                        T.C. Memo. 1997-43




                      UNITED STATES TAX COURT



         PETER S. PAU AND SUSANNA H. PAU, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 20475-94.              Filed January 27, 1997.



     John M. Youngquist, for petitioners.

     Patricia Anne Golembiewski, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION

     PARR, Judge:   Respondent determined a deficiency in and a

penalty on petitioners' 1990 Federal income tax as follows:

                                      Penalty
      Year           Deficiency     Sec. 6662(a)
      1990            $438,692        $61,040

     On November 7, 1994, the Paus filed a petition with this

Court.   An answer was filed on December 20, 1994, in which
                                 - 2 -

respondent asserted further adjustments to petitioners' 1990

joint return, including:    (1) An increase of $195,101 in the

deficiency in income tax set forth in the original notice; and

(2) an addition to tax of $373,731 under the civil fraud penalty

of section 6663 or, alternatively, an increased penalty pursuant

to section 6662(a) of $99,662.1

     After concessions, two issues remain regarding petitioners'

income tax liability for 1990:    (1) Whether petitioners are

liable for the penalty pursuant to section 6663 for failure to

report $990,000 of income with the intent of evading the payment

of Federal income tax.   We hold they are.    (2) Whether section

163(h)(3) limits petitioners' Schedule A deduction for home

mortgage interest to interest paid on acquisition debt of $1

million.   We hold it does.

                           FINDINGS OF FACT

     The parties have stipulated to some of the facts and the

Court has so found.   The stipulation of facts and accompanying

exhibits are incorporated herein.    Peter S. Pau (petitioner) and

Susanna H. Pau (Susanna) were married and resided in

Hillsborough, California, at the time they filed their petition

in this case.



     1
        All section references are to the Internal Revenue Code
in effect for the year in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
                                 - 3 -

I.   The Unreported Income

     During 1990, and at all relevant times before and after that

year, the Paus operated a real estate development, management,

and brokerage business as sole proprietors doing business as

d.b.a. Sand Hill Property Co. (Sand Hill).     Petitioner was

actively engaged in the real estate management and development

side of the business; Susanna was largely concerned with

commercial real estate purchases and sales.     Susanna generally

dealt with major commercial properties, and most of her clients

hailed from Hong Kong and Japan.     Despite separate roles in Sand

Hill, petitioners worked together and were aware of each other's

transactions.

     Petitioner began working as a developer in 1979, having

earned a bachelor's degree in civil engineering from the

University of California at Berkeley in 1975 and a master's

degree in construction management from Stanford University in

1976.     Susanna earned a bachelor's degree in business

administration and accounting from the University of California

at Berkeley in 1974.

     A.     The Stockton Street Property Transaction

     In March of 1990, Susanna brokered the sale of real property

located at 39 Stockton Street in San Francisco, California (the

Stockton Street property).     Meiyan Enterprises, Inc. (Meiyan),

sold the property to Sanrio, Inc. (Sanrio), a Japanese company,

for use as a retail outlet.     The sale generated a broker's
                                 - 4 -

commission of $250,000, which was paid to Sand Hill at the time

of the closing on March 15, 1990.    Payment was made by a check

drawn on the escrow account by Founders Title Co.; the check was

deposited in full in Sand Hill's business checking account at the

Bank of America (the Bank of America account).     The $250,000

commission was included in the total gross receipts reported on

petitioners' 1990 Schedules C.

     In addition to the broker's commission, on March 20, 1990,

Meiyan paid Susanna a $150,000 finder's fee for locating the

buyer of the Stockton Street property.    The payment was made by a

check in Sand Hill's name bearing the handwritten notation

"consultation fee".   Susanna deposited the check in full into the

Bank of America account on March 20, 1990.

     B.   The Eccles Avenue Property Transaction

     Beginning in March of 1990, petitioner worked with Sanrio on

a build-to-suit development deal which evolved into the purchase

of an existing building located at 570-586 Eccles Avenue in San

Francisco (the Eccles Avenue property).    On June 29, 1990,

petitioner, d.b.a. Sand Hill, executed a purchase and sale

agreement (the agreement) with the seller for the purchase of the

Eccles Avenue property.   When he signed the agreement, petitioner

knew that Sanrio wanted to purchase the Eccles Avenue property

for use as its headquarters.   Because of a bad business

relationship between Sanrio and the seller, petitioner, rather
                                - 5 -

than Sanrio, signed the agreement so that the seller would not

learn that in fact Sanrio was the real buyer.

