                         T.C. Memo. 1998-340



                       UNITED STATES TAX COURT



           JAMES R. AND SUSAN B. BRICKMAN, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 21381-96.                Filed September 23, 1998.



     Dan G. Baucum and William A. Roberts, for petitioners.

     Michael C. Prindible and Helen T. Repsis, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     VASQUEZ, Judge:    Respondent determined deficiencies in and

accuracy-related penalties on petitioners' Federal income tax as

follows:

                                           Penalty
                Year        Deficiency    Sec. 6662

                1992         $341,896      $68,379
                                   - 2 -


                    1993         51,328          10,266
                    1994         32,269           6,454




        After concessions,1 the issue for decision is whether

certain net operating losses (NOL's) are reduced under section

108 because of discharge of indebtedness income (COD income).2

                             FINDINGS OF FACT

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

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.       Petitioners, husband and

wife,       resided in Dallas, Texas, at the time they filed their

petition.

     Petitioner James R. Brickman (James) invested, as a limited

partner, in Sovereign Partners V, Ltd., a Texas limited

partnership (the partnership).       On or about May 23, 1984, the

partnership was formed to acquire a tract of land in Flower

Mound, Texas, develop the land into residential lots, and sell

the lots to homebuilders (the project).         James had a 74.1-percent

limited partner interest in the partnership.        The interest in the




        1
        Respondent concedes the 1992 deficiency and the accuracy-
related penalties for all years in issue.
        2
        Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
                               - 3 -


partnership was community property of petitioners.   In 1992, the

partnership terminated.

     The Second Amended and Completely Restated Certificate and

Agreement of Limited Partnership (the partnership agreement)

stated that each partner shall make, and be personally liable to

make, additional capital contributions equal to any pro rata

share of any debt service installment.   James never made any

capital contributions to the partnership to allow the partnership

to pay its debt.

     On May 8, 1985, the partnership entered into a recourse all-

inclusive promissory note (the note) with Sunbelt Service Corp.

(the bank) in the amount of $12,500,000.   Additionally, James and

two other partners in the partnership signed a personal guaranty

agreement (the guaranty) for the bank.   The guaranty made James

and the other two partners personally and jointly liable on the

note.   Petitioner Susan B. Brickman (Susan) did not sign the

guaranty.

     The partnership, with the proceeds from the note, purchased

real property in Flower Mound, Texas.    Initially, the partnership

received approximately $9,900,000 in funding on the note.   In

August 1987, the bank stopped funding the note because of

government intervention into the bank's affairs.   At this time,

the project was 75 percent complete.    After funding was cut off

by the bank, the partnership did not have the money needed to
                               - 4 -


complete the project.   The partnership defaulted on the note,

interest accrued, and it was not paid.

     From 1984 through 1991, the partnership allocated to James

at least $6,166,647 in partnership losses (the allocated losses).

On their 1984 through 1991 joint Federal income tax returns,

petitioners did not fully use the allocated losses.3    Therefore,

a portion of the allocated losses became NOL carryovers.

     On or about April 9, 1991, and again on July 15, 1991, the

bank sent a demand letter to the partnership and to the

individual partners (including James).   On or about August 6,

1991, the bank conducted a foreclosure sale of the partnership's

real property securing the note.   At the time of the foreclosure

sale, the partnership owed $9,967,301 on the note.     The

guarantors' exposure on the principal of the note was the same.

     The bank issued a Form 1099 to the partnership that

documented the foreclosure sale of the real property and the

bank's forgiveness of the partnership's debt to the bank.       On its

1991 tax return, the partnership reported a loss in the amount of

$5,455,004 as a result of the bank's foreclosure sale.       On its

1992 tax return, the partnership reported $14,094,231 in COD

income from the discharge of the partnership's principal and




     3
        Petitioners, however, were able to use at least
$3,053,203 of the allocated losses.
                                - 5 -


accrued interest indebtedness to the bank.4      The partnership

treated the COD income as an item of partnership income and

allocated the COD income separately to all of the partners,

including James, pursuant to the "special allocation" provisions

of the partnership agreement.    On the 1992 Form K-1 that the

partnership issued to James, the partnership reported that it

allocated $6,166,647 of COD income to James.

