                  T.C. Summary Opinion 2005-125



                     UNITED STATES TAX COURT



          GARY E. AND REBECCA L. HURLEY, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 20949-03S.              Filed August 16, 2005.


     Gary E. Hurley, pro se.

     John W. Strate, for respondent.




     COUVILLION, Special Trial Judge:   This case was heard

pursuant to section 7463 in effect when the petition was filed.1

The decision to be entered is not reviewable by any other court,

and this opinion should not be cited as authority.


     1
      Unless otherwise indicated, subsequent section references
are to the Internal Revenue Code in effect for the years at
issue. All Rule references are to the Tax Court Rules of
Practice and Procedure.
                                 - 2 -

     Respondent determined deficiencies of $4,938 and $6,838 in

petitioners’ Federal income taxes for the years 1998 and 1999,

respectively, and the accuracy-related penalty under section

6662(a) of $1,367.60 for 1999.

     After concessions by respondent,2 the issues remaining for

decision are:   (1) Whether petitioners are entitled to exclude 30

percent of petitioner husband’s salary from gross income due to

his 30 percent disability; (2) whether petitioners are entitled

to an additional mortgage interest deduction of $5,567 under

section 461(g)(2) for 1999; and (3) whether petitioners are

liable for the section 6662(a) penalty for 1999.   One other

adjustment, petitioners’ miscellaneous itemized deduction, is a

computational adjustment that is resolved by the Court’s holding

on the other issues.

     Some of the facts were stipulated.   Those facts, with the

exhibits annexed thereto, are so found and made part hereof.

Petitioners’ legal residence at the time the petition was filed

was Paso Robles, California.




     2
      Respondent incorrectly amortized points petitioners paid in
the refinancing of their home mortgage over a 30-year period and
based part of the $5,567 disallowed interest on that calculation.
At trial, respondent conceded that petitioners had a 15-year
mortgage, and the points paid should be amortized over a 15-year
period. In addition, respondent conceded that petitioners were
entitled to an additional deduction of $866 in interest for 1999
based on evidence petitioners presented before trial.
                               - 3 -

     Petitioner husband (Mr. Hurley) was employed as a

correctional officer for the California Department of Corrections

(CDC), at the California Training Facility (CTF) in Soledad,

California, since 1990.   Sometime during 1995, Mr. Hurley

sustained a back injury while lifting a heavy coffee urn at work.

He was required to undergo surgery to replace several disks in

his back, and, as a result, the California workers’ compensation

board determined he sustained a 30-percent permanent disability.

Mr. Hurley received the full amount of a lump-sum workers’

compensation settlement payment prior to the taxable years at

issue.

     During 1998 and 1999, Mr. Hurley had returned to work full

time as a correctional officer at the CTF.   In spite of his 30

percent disability, Mr. Hurley worked a full 40 hours a week and

was no longer receiving any workers’ compensation benefits.    The

CDC paid Mr. Hurley at the same rate during 1998 and 1999 as it

did prior to his 1995 injury, and he had the same work duties.

On their 1998 and 1999 Federal income tax returns, petitioners

excluded 30 percent of his salary from gross income because of

Mr. Hurley’s continuing disability.    Respondent disallowed this

exclusion.
                                 - 4 -

     On April 1, 1999, petitioners refinanced the mortgage on

their primary residence and paid points of $4,400.3      They

deducted the entire $4,400 on their 1999 Federal income tax

return.   Petitioners used the money saved from their reduced

monthly payments for various improvements on their home.

Petitioners’ new mortgage payment was $300 a month less than

their prior mortgage payments.    Petitioners’ home improvements

consisted of replacing their roof, kitchen and bathroom floors,

and a door.   Respondent disallowed the $4,400 deducted for points

and allowed an amortization of that amount based on a 30-year

mortgage.   At trial, respondent conceded petitioners were

entitled to a 15-year amortization.

