                          T.C. Memo. 2003-171



                        UNITED STATES TAX COURT



        FAWZI AND DOLORES TAY TAY ASSAAD, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 12401-00.                Filed June 11, 2003.


     Benjamin W. Gale, for petitioner.

     Christian A. Speck, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     RUWE, Judge:     Respondent determined the following

deficiencies in petitioners’ Federal income taxes, an addition to

tax, and penalties:

                                   Addition to tax and penalties
     Year      Deficiency          Sec. 6651(a)(1) Sec. 6662(a)

     1996        $3,221                 –             $644.20
     1997        94,904              $23,595.25     18,980.80
                               - 2 -

The only issues are:   (1) Whether petitioners are entitled to a

net operating loss carryforward, from 1992 to 1996 and 1997, in

an amount exceeding that allowed in the notice of deficiency; and

(2) whether petitioners are liable for the section 6651(a)(1)1

addition to tax for 1997 and the section 6662(a) accuracy-related

penalties for 1996 and 1997.




     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code as amended, and all Rule references are
to the Tax Court Rules of Practice and Procedure.
                               - 3 -

                         FINDINGS OF FACT2

     Some of the facts have been stipulated and are so found.

The stipulation of facts, the supplemental stipulation of facts,

and the attached exhibits are incorporated herein by this


     2
      We note that our resolution of the issues in this case has
been made more difficult by petitioners’ failure to comply with
our Rules regarding the form and content of briefs. Our Rules
require that proposed findings of fact be complete and that they
“consist of a concise statement of essential fact and not a
recital of testimony nor a discussion or argument relating to the
evidence or the law.” Rule 151(e)(1). Petitioners’ entire
proposed findings of fact consist of the following:

     1. The respondent’s mailing of an audit appointment
     letter to petitioners on or about July 16, 1998, to
     petitioners at Unionstone Lane, San Rafael, California,
     did not “commence an examination” of the petitioners’
     1996 tax return within the meaning of IRC Sec. 7491.
     (See Exhibit 10-R)

     2. The respondent did not otherwise “commence an
     examination” of the petitioners’ 1996 tax return within
     the meaning of IRC Sec. 7491 before July 22, 1998.

     3. The petitioners presented credible evidence of a
     net operating loss carryforward to 1996 at least
     sufficient to reduce to zero the amount of income tax
     owed for 1996.

     4. The petitioners presented credible evidence of a
     net operating loss carryforward to 1997 at least
     sufficient to reduce to zero the amount of income tax
     owed for 1997.

     5. The burden of proof shifted to the respondent with
     respect to the factual issues underlying the proposed
     deficiencies for 1996 and 1997.

     6. The respondent failed to meet his burden of proof
     with respect to the evidence presented in support of
     the net operating loss carryovers to 1996 and 1997.

     7.   The petitioners owe no penalties for 1996 and 1997.
                                   - 4 -

reference.       At the time of filing the petition, petitioners

resided in Novato, California.

        Mr. Assaad was a real estate developer and investor.3      On or

about December 8, 1988, petitioners purchased approximately 2.2

acres of land in Atherton, California, which consisted of three

parcels:       3, 9, and 15 Isabella.   Mr. Assaad intended to develop

the three parcels by constructing three residential homes for

sale.       Pacific Bank (Pacific) lent $1.46 million to Mr. Assaad

(the land loan) for the purchase of the land.        The land loan was

secured by a deed of trust covering the three parcels of land.

     On July 29, 1989, Pacific lent Mr. Assaad $2.64 million

under a construction loan agreement (the Pacific construction

loan) for two of the units in the Atherton project, 3 and 15

Isabella.       A deed of trust in favor of Pacific was recorded with

respect to the two parcels.4      Mr. Assaad signed a promissory note

and executed a guaranty of completion and performance in favor of

Pacific for the construction loan.         The note provided for an

initial interest rate of 12.5 percent and a variable interest

rate on the basis of “an index which is THE PACIFIC BANK GUIDANCE

RATE”.       A 12-month interest reserve of $228,000 was included in




        3
      Mr. Assaad was also the sole shareholder of Golden Sunset
Homes, Inc., which owned a residential care home, Hopkins Manor.
        4
      The loan was also collateralized with a deed of trust of
$1.5 million with respect to Hopkins Manor.
                                 - 5 -

the loan commitment.    On May 15, 1990, the Pacific construction

loan was increased to $2.96 million.

     On March 7, 1991, Pacific lent petitioners an additional

$320,000 (the $320,000 loan).5    Also, on or about March 7, 1991,

Pacific lent Mr. Assaad $250,000 (the $250,000 loan) secured by a

bank guaranty that Mr. Assaad’s brother posted through Credit

Suisse.    A portion of this loan was made in renewal of a prior

loan of $150,000.    On January 21, 1992, petitioners executed a

promissory note to Pacific of $350,000 for a loan that Pacific

made to petitioners (the $350,000 loan).

     At some point in 1992, the house at 3 Isabella was sold for

$1,295,800, and the principal amount due on the Pacific

construction loan was reduced to $1.95 million.    Mr. Assaad was

unable to sell the residence at 15 Isabella, and, in 1992,

Pacific sold the property through foreclosure.    The trustee’s

deed states that the amount of consideration was $1.47 million,

and the amount of unpaid debt was $2,052,385.23.    There were no

bidders at the foreclosure sale, and the property went to

Pacific.