     Sanrio expected to pay a commission to petitioner after it

purchased the Eccles Avenue property, because he had acted as its

agent.

     Petitioner expressed some concern after the deal shifted

from development to purchase as to how he would be remunerated

for his work for Sanrio.    On June 12, 1990 (before he signed the

purchase agreement), petitioner sent a letter to Sanrio detailing

his negotiations for Sanrio's purchase of the property.    As of

that date, petitioner expected to receive $840,000 (representing

3 percent of the purchase price) from Sanrio upon its purchase of

the property.   Additionally, while petitioner worked for Sanrio

to buy the property, he had incurred expenses for inspectors and

engineers.   In September of 1990, Sanrio reimbursed him for his

out-of-pocket expenses.    On October 30, 1990, Sanrio paid

$840,000 to petitioners in consideration of the assignment of

petitioner's rights d.b.a. Sand Hill as purchaser of the Eccles

property.

     The payment was made as follows:    on October 30, 1990, at

Susanna's request, Sanrio directed the Bank of California to

debit its account there by $840,000 and remit the sum by

electronic funds transfer to the account of Susanna Pau at the

Banque Nationale de Paris (BNP) branch located in San Francisco,

California (the BNP account).    On that same date, Susanna
                                 - 6 -

directed BNP to transfer $100,000 of the $840,000 to the Bank of

America account.     Sanrio mistakenly failed to issue a Form 1099

to petitioner for its payment of $840,000, because the payment

was made via a wire transfer rather than through its accounts

payable system.     Petitioners and Sanrio never discussed the

issuance of a Form 1099 upon the completion of the transaction.

     The BNP account was an interest-bearing account from which

Susanna periodically transferred funds to the Bank of America

account or to a checking account maintained at the Bank of the

West.     Except for the $840,000 from Sanrio, petitioners did not

deposit any other business income directly into the BNP account

in 1990; all other deposits in BNP were transfers from other

accounts held by petitioners.

     C.     Petitioners' Recordkeeping Methods

     Despite Susanna's accounting background, petitioner is Sand

Hill's bookkeeper.     He alone possessed signature authority over

the Bank of America account.     Petitioners used that account to

deposit their commission checks, management fees, and reimbursed

expenses.     Whenever the Bank of America account held a

particularly large balance, petitioner would transfer funds via

check into other accounts, especially the BNP account, for the

purpose of accruing greater interest.     Petitioner claimed that

when he wrote checks on the Bank of America account for deposit

into another account, he did not verify that it contained
                                 - 7 -

sufficient funds to cover the checks because there was always a

large balance.

     Business income and expenses for Sand Hill during 1990 were

evenly apportioned between petitioner and Susanna and reported on

two separate Schedules C attached to their 1990 return.    To track

expenses incurred by petitioners on Sand Hill's behalf,

petitioner used the check register which showed the various types

and amounts of expenses.   Petitioner did not keep copies of bank

deposit slips and did not record the sources of the deposits,

although he did have access to monthly bank statements.    When

petitioner was ready to file the income tax return for himself

and Susanna, he simply resorted to his memory to determine what

transactions took place, since Susanna engaged in very few

transactions on a yearly basis which generated commissions.

Petitioner did not consult with Susanna to verify her income, nor

did he search Sand Hill's files.     For miscellaneous income,

including interest from banks and brokerage firms, petitioner

relied on Forms 1099.

     For petitioners' Federal income tax returns, including the

1990 return, petitioner then prepared a one-page summary of Sand

Hill's income and expenses on his computer and gave it to

petitioners' accountant.   The accountant used the summary to

prepare the Paus' tax returns.    The one-page summary is the only

record petitioner gave to the accountant.     In the summary,
                               - 8 -

petitioner listed expenses in categories such as travel,

telephone, and office rent.   For income, he listed three sources:

Commissions earned by Susanna, management income he earned, and

miscellaneous income.   In 1990, Susanna earned commissions from

four transactions, and petitioners reported the income on their

Schedules C.   Sand Hill received these commission checks

generally through escrow accounts, and petitioners deposited the

checks into various bank accounts, including the Bank of America

account.

     Petitioner did not include Susanna's consultation fee as

income on the one-page summary of Sand Hill's income and expenses

prepared for the Paus' accountant, even though he knew that she

had received $150,000 as a consultation fee from Meiyan.

Moreover, the same day Susanna deposited the check for $150,000

into the Bank of America account, petitioner wrote a check on

that account payable to Susanna for the same amount, which she

deposited into the BNP account.   Another check for $50,000 was

also debited on March 20, 1990.   Prior to the deposit of the

$150,000, the account contained a balance of $155,874.47.    In

completing Sand Hill's 1990 income and expense summary for

petitioners' accountant, petitioner was aware of but

intentionally failed to include the $840,000 from Sanrio.