     With respect to the first issue, petitioners contend that

they excluded 30 percent of Mr. Hurley’s wages from gross income

on their 1998 and 1999 Federal income tax returns because they

were informed by their tax preparer and some of Mr. Hurley’s

colleagues that this was an accepted practice among partially

disabled law enforcement officers.       Petitioners cite section

104(a)(1) in support of this exclusion which provides, in part:

“Gross income does not include amounts received under workmen’s

compensation acts as compensation for personal injuries or


     3
      The term “points” refers to a fee, generally equal to a
percentage of the total loan, which is paid to the lending
institution to lower the interest rate. They are classified, for
purposes of sec. 163, as “prepaid interest”.
                                 - 5 -

sickness.”    Petitioners argue that, since Mr. Hurley was only 70

percent capable for the work that he was once 100 percent able to

do, it followed that 30 percent of the wages he received was

attributable to workers’ compensation and, therefore, was

excludable from gross income.    The Court disagrees.

     Gross income includes compensation for services and wages.

Sec. 61(a); Abrams v. Commissioner, 82 T.C. 403, 407 (1984); sec.

1.61-2(a)(1), Income Tax Regs.    Although section 104 does allow a

taxpayer to exclude workers’ compensation payments from gross

income, Mr. Hurley agreed that he was no longer receiving

workers’ compensation, nor were his wages reduced by 30 percent

when he returned to work.   Although Mr. Hurley is 30 percent

disabled, petitioners may not redefine the application of section

104 to allow a portion of his wages to be excluded from gross

income.   Exclusions from income must be based upon an explicit

statute and may not be inferred.     Commissioner v. Schleier, 515

U.S. 323, 328 (1995); United States v. Wells Fargo Bank, 485 U.S.

351 (1988).   Respondent, therefore, is sustained on this issue.

     The next issue is deductions petitioners claimed on Schedule

A, Itemized Deductions, of their 1999 Federal income tax return.

Petitioners deducted the $4,400 in points they paid to refinance

their mortgage.   In the notice of deficiency, amortization of the

points was allowed based on a 30-year mortgage, but, as noted

earlier, respondent conceded at trial that the points were
                               - 6 -

amortizable over 15 years rather than 30 years.   The issue,

however, is whether petitioners should have been allowed to

deduct the entire $4,400 in 1999.

     Section 163(a) allows a deduction in full for interest paid

or accrued within the taxable year on indebtedness.   For Federal

income tax purposes, interest generally is defined as

“compensation for the use or forbearance of money”.     Deputy v.

duPont, 308 U.S. 488, 498 (1940).   With regard to prepaid

interest, however, section 461(g) provides in part:


     SEC. 461(g).   Prepaid Interest.

          (1) In general. If the taxable income of the
     taxpayer is computed under the cash receipts and
     disbursements method of accounting, interest paid by
     the taxpayer which * * * is properly allocable to any
     period–-

               (A) with respect to which the interest
          represents a charge for the use or forbearance of
          money, and

               (B) which is after the close of the taxable
          year in which paid,

     shall be charged to capital account and shall be
     treated as paid in the period to which so allocable.


Therefore, a cash basis taxpayer must amortize prepaid interest

over the life of his loan just as if he were on the accrual

method of accounting.   There is an exception, however, that

allows a taxpayer to deduct the full amount of points paid “in

respect of any indebtedness incurred in connection with the
                                - 7 -

purchase or improvement of, and secured by, the principal

residence of the taxpayer”.    Sec. 461(g).

     Section 461(g)(2) provides two instances where a taxpayer

may deduct the entire amount of points paid to refinance a

personal residence:    when the taxpayer refinances in order to

purchase a new home or refinances to make improvements to the

home.    Consequently, points paid when the taxpayer refinances a

personal residence simply or only for the purpose of obtaining a

lower payment are not deductible.       Kelly v. Commissioner, T.C.