     On or about August 14, 1989, First National Bank of Daly

City (First National) lent Mr. Assaad $875,000 (First National


     5
      Petitioners, as borrowers, Pacific, as lender, and Golden
Sunset Homes, Inc., as grantor, executed a commercial pledge
agreement with respect to the $320,000 loan. Golden Sunset
Homes, Inc., granted Pacific a security interest in a certain
note and deed of trust it held.
                               - 6 -

loan).   Mr. Assaad signed a deed of trust in favor of First

National, which secures 9 Isabella as collateral for the First

National loan.6   On or about April 17, 1990, First National lent

Mr. Assaad an additional $100,000 (additional First National

loan).   Mr. Assaad signed a deed of trust in favor of First

National, which secures 9 Isabella as collateral for this loan.7

At some point, California Federal Savings and Loan Association

(California Federal) lent money to petitioners to repay the loans

from First National, and for other purposes.8   On October 31,

1990, California Federal recorded a deed of trust and assignment

of rents that petitioners executed in favor of California Federal

and against the real estate at 9 Isabella.   A statement from

California Federal to petitioners, dated March 9, 1992, states

that the total interest paid on a certain loan no. 10743062 for

1991 was $113,812.35.   At some point in 1992, the house at 9

Isabella was sold for $1,250,000.9

     Petitioners filed joint Federal income tax returns for their

1992, 1996, and 1997 taxable years.    They attached a Schedule C,



     6
      The construction trust deed cites a note of $875,000, which
contains a variable interest rate.
     7
      The deed of trust cites a note of $100,000, which contains
a variable interest rate.
     8
      Petitioners received $120,802.70 cash back on this
refinancing transaction.
     9
      Petitioners were paid $131,514.95 of the proceeds from the
sale of 9 Isabella.
                               - 7 -

Profit or Loss From Business (Sole Proprietorship), to their

joint return for 1992 reporting a loss of $1,890,682 for Mr.

Assaad’s real estate development business.   Petitioners reported

gross receipts of $2,675,272, cost of goods sold of $2,226,664,

and a gross profit of $448,608 for that business.   Petitioners

claimed expenses of $2,339,290 (separate from, and in addition

to, the cost of goods sold).   Petitioners did not report

sufficient income on their 1992 Form 1040, U.S. Individual Income

Tax Return, from which to deduct the entire loss.   They carried

forward the loss to their 1993, 1994, 1995, 1996, and 1997

taxable years.   On petitioners’ 1996 and 1997 Forms 1040, they

claimed net operating loss (NOL) carryforward deductions which

reduced their taxable income to zero for those taxable years.

     In computing the gross receipts from the development

business for 1992, petitioners did not report any of the proceeds

from the foreclosure sale of 15 Isabella on the 1992 return.    The

gross receipts from that sale in 1992 were at least $2,052,385.

     For many years, Roy Hunt prepared petitioners’ tax returns,

and he was their accountant.   At some point, Anthony Lopez took

over Mr. Hunt’s practice, and he became petitioners’ tax return

preparer and accountant about a year before Mr. Hunt’s death.

Mr. Lopez could not recall whether he prepared petitioners’ 1992
                                 - 8 -

tax return.10    Mr. Lopez testified that whatever records relating

to petitioners that were in Mr. Hunt’s office were left there

following his death.    He also testified that Mr. Assaad’s records

were returned to him as far as he knew and that he does not

withhold records in his practice “Even if they don’t pay you.”

Mr. Lopez also represented petitioners in the audit of their 1992

tax return.     He testified that he experienced difficulty

assembling petitioners’ records for substantiation of expenses

and other costs, including interest, in part because of Mr.

Hunt’s death and in part because of Mr. Assaad’s lack of

cooperation.

     In 1993, petitioners purchased, and began to rent out,

property known as St. Rose Manor.     Petitioners overstated

depreciation deductions with respect to St. Rose Manor by at

least $148,747 for 1993, $324,033 for 1994, $324,033 for 1995,

and $324,033 for 1996, a total of $1,120,846 over the 4-year

period.   Petitioners’ overstatement of the depreciation

deductions in 1993, 1994, 1995, and 1996, when corrected, reduces

the amount of the NOL carryforward available for 1996 and 1997.



     10
      Mr. Hunt continued to work with Mr. Lopez, and he handled
all the clients he previously serviced. Mr. Lopez testified that
he thought Mr. Hunt was handling petitioners’ returns when he
died, but he could not be certain. Mr. Lopez signed petitioners’
return for the 1992 taxable year; however, he was unsure whether
he or Mr. Hunt prepared that return. Mr. Hunt and Mr. Lopez did
not prepare any of petitioners’ returns for years after the 1992
taxable year.
                               - 9 -

     Petitioners’ Federal income tax returns for 1996 and 1997

were filed on October 20, 1997, and January 6, 2000,

respectively.   Mr. Assaad could not offer any explanation as to

why the 1997 return was filed untimely.   Respondent audited

petitioners’ 1996 return.11   On July 16 or 17, 1998, respondent

mailed to petitioners an audit appointment letter with respect to

their 1996 taxable year.   The record does not reflect when

respondent commenced an examination regarding petitioners’ 1997

taxable year.

     In computing the NOL carryforward from 1992, respondent

determined that petitioners should have reported foreclosure

income of $2,052,385 with respect to 15 Isabella in addition to

the $448,608 gross profit that they reported on their 1992

return.   He made no adjustments to the $2,226,664 cost of goods

sold that petitioners reported.   Respondent revised petitioners’

income from the real estate development business to $2,500,993.

He disallowed $369,023 of the expenses that petitioners claimed

on their 1992 Schedule C, but he allowed $915,002 of additional

expenses not originally shown on petitioners’ 1992 return.



     11
      Respondent previously audited petitioners’ 1992, 1993,
1994, and 1995 tax returns. Respondent disallowed the NOL
carryforward deductions for 1993, 1994, and 1995. However,
petitioners petitioned the Tax Court. Respondent represents that
he “settled the Tax Court case for no deficiency on the basis
that some net operating loss existed and to the extent it
existed, it was sufficient to eliminate all of the petitioners’
income and income tax liability for those years.”
                                - 10 -

Respondent computed an NOL of $391,243 for 1992, which he allowed

as carryback and carryforward deductions for petitioners’ 1989,

1990, 1991, 1993, 1994, 1995, and 1996 taxable years.     After

accounting for the adjustments to the NOL carryforward deductions

and the depreciation deduction for 1996, as well as other items,

respondent determined deficiencies of $3,221 for 1996 and $94,904

for 1997.

                                OPINION

      This case involves the question whether petitioners are

entitled to NOL carryforward deductions for 1996 and 1997 in

amounts greater than those which respondent allowed in the notice

of deficiency.   To decide that issue, we must determine whether

petitioners have adequately substantiated their claimed costs and

expenses in their construction project for purposes of computing

the NOL for 1992.

