                      111 T.C. No. 11



                UNITED STATES TAX COURT



 RICHARD D. FRAZIER AND YVONNE FRAZIER, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 3343-96.             Filed September 22, 1998.



     Ps owned investment real property subject to a
recourse mortgage. Upon default, the property was
acquired by the lender at a foreclosure sale. At the
foreclosure sale, the lender bid in an amount for the
property which was in excess of the property's fair
market value. R determined that the "amount realized"
by Ps at the foreclosure sale was the amount bid in by
the lender, regardless of fair market value.

     Held: P's "amount realized" at the foreclosure
sale is the property's fair market value.

     Held, further: Bifurcated analysis used to
determine income tax consequences of "amount realized"
and income from cancellation of indebtedness.

     Held, further: Ps are not liable for accuracy-
related penalty determined by R.


Michael L. Cook and William R. Leighton, for petitioners.
                                 - 2 -


       Steven B. Bass, for respondent.

       PARR, Judge:   Respondent determined deficiencies in

petitioners' Federal income tax for taxable years 1988 and 1989

in the amounts of $387 and $40,482, respectively.    In the answer,

respondent asserted that petitioner is liable for an addition to

tax pursuant to section 6662(a).1

       After concessions, the issues for decision are:   (1) Whether

for 1989 petitioners realized $571,179 on the foreclosure sale of

certain real property or a lower amount which represents the

property's fair market value.    We hold petitioners realized a

lower amount which represents the property's fair market value.

(2) Whether for 1989 petitioners are liable for the accuracy-

related penalty pursuant to section 6662(a).    We hold they are

not.

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

The stipulated facts and the accompanying exhibits are

incorporated herein by this reference.    At the time the petition

in this case was filed, petitioners resided in Austin, Texas.

                           FINDINGS OF FACT

       Petitioners owned real property located at 3501 Dime Circle

in Austin, Texas (the Dime Circle property).    The Dime Circle



       1
          All section references are to the Internal Revenue Code
in effect for the taxable years in issue, and all Rule references
are to the Tax Court Rules of Practice and Procedure, unless
otherwise indicated. References to petitioner are to Richard D.
Frazier. All dollar amounts are rounded to the nearest dollar.
                                 - 3 -


property was not used in any trade or business of petitioner.

The mortgage on the Dime Circle property, which secured a

recourse obligation against petitioner, was foreclosed by the

lender on August 1, 1989, at which time petitioners were

insolvent.   The lender bid in the Dime Circle property at the

foreclosure sale for $571,179.    The record is silent as to how

the bid-in price was determined.    Apparently, the only bid was

that of the lender.

     At the time of the foreclosure sale, the outstanding

principal balance of the debt was $585,943.       The lender did not

attempt to collect the difference between the outstanding balance

of the debt and the bid-in amount.       On August 1, 1989,

petitioners' adjusted basis in the Dime Circle property was

$495,544 (cost basis of $682,682 minus accumulated depreciation

of $187,138).   After the transaction, petitioners were still

insolvent.

     At the time of the sale, real estate prices had dropped

dramatically throughout Texas, causing many foreclosures and bank

failures throughout the State.    The Dime Circle property was not

resold until about 2 and a half years later for approximately

$382,000.

     The fair market value of the Dime Circle property at the

time of the foreclosure sale was $375,000.
                                - 4 -


                               OPINION

Issue 1.    Amount Realized on Foreclosure Sale

     Respondent determined that petitioners realized $571,179 on

the foreclosure sale of the Dime Circle property, which

represents the amount bid in by the lender.    Petitioners assert

that the amount realized on the foreclosure sale is determined by

the fair market value of the property, which is different from

the amount bid in by the lender.    We agree with petitioners.

     In general, the transfer of property in consideration of the

discharge or reduction of indebtedness is equivalent to the sale

of property upon which gain or loss is realized.    E.g., Gehl v.

