                         T.C. Memo. 1996-281



                       UNITED STATES TAX COURT



           MAX M. AND JOAN E. GREENBERG, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 6843-94.                         Filed June 19, 1996.



     Andrew M. Glatt, for petitioners.

     Christine V. Olsen, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     JACOBS, Judge: Respondent determined an $11,644 deficiency in

petitioners’ 1990 Federal income tax, and a $2,329 section 6662(a)

accuracy-related penalty for such year.

     The   principal   issue   for   decision   concerns   the   proper

characterization of payments petitioners received from or through

an entity known as Pioneer Mortgage in 1990 totaling $44,396 (viz,

whether said payments should be characterized as interest income,
                                             -2-

as respondent contends, or as a return of capital, as petitioners

contend).        In the event we accept respondent’s characterization of

these payments, then we must further decide whether petitioners are

liable for the section 6662(a) accuracy-related penalty.

       All section references are to the Internal Revenue Code for

the year in issue, all Rule references are to the Tax Court Rules

of   Practice         and    Procedure,   and      all   dollar   amounts    have    been

rounded.

       Some      of    the    facts   have    been       stipulated   and   are     found

accordingly.          The stipulation of facts and the attached exhibits

are incorporated herein by this reference.

                                   FINDINGS OF FACT

       At the time they filed their petition, petitioners Max M. and

Joan       E.   Greenberg,      husband   and      wife,    resided   in    San   Diego,

California.           They timely filed a joint Federal income tax return

for 1990.

Pioneer Mortgage, Inc.

       Pioneer Mortgage, Inc. (Pioneer Mortgage or the company) was

incorporated by Morrie Naiman (M. Naiman) on July 12, 1967.                            In

1975, M. Naiman died; thereafter his nephew, Gary Naiman (G.

Naiman) continued the business previously conducted by his uncle

(viz, the secondary mortgage market in the San Diego area) using

the Pioneer Mortgage name for several interrelated companies.1                         G.

       1
                G. Naiman operated and controlled the following
                                                         (continued...)
                                    -3-

Naiman   was   president   and   chief    executive   officer   of   Pioneer

Mortgage from the mid-1970's until the company filed for bankruptcy

in January 1991.

     Pioneer Mortgage originated and serviced real estate loans and

sold investments purportedly related to these loans to third

parties.   The loans originated by Pioneer Mortgage generally were

of a short-term duration and were secured by real estate.                The

loans were commonly known as "equity loans" because they were based

primarily on the borrower's equity in the real estate securing the

loan, as opposed to the borrower’s creditworthiness. The interest

rate and origination fees on equity loans were commensurate to the

relatively high degree of risk involved.

     Pioneer Mortgage offered several types of investments related

to the equity loans it originated. The primary investment it

offered was a purported fractionalized interest in a note and deed

of trust from the borrower to Pioneer Mortgage.             This type of

investment was portrayed to the investor as safe and conservative.

Potential investors were advised that the borrower had sufficient

equity in the collateralized property to support the loan.

     Another type of investment offered by Pioneer Mortgage was a

mortgage pool investment known as a Collateral Mortgage Obligation

     1
      (...continued)
companies under the Pioneer Mortgage umbrella: Naiman Financial
Corp.; Naimpro, Inc.; Naimco-Clairemont, Inc.; Naimco, Inc.;
Alvarado Investment Corp.; and Frontier Service Corp. As used
hereinafter "Pioneer Mortgage" refers to Pioneer Mortgage and its
interrelated companies.
                                     -4-

(CMO). The company bundled different "assets" (such as limited

partnership interests and subordinated deeds of trust) and placed

them in a trust account to secure the CMO.                  Pioneer Mortgage

administered the CMO investment.            The investor received a CMO

certificate, which represented his proportionate ownership interest

in the bundled assets, as well as a note from Pioneer Mortgage.

     For his investment, the investor received purported monthly

interest   payments     drawn   on   Pioneer    Mortgage's     bank   account.