A.   Net Operating Loss Carryforward Deductions

      Deductions are a matter of legislative grace, and the

taxpayer bears the burden of proving that he is entitled to any

deductions claimed.   Rule 142(a); INDOPCO, Inc. v. Commissioner,

503 U.S. 79, 84 (1992).     In certain circumstances, if the

taxpayer introduces credible evidence with respect to any factual

issue relevant to ascertaining his tax liability, the

Commissioner shall have the burden of proof with respect to that

issue.   Sec. 7491(a)(1).    Section 7491 was added to the Code by
                              - 11 -

the Internal Revenue Service Restructuring and Reform Act of 1998

(RRA 1998), Pub. L. 105-206, sec. 3001, 112 Stat. 726, and is

applicable in the case of court proceedings arising only in

connection with examinations commencing after July 22, 1998, RRA

1998 sec. 3001(c), 112 Stat. 727.   In the instant case,

respondent selected petitioners’ 1996 return for audit and mailed

to petitioners notice of that audit on July 16 or 17, 1998,

before the effective date of section 7491.    Absent any contrary

evidence, we treat that date as the date the examination of

petitioners’ 1996 taxable year commenced.    See Jombo v.

Commissioner, T.C. Memo. 2002-273; see also H. Conf. Rept. 105-

599, at 242 (1998), 1998-3 C.B. 747, 996.    There is nothing in

the record which establishes that the “examination” of

petitioners’ 1997 taxable year commenced after July 22, 1998.

Petitioners did not present any argument on brief regarding when

an “examination” commenced with respect to that year.    We hold

that section 7491 is not applicable with respect to petitioners’

1997 tax liability.   See Castro v. Commissioner, T.C. Memo. 2001-

115; Nitschke v. Commissioner, T.C. Memo. 2000-230.

     Even if the examination of petitioners’ 1996 and 1997

taxable years started after the effective date of section 7491,

the burden of proof would not have shifted to respondent.

Section 7491(a)(1) applies with respect to an issue only if “the

taxpayer has complied with the requirements under this title to
                                    - 12 -

substantiate any item” and “the taxpayer has maintained all

records required under this title and has cooperated with

reasonable requests by the Secretary for witnesses, information,

documents, meetings, and interviews”.          Sec. 7491(a)(2)(A) and

(B).    For reasons discussed in more detail below, petitioners

failed to comply with the applicable substantiation requirements,

and they have failed to maintain all required records with

respect to their expenses in the Atherton project.

       Taxpayers are required to keep such permanent records as are

sufficient to substantiate the amount and the purpose of any

deductions.     Sec. 6001; Higbee v. Commissioner, 116 T.C. 438, 440

(2001); Hradesky v. Commissioner, 65 T.C. 87, 90 (1975), affd.

per curiam 540 F.2d 821 (5th Cir. 1976); sec. 1.6001-1(a), Income

Tax Regs.     Petitioners have failed to substantiate the vast

majority of the expenses that they rely upon to compute the 1992

NOL.

       1.   Land Purchase and Related Expenses

       Petitioners claim that they paid a total of $2,017,397.50 to

purchase the land used for the Atherton project, consisting of

the following:

                     Item                               Amount

             Land loan                              $1,460,000.00
             Deposit from Assaad savings               422,397.50
             Deposit paid outside escrow               200,000.00
             Advance by Trudell & Coghan              (200,000.00)
             Credit for amount paid before escrow      141,125.08
                                                       1
             Interest portion of this Credit             (6,125.08)
                                    - 13 -
                   1
                     Petitioners do not explain how they arrived at this
             figure; however, the buyer’s closing statement for the
             Atherton properties shows interest of $10,722.60. The
             credit is $130,402.48 apart from the interest.

Petitioners have substantiated to our satisfaction that they

borrowed $1.46 million from Pacific to purchase the 3 parcels of

land.     However, petitioners have not established that they paid

$2,017,397.50, as they claim on brief.

     When counsel for Mr. Assaad asked him at trial whether he

put any money into the project other than the loan amounts, Mr.

Assaad testified that “We put our money in there” but that he

could not “remember exactly”.         There is also evidence that other

parties may have invested in the Atherton project.              Indeed, at

trial, Mr. Assaad testified that the Atherton project’s general

contractor, Rick Trudell, and a friend of Mr. Assaad’s, Hayden

Coghan, each contributed $200,000 into the Atherton project.12

Mr. Assaad testified:

     Q    And then the $200,000 for deposit retained, paid
     outside.

     A      We borrowed that from Rick Trudell.

     Q      Okay.

     A    Okay. Because he wanted to be like a partner in
     the project.

     Q      Did you pay it or did he pay it?



     12
      Mr. Assaad could not remember whether Mr. Trudell also got
a $200,000 line of credit to be put towards the Atherton
properties.
                              - 14 -

     A     He give it to me and   I pay it, I think. And then
     maybe I pay $100,000 from    Mr. Hayden, Coghan. That’s
     the right name. And then     $100,000 from Rick. And we
     kept that $200,000 to pay    the City and the architect.
     * * *

               *    *     *       *   *   *     *

     A    * * * Mr. Hayden and Rick Trudell and me, I
     believe that will make some arrangement, I build that
     money, the $422,000 from my own bank account. The
     deposit that we pay out of escrow I believe, it be
     between Rick Trudell $100,000, he give $200,000. We
     kept another $100,000, and another $200,000 get from
     Mr. Coghan Hayden, who live in Half Moon Bay. And then
     we complete the deal.

           In order to get the bank after that to look, and
     construction loan, and that was our agreement at that
     time.

Mr. Assaad later testified to an oral agreement with Mr. Trudell

and Mr. Coghan with respect to these amounts.       He testified that

he planned to “give everyone his money plus 100 percent” when the

properties were sold.   He also testified that Mr. Trudell was

“Not exactly” a partner with him with respect to the Atherton

project, because there was no written agreement or contract.

Given Mr. Assaad’s testimony, there is evidence that Mr. Trudell

and Mr. Coghan contributed at least $400,000 to the Atherton

project.