     Petitioners did not tell their accountant of either omission

from their summary.   Neither the $150,000 fee nor the $840,000
                               - 9 -

from Sanrio was reported on the Schedules C attached to

petitioners' 1990 return.

     D.   Petitioners' Explanation of Unreported Sanrio Income

     From 1978 to 1984 petitioners lived in Boise, Idaho, where

they engaged in real estate transactions.   In 1983, they acquired

an interest in Regent Properties (Regent), a 40-acre real estate

development in Boise.   In 1984, petitioners stopped paying equity

into Regent, which had generated losses for them.   Since then,

they have not been actively involved in the property.   At trial,

petitioner was unaware of Regent's status, although the Paus

still held their interest in it.

     Since 1986, petitioners had wanted to take advantage of

projected losses from Regent but had been unsuccessful, because

their ordinary income could not be applied against capital losses

from the property.   Petitioner hoped to treat the $840,000 as a

capital gain and to apply $300,000 to $350,000 of capital losses

from Regent against it if and when such losses were realized.

Petitioners deliberately did not report the $840,000 of income

from Sanrio on their 1990 income tax return, because they wanted

to wait until the losses were realized, in order to report the

income and the losses simultaneously.   Therefore, they thought it

would be easier to file an amended return to report the

additional income, rather than to report it on the original

return for 1990 and later file an amended return to claim a large

refund.
                               - 10 -

     Petitioners never did file an amended return.

     Petitioners did not consult a certified public accountant or

a tax attorney with respect to the tax treatment of the income

from Sanrio and losses from Regent.     However, they did ask an

accountant about the extent of their mortgage interest deduction

and about amending their return to claim an additional deduction.

     E.   The Audit Process

     Richard Clement (Clement) is respondent's revenue agent

responsible for the audit of petitioners' 1990 Federal income tax

return.   He is familiar with real estate practices in the San

Francisco Bay area and has conducted audits of companies engaged

in real estate transactions.

     In July of 1994, Clement examined the Federal income tax

return filed by Sanrio.   While auditing this return, he noticed

Sanrio's $840,000 payment by wire transfer to Susanna's account

at BNP.   Accordingly, he requested an RTVUE, which is a computer-

generated document showing certain types of information from a

tax return (such as gross receipts reported on a Schedule C).

Using the RTVUE, Clement discovered that the Paus had reported

gross receipts on their 1990 Schedules C in an amount less than

the $840,000 transfer reflected on Sanrio's return.

     After reviewing the Paus' 1990 return, Clement decided to

audit it.   He selected for examination gross receipts and

expenses from the Schedules C, and Schedule A deductions for home

mortgage interest and contributions.     Clement left several
                               - 11 -

messages on the Paus' telephone answering machine upon commencing

the audit.    He left the initial message on July 13, 1994.

Clement spoke with Susanna for the first and only time on July

18, 1994.    During that conversation, Clement told Susanna that

petitioners' 1990 return had been selected for audit and that he

wished to arrange an appointment with them.    A meeting was

scheduled for July 25, 1994.    On July 19, 1994, Susanna left

Clement a message on his answering machine canceling the

appointment and rescheduling it for July 27, 1994.

       On July 25, 1994, Clement and petitioner spoke by telephone.

At that time, Clement asked petitioners to sign a consent form to

extend the period of limitations (Form 872) for their 1990

return, because the period was to expire on August 15, 1994.

Petitioners refused to execute the Form 872.    Petitioner

erroneously told Clement that the Paus had filed their 1990 tax

return in June or July of 1991, so that the period had already

run.

       Clement and petitioner engaged in another telephone

conversation on July 26, 1994, during which Clement again sought

the Paus' consent to extend the period of limitations.

Petitioner told the agent that his accountant had advised him

that the period had expired; he also indicated, without

elaborating, that the gross receipts reported on petitioners'

1990 return might have been incorrect.    They discussed their
                              - 12 -

meeting set for July 27, 1994.   However, petitioners and Clement

never met that day or at any other time prior to October 31,

1995, although they did have a telephone conversation on August

1, 1994. Clement and petitioner discussed the receipt of the

$840,000 from Sanrio.   Petitioner did not provide a direct answer

to Clement's inquiry about this sum.   This conversation was

Clement's last personal contact with either petitioner before

respondent issued the notice of deficiency.