     On petitioners' 1992 joint Federal income tax return,

petitioners excluded $5,750,737 of the $6,166,647 of COD income

from their joint gross income due to insolvency pursuant to

section 108(a)(1)(B) (the insolvency exception) and reported

$415,910 of the $6,166,647 of COD income.      Petitioners did not

reduce a $487,730 NOL carryover from 1992 to 1993 (Susan's NOL)

by the $5,750,737 of excluded COD income.5


     4
        The partnership reported the $14,094,231 of COD income on
its 1992 tax return because that is when the period of
limitations for collecting on the note expired. Additionally, in
1992, the period of limitations for collecting on the guaranty
also expired.
     5
        Petitioners, in an attachment to their 1992 Form 1040,
explained the generation of Susan's NOL as follows:

                                 Total       James       Susan

     NOL   generated in 1983      $67,432     $33,716     $33,716
     NOL   generated in 1984    1,063,747     531,873     531,874
     NOL   generated in 1985      590,075     295,037     295,038
     NOL   generated in 1986      352,211     176,105     176,106
     NOL   generated in 1987      340,178     170,089     170,089
     NOL   utilized in 1988      (866,246)   (433,123)   (433,123)
     NOL   generated in 1989      233,969     116,984     116,985
     NOL   generated in 1990      454,053     227,026     227,027
                                                         (continued...)
                                            - 6 -


                                        OPINION

        Respondent contends that petitioners must reduce Susan's NOL

to zero because they excluded COD income pursuant to section

108.6       Petitioners first argue that James' release from his

        5
         (...continued)
        NOL generated in 1991                878,025     439,012     439,013
        NOL before sec.
            108 Reduction                   3,113,444   1,556,719   1,556,725

        Sec. 108 NOL Reduction
            in 1990                         (751,610)   (751,610)        -0-
        Sec. 108 NOL Reduction
            in 1991                         (708,059)   (708,059)        -0-

        NOL carryover to 1992            1,653,775        97,050   1,566,725
        NOL utilized in 1992            (1,166,045)      (97,050) (1,068,995)

        Carryforward to 1993                 487,730         -0-     487,730

        6
             Sec. 108, in pertinent part, provides:

        (a) Exclusion From Gross Income.--

             (1) In General.--Gross income does not include any
        amount which (but for this subsection) would be includible
        in gross income by reason of the discharge (in whole or in
        part) of indebtedness of the taxpayer if--

                      *   *     *   *   *     *   *

                    (B) the discharge occurs when the taxpayer is
               insolvent,

                      *   *     *   *   *     *   *

        (b) Reduction of Tax Attributes.--

             (1) In General.--The amount excluded from gross income
        under subparagraph (A), (B), or (C) of subsection (a)(1)
        shall be applied to reduce the tax attributes of the
        taxpayer as provided in paragraph (2).

             (2) Tax Attributes Affected; Order of Reduction.--
        Except as provided in paragraph (5), the reduction referred
                                                      (continued...)
                               - 7 -


guaranty generated the COD income and that Susan had no COD

income because she was not liable under the guaranty.

     Petitioners' argument is contrary to the facts.    On the

partnership's 1992 tax return, the partnership reported

$14,094,231 in COD income from the discharge of the partnership's

principal and accrued interest indebtedness to the bank.     The

partnership treated the COD income as an item of partnership

income and allocated the COD income separately to James pursuant

to the "special allocation" provisions of the partnership

agreement.   On the 1992 Form K-1 that the partnership issued to

James, the partnership allocated $6,166,647 of COD income to

James.   Thus, the facts are that the COD income was not generated

from James' release from his guaranty, but rather the COD income

was generated by the discharge of the partnership's indebtedness,

and the partnership made a special allocation of that income to

James (i.e., it passed through the partnership interest).7

     Petitioners next argue that COD income is not "income" to be

divided between spouses under Texas community property law, that

     6
      (...continued)
     to in paragraph (1) shall be made in the following tax
     attributes in the following order:

               (A) NOL.--Any net operating loss for the taxable
          year of the discharge, and any net operating loss
          carryover to such taxable year.
     7
        Furthermore, we note that a guarantor generally does not
recognize income when he is relieved of his guaranty obligation.
See Landreth v. Commissioner, 50 T.C. 803, 812-813 (1968).
                                 - 8 -


Susan did not recognize COD income (i.e., that COD income from

the partnership did not pass through to Susan), and therefore

petitioners were not required to reduce Susan's NOL.

     Petitioners' contention that COD income is not income under

Texas law is irrelevant.