     Petitioners contend that those contributions were loans.

However, Mr. Assaad testified that Mr. Coghan did not receive any

of his money back, and Mr. Trudell received only $100,000, but

“he said that he doesn’t want anymore.”    To the extent the

amounts from Mr. Trudell and Mr. Coghan were loans and were
                               - 15 -

forgiven, those amounts represent income that reduces dollar for

dollar any amount used in computing the NOL.    Thus, whether the

amounts that Mr. Trudell and Mr. Coghan contributed were loans

that were forgiven,13 or amounts those parties invested in the

project, petitioners have not established that they paid those

amounts into the project.14   As such, petitioners have

substantiated $1,812,799.9815 as amounts that they paid into the

land purchase.

     2.   Costs in Selling 3 and 9 Isabella

     Petitioners substantiated to our satisfaction that they

incurred $60,634.76 in closing and settlement costs with respect

to the sale of 3 Isabella.    The record also reflects that

$100,000 was paid to Mr. Trudell to release his lien with respect


     13
      We have given Mr. Assaad credit for the $100,000 that was
paid to Mr. Trudell. See infra.
     14
      One of respondent’s primary contentions on brief is that
Mr. Assaad and Mr. Trudell, and perhaps Mr. Coughan, were engaged
in a partnership and that petitioners have not shown that the
costs and losses resulting from the Atherton houses belonged to
them as opposed to other partners. Although there is some
evidence in the record which might suggest a partnership between
Mr. Assaad and Mr. Trudell, the evidence is not sufficient for us
to conclude that there was a partnership. Further, there is no
basis in the record for allocating the costs and losses to the
other alleged partners and for making adjustments, if any, to the
amounts realized from the sale and foreclosure of the Atherton
properties.
     15
      This amount is equal to the $1.46 million land loan plus
the $422,397.50 deposit or earnest money, plus the $130,402.48
credit for the amount paid before escrow plus the $200,000
deposit retained, and minus the $400,000 received from Mr.
Trudell and Mr. Coghan.
                               - 16 -

to 3 Isabella and, as Mr. Assaad claims, to repay a portion of

Mr. Trudell’s prior loan or contribution.    Petitioners have also

substantiated that they paid $26,657.58 with respect to the sale

of 9 Isabella.16   Petitioners substantiated the following

miscellaneous sales costs for 3 Isabella:    (1) A home warranty

expense of $275, and (2) prorated taxes of $674.36.

     Petitioners did not substantiate the remaining amounts that

they claim as miscellaneous sales costs for 3 Isabella.      Those

amounts represent a “credit to buyer” of $1,445 for a fence and a

“credit to buyer” of $565 for downspouts as part of the sale of 3

Isabella.   Petitioners did not establish that those expenses were

actually incurred to the extent claimed.    Petitioners, likewise,

did not substantiate the $63,000 they claim as expenses for

“Fence, chandeliers, etc.”    Petitioners rely on a handwritten

document that a representative of Pacific prepared as evidence of

these expenses.    That document fails to properly substantiate the

amounts petitioners claim.    There is no evidence that petitioners

actually incurred those expenses in the amount claimed.

     3.   Foreclosure Expenses (15 Isabella)

     Petitioners claim that they incurred $102,385.23 as

foreclosure expenses.    Petitioners rely on two documents to


     16
      We note that $11,482.95 of this amount represents interest
from Mar. 1 to Apr. 7, 1992. Pursuant to our discussion, which
follows, this amount would have to be reduced to account for the
portion of the loan from California Federal which petitioners
have failed to establish as deductible expenses.
                               - 17 -

substantiate this alleged expense.      The first document dated

January 24, 1992, shows an unpaid principal balance on the

Pacific loan of $1.95 million.    The second document dated

December 2, 1992, shows the amount of unpaid debt as

$2,052,385.23.    Petitioners surmise that the difference in the

two amounts must constitute foreclosure expenses.      We disagree.

Petitioners have not established to our satisfaction that the

difference represents expenses which offset the amount realized

on the foreclosure of 15 Isabella.

     4.   Construction Expenses

     The vast majority of the expenses which petitioners claim

with respect to the 1992 NOL relate to the costs of construction

in the Atherton project.    Petitioners have failed to produce any

records which directly substantiate any of those construction

expenses.   Instead of producing direct evidence of those

expenses, petitioners rely on indirect evidence.      They seek to

use the amounts of the various construction and other loans as a

proxy for estimating the amount of the construction expenses.

     If the taxpayer fails to keep adequate records but the Court

is convinced that deductible expenditures were incurred, the

Court should make as close an approximation as it can, bearing

heavily if it chooses upon the taxpayer whose inexactitude is of

his own making.    Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir.

1930); Shea v. Commissioner, 112 T.C. 183, 187 (1999); see also
                              - 18 -

Sandoval v. Commissioner, T.C. Memo. 2000-189 (we may estimate

basis).   However, there must exist some reasonable evidentiary

basis upon which to make such an estimate.   Vanicek v.

Commissioner, 85 T.C. 731, 742-743 (1985); Edwards v.

Commissioner, T.C. Memo. 2002-169.17

     Except with respect to the interest reserves which were set

up with respect to those loans, petitioners claim that the entire

amounts of the loans represent expenses that are deductible or

which add to their basis in the Atherton project.   Petitioners

contend that their position is based on the common sense that

“construction loans are not distributed until and unless the

builder proves that the applicable work has been done”.

     As a general matter, we might agree that the Atherton

project gave rise to deductible expenses or expenses that

increased basis.   The testimony of Richard X. Waters, vice

president of Pacific, Allan Butler, Pacific’s jobsite inspector,

and Jimmy Dean Black, an employee of First National, indicates



     17
      Under sec. 274, certain business expenses are subject to
more stringent substantiation rules. Those business expenses
include traveling expenses, entertainment expenses, meal
expenses, and expenses with respect to certain listed property
such as passenger automobiles. Secs. 274(d), 280F(d)(4). The
rules under sec. 274 supersede our discretion to estimate
expenses under the doctrine of Cohan v. Commissioner, 39 F.2d 540
(2d Cir. 1930). Sanford v. Commissioner, 50 T.C. 823, 827-828
(1968), affd. 412 F.2d 201 (2d Cir. 1969). We cannot discern
from the record, and petitioners have not shown, what amounts of
the various loans, if any, represent the type of expenses covered
by the rules of sec. 274.
                              - 19 -

that a significant portion of the Pacific construction loan and

the First National loans went into the Atherton project.