Commissioner, 102 T.C. 784, 785 (1994), affd. without published

opinion 50 F.3d 12 (8th Cir. 1995); Danenberg v. Commissioner, 73

T.C. 370, 380-381 (1979); Estate of Delman v. Commissioner, 73

T.C. 15, 28 (1979); Bialock v. Commissioner, 35 T.C. 649, 660

(1961); Marcaccio v. Commissioner, T.C. Memo. 1995-174.    The

amount of gain realized is the excess of the amount realized over

the taxpayer's adjusted basis in the property, and the amount of

loss realized is the excess of the adjusted basis over the amount

realized.    Sec. 1001(a).

     For purposes of computing gain or loss, the "amount

realized" is defined by section 1001(b) as the sum of any money

received plus the fair market value of the property received.
                               - 5 -


However, the amount realized from the transfer of property in

consideration of the discharge or reduction of indebtedness

depends on whether the debt is recourse or nonrecourse in nature.

In the case of nonrecourse debt, the amount realized includes the

full amount of the remaining debt.     See, e.g., Commissioner v.

Tufts, 461 U.S. 300 (1983); Gershkowitz v. Commissioner, 88 T.C.

984, 1016 (1987); Estate of Delman v. Commissioner, supra at 28-

29.   In the case of recourse debt, on the other hand, the amount

realized from the transfer of property is the fair market value

of the property.   See, e.g., Bialock v. Commissioner, supra at

660-661; Marcaccio v. Commissioner, supra.

      Furthermore, the amount realized from the sale or other

disposition of property that secures a recourse debt does not

include income from the discharge of indebtedness under section

61(a)(12).   See sec. 1.1001-2(a)(2), Income Tax Regs.   Such

income will arise when the discharged amount of the recourse debt

exceeds the fair market value of the property.

      Generally, a taxpayer must recognize income from the

discharge of indebtedness.   Sec. 61(a)(12); United States v.

Kirby Lumber Co., 284 U.S. 1 (1931).     There are exceptions,

however, to the recognition of income from the discharge of

indebtedness, including cases where the discharge occurs when the

taxpayer is insolvent.   See sec. 108(a).
                                - 6 -


     Absent clear and convincing proof to the contrary, the sale

price of property at a foreclosure sale is presumed to be its

fair market value.   See Community Bank v. Commissioner, 79 T.C.

789, 792 (1982), affd. 819 F.2d 940 (9th Cir. 1987); Marcaccio v.

Commissioner, supra.    In this case, however, petitioners have

rebutted this presumption with the required clear and convincing

proof.   Petitioners introduced an appraisal opining that the fair

market value of the Dime Circle property on August 1, 1989, was

$375,000, not $571,179 as bid in by the lender.   Respondent

offered no expert testimony on the fair market value and does not

challenge the accuracy of the appraisal.   Respondent merely

argues that the bid-in amount must be used to determine the

amount realized, regardless of how arbitrarily that amount may

have been determined.   We disagree.

     In arguing that the bid-in amount must be used to determine

the amount realized, respondent, in effect, maintains that we

must respect the transaction for Federal income tax purposes.     We

are not bound to blindly accept a transaction, and the law is

clear that courts may look behind a paper facade to find the

actual substance and economic realities of a transaction.

Knetsch v. United States, 364 U.S. 361, 369 (1960); Gregory v.

Helvering, 293 U.S. 465, 469 (1935); Sandvall v. Commissioner,

898 F.2d 455, 458 (5th Cir. 1990), affg. T.C. Memo. 1989-56 and

T.C. Memo. 1989-189; Merryman v. Commissioner, 873 F.2d 879, 881
                              - 7 -


(5th Cir. 1989), affg. T.C. Memo. 1988-72; Killingsworth v.

Commissioner, 864 F.2d 1214, 1216 (5th Cir. 1989), affg. 87 T.C.