     On August 2, 1994 petitioner left a voice message for

Clement, informing him that petitioners had received an

appointment letter, a Form 872, and an information document

request (IDR) seeking books and records needed to audit the

return.   Petitioner once again stated that the Paus would not

extend the period and that they would be unable to obtain the

documents requested because of the short time left in the period.

Clement then served a summons on petitioners on August 5, 1994,

for the records identified in the IDR.    Prior to the issuance of

the notice of deficiency, the Paus did not produce any books and

records requested from them by the IDR.

     In addition to the summons served on petitioners, Clement

issued summonses to financial institutions and a title company.

He received the books and records from these entities after the

notice of deficiency had been mailed to petitioners.
                              - 13 -

     On August 5, 1994, Susanna informed Clement's manager that

petitioners had retained counsel.    However, as of August 10,

1994, Clement had not received a power of attorney from

petitioners, and he therefore could not discuss the Paus' tax

matters with another individual.    A power of attorney was not

received until after Clement prepared the notice of deficiency

and forwarded petitioners' file on August 10, 1994, to the office

responsible for mailing such notices.

     The notice of deficiency was issued on August 11, 1994, and

increased petitioners' Schedule C income for 1990 by $545,000

each, for a combined increase in their taxable income of

$1,090,000, as a result of the $840,000 income from Sanrio and

the $250,000 commission from the sale of the Stockton Street

property.   (That commission had in fact been reported.)

Respondent also disallowed a total of $334,073 in Schedule C

expenses and $132,261 in itemized deductions.

     Clement learned of Susanna's $150,000 consultation fee only

after receiving a copy of the canceled check pursuant to the

summons served upon the Bank of America.   Neither Susanna nor

petitioner explained to Clement why they had not reported the

consultation fee on their return.

     After Clement notified petitioners of the audit, petitioner

prepared a bank deposits analysis to show the transfer of funds

between and among petitioners' various accounts.   Petitioner did
                              - 14 -

not give this analysis to Clement.     Among the records petitioner

used to reconstruct Sand Hill's income were monthly statements

from its Bank of America account.

     On October 31, 1995, Clement met with petitioner and his

accountant to review records for Sand Hill's expenses and

petitioners' deductions disallowed in the notice of deficiency.

For recording Sand Hill's expenses, petitioner used a spiral-

bound notebook with accounting paper.    Using this notebook,

petitioner verified each and every expense paid by Sand Hill for

which deductions were claimed by petitioners on their Schedules

C.   Clement determined that petitioner kept the notebook in the

ordinary course of business during 1990 and that it was an

adequate record for petitioners' business.    Petitioner, however,

did not present records of Sand Hill's income to Clement, so the

agent used petitioners' bank records to analyze deposits and

transfers to reconstruct Sand Hill's income.

     In their petition, the Paus denied that they had received

income of $840,000 that they did not report on their 1990 return.

Respondent's answer asserted that petitioners failed to report

additional Schedule C income of $616,789, including the $150,000

consultation fee received by Susanna.    Respondent further

asserted that the underpayment of petitioners' tax for 1990

attributable to their unreported income was due to fraud, and

that any deficiency stemming from that income is subject to the
                               - 15 -

penalty under section 6663.    Petitioners' reply denied receipt of

the $150,000.

      The parties have since stipulated that petitioners omitted

only the following items of income from their Schedules C

attached to their 1990 return:    (1) The consultation fee of

$150,000 paid to Susanna d.b.a. Sand Hill on March 20, 1990, by

Meiyan; and (2) the sum of $840,000 paid to petitioners on

October 30, 1990, by Sanrio.   The parties agree that section

6662(a) applies to the deficiency attributable to the unreported

income to the extent that the Court concludes that section 6663

is inapplicable.

II.   The Mortgage Interest Deduction

      Until 1989, petitioners owned a condominium in San Mateo,

California, that they used as their primary residence.    In 1989,

after their move, petitioners subsequently reclassified the

condominium as rental property.    In that year, petitioners also

purchased a home in Hillsborough, California, for use as their

primary residence and they have since lived there at all times.

The purchase price of the residence was $1,780,000.    Petitioners

have a mortgage on the Hillsborough residence, the original

principal amount of which was $1,330,000.

      In 1990, petitioners claimed a home mortgage interest

deduction on Schedule A of $107,226.    Despite having actually

paid a greater amount of mortgage interest, petitioners limited
                               - 16 -

their deduction to interest on $1.1 million indebtedness based on

advice from an accountant.    In her notice of deficiency,

respondent completely disallowed petitioners' Schedule A

deduction for home mortgage interest.