However, we cannot agree with the assumption inherent in

petitioners’ indirect method of reconstructing those expenses,

that the entire amounts of the construction loans represent

deductible expenses.   Thus, we cannot agree that petitioners’

reliance on the construction loans provides a rational basis for

estimating the amount of those expenses.

     There is evidence that Mr. Assaad received some of the loan

proceeds as direct disbursements.   Indeed, Mr. Assaad testified:

     The construction guy, Trudell, do the computer run and
     then every month we do development, and we go to the
     two bank and we said: We develop $150,000 here,
     $100,000 debt.

          They pay us. We pay all the subcontractor. We
     pay all the labor. We have 49 people working on those
     three houses, every day, six days a week.

     Q    Did you ever write checks?

     A    Of course we have write checks, yes.

Petitioners did not produce any checks or any other comparable

evidence showing the amount of the loan proceeds that was paid

into the project.   Further, Mr. Assaad received cash back on at

least one of the loan transactions involved in this case:     He

received $120,802.70 cash on California Federal’s refinancing of

the First National Bank loans.   Although petitioners do not rely

on that amount to estimate their construction expenses, the fact

that Mr. Assaad received cash directly on that loan suggests that
                                - 20 -

there may have been additional amounts advanced to Mr. Assaad,

which we cannot state with certainty were applied to the Atherton

project as deductible expenses.

     We might agree that, in certain circumstances, construction

loans might provide a basis for estimating deductible expenses or

basis.    However, petitioners have not established to our

satisfaction that all the loans that they rely upon herein were

construction loans.    Mr. Assaad’s general testimony and his

specific testimony with respect to the First National loans did

not assist petitioners in substantiating their construction

expenses or otherwise convince us that the various loans provide

a rational evidentiary basis for estimating their expenses.

Indeed, with respect to the additional First National loan of

$100,000, Mr. Assaad testified that he could not remember what

this additional loan was for or “anything”.

     Further, petitioners have not established that the usual

formalities for advancing funds on construction loans were

followed with respect to each of the loans that petitioners rely

upon.    With respect to the loans from First National, Mr. Black

testified generally regarding the formalities followed with

respect to construction loans.    However, he could not recall the

specifics of the loans to Mr. Assaad or Mr. Assaad’s actual

association with those loans.    The record does not reflect, and

petitioners did not introduce any evidence, regarding any
                              - 21 -

inspection and advance process with respect to the First National

loans.   Mr. Black’s testimony and the evidence of record do not

preclude the possibility that some portions of the loans to Mr.

Assaad were set up as an interest reserve.   In a case like that,

allowing interest deductions on the basis of other evidence in

the record might result in a double-counting of those expenses.

     Petitioners rely on several loans which are not construction

loans.   Those loans are fully secured with property other than

the Atherton real estate.   After examining the evidence of record

with respect to those loans, we are not convinced that they

provide a rational basis for estimating the expenses they

purportedly represent under petitioners’ method of

reconstruction.   Further, we are not convinced that those amounts

were used in their entirety to pay construction expenses in the

Atherton project.   Indeed, it appears plausible, and with respect

to some of the loans it is clear, that the loan proceeds may have

been used to pay interest on the Pacific construction loan.    In

that case, and since petitioners claim to have paid interest with

funds other than those loan proceeds, there could result in a

double-counting of interest expenses.

     Pacific prepared a document entitled “Loan Credit

Memorandum” which indicates that the $320,000 loan was earmarked

in its entirety for payment of $160,000 of past due interest on,

and an additional $160,000 interest reserve for, the Pacific
                               - 22 -

construction loan.   Petitioners claim the entire amount of this

loan as expenses in computing the NOL for 1992.    However, in

their opening brief, they claim that interest expense was paid on

the Pacific construction loans in excess of the interest reserves

set up therein and according to Federal “G” rates.    Again,

petitioners’ method of reconstruction fails to preclude the

possibility of a double-counting of expenses.    Further, this loan

was secured by a pledge of a note and a deed of trust from Golden

Sunset Homes, Inc., petitioners’ wholly owned corporation.      There

is evidence in the record that the interest obligations to Golden

Sunset on the note were assigned to the bank, and those interest

payments may have been credited against petitioners’ obligations

on the Pacific loan.    Petitioners did not report the pledge of

the note, the deed of trust, or any interest payments as

corporate distributions or dividends.    In any event, there is no

evidence in the record showing whether this loan was repaid.

     With respect to the $250,000 loan, a portion of that loan

represents the renewal of an existing loan of $150,000.    There is

nothing in the record showing that the prior loan was paid into

the Atherton project.    Documents from Pacific indicate that

$90,000 of the $250,000 loan was earmarked for the payment of

outstanding material and subcontractor bills.    However, those

documents are insufficient substantiation of those expenses.

Petitioners have failed to provide a reasonable basis for
                              - 23 -

concluding that any amount of the $250,000 loan was paid into the

Atherton project.   Any interest reserve in that loan has likewise

not been shown to be deductible.

     With respect to the $350,000 loan, petitioners on brief

indicate that $212,000 of this loan was used to pay off the

remaining amount of the $250,000 loan.    For the reasons mentioned

above, that portion of the loan would not be deductible.     With

respect to the remaining portion of that loan, $138,000, there is

no documentary evidence showing that amount represents deductible

expenses paid into the Atherton project.    Petitioners rely on a

letter from Mr. Assaad to Mr. Waters and a handwritten note from

another representative of Pacific.     However, those items indicate

only that the remaining amount of the $250,000 loan was increased

to $350,000.   They do not take the further step of substantiating

the increase as deductible expenses.

