                        T.C. Memo. 1998-165



                      UNITED STATES TAX COURT



            JOHN H. & MARY E. DOUGLAS, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 21113-96.                        Filed May 6, 1998.




     John H. Douglas, pro se.

     Gregory S. Matson, for respondent.


                        MEMORANDUM OPINION


     PANUTHOS, Chief Special Trial Judge:     This case was heard

pursuant to the provisions of section 7443A(b)(3) and Rules 180,

181, and 182.1   Respondent determined deficiencies in

     1
         All section references are to the Internal Revenue Code
in effect for the years in issue, unless otherwise indicated.
All Rule references are to the Tax Court Rules of Practice and
                                                   (continued...)
                                - 2 -

petitioners' Federal income taxes for 1992 and 1993 in the

amounts of $6,503 and $174, respectively.

     After concessions,2 the issues for decision are whether

petitioners are entitled to a bad debt deduction claimed on

Schedule C of their 1992 return and whether petitioners are

entitled to deduct legal expenses claimed on Schedule C of their

1992 and 1993 returns or whether said expenses are properly

allowable as miscellaneous itemized deductions.

Background

     The facts have been fully stipulated.    The stipulation of

facts and the attached exhibits are incorporated herein by this

reference.    At the time of filing the petition, petitioners

resided at Fort Washington, Maryland.

     From March 1982 through December 1989, petitioner John H.

Douglas (hereinafter petitioner) purchased 11 residential

properties.    During this period, petitioner renovated seven of

the properties and sold two of the properties.

     In May 1983, petitioner bought an improved lot in Fort

Washington, Maryland (hereinafter Fort Washington property), for


     1
      (...continued)
Procedure.
     2
         Respondent conceded that petitioners are entitled to
Schedule A miscellaneous itemized deductions, after limitations,
in the total amount of $1,001 and $2,664 for years 1992 and 1993,
respectively. This exceeds the amount allowed in the statutory
notice of deficiency by $541 and $1,121 for years 1992 and 1993,
respectively.
                                 - 3 -

$15,000.    In November 1989, he sold the property to Vinson L.

Baker and Danella M. Baker (the Bakers) for $61,000.    The Bakers

obtained a mortgage loan through First Security Federal Savings

and Loan Bank (hereinafter First Security) and paid petitioners

$39,100 in cash at settlement.    The Bakers also provided

petitioner with a deferred purchase money second deed of trust

(hereinafter second deed) in the amount of $21,900.    The second

deed was payable in one year at 12-percent interest.

     A dispute arose between the Bakers and First Security, and

the Bakers were unable to meet the interest obligations on their

mortgage.    The Bakers brought a legal action against First

Security, alleging that First Security had "set them up" to fail

in order to obtain possession of the property.    The dates with

respect to the dispute and the legal action against First

Security are not clear from the record.    Petitioners agreed with

the Bakers' allegations and paid legal fees and costs in order to

protect petitioners' interests.

     In 1989, Vinson Baker filed for Chapter 7 bankruptcy, and

petitioner filed a claim as a creditor for $21,900 from the

second deed and for $3,285 in accrued interest.    In 1992, Danella

Baker filed for Chapter 7 bankruptcy, and petitioner claimed a

debt in the amount of $28,000, which represented $21,900 from the

second deed and $6,100 in accrued interest.    The U.S. Bankruptcy

Court for the District of Columbia discharged Vinson Baker's

debts in December 1991, and the U.S. Bankruptcy Court for the
                                - 4 -

District of Delaware discharged Danella Baker's debts in April

1993.    The Bakers did not make any payments to petitioners on the

second deed, and petitioners did not receive any distribution

with respect to their respective claims made with the bankruptcy

courts.    On January 6, 1992, First Security was the sole bidder

at the foreclosure of the Fort Washington property.      First

Security purchased the property for $70,000.      This event

precluded any disbursement to petitioners and rendered

petitioners' second deed worthless.3

     On their 1989 income tax return, petitioners reported the

gain on the sale of the improved lot to the Bakers as long-term

capital gain on Form 6252, Installment Sale Income.      Petitioners'