     As a result of the October 31, 1995, meeting with

petitioner, Clement allowed the Paus a home mortgage interest

deduction, but he limited the allowable deduction to the interest

on $1 million indebtedness.    Consequently, he calculated that the

allowable deduction is $99,040 rather than the $107,226 claimed

by petitioners, a difference of $8,186.      Clement also increased

the Schedule A deduction for personal interest by $819, from

$4,210 to $5,029.

                               OPINION

     As a general rule, the Commissioner's determinations are

presumed correct, and taxpayers bear the burden of proving that

those determinations are erroneous.      Accordingly, with respect to

deficiencies flowing from the home mortgage interest deduction

and the $840,000 omission, petitioners have the burden of proof.

Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933).      Since the

$150,000 omission was asserted by respondent after the notice of

deficiency was mailed, it is new matter on which respondent bears

the burden.   Rule 142(a).   Respondent also bears the burden of

proving, by clear and convincing evidence, that petitioners are

liable for the civil fraud penalty.      Sec. 7454(a); Rule 142(b).

Issue 1.   Penalty Pursuant to Section 6663
                                - 17 -

     Section 6663 provides for a penalty equal to 75 percent of

the underpayment of tax attributable to fraud.      Sec. 6663(a).

For section 6663 to apply, respondent must show that:       (1) An

underpayment of tax exists for the period at issue, and (2) a

portion of the underpayment stems from fraud.      Laurins v.

Commissioner, 889 F.2d 910, 913 (9th Cir. 1989), affg. Norman v.

Commissioner, T.C. Memo. 1987-265; Parks v. Commissioner, 94 T.C.

654, 660-661 (1990); Petzoldt v. Commissioner, 92 T.C. 661, 699

(1989).   The mere failure to report income generally is not

sufficient to establish fraud.     Switzer v. Commissioner, 20 T.C.

759, 765 (1953).

     A.   Underpayment of Tax

     There is no question that petitioners underpaid their tax

due for 1990, given their admission that they did not report

income of $990,000 on their return.      Thus, we may proceed with

the second prong of the analysis.    See Niedringhaus v.

Commissioner, 99 T.C. 202, 210 (1992).

     B.   Fraudulent Intent

     Fraud is intentional wrongdoing on the part of the taxpayer

with the specific purpose of evading a tax believed to be owing.

Petzoldt v. Commissioner, supra at 698; McGee v. Commissioner, 61

T.C. 249, 256 (1973), affd. 519 F.2d 1121 (5th Cir. 1975).       The

existence of fraud is a question of fact to be resolved from the

entire record.     King's Court Mobile Home Park, Inc. v.

Commissioner, 98 T.C. 511, 516 (1992); Gajewski v. Commissioner,
                               - 18 -

67 T.C. 181, 199 (1976), affd. without published opinion 578 F.2d

1383 (8th Cir. 1978).   Direct proof of intent is rarely

available, so courts may look to circumstantial evidence and draw

reasonable inferences from the facts.    Spies v. United States,

317 U.S. 492 (1943); Bradford v. Commissioner, 796 F.2d 303, 307

(9th Cir. 1986), affg. T.C. Memo. 1984-601.    Fraud must be

affirmatively established and is never imputed or presumed.

Beaver v. Commissioner, 55 T.C. 85, 92 (1970).

     For the Commissioner to carry her burden of proving that the

underpayment of tax is attributable to fraud, she must show that

a taxpayer intended to conceal, mislead, or otherwise prevent the

collection of taxes.    Powell v. Granquist, 252 F.2d 56, 60-61

(9th Cir. 1958); Rowlee v. Commissioner, 80 T.C. 1111, 1123

(1983).   A taxpayer's entire course of conduct can be indicative

of fraud.   Stone v. Commissioner, 56 T.C. 213, 224 (1971); Otsuki

v. Commissioner, 53 T.C. 96, 105-106 (1969).

     Over the years, courts have developed a nonexclusive list of

factors that demonstrate fraudulent intent.    These badges of

fraud include:   (1) Understating income, (2) keeping inadequate

records, (3) offering implausible or inconsistent explanations of

behavior, (4) concealing assets, and (5) failing to cooperate

with the Commissioner's agent.   See Bradford v. Commissioner,

supra at 303, and cases cited therein; Recklitis v. Commissioner,

91 T.C. 874, 910 (1988).   Although no single factor necessarily

suffices to establish fraud, a confluence of factors constitutes
                              - 19 -

persuasive evidence.   Solomon v. Commissioner, 732 F.2d 1459,

1461 (6th Cir. 1984), affg. per curiam T.C. Memo. 1982-603.    Some

conduct and evidence can be classified under more than one

factor.   A taxpayer's intelligence, education, and tax expertise

are also relevant in determining fraudulent intent.   See

Stephenson v. Commissioner, 79 T.C. 995, 1006 (1982), affd. 748

F.2d 331 (6th Cir. 1984); Iley v. Commissioner, 19 T.C. 631, 635

(1952).