     We are mindful that there must be sufficient evidence

contained in the record to provide a basis for us to make an

estimate and to conclude that a deductible expense was incurred

in at least the amount to be allowed.     Pratt v. Commissioner,

T.C. Memo. 2002-279.   We are not required to guess with respect

to the amount of deductible expenses.     Norgaard v. Commissioner,

939 F.2d 874, 879 (9th Cir. 1991), affg. in part and revg. in

part T.C. Memo. 1989-390; Williams v. United States, 245 F.2d

559, 560 (5th Cir. 1957).   In the instant case, we bear heavily
                               - 24 -

against petitioners as we must.18   Petitioners have not shown a

reasonable basis for concluding that any amount of the $320,000

loan, the $250,000 loan, and the $350,000 loan represents

deductible expenses.   With respect to the Pacific construction

loan and the First National loans, we are not convinced that the

full amounts of those loans were paid into the project and are

deductible.   Given the circumstances of this case and the

inexactitude apparent from petitioners’ evidence, we have no

reasonable evidentiary basis to make an approximation as to the

amount of the deductible expenses which were paid from those

loans.    We cannot, as petitioners would have us do, conclude that

the entire amounts of the construction loans were paid into the

Atherton project.   We could choose a raw percentage, perhaps as

high as 80 or 90 percent, and apply that percentage to the total

amount of the loans.   However, our choice of a percentage would

be mere guesswork with no reasonable evidentiary basis.

     5.   Interest Expense

     The parties stipulated that “During respondent’s audit of

the 1992-generated net operating loss carryover deduction claimed


     18
      Petitioners’ situation in this case is a result of their
own inexactitude and failure to maintain records of their
expenses. Further, we find petitioners’ efforts before trial to
locate any records that might be in the hands of third parties
especially lax. Moreover, Mr. Assaad’s testimony at trial was
confusing, and he repeatedly could not remember seemingly
important facts. His testimony did not help to substantiate his
expenses, and he did not provide any rational basis from which to
estimate those expenses.
                                 - 25 -

on petitioners’ 1996 and 1997 Forms 1040, petitioners

substantiated only $519,135 in mortgage interest paid in

connection with the development of the Atherton properties.”

Petitioners claim, however, that they incurred interest expenses

in excess of that amount.    Petitioners account for the interest

reserves which were set up as part of the construction and other

loans.    However, they suggest that those interest reserves

covered only a portion of their interest expenses.    Petitioners

contend that they paid interest at rates equal to the Federal

guidance rates or “G” rates.19    They use those rates to estimate

the interest that they purportedly paid on the loans.20

     Even if we were to assume that the “Pacific Bank Guidance

Rate” is the same as the “G” rate, we cannot take the next step

and assume that petitioners paid interest at those rates.      There

is no direct evidence that petitioners paid any interest in

excess of those amounts which Pacific collected from interest

reserves in the loans.



     19
      On Feb. 25, 2002, petitioners filed a request for judicial
notice of the Federal guidance rates (“G” rates) applicable to
the period Dec. 1, 1988, through Jan. 23, 1992, as published by
the Federal Reserve Board. We take judicial notice of the “G”
rates as published.
     20
      The Pacific loan documents cite a variable interest rate
determined under “The Pacific Bank Guidance Rate”. Petitioners
assume that this guidance rate provides for the same interest
rates for the relevant period as the “G” rates. On the record
before us, petitioners have not established that this guidance
rate is the same as the “G” rates for the applicable period.
                                - 26 -

     We also point out that petitioners’ method of estimating

their expenses fails to establish the precise amount of the

interest reserves set up in the various loans upon which they

rely.     Given this failure and the possibility apparent from the

testimony at trial that additional interest reserves, apart from

those established in the record, might have been set up, adopting

petitioners’ method might result in a double-counting of

deductible expenses.21    This provides us all the more reason for

rejecting petitioners’ method of estimating their construction

and interest expenses.

     Relatedly, petitioners also claim additional interest

expense on the land loan from Pacific for the period December 1,

1988, to July 28, 1989, estimated on the basis of the “G” rates

for that period.    First, as above, we are not inclined to accept



     21
      As we discussed above, petitioners attempt to estimate
their construction expenses by referencing the amounts of the
construction and other loans. They argue that the entire amount
of those loans represents construction expenses that are
deductible or increase their basis in the project. With respect
to their claims of additional interest expenses, they rely on the
Federal “G” rates to estimate the interest that accrued on, and
was paid with respect to, the construction and other loans.
However, there is evidence and testimony that interest reserves,
other than those reserves which petitioners account for on brief,
might have been set up in the various loans. Allowing the
construction loans as an estimate of the construction expenses,
as petitioners argue, and allowing these additional interest
expenses would result in a double deduction, if in fact
additional interest reserves were set up and these supposed
additional interest expenses were paid from those reserves.
Petitioners have failed to preclude this possibility in the
reconstruction of their construction and interest expenses.
                                - 27 -

the “G” rates as an estimate of the interest paid on the loan.

Second, although there is no direct evidence of an interest

reserve’s having been established with respect to the land loan,

Mr. Waters testified that $1.4 million was paid into the land and

that $60,000 could have been used for fees or may have been used

as an interest reserve.    Petitioners again have not precluded the

possibility of a double-counting of their claimed additional

interest expense.

     Petitioners also claim that they paid $113,812 in interest

to California Federal in 1991 with respect to the refinancing of

the First National Bank loan.    Petitioners rely on a statement

from California Federal which states that the total interest paid

in 1991 was $113,812.35.    Although this interest appears to have

been paid on the California Federal refinancing of the original

First National loans to Mr. Assaad, it is also clear that the

interest was paid on the entire amount of the California Federal

loan of $1.1 million.   However, petitioners received cash back in

that loan transaction in the amount of $120,802.70, which amount

they did not establish was paid into the Atherton project.