Pioneer    Mortgage    paid   interest     at   a   rate   higher   than   that

obtainable from conventional savings accounts, Treasury bills, or

money market accounts. Pioneer Mortgage forwarded monthly payments

to the investors regardless of whether the borrower had at the time

remitted its payment to the company.

     The investors and Pioneer Mortgage typically entered into a

loan service agreement pursuant to which the investor authorized

Pioneer Mortgage to collect payments on, and otherwise service, the

borrower's note.      The loan service agreement provided that Pioneer

Mortgage could grant the borrower an extension of time to remit the

required monthly payments.       If the borrower failed to make timely

the interest payment, Pioneer Mortgage could and normally did

advance the borrower an amount equal to that which was due.                 The

loan service agreement further provided that if Pioneer Mortgage

made a payment to the investor to cover the payment due from the

borrower, such payment would constitute an advance and would be
                                -5-

repaid to Pioneer Mortgage upon receipt of the late payment from

the borrower.

     Pioneer Mortgage was required to inform the investor if any

payment it remitted to the investor came from a source other than

the borrower by designating on the check sent to the investor that

such funds constitute a "loan to the lender".   Thus, when Pioneer

Mortgage advanced funds to the investor to cover the borrower's

late interest payments, Pioneer Mortgage labeled such payment with

an "L".

     As of 1990, over 2,000 persons (many of whom were elderly and

counted on their investments through Pioneer Mortgage to provide a

fixed income retirement) had made investments through Pioneer

Mortgage; the amount of these investments totaled approximately

$250 million.

Petitioners’ Investments

     Petitioners invested in several fractionalized interests in

notes and deeds of trust through Pioneer Mortgage.      They also

invested in a CMO.   The   following   is a list of petitioners’

investments with Pioneer Mortgage:
                                     -6-
Loan                       Loan                  Date of
Provided To                Number   Investment   Investment      Interest Rate

A-440 Enterprises,         13230    $25,000      Sept. 1, 1988      12.75%
 Inc. (Foster)
Scott Wellington           13232    25,000       Feb. 10, 1989      12.75%
 Rudolph
Avion Properties,          13412    50,000       Aug. 21, 1989      14%
 Ltd.
Naimco-Clairemont,         13586    25,000       Aug. 21, 1989      14%
 Inc.(Sunnymead)
Hermosa Beach              135662   150,000      Aug. 21, 1989      14%
 Investment Co.
3.0 CMO                     ---     100,000      Aug. 21, 1989      14%

      Petitioners received the following payments purportedly as

interest in 1990 from Pioneer Mortgage with respect to the CMO:

                 Check Date                       Payments

                  1/6/90                         $1,166.67
                  2/6/90                          1,166.67
                  3/6/90                          1,166.67
                  4/6/90                          1,166.67
                  5/6/90                          1,166.67
                  6/6/90                          1,166.67
                  7/6/90                          1,166.67
                  8/6/90                          1,166.67
                  9/6/90                          1,166.67
                 10/6/90                          1,166.67
                 11/6/90                          1,166.67

                   Total                         12,833.37

Two of the statements for these payments have the notation "L".

      Petitioners received the following payments purportedly as

interest in 1990 with respect to their interests in notes and deeds

through Pioneer Mortgage:

                Check Date                        Payments

                   2/1/90                        $3,156.26
                   3/1/90                         3,156.26


      2
              In some documents, this loan is referred to as Loan No.
13567.
                                       -7-

                    4/1/90                          3,156.26
                    5/1/90                          3,156.26
                    6/1/90                          3,156.26
                    6/30/90                         3,156.26
                    8/1/90                          3,156.26
                    9/1/90                          3,156.26
                   10/1/90                          3,156.26
                   11/1/90                          3,156.26

                    Total                          31,562.60

The monthly payment statements with respect to these investments

indicate    that    the     majority   of   the   payments   included   an   "L"

notation.