Form 6252 for 1989 reflects the following:4

     Selling price                                 $61,000
     Mortgage held by petitioners                  (21,900)
     Cash received by petitioners                   39,100
     Cost or other basis                $15,000
     Depreciation                           -0-
     Adjusted basis                      15,000
     Commissions and expenses             1,561    (16,561)
     Gross profit                                   44,439

     Cash received in 1989                          39,100
     Taxable gain reported in 1989                   5,339




     3
         Respondent does not dispute that the second deed became
worthless at this time.
     4
        We note that petitioners' Form 6252 for 1989 contains
mathematical errors which are not at issue in this case.
                               - 5 -

Thus, petitioners did not include as income in 1989 the $21,900

amount of the second deed.5

     Respondent argues that petitioners improperly excluded the

amount of $21,900 attributable to the second deed from their

income.   Thus, respondent concludes that petitioners' gain should

be calculated as follows:

     Selling price                                  $61,000
     Mortgages assumed by buyers
       or property subject to (not new)                 -0-
     Contract price                                  61,000
     Cost or other basis                $15,000
     Depreciation                           -0-
     Adjusted basis                      15,000
     Commissions and expenses             1,561     (16,561)
     Gross profit                                    44,439

     Cash in year of sale                            39,100
     Taxable gain to be reported in 1989
       ($39,100 x $44,439/$61,000)                   28,484

     On their 1992 income tax return, petitioners deducted

$33,560 as a business bad debt on Schedule C.     The amount of

$33,560 represented the following:     (1) $21,900 in unpaid

principal from the second deed, (2) $9,160 in accrued interest

and late fees, and (3) $2,500 in legal expenses.     On Schedule C

of their 1993 return, petitioners deducted $3,171 as legal

expenses also associated with the legal action discussed above.

     On their 1992 Form 1040, petitioner's Schedule C reflects

"Real Estate (Rental, Buying & Selling)" as petitioner's



     5
         In fact, petitioners did not include the $21,900 as
income in any other year.
                                 - 6 -

principal business activity.6    Although petitioner's Schedule C

does not reflect any income for 1992, his Schedule E reflects

rental income and expenses from petitioner's properties.7       The

1992 return also reflects that petitioners each received wages

from employment unrelated to the Schedule C or rental activity

and that petitioners' wages from such employment totaled

$91,343.65.

         Petitioner's 1993 Schedule C reflects "Real Estate--

Managing Residential Property" as his principal business

activity.     Again, the Schedule C does not reflect any income.

The Schedule E, however, reflects rental income and expenses

attributable to petitioner's properties.     For 1993, petitioners

reported wages in the total amount of $34,821.17.

     Respondent determined that petitioners are not entitled to

the claimed business bad debt deduction in the amount of $31,060

on Schedule C of their 1992 return.      Respondent further argues

that if petitioners are entitled to a bad debt deduction with

respect to the amount described above, then the loss should be

characterized as a nonbusiness bad debt rather than a business

bad debt.     Respondent also determined that the $2,500 in legal


     6
        Petitioner's Form 1040 for 1989 does not include a
Schedule C.
     7
         Petitioner also reported rental income and expenses from
his properties on Schedule E for 1987, 1988, and 1989.
Petitioner did not list the Fort Washington property on Schedule
E for either the tax years in issue or previous tax years.
                                  - 7 -

expenses that petitioners deducted as a bad debt in 1992 was not

a bona fide debt and, therefore, not deductible as a business bad

debt.     Finally, respondent determined that the $2,500 in legal

expenses deducted in tax year 1992 and the $3,171 in legal

expenses deducted in tax year 1993 are nonbusiness expenses

properly allowable as miscellaneous itemized deductions.

Discussion

     1.      Bad Debt Deduction

             (a) Second Deed

     Section 166(a) generally allows a deduction for any bona

fide debt that becomes worthless during the taxable year.     Bad

debts may be characterized as either business bad debts or

nonbusiness bad debts.     Sec. 166(d).   A taxpayer is not entitled

to a deduction for a worthless debt under section 166 in

connection with an income item unless it has been included in the

taxpayer's gross income for Federal income tax purposes either

for the year for which the deduction is claimed or for a prior

year.   Gertz v. Commissioner, 64 T.C. 598, 600 (1975); O'Meara v.