Petitioners do not rely upon that amount on brief in computing

their NOL for 1992.   Any interest deduction would have to be

reduced to account for this amount, because this amount could

have conceivably been used for personal expenses.    Further, per

our discussion above, petitioners did not establish that the
                              - 28 -

entire amount of the loans from First National was paid into the

Atherton project.   Thus, petitioners did not provide any

reasonable evidentiary basis for estimating the deductible

expenses that were paid with proceeds of those loans.   For

similar reasons, petitioners did not establish what amounts of

the interest payments were made on account of expenditures for

the Atherton project.22

     6.   Other Expenses (“Soft Costs”)

     Petitioners claim that they incurred certain “soft costs”23

in constructing the Atherton houses and that those soft costs

were not a part of the loans from Pacific, First National, or

California Federal.   They contend that those loans covered only



     22
      Relatedly, in petitioners’ reply brief, they point to a
$120,012 excess passive investment carried over from 1991. On a
Schedule E, Supplemental Income and Loss (From rents,
partnerships, estates, trusts, REMICs, etc.), attached to their
1991 return, petitioners reported expenses from a rental property
located at Atherton. Those expenses consist of $469 insurance,
$113,812 mortgage interest paid to banks, $1,200 taxes, $4,231
utilities, and $300 gardening. Petitioners claim that $6,200
($120,012 minus $113,812 interest expense) of this amount is
allowable in computing their NOL for 1992. We disagree.
Petitioners provided no substantiation for those purported
expenses other than their return. Further, it is conceivable
that those expenses were paid from the construction loan proceeds
and not from petitioners’ own resources.
     23
      Mr. Butler testified that banks normally refer to “hard
costs” and “soft costs”. Soft costs include legal fees, owner’s
insurance, utilities, and other costs not related to the
construction of the job. Hard costs include architect fees,
permit fees, management fees, and job insurance. Costs relating
to business vehicles would normally be soft costs, unless they
were related to the construction job.
                                - 29 -

“hard costs” and that Mr. Assaad paid the soft costs from his own

funds.    Petitioners claim that respondent allowed those expenses,

which were claimed in their 1992 return, in his examination of

the 1996 and 1997 returns.

     The only item in the record regarding these expenses is the

Schedule C attached to the 1992 return that petitioners filed.

The fact that a return is signed under penalty of perjury is not

sufficient to substantiate deductions claimed on it.    Wilkinson

v. Commissioner, 71 T.C. 633, 639 (1979).    Petitioners provided

no direct or indirect evidence to substantiate their so-called

“soft costs” of construction.    We have no rational basis for

estimating those expenses, verifying whether they were in fact

incurred, or determining their deductibility.    Further,

petitioners have not adduced sufficient proof to show that those

costs were not paid with the proceeds of the construction loans.

Petitioners claim, but point to no evidence of record to

establish, that respondent allowed the expenses as part of his

examination of the 1996 and 1997 returns.

     7.    Conclusion

     Because petitioners have failed to substantiate properly, or

otherwise present a reasonable evidentiary basis for estimating,

the expenses that were paid into the Atherton project in amounts

greater than the amounts that respondent allowed in the notice of

deficiency, we sustain respondent’s computation of the NOL for
                                 - 30 -

1992.      Petitioners are not entitled to NOL carryforward

deductions in 1996 and 1997, except to the extent determined in

the notice of deficiency.

B.   Addition to Tax and Penalties24

        Respondent determined an addition to tax under section

6651(a)(1) for petitioners’ failure to file timely their 1997

return.      Section 6651(a)(1) imposes an addition to tax in the

case of a failure to file a return on or before the specified

filing date.25     The taxpayer bears the burden of proving that the

failure to file the required return did not result from willful



      24
      Under sec. 7491(c), the Commissioner has the burden of
production in any court proceeding with respect to the liability
of any individual for any addition to tax or penalty. However,
this provision applies only to those court proceedings which
arise in connection with examinations commencing after July 22,
1998. RRA 1998 sec. 3001(c), 112 Stat. 727. The examination for
petitioners’ 1996 taxable year commenced before July 22, 1998.
Thus, sec. 7491(c) is not applicable to that taxable year. With
respect to petitioners’ 1997 taxable year, there is no evidence
of record establishing when the examination commenced for that
taxable year, and petitioners make no argument on this issue with
respect to their 1997 taxable year. We hold that sec. 7491(c)
does not apply. Even if the examination of petitioners’ 1996 and
1997 taxable years commenced after the effective date of sec.
7491(c), respondent has presented sufficient evidence to show
that imposition of the addition to tax and penalties is
appropriate. See Higbee v. Commissioner, 116 T.C. 438, 446
(2001).
      25
      The addition to tax is equal to 5 percent of the amount of
the tax required to be shown on the return if the failure to file
is not for more than 1 month. An additional 5 percent is imposed
for each month or fraction thereof in which the failure to file
continues, to a maximum of 25 percent of the tax. The addition
to tax is imposed on the net amount due. Sec. 6651(a)(1) and
(b); Pratt v. Commissioner, T.C. Memo. 2002-279.
                               - 31 -

neglect and that the failure was due to reasonable cause.      Higbee

v. Commissioner, 116 T.C. at 447.

     Petitioners did not file their 1997 Federal income tax

return until January 6, 2000, approximately 1 year and 9 months

after the due date for that return.     Petitioners did not

introduce any evidence showing a reasonable cause for their

failure to file timely their return.     At trial, respondent’s

counsel asked Mr. Assaad the reason for the untimely filing of

the 1997 return.   Mr. Assaad could not offer any explanation as

to why the 1997 return was filed untimely, but testified:     “I

don’t know the reason, to be honest.     The accountant always deal

with my wife, because we changing Mr. Lopez to someone else.       So

I am not sure.”    Mrs. Assaad did not testify at trial, and, since

she is a party to this proceeding, any failure on her part, and

consequently any reliance by Mr. Assaad on his wife, does not

provide reasonable cause with respect to the section 6651(a)(1)

addition to tax.   Further, reliance on an accountant or tax

return preparer to file timely a Federal income tax return

generally does not establish reasonable cause or preclude willful

neglect.   See Schirle v. Commissioner, T.C. Memo. 1997-552.