Memo. 1991-605.    Respondent determined that, because petitioners

enjoyed a lower monthly payment after refinancing, they must

amortize the points over the life of their mortgage.      That fact

alone, however, is not decisive.    Petitioners contend that

section 461(g)(2) applies because they refinanced to enable them

financially to complete certain improvements to their principal

residence, which they, in fact, completed.

     Petitioners presented evidence at trial of numerous

improvements they made to their principal residence between 1999

and 20034 totaling $18,735.   During that period, petitioners

saved $300 per month as a result of their lower mortgage payment,

for an approximate savings of $14,400, which enabled them to



     4
      Petitioners again refinanced the mortgage on their
principal residence sometime in 2003; however, only the
improvements made pursuant to the 1999 refinancing and prior to
2003 are before the Court here.
                                - 8 -

finance their improvements.   Respondent does not dispute or

challenge the fact that improvements were both made and paid for

by petitioners.   Respondent contends that, because the cost of

their improvements exceeded the amount saved from the

refinancing, section 461(g)(2) does not apply.     The Court

disagrees.

     Section 461(g)(2) applies if the taxpayer pays points to

refinance “in connection with” the improvement of his principal

residence.    The Court has never specifically addressed under what

facts or circumstances section 461(g)(2) allows a taxpayer to

deduct points paid during refinancing; however, the Court has

addressed how narrowly the phrase “in connection with”, as used

in section 461(g)(2) and other Internal Revenue Code sections,

should be construed.   Based on the intent of Congress, the Court

applies a broad interpretation of the phrase “in connection

with”.   Fort Howard Corp. & Subs. v. Commissioner, 103 T.C. 345

(1994), superseded by legislation and supplemented by 107 T.C.

187 (1996).

     In Fort Howard Corp. & Subs., the Court defined the meaning

of the phrase “in connection with” as pertaining to a redemption

deduction under section 162(k)(1).      The Court, id. at 353-354,

cited congressional reports that stated:     “the phrase ‘in

connection with’ is intended to be construed broadly” and would

extend to “any other expenditure that is necessary or incident to
                               - 9 -

the repurchase”.   S. Rept. 99-313, at 223 (1986), 1986-3 C.B.

(Vol. 3) 1, 223; H. Conf. Rept. 99-841, at 168-160 (1986), 1986-3

C.B. (Vol. 4) 1, 168-160.   In holding that the phrase “in

connection with” should be interpreted broadly, the Court also

noted:


     When Congress adopted “in connection with” for use in
     section 461(g)(2), it was aware of the Supreme Court’s
     interpretation of the same language in Snow.[5]
     Therefore, it is reasonable to assume that they
     intended the same broad interpretation to be given to
     section 461(g)(2). Thus, based on the language of the
     statute and past judicial interpretations of that
     language, we conclude that section 461(g)(2) should be
     broadly construed. [Fort Howard Corp. & Subs v.
     Commissioner, supra at 353 n.16 (quoting Huntsman v.
     Commissioner, 905 F.2d 1182, 1183 (1990), revg. 91 T.C.
     917 (1988)).]


     Petitioners commenced their home improvements 9 days after

their refinancing.   Mr. Hurley testified that they refinanced

their home mortgage in order to “free up money to be able to do

home improvements.   That was the whole idea of it”.   It is

immaterial that the cost of the improvements exceeded

petitioners’ savings from the refinancing.   The difference is not

grossly disproportionate.   The Court finds petitioners’ testimony

and the evidence presented credible and is satisfied that they



     5
      The Supreme Court, in Snow v. Commissioner, 416 U.S. 500
(1974), held that Congress intended the phrase “in connection
with”, as used in sec. 174, to have a broad legislative objective
and provide an economic incentive; therefore, it should be
interpreted broadly.
                                - 10 -

negotiated the refinancing of their personal residence in order

to finance their home improvements.      Respondent presented no

authority that would require the improvements to be performed in

the year of the refinancing, nor does the evidence suggest to the

Court that petitioners’ claim came as an afterthought after the

deduction was disallowed by respondent.      Therefore, the

refinancing was “in connection with” home improvements.       Sec.