     Applying the aforementioned criteria, as set out below, we

conclude that petitioners underreported their income for 1990

with the intention to evade income tax on $990,000 and are

therefore liable for a penalty under section 6663.

     1.   Understatement of Income

     Petitioners assert that they are not liable for the civil

fraud penalty because there is no "pattern of underreporting"

income.   Respondent acknowledges that the evidence does not

demonstrate such a pattern.   Nevertheless, she contends that a

pattern of underreporting is not a sine qua non for the

imposition of the civil fraud penalty.

     We agree with respondent that she may assert such a penalty

where a taxpayer fails to report income, even for only 1 year,

with the intention of evading tax due on that income.    In

Mitchell v. Commissioner, T.C. Memo. 1994-242, the Court examined

facts relating to a corporate taxpayer and an officer.    Acting

for the corporation, the officer sold its airplane and diverted

the sales proceeds to a Swiss bank account.   Neither the
                                - 20 -

corporation nor the officer reported income from the sale of the

airplane or the diversion of the sale proceeds.      We held both

taxpayers were liable for the civil fraud penalty, because they

failed to report the income with the intention of evading Federal

income tax.    In Mitchell, as in the case before us, the

taxpayers' conduct occurred in only 1 year, and the conduct

related to a single transaction.    See also Taylor v.

Commissioner, T.C. Memo. 1993-546.

     Petitioners cite Stone v. Commissioner, 22 T.C. 893 (1954),

arguing that respondent cannot establish fraud in reliance on

unreported income for 1 year.    However, that case does not stand

for such a broad proposition.    Rather, in Stone, we held that,

without more, a gross understatement of income in 1 year did not

establish that "there was fraud with intent to evade tax in this

instance."     Id. at 904 (emphasis added).   In the case before us,

respondent relied on a number of factors to prove fraud, as shown

below.

     2.   Inadequacy of Books and Records

     In October of 1995, petitioner met with Clement for the

first time, presenting Sand Hill's records of expenses to

establish petitioners' entitlement to deductions claimed on their

Schedules C.    Clement found the records adequate to verify each

and every expense claimed for Sand Hill.      However, petitioner

presented no records for Sand Hill's income and conceded that his

handling of the income of Sand Hill was entirely inadequate.
                                 - 21 -

      The inadequacy of the records was not due to negligence on

the part of petitioners, but fraud.       Petitioners' reliance on

Tabbi v. Commissioner, T.C. Memo. 1995-463, is misplaced.       In

that case, the Court held that the taxpayer was not liable for

the civil fraud penalty, in part because his failure to keep

books and records, other than checks, was due to the fact that he

was "disorganized and because he could not afford accountants."

Id.     Other factors also weighed in his favor.     In the instant

case,      petitioners present only their self-serving testimony that

they were disorganized, which we do not find credible.

Petitioners were able to prove every expense they had claimed for

Sand Hill.      They also had ready access to monthly bank statements

and the ability to use them, which petitioner showed in

conducting his deposits analysis.      Even more telling, petitioners

could afford and did use an accountant but intentionally failed

to provide him with accurate records.       See Korecky v.

Commissioner, 781 F.2d 1566, 1568-1569 (11th Cir. 1986), affg.

T.C. Memo. 1985-63; Merritt v. Commissioner, 301 F.2d 484, 486-

487 (5th Cir. 1962), affg. T.C. Memo. 1959-172.

      3.     Implausible or Inconsistent Explanations of Behavior

      Petitioners refused to acknowledge their receipt of the

$840,000 from Sanrio until after respondent's answer, even though

petitioner earlier had mentioned a potential problem with the

gross receipts reported on the return, and despite the fact that

the $840,000 was specifically brought up in their conversation

with Clement on August 1, 1994.      Petitioner subsequently stated
                                - 22 -

that he failed to report the income, not to evade tax, but

because he viewed the payment as a short-term capital gain which

he intended to offset by capital losses from his interest in

Regent when such losses were realized.    The Court discounts this

explanation as an afterthought.    See Gajewski v. Commissioner, 67

T.C. at 202.   Petitioner had at least two clear opportunities to

offer this explanation to Clement before petitioners retained

counsel, yet he said nothing.