Commissioner, 8 T.C. 622, 633 (1947); sec. 1.166-1(e), Income Tax

Regs.     This principle also applies to interest owed to a taxpayer

but never reported as income.      W.L. Moody Cotton Co. v.

Commissioner, 2 T.C. 347, 353-357 (1943), affd. 143 F.2d 712 (5th

Cir. 1944).

     Petitioners sold the Fort Washington property in 1989.

Petitioners do not contend, nor does the record support a
                                  - 8 -

finding, that petitioners included in their gross income the

$21,900 of unpaid principal from the second deed.      Under the

installment reporting method, gain is not recognized until

payments are received.     Sec. 453(c).    Since petitioners did not

receive payments and never would report gain which corresponded

to the $21,900 loss, petitioners never created a basis on which a

later bad debt deduction could be claimed.      See Lombard v.

Commissioner, T.C. Memo. 1994-154, affd. per curiam without

published opinion 57 F.3d 1066 (4th Cir. 1995).      They also did

not report as income the $9,160 in accrued interest and late fees

attributable to the second deed.     Since petitioners did not

include in income any of the total amount of $31,060 in unpaid

principal, interest, and late fees from the second deed, they are

not entitled to a bad debt deduction under section 166.

            (b)   Legal Expenses in 1992

     A deduction for a bad debt is limited to a bona fide debt.

Sec. 1.166-1(c), Income Tax Regs.     A taxpayer must establish the

validity of a debt before any portion of it may be deducted under

section 166.      American Offshore, Inc. v. Commissioner, 97 T.C.

579, 602 (1991); sec. 1.166-1(c), Income Tax Regs.      A bona fide

debt is defined as one which arises from a debtor-creditor

relationship based upon a valid and enforceable obligation to pay

a fixed or determinable sum of money.      Sec. 1.166-1(c), Income

Tax Regs.
                                - 9 -

     Petitioners do not contend, nor does the record support a

finding, that they were entitled to a return of the $2,500 that

they contributed toward the Bakers' legal action against First

Security.    Further, petitioners do not contend, and the record

does not show, that a valid debtor-creditor relationship existed

between petitioners and the Bakers, or any other person, with

respect to the $2,500 in legal expenses.      Rather, petitioners

paid the legal fees in order to protect their own interests.

Therefore, the $2,500 in legal expenses was not a bona fide debt

within the meaning of section 166 and does not give rise to a

claim for a bad debt deduction.

            (c) Conclusion

     Petitioners have not established that they are entitled to a

business bad debt deduction with respect to the worthlessness of

the $21,900 in unpaid principal on the second deed, the $9,160 in

accrued interest and late fees from the second deed, or the

$2,500 in legal expenses.    Accordingly, respondent is sustained

on this issue.

     Since petitioners are not entitled to a bad debt deduction

under section 166, we need not consider whether the debt was a

business bad debt or a nonbusiness bad debt.

     2.     Legal Expenses in 1992 and 1993

     Section 212 allows an individual to deduct all of the

ordinary and necessary expenses paid or incurred in connection

with (1) the production of income, (2) the management,
                               - 10 -

conservation, or maintenance of property held for the production

of income, or (3) the determination, collection, or refund of any

tax.    Section 212 applies to income-producing activity that is

not a trade or business.    Woodward v. Commissioner, 397 U.S. 572,

575 n.3 (1970); United States v. Gilmore, 372 U.S. 39, 44-45

(1963).

       Section 162(a) allows a deduction for all ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on any trade or business.      Petitioners must establish

that the expenditures in question related to activities which

amounted to the present carrying on of a business.      Reisinger v.

Commissioner, 71 T.C. 568, 572 (1979).