461(g)(2).    Petitioners may deduct the entire $4,400 paid in

points on their 1999 Federal income tax return.      Petitioners are

sustained on this issue.

       Respondent determined a section 6662(a) penalty of $1,367.60

for 1999.    Section 6662 provides for a 20-percent penalty for any

underpayment to which the section applies.      Sec. 6662(a).

Respondent determined, under section 6662(b):      (1) Petitioners

were negligent or disregarded rules or regulations, or (2)

petitioners’ deficiency represented a substantial understatement

of income tax.    Under section 7491(c), the Commissioner bears the

burden of production with regard to penalties and additions to

tax.

       Negligence is defined as “any failure to make a reasonable

attempt to comply with the provisions of this title”, and

disregard includes “careless, reckless, or intentional

disregard.”    Sec. 6662(c).   A taxpayer is not negligent if he can

demonstrate that the underpayment of tax was due to reasonable
                              - 11 -

cause and that the taxpayer acted in good faith.    Sec. 6664(c);

sec. 1.6664-4(a), Income Tax Regs.     Reasonable cause may be shown

by a good faith effort by the taxpayer to determine the correct

tax liability.   Larson v. Commissioner, T.C. Memo. 2002-295.

     Mr. Hurley testified that he discussed this exclusion with

numerous law enforcement individuals who were excluding a portion

of their income due to a permanent disability, and they confirmed

to him that this was a common practice among law enforcement

officers.   In addition, petitioners conferred over the phone with

a representative of a tax return preparation service, H&R Block,

who also advised that such a reduction was allowable and common

practice.   The Court finds Mr. Hurley’s testimony credible.

Petitioners made no effort to hide the reason they were excluding

30 percent of Mr. Hurley’s income; in fact, they attached a

written explanation of the exclusion to their 1999 Federal income

tax return.   In addition, once petitioners received the notice of

deficiency, they included 100 percent of Mr. Hurley’s income on

their subsequent income tax returns while awaiting a decision by

this Court.   Petitioners’ actions amount to reasonableness under

section 6662(c), and their actions are not considered by the

Court to amount to “careless, reckless, or intentional

disregard”.

     Section 6662(b)(2) also provides a penalty in the amount of

20 percent for any “substantial understatement of income tax”.      A
                              - 12 -

substantial understatement is defined as the greater of 10

percent of the tax required or $5,000.   Sec. 6662(d)(1)(A).

Petitioners’ understatement does amount to greater than $5,000;

however, they qualify for a reduction of the understatement.

Sec. 6662(d)(2)(B).   Section 6662(d)(2)(B) provides for a

reduction of an understatement due to the position of the

taxpayer and his disclosure of a disputed item.   Generally, under

that provision, the amount of the understatement shall be reduced

by that portion of the understatement that is attributable, in

this case, to an item if the relevant facts affecting the item’s

tax treatment are adequately disclosed in the return or in a

statement attached to the return, and there is reasonable cause

for the tax treatment of such item and good faith on the part of

the taxpayer.   Sec. 1.6662-3(b)(3), Income Tax Regs.

     As previously discussed, petitioners consulted with and

relied on the advice of a tax preparation service.   They attached

to their 1999 income tax return an explanation of why they

excluded a portion of Mr. Hurley’s wages.   The explanation even

included the Code section they, albeit mistakenly, relied on to

take the exclusion.   Mr. Hurley reasonably believed that section

104 provided for an exclusion because of his permanent

disability.   The Court is satisfied that petitioners acted in

good faith and with reasonable cause.    Therefore, the amount of

the understatement for purposes of determining whether it amounts
                               - 13 -

to a “substantial understatement of income tax” is reduced to

zero.   Sec. 6662(d)(1)(A).   Petitioners are not liable for the

section 6662(a) penalty.

     Reviewed and adopted as the report of the Small Tax Case

Division.



                                    Decision will be entered

                               under Rule 155.