     Even if we did not regard petitioner's explanation as a

recent fabrication, we find highly improbable his testimony that

he viewed the income received from Sanrio as capital, rather than

ordinary, in nature.   Although his wife usually engaged in

brokerage sales for Sand Hill, petitioner was familiar with real

estate practices.   The evidence overwhelmingly suggests that

Sanrio viewed petitioner merely as an agent, and that petitioner

knew of his role as intermediary.    Petitioner wrote a letter to

Sanrio before the Agreement was signed describing his fee.

Moreover, Sanrio reimbursed petitioner for his out-of-pocket

expenses.   Petitioner signed the agreement, rather than Sanrio,

due to the seller's antipathy toward Sanrio.    Cf. Solomon v.

Commissioner, 732 F.2d at 1461.     Consequently, petitioner must

have known that the $840,000 was a commission and therefore

ordinary income against which, he was aware, capital losses could

not be applied.   His explanation is incongruous with these

circumstances.
                              - 23 -

     Moreover, even if the payment from Sanrio could have been

characterized as a capital gain rather than ordinary income,

section 441 requires a taxpayer to report taxable income on the

basis of a taxable year.   Petitioners had an obligation to report

the $840,000 on their 1990 return, not in the future when they

might possibly realize a capital loss.   Petitioners surely

recognized that duty in light of their relative sophistication in

tax matters; they were aware that their capital losses could be

carried forward and that they could have received a refund.

Furthermore, Susanna held a bachelor's degree in accounting.    Cf.

Laurins v. Commissioner, 889 F.2d at 913 (the fact that a

taxpayer is sophisticated in tax matters may permit an inference

of intent to defraud when he willfully underpays his taxes).

Finally, there is no evidence in the record before us that

petitioners realized their losses in Regent at any time from 1990

until the date of trial.   Petitioner himself stated that he did

not know when, if ever, the losses from Regent would be realized.

This indicates to us that, had petitioners not been audited, the

$840,000 income would never have been disclosed.

     Petitioner's claim that the omission of Susanna's $150,000

consultation fee was inadvertent also rings false.   Susanna had

engaged in only a handful of transactions that year, and she

testified that petitioner was aware of her transactions and of

the consultation fee.   Moreover, petitioner wrote a check to

Susanna drawn on the Bank of America account for that exact

amount on the same day the consultation fee was deposited in that
                               - 24 -

account, which accords with petitioners' stated practice of

transferring large sums of money from their business accounts to

the BNP account to earn greater interest.     Finally, contrary to

petitioner's testimony, monthly bank statements reveal that the

Bank of America account did not always carry a large balance.

Petitioner must have known of the additional income because

otherwise, given the outstanding checks he had written on that

account and its prior balance of only $155,874.47, he would have

overdrawn the account by almost $45,000.

     4.   Attempts To Conceal Assets

     Susanna instructed Sanrio to pay $840,000 by wire transfer

into her nonbusiness account at BNP.     This was the only direct

business deposit into that account in 1990.     Sanrio did not issue

a Form 1099 for its payment, an error on its part because of the

method of payment.   However, petitioners did not request a Form

1099, despite petitioner's knowledge of the existence of such a

form and his reliance on it in other instances to verify interest

and miscellaneous income.

     Furthermore, although petitioners consulted an accountant

about the limit to their home mortgage interest deduction and

about amending their return to increase another deduction, they

did not discuss applying unrealized capital losses against the

$840,000 with an accountant.   In fact, they concealed that income

completely from their tax preparer.     Case law is replete with

support for holding that petitioners may be liable for the civil

fraud penalty as a result of such an action.     See Korecky v.
                                 - 25 -

Commissioner, 781 F.2d at 1568; Paschal v. Commissioner, T.C.

Memo. 1994-380, affd. 76 AFTR2d 95-7975, 96-1 USTC par. 50,013

(3d Cir. 1995); Morris v. Commissioner, T.C. Memo. 1992-635,

affd. without published opinion 15 F.3d 1079 (5th Cir. 1994); cf.

Ross Glove Co. v. Commissioner, 60 T.C. 569, 608 (1973) (no fraud

demonstrated where evidence did not show the taxpayer ignored or

misinformed his attorneys or accountants); Marinzulich v.

Commissioner, 31 T.C. 487, 492 (1958) (no fraud proven where the

taxpayers' accountant had complete access to all the information

bearing on their tax liability); Dagon v. Commissioner, T.C.