       Whether the taxpayer is engaged in a trade or business and

what is the nature of such trade or business are questions of

fact.    Ford v. Commissioner, 56 T.C. 1300, 1307 (1971), affd. per

curiam 487 F.2d 1025 (9th Cir. 1973); Corbett v. Commissioner, 55

T.C. 884, 887 (1971).    The Supreme Court has interpreted the

"trade or business" terminology of section 162 to mean that "the

taxpayer must be involved in the activity with continuity and

regularity and that the taxpayer's primary purpose for engaging

in the activity must be for income or profit."      Commissioner v.

Groetzinger, 480 U.S. 23, 35 (1987).      The courts distinguish

between business losses and investment losses.      See, e.g.,

Whipple v. Commissioner, 373 U.S. 193 (1963).
                                - 11 -

     Legal expenses are deductible under section 162(a) as

ordinary and necessary business expenses if the litigation is

directly connected with, or proximately related to, the

taxpayer's business.     Bingham's Trust v. Commissioner, 325 U.S.

365, 373-374 (1945); Kornhauser v. United States, 276 U.S. 145,

153 (1928); Rafter v. Commissioner, 60 T.C. 1, 8 (1973), affd.

without published opinion 489 F.2d 752 (2d Cir. 1974).

     Petitioner claims that he was engaged in the business of

selling real estate as part of his renovation, management, and

rental activities.     While respondent concedes that petitioner

participated in the purchase, renovation, management, rental, and

sale of property, respondent contends that petitioner was not in

the business of selling real estate during the years in issue.

Rather, respondent characterizes petitioner's activities as

investment activity.

     We conclude that petitioner was not engaged in the business

of selling real estate during 1992 and 1993.     Although petitioner

purchased 11 properties during the period 1982 through 1989, he

renovated 7 of the properties and sold only 2 of the properties,

1 in 1989 and 1 in 1990.     Thus, petitioner's sales activity was

neither regular nor continuous.     See Polakis v. Commissioner, 91

T.C. 660, 670-672 (1988).     Further, petitioner's Schedules C for

tax years 1992 and 1993 do not reflect any income; rather,

petitioner reported the rental income and expenses from his

properties on Schedule E.     Petitioners reported the gain on the
                                - 12 -

sale of the property for which petitioners received the second

deed as long-term capital gain and not as ordinary income.

Petitioners also maintained outside employment and reported wages

for 1992 and 1993 in the amounts of $91,343.65 and $34,821.17,

respectively.

     While petitioner participated in the purchase, renovation,

management, rental, and sale of his property, he has not shown

that he was engaged in the trade or business of selling real

estate or in any other real estate business during the years in

issue.   From this record, it appears that petitioner engaged in

the activities for investment purposes.    Since petitioner's

activities do not rise to the level of a trade or business within

the intent and meaning of section 162(a), petitioners' legal

expenses from years 1992 and 1993 are not deductible as business

expenses attributable to an active trade or business.

     Petitioners further contend that respondent previously

treated petitioner's activities as an active trade or business

for purposes of examinations conducted in 1989, 1990, and 1991.

The parties have stipulated that

     The petitioners' income tax returns had been audited
     for 1989, 1990 and 1991; the activities of * * *
     [petitioner] were treated by the auditors at that time
     as an active trade or business for purposes of the
     audit, which did not involve issues related to taking a
     bad-debt deduction.

     Each tax year stands on its own and must be separately

considered.     United States v. Skelly Oil Co., 394 U.S. 678, 684
                                - 13 -

(1969).    The Commissioner is not bound in any given year to allow

a deduction permitted in a previous year.     Lerch v. Commissioner,

877 F.2d 624, 627 (7th Cir. 1989), affg. T.C. Memo. 1987-295;

Knights of Columbus Council No. 3660 v. United States, 783 F.2d

69 (7th Cir. 1986).

     Petitioners have failed to establish that they are entitled

to a business expense deduction with respect to the $2,500 in

legal expenses from 1992 or the $3,171 in legal expenses from

1993.     Rather, as allowed by respondent in the notice of

deficiency, the legal expenses of $2,500 for 1992 and $3,171 for

1993 are properly allowed as miscellaneous itemized deductions

pursuant to section 212.     Accordingly, respondent is sustained on

this issue.

     To reflect the foregoing,

                                           Decision will be entered

                                      under Rule 155.