1087 (1986); Boynton v. Commissioner, 649 F.2d 1168, 1172 (5th

Cir. 1981), affg. 72 T.C. 1147 (1977); Swaim v. United States,

651 F.2d 1066, 1069-1070 (5th Cir. 1981); Kuper v. Commissioner,

533 F.2d 152, 155-156 (5th Cir. 1976), affg. in part and revg. in

part 61 T.C. 624 (1974); Horn v. Commissioner, 90 T.C. 908, 939

(1988); Price v. Commissioner, 88 T.C. 860, 884 (1987); Capek v.

Commissioner, 86 T.C. 14, 47 (1986); Forseth v. Commissioner, 85

T.C. 127, 164 (1985), affd. 845 F.2d 746 (9th Cir. 1988);

Houchins v. Commissioner, 79 T.C. 570, 589-590 (1982).    In a case

such as this, where the transaction is so disparate from the

actual substance and economic realities of the situation, we are

empowered, and in fact duty-bound, to look behind the transaction

in order to apply the Internal Revenue Code accurately.     Forseth

v. Commissioner, supra at 164 (citing Saviano v. Commissioner,

765 F.2d 643, 654 (7th Cir. 1985), affg. 80 T.C. 955 (1983)).

     The facts of the instant case are analogous to those

provided in an example in the regulations.   Section 1.1001-2(c),

Example(8), Income Tax Regs., provides as follows:

     In 1980, F transfers to a creditor an asset with a fair
     market value of $6,000 and the creditor discharges
     $7,500 of indebtedness for which F is personally
     liable. The amount realized on the disposition of the
     asset is its fair market value ($6,000). In addition,
     F has income from the discharge of indebtedness of
     $1,500 ($7,500 - $6,000).
                                - 8 -


     Respondent relies on Aizawa v. Commissioner, 99 T.C. 197

(1992), affd. without published opinion 29 F.3d 630 (9th Cir.

1994), for the proposition that the amount realized constitutes

the amount of the proceeds of the foreclosure sale, i.e., the

bid-in amount of the lender.   In Aizawa, the taxpayers owned

rental property which was subject to a recourse mortgage, and

upon default, the property was acquired by the mortgagee at a

foreclosure sale.   We held that the amount of the proceeds of the

foreclosure sale constituted the amount realized under section

1001(a).   Notwithstanding the similar facts and circumstances,

Aizawa is distinguishable from the instant case on one key

matter.    In Aizawa, the amount that the lender paid for the

property at the foreclosure sale was equal to the fair market

value of the property.   In Aizawa v. Commissioner, supra at 200-

201, the Court stated:

     It cannot be gainsaid that the property was sold for
     $72,700 (an amount which we have no reason to conclude
     did not represent the fair market value of the
     property) and that petitioners received, by way of a
     reduction in the judgment of the foreclosure, that
     amount and nothing more. That is the "amount realized"
     under section 1001(a) which is subtracted from
     petitioners' basis in order to determine the amount of
     their loss. [Fn. ref. omitted; emphasis added.]

In the instant case, we have clear and convincing proof to

conclude that the bid-in price of the lender does not represent

the fair market value of the Dime Circle property.

     We note that this was not an arm's-length transaction
                                - 9 -


between a willing buyer and a willing seller, neither being under

compulsion to buy or sell and both having reasonable knowledge of

relevant facts.    See United States v. Cartwright, 411 U.S. 546,

551 (1973); United States v. Simmons, 346 F.2d 213, 217 (5th Cir.

1965); Frazee v. Commissioner, 98 T.C. 554, 562 (1992); see also

sec. 1.170A-1(c)(2), Income Tax Regs.   The amount bid in by a

lender at a foreclosure sale may be arbitrary.   As petitioners

stated on brief, there are many possible reasons why a lender

would bid in higher than the fair market value, such as if the

lender believed it would be unable to collect a deficiency

judgment because the debtor is contemplating bankruptcy, or

simply to erase the loss from its books.    See, e.g., Securities

Mortgage Co. v. Commissioner, 58 T.C. 667, 669-670 (1972).