Memo. 1984-138 (no fraud where the taxpayer did not conceal any

records from his tax return preparer); Compton v. Commissioner,

T.C. Memo. 1983-647 (no fraud where the taxpayer turned over

sufficient records to his tax preparer for her to accurately

determine his tax liability for the years in issue).   We agree

with respondent that the only rationale for petitioners' failure

to disclose the income to the accountant was so that they could

avoid the accountant's duty to report the income.

     5.   Failure To Cooperate

     Petitioners did not cooperate with respondent's agent

initially, canceling appointments, refusing to extend the period

of limitations, and failing to produce records and books used to

prepare their Schedules C and their tax return.   Using the

limited information available to him, the agent prepared, and

respondent issued, the notice of deficiency to petitioners.    Cf.
                               - 26 -

Dagon v. Commissioner, supra (no fraud where the taxpayer met

with the Commissioner's agent several times during the course of

criminal investigation and gave the agent all books and records,

explained procedures followed in preparation of those records,

and provided complete access to personal banking records).       Only

after counsel was retained did petitioners cooperate with

respondent's agent, which of course does not rectify their

previous intransigence.    Cf. Badaracco v. Commissioner, 464 U.S.

386, 394 (1984).

     6.   Petitioners' Sophistication and Experience

     Petitioners seek to portray themselves as tax naifs who

operated a "mom-and-pop" business.      They rely on Cheek v. United

States, 498 U.S. 192 (1991), in arguing that a good faith

misunderstanding of the tax law may negate fraud.     However,

petitioners' own testimony clearly belies their assertions of

inexperience and good faith.   Petitioners are both well-educated,

adept business people who have successfully cultivated an

international clientele.   Susanna has a degree in accounting.     At

trial, petitioner demonstrated an awareness of capital loss

carryforwards; he knew that the general statute of limitations

for tax returns was 3 years, and that taxpayers could amend their

tax returns at any time to report additional income.     Moreover,

he knew how to structure business ventures in a tax-advantaged

manner.   Their experience reveals that petitioners understood the
                               - 27 -

tax laws but chose to ignore them in their effort to evade the

payment of income tax.

     Thus, we find that respondent has clearly and convincingly

proven fraud on the part of petitioners for both items of

unreported income for the year in issue, and we so hold.     Our

conclusion is premised on the record as a whole and reasonable

inferences therefrom, taking into account our determination as to

the credibility of petitioners and the other witnesses presented

at trial.    Therefore, we sustain respondent's determination that

petitioners are liable for the penalty for 1990 pursuant to

section 6663.

Issue 2. Section 163(h)(3) Restriction on Home Mortgage Interest
Deduction

     Section 163(a) states the general rule for deductions for

interest paid or incurred on indebtedness within the taxable

year.   Other provisions of section 163 limit such deductions.

Section 163(h) disallows personal interest deductions unless they

fit within certain narrowly prescribed categories.     Among these

narrow exceptions is the deduction for interest on a qualified

residence.    Sec. 163(h)(2)(D).   The parties agree that the

interest paid on the mortgage for petitioners' home was qualified

residence interest, because the Paus paid it on acquisition

indebtedness pursuant to section 163(h)(3)(A)(i) and (B)(i).       The

parties dispute only the amount of acquisition indebtedness

petitioners may use in computing their deduction.
                              - 28 -

     Section 163(h) restricts home mortgage interest deductions

to interest paid on $1 million of acquisition indebtedness for

debt incurred after October 13, 1987.    Acquisition indebtedness

is defined as that which is "incurred in acquiring, constructing,

or substantially improving any qualified residence of the

taxpayer, and * * * is secured by such residence."    Sec.

163(h)(3)(B).   A taxpayer may be entitled to a greater deduction

if he has incurred home equity indebtedness up to $100,000, as

allowed by section 163(h)(3)(C)(ii).    There can be no additional

deduction where taxpayers fail to show that they had home equity

indebtedness.   See Notice 88-74, 1988-2 C.B. 385.   Home equity

indebtedness is defined as "any indebtedness (other than

acquisition indebtedness) secured by a qualified residence".

Sec. 163(h)(3)(C) (emphasis added).

     Petitioners, who purchased their home in 1989, did not

demonstrate that any of their debt was not incurred in acquiring,

constructing or substantially improving their residence and thus

have failed to carry their burden of proof.    We therefore sustain

respondent's determination as to the amount petitioners may

properly deduct for home mortgage interest.

     To reflect the foregoing and issues previously resolved,



                                      Decision will be entered

                               under Rule 155.