The Demise of Pioneer Mortgage

     In late 1990, Pioneer Mortgage acknowledged certain financial

difficulties. In December 1990, Pioneer Mortgage stopped advancing

funds to the borrowers, and failed to make interest payments for

the first time. On January 9, 1991, Pioneer Mortgage and its

interrelated companies filed for Chapter 11 bankruptcy protection.3

     Shortly after Pioneer Mortgage’s bankruptcy filing, the facts

surrounding the company’s downfall became public.                  Apparently

Pioneer Mortgage’s financial difficulties began as a result of the

rapid expansion of the company into new types of products.              Before

the mid-1980's, Pioneer Mortgage primarily arranged short-term

loans that were secured by first- or second-trust deeds on single-

     3
          The bankruptcy court concluded that, contrary to
petitioners' belief, they did not own a direct interest in
borrower notes secured by trust deeds, but rather, petitioners
were unsecured creditors of Pioneer Mortgage. In 1991, all of
the Pioneer Mortgage investors (including petitioners) were
required to relinquish their investments to a new entity called
Pioneer Liquidating Corporation.
                                     -8-

family residences.     Gradually, the company shifted to junior deeds

on larger residential and commercial loans, including hotels,

resorts, and undeveloped land in California and Arizona.

     Accordingly, in 1990, certain borrowers had not been making

their monthly payments; rather than foreclose on the properties or

notify   the    Pioneer   Mortgage   investors,   G.   Naiman   used   new

investors’ money to fund the continued flow of purported interest

payments.4     The end result was a financial house of cards dependent

on the influx of new investment dollars.      The house of cards could

not survive in the long run.

     On January 2, 1992, petitioners filed a civil lawsuit against

G. Naiman and other defendants for, among other things, intentional

misrepresentation, fraudulent concealment, breach of fiduciary

duty, and aiding and abetting/conspiracy.5         A jury verdict was

rendered in favor of petitioners on April 30, 1993.        The jury also

awarded punitive damages.     On May 12, 1994, G. Naiman was indicted

in Federal Court on charges of mail fraud and money laundering.         G.

Naiman pleaded guilty to a scheme to defraud Pioneer Mortgage


     4
          Newspaper articles portray G. Naiman’s activities as a
typical “Ponzi” scheme. Such a scheme involves a pyramiding
technique by which the earlier investors receive their returns
from the principal of their own funds and from the principal of
later investors.
     5
          Petitioners’ suit was consolidated with some 850 other
lawsuits filed by Pioneer Mortgage investors seeking return of
investment funds and damages in Mertyle H. Owens Trust v. San
Diego Trust & Savings Bank, Consolidated Case No. 633381, in
Superior Court of California, County of San Diego.
                                       -9-

investors through illegal acts, including mail fraud and money

laundering (promotion and concealment) on October 18, 1994.                   He is

presently serving a 6-1/2 year prison sentence.

     At    the   time   of   trial    herein,      petitioners     had    recovered

approximately $25,000 out of their total $375,000 investment with

Pioneer Mortgage.

Forms 1099

     In 1991, Pioneer Service Co. (the trustee in bankruptcy)

issued to    petitioners      two    Forms    1099-INT,     in   the     amounts   of

$12,833.37 and $33,416.10,6 with regard to the payments labeled

"interest" on the CMO loan and the remaining loans, respectively.

Petitioners’ 1990 Federal Income Tax Return

     Petitioners’       accountant,         Kenneth    B.     Healey,      prepared

petitioners' 1990 Federal income tax return.                     Because of the

document    matching    program      that    the   Internal      Revenue    Service

employed, Mr. Healey determined that petitioners should report as

interest income the amount ($46,2497) reported on the two Forms

1099-INT from Pioneer Service Co. and wash that amount out by

claiming $46,249 as negative income on line 22 (Other income) of

their 1990 Form 1040.