However, we need not determine the intent of the lender in

formulating the bid-in price.   We are satisfied that the bid-in

price did not represent the fair market value of the Dime Circle

property.   We find that the fair market value of the Dime Circle

property on August 1, 1989, was $375,000.    Accordingly,

petitioners realized $375,000 on the disposition of the Dime

Circle property.

     We must now determine the Federal income tax consequences of

this transaction for petitioners.   Petitioners rely on Rev. Rul.

90-16, 1990-1 C.B. 12, and argue for bifurcation of the

transaction.   Respondent argues against his own revenue ruling,
                                - 10 -


asserting that a revenue ruling has limited precedential value

for a court.     While we agree that a revenue ruling is not binding

on the Court, Stubbs, Overbeck & Associates, Inc. v. United

States, 445 F.2d 1142, 1146-1147 (5th Cir. 1971), a bifurcated

analysis of the tax consequences for petitioners is appropriate

here.

     As discussed above, petitioners' gain or loss on their

disposition of the Dime Circle property is computed pursuant to

section 1001 and, as a general rule, the amount realized includes

the full amount of the remaining debt.     Sec. 1.1001-2(a)(1),

Income Tax Regs.     However, section 1.1001-2(a)(2), Income Tax

Regs., provides an exception for recourse liabilities.     The

regulation states that

     The amount realized on a sale or other disposition of
     property that secures a recourse liability does not
     include amounts that are (or would be if realized and
     recognized) income from the discharge of indebtedness
     under section 61(a)(12). * * *

     This regulation effectively bifurcates the instant

transaction into a taxable transfer of property and a taxable

discharge from indebtedness.     Cf. Michaels v. Commissioner, 87

T.C. 1412, 1415 (1986).     Thus, according to the regulation, each

         should be treated as a separate transaction for tax

purposes.2    Id.


     2
          For a complete review of the bifurcation approach, see
Cunningham, "Payment of Debt with Property--The Two-Step Analysis
                                                   (continued...)
                                - 11 -


     Therefore, on the first step of the bifurcation analysis,

petitioners realized a capital loss of $120,5443 on the transfer

of the Dime Circle property.    On the second step of the analysis,

petitioners realized $210,9434 of ordinary income from discharge

of indebtedness.

     Under certain circumstances, a taxpayer may exclude from

gross income the income from discharge of indebtedness if the

discharge occurs when the taxpayer is insolvent.    Sec.

108(a)(1)(B).   However, the exclusion cannot exceed the amount by

which the taxpayer is insolvent.    For purposes of this section,

"insolvent" is defined as "the excess of liabilities over the

fair market value of assets."    Sec. 108(d)(3).

     Petitioners' insolvency exceeded the income they realized

from discharge of indebtedness.    Accordingly, the income

petitioners realized from discharge of indebtedness in the

instant transaction is excluded from their gross income pursuant

to section 108(a)(1)(B).



     2
      (...continued)
After Commissioner v. Tufts", 38 Tax Law. 575 (1985).
     3
          This represents the difference between the fair market
value of the property, $375,000, and petitioners' adjusted basis
in the property, $495,544.
     4
          This represents the difference between the fair market
value of the property, $375,000, and the outstanding balance of
the debt, $585,943. Petitioner testified that the lender did not
attempt to collect the difference between the outstanding balance
of the debt and the bid-in amount.
                               - 12 -


Issue 2.   Penalty Under Section 6662(a)

     In the answer, respondent determined that for 1989

petitioners were liable for the accuracy-related penalty of

section 6662(a).

     On the basis of our holding above, there was no underpayment

of tax due to petitioners' characterization of the disposition of

the Dime Circle property.   Accordingly, petitioners are not

liable for the accuracy-related penalty pursuant to section 6662.

     To reflect concessions,



                                           Decision will be entered

                                    under Rule 155.