          In dealing with the meaning and application of an
     act of Congress enacted in the exercise of its plenary
     power under the Constitution to tax income and to grant
     exemptions from that tax, it is the will of Congress
     which controls, and the expression of its will, in the
     absence of language evidencing a different purpose,
     should be interpreted "so as to give a uniform
     application to a nation-wide scheme of taxation".
     * * * Congress establishes its own criteria and the
     state law may control only when the federal taxing act
     by express language or necessary implication makes its
     operation dependent upon state law. [Lyeth v. Hoey,
     305 U.S. 188, 194 (1938) (quoting Burnet v. Harmel, 287
     U.S. 103, 110 (1932)).]

     In the application of a Federal revenue act, State law

determines the nature of the legal interest that the taxpayer had

in the property or income sought to be reached by the statute.

Morgan v. Commissioner, 309 U.S. 78, 82 (1940).       "In the

determination of ownership, state law controls. 'The state law

creates legal interests but the federal statute determines when

and how they shall be taxed.'"     United States v. Mitchell, 403

U.S. 190, 197 (1971) (citations omitted).       "Thus, with respect to

community income, as with respect to other income, federal income

tax liability follows ownership."        Id. (citing Blair v.

Commissioner, 300 U.S. 5, 11-14 (1937)); see also United States

v. Mitchell, supra at 195 (stating that the Court looked to the
                               - 9 -


law of the State to determine the ownership of community property

and community income).   Simply put, Federal law defines what is

income for Federal income tax purposes, and State law determines

who "owns", or has the right to, the income.

     Federal law provides that, 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).

The Code provides an exception to the recognition of COD income

in cases where the discharge occurs when the taxpayer is

insolvent.   See sec. 108(a)(1)(B); see also Babin v.

Commissioner, 23 F.3d 1032, 1035 (6th Cir. 1994), affg. T.C.

Memo. 1992-673.   Section 108(b)(1) provides in turn that, upon

discharge, the taxpayer must reduce certain tax attributes by the

amount of the COD income excluded from gross income.    Section

108(b)(2) provides that NOL's are the first tax attribute to be

reduced,8 and section 108(b)(3) provides that they be reduced

dollar-for-dollar by the amount of the COD income excluded under

section 108(a).

     If the debtor is a partnership, then the gain or loss

realized from the transfer of property in consideration of the

reduction or discharge of a debt is passed through to each of the


     8
        A taxpayer can elect to reduce the basis of any
depreciable property by the amount of debt discharged before
reducing the amount of any other tax attributes. Sec. 108(b)(5).
Petitioners did not make such an election.
                              - 10 -


partners under section 702 in accordance with his or her interest

in the partnership and is reflected in each partner's adjusted

basis in the partnership pursuant to section 705(a).     See secs.

702(a)(1), (2), and (3), 705(a); Babin v. Commissioner, supra;

Gershkowitz v. Commissioner, 88 T.C. 984, 1005 (1987).     In the

case of a partnership, the insolvency exception to the

recognition of COD income provided by section 108(a) is applied

at the partner level.   See sec. 108(d)(6).

     As we have found, the COD income was an item of partnership

income that passed through to the partners.     We now turn to State

law to ascertain who owned this income.

     Texas is a community property State.     Tex. Fam. Code Ann.

secs. 3.001-3.005 (West 1998); Lange v. Phinney, 507 F.2d 1000,

1005 (5th Cir. 1975).   Generally, spouses residing in a community

property State are liable for the Federal income tax on one-half

of their community income.   United States v. Mitchell, supra.

Income and deductions attributable to community property are also

petitioners' community property.   See Tex. Fam. Code Ann. secs.

3.001, 3.002; Adams v. Commissioner, 82 T.C. 563, 567-568 (1984);

Hockaday v. Commissioner, 22 T.C. 1327, 1329 (1954); Harris v.

Harris, 765 S.W.2d 798, 802 (Tex. App. 1989); Marshall v.

Marshall, 735 S.W.2d 587, 594 (Tex. App. 1987).9

     9
        The decisions of the State's highest court are conclusive
as to that State's law, but in the absence of a decision by that
                                                   (continued...)
                              - 11 -


     Petitioners stipulated that the partnership interest was

community property.   Under Texas law, therefore, income and

deductions attributable to the partnership interest are

petitioners' community property.

     We conclude that Susan had a community interest in the COD

income of the partnership that flowed through to James (i.e., she

owned one-half of the COD income).     Thus, under section 108(b),

petitioners must reduce Susan's NOL by her COD income.

     To reflect the foregoing,

                                           Decision will be entered

                                     under Rule 155.




     9
      (...continued)
court we may look to the State's lower courts' rulings and
holdings. Commissioner v. Estate of Bosch, 387 U.S. 456, 465
(1967).
