liable for the

accuracy-related penalty.

     In reaching our holdings herein, we have considered all

arguments made, and to the extent not mentioned above we find

them to be irrelevant, moot, or without merit.    All of

petitioners’ objections on the ground of relevancy contained in

the Stipulation of Facts have been considered and are denied.


                                 Decision will be entered

                            for respondent.