Taxpayers have a personal and nondelegable duty to file a timely

return, and reliance on an accountant to file a return does not

provide reasonable cause for an untimely filing.     United States

v. Boyle, 469 U.S. 241, 249 (1985) (and cases cited thereat).
                                 - 32 -

Petitioners did not introduce evidence to show that the untimely

filing was attributable to any reasonable reliance on their

accountant(s).   We sustain the section 6651(a)(1) addition to tax

which respondent determined.26

     Respondent determined accuracy-related penalties under

section 6662(a) for petitioners’ 1996 and 1997 taxable years.

Under section 6662(a), an accuracy-related penalty of 20 percent

is imposed on any portion of an underpayment of tax that is

attributable to negligence or to any substantial understatement

of income tax.   For the 1996 taxable year, respondent determined

that petitioners are liable for an accuracy-related penalty

attributable to negligence or disregard of rules or regulations.

For the 1997 taxable year, respondent determined that petitioners

are liable for an accuracy-related penalty attributable to a

substantial understatement of tax or, in the alternative, due to

negligence or disregard of the rules or regulations.

     Negligence is defined as a lack of due care or failure to do

what a reasonable and prudent person would do under like

circumstances.   Sec. 6662(c).    In the instant case, petitioners’



     26
      Petitioners’ only argument on brief is that “Petitioners
would clearly have owed no tax but for the loss of their records.
It is debatable whether having no tax liability was justification
for the petitioners in filing their 1997 return”. Even if a
reasonable belief that no taxes were owing and consequently a
belief that no tax return need be filed might establish
reasonable cause, petitioners did not introduce testimony or
evidence as to this issue.
                               - 33 -

made an erroneous computation of their 1992 NOL and their

resulting carryforward deductions.      They failed to report

$2,052,385.23 of foreclosure income that they realized from the

sale of 15 Isabella in 1992.   They failed to substantiate

properly their expenses in the Atherton project, and they failed

to maintain adequate records for purposes of determining their

correct tax liability for 1992, 1996, and 1997.      See Higbee v.

Commissioner, supra at 449; Joseph v. Commissioner, T.C. Memo.

2003-19 (failure to substantiate items properly is evidence of

negligence); Bishop v. Commissioner, T.C. Memo. 2001-82; sec.

1.6662-3(b)(1), Income Tax Regs.   They overstated their

depreciation deductions by at least $148,747 for 1993, $324,033

for 1994, $324,033 for 1995, and $324,033 for 1996.      These

overstatements reduce the amount of the NOL available for a

carryforward to the 1996 and 1997 taxable years and also result

in an additional adjustment of $324,033 for the 1996 taxable

year.   We find that the understatements for 1996 and 1997 are

attributable to petitioners’ negligence in failing to ascertain

their correct income tax liability, in failing to maintain

required records, and in failing to substantiate their

construction expenses.

     The accuracy-related penalty is not imposed if the taxpayer

shows there was a reasonable cause for the underpayment and that

he acted in good faith with respect to the underpayment.        Sec.
                              - 34 -

6664(c)(1).   This determination is made considering all relevant

facts and circumstances.   Relevant factors include the taxpayer’s

efforts to assess his proper tax liability, including his

reasonable and good faith reliance on the advice of a

professional.   An honest misunderstanding of fact or law that is

reasonable in light of the experience, knowledge, and education

of the taxpayer may indicate reasonable cause and good faith.

Higbee v. Commissioner, supra at 448-449.   The taxpayer bears the

burden of proof regarding this exception.   Id. at 447.

     On brief, petitioners do not point to any specific

circumstances which might trigger the reasonable cause exception.

However, they do suggest that their failure to maintain adequate

records and to substantiate properly their expenses is

attributable to the alleged fact that “petitioners’ records

disappeared while in the possession of his now-deceased

accountant and that his subsequent accountant made an inadequate

effort to replace them.”   Good faith reliance on a tax return

preparer or accountant to maintain required records, and a

failure by that representative to do so, may establish the

taxpayer’s entitlement to relief under section 6664(c)(1).    See

Xuncax v. Commissioner, T.C. Memo. 2001-226.    However, such a

loss or destruction of required records alone does not establish

that the taxpayer’s deductions and claimed expenses were founded

on reasonable cause and good faith when made.   See id.
                              - 35 -

     Petitioners did not establish that the underpayments on

their 1996 and 1997 returns were attributable to the death of Mr.

Hunt, to any loss or destruction of the records of their

expenses, or to any failure to replace records by Mr. Lopez.

Although Mr. Lopez testified that the failure in substantiating

the expenses in the audit of the 1992 return was due in part to

Mr. Hunt’s death, he also testified that this failure was also

due to Mr. Assaad’s lack of cooperation.   Mr. Lopez testified

that, as far as he knew, petitioners got the records back.     Also,

the testimony of Mr. Waters and Mr. Assaad suggests that records

of the various expenses in the Atherton project do exist and that

Mr. Assaad made no genuine attempt to obtain those records and to

present those records into evidence.   Mr. Waters testified that

Pacific kept records of the expenses in the Atherton project and

that Mr. Assaad had, or obtained, those records when he sued the

bank and Mr. Waters personally in a lawsuit related to the

Atherton project.   Further, Mr. Assaad testified that Mr. Trudell

was in possession of the construction expense records, including

computer records, for the Atherton project.   He further testified

that he did not contact Mr. Trudell until 1 week before trial

“Because there wasn’t any need for me to contact him.   I just

forgot about the whole thing.”

     Petitioners’ underpayment of taxes for 1996 and 1997 was

also attributable to their substantial overstatement of their
                                - 36 -

depreciable basis in St. Rose Manor.     Neither Mr. Hunt nor Mr.

Lopez prepared petitioners’ returns after 1992, and petitioners

offered no explanation for this overstatement.     Petitioners did

not establish that the underpayment of taxes was due to errors by

their representatives and not due to errors on their part.

Petitioners did not demonstrate that they supplied accurate

information to their representatives for purposes of preparing

the relevant returns.    See Xuncax v. Commissioner, supra.

Petitioners have not shown that they are entitled to relief under

section 6664(c)(1).     We sustain the accuracy-related penalties as

determined.


                                                Decision will be

                                           entered for respondent.