     6
          The parties acknowledge that this amount is $1,853.50
more than the $44,396 petitioners actually received from Pioneer
Mortgage in 1990.
     7
          The $46,249 comprises the sum total of the amounts
reported on the Forms 1099-INT issued to petitioners for 1990.
                                -10-

     Petitioners attached a statement to their 1990 tax return

which read:

          The taxpayers are holders of notes receivable,
     whose principal repayment is in doubt due to
     bankruptcy proceedings; therefore, the taxpayers are
     allocating payments received in 1990 to repayment of
     principal. The amount of the payments is $46,249.

Notice of Deficiency

     Respondent   disallowed   the     $46,249   negative   income   on

petitioners’ 1990 return on the premise that petitioners failed to

establish "that any amount is deductible under the provisions of

the Internal Revenue Code."        This disallowance resulted in a

$46,249 increase in petitioners’ 1990 taxable income.

                               OPINION

     Respondent claims that because the trustee in bankruptcy

labeled the payments to petitioners as interest on Forms 1099-INT,

such payments constitute income.     Petitioners posit that the money

they received from Pioneer Mortgage in 1990 does not represent

interest income, but rather payments made to conceal a fraud.        As

such, petitioners take the position that the payments constitute a

return of their capital.

     The issue involved is purely factual.        In their post-trial

briefs, petitioners argue:

          Beginning on or about May 1, 1989 and continuing
     until approximately January 9, 1991, G. Naiman and others
     devised a scheme to defraud and obtain money and property
     from investors by means of false and fraudulent
     pretenses, representations and promises, and the
     concealment of material facts. As part of the scheme to
     defraud in the year preceding Pioneer Mortgage's
                                -11-

     bankruptcy filing on January 9, 1991, G. Naiman and
     others created and maintained the illusion that Pioneer
     Mortgage was financially stable when in fact it was not.
     Pioneer Mortgage maintained this illusion in order to
     attract new investor funds. These new funds were applied
     to the monthly interest payments due previous Pioneer
     Mortgage investors, prior financial obligations of the
     various Pioneer Mortgage companies and bank over-drafts
     at several financial institutions.

          Due to the nature of the fraud perpetrated on
     petitioners, there was no agreement between petitioners
     and Pioneer Mortgage.   Petitioners believed that they
     were investing directly in specific promissory notes
     which were adequately secured by trust deeds. However,
     as the facts in this case clearly indicate, what
     petitioners ended up with was instead some sort of
     undivided interest as a creditor of Pioneer Mortgage's
     successor which is being liquidated via a bankruptcy
     proceeding.

          The payments received by petitioners during 1990 did
     not originate from investments of a character and quality
     in which petitioners believed they had invested. Rather,
     the evidence clearly demonstrates that the petitioners
     were defrauded as to the character and quality of the
     investment instruments owned by them.

     We agree with   petitioners' characterization of the payments

in question.   Interest is compensation for the use or forbearance

of money.   Deputy v. duPont, 308 U.S. 488, 498 (1940).   We conclude

that the payments petitioners received through their investment

with Pioneer Mortgage in 1990 were not for the use and forbearance

of their money, but rather such payments were made to conceal G.

Naiman's fraudulent misappropriation of petitioners' investment.

Accordingly, the payments represented a return of petitioners'

investment and should not be included in income as interest simply

because the payments were reported as interest on Forms 1099-INT.

Cf. Burnet v. Logan, 283 U.S. 404 (1931).   The interest label given
                              -12-

to these payments was patently erroneous.   Petitioners' money was

not invested in the manner promised by Pioneer Mortgage.

     Because the payments petitioners received from or through

Pioneer Mortgage in 1990 represented a return of capital, and not

interest income, respondent's determination that petitioners are

liable for the accuracy-related penalty falls by the wayside.8

Consequently,



                                          Decision will be entered

                                     for petitioners.




     8
          Were we required to decide this issue, we would rule in
favor of petitioners.
