                          T.C. Memo. 2002-276



                      UNITED STATES TAX COURT



   FRGC INVESTMENT, LLC, JAMES P. MEHEN, TAX MATTERS PARTNER,
   Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 5443-01.                 Filed October 31, 2002.



     Stephen E. Silver and Jason M. Silver, for petitioner.

     Michael L. Boman and James E. Cannon, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     COHEN, Judge:   Respondent sent a Notice of Final Partnership

Administrative Adjustment (FPAA) for 1997 and 1998 to FRGC

Investment, LLC (FRGC).    James P. Mehen (petitioner), the

designated tax matters partner for FRGC, filed a timely petition

for readjustment with the Court.    The issues for decision are:

(1) Whether FRGC’s expenses in 1997 are deductible as an
                                - 2 -

abandonment loss under section 165(a) and (2) whether FRGC is

entitled to deduct $189,447 in other expenses for 1998.

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue.

                           FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

     FRGC is an Arizona limited liability company whose principal

place of business was Flagstaff, Arizona.      In May 1997, FRGC was

formed to engage in predevelopment activities to acquire

undeveloped real estate.    The private placement memorandum

materials for FRGC provided that any property or work product

acquired would be contributed to a subsequently established

entity, Flagstaff Ranch Golf Club, LLC (Flagstaff Ranch), for

which FRGC’s investors would receive membership interests in

Flagstaff Ranch in an amount equal to those interests held in

FRGC.   Flagstaff Ranch was organized for the purpose of

developing the property to include a golf course, community

center, clubhouse, and residential lots for custom homes.

     FRGC’s managing partner was FR Management, LLC (FR

Management), which was wholly owned by petitioner and his wife,

Susie Mehen.   FRGC’s operating agreement provided that FRGC would

pay FR Management $10,000 per month for management fees and

$13,000 per month for overhead expenses.      FRGC also paid Susie
                                 - 3 -

Mehen $4,000 per month from August 1997 through June 1998 for

marketing services.

     Petitioner was president of Peyton Community Builders (PCB),

a residential and commercial building construction company,

during all relevant times.   Previously, petitioner had been

president and chairman of the Del Webb Commercial Properties

Division, a land development company.    In 1987, petitioner was

involved in developing Forest Highlands, an upscale golf

community located in the Flagstaff area.

Subject Property

     The subject property was 404 acres of undeveloped land with

a mix of dry lake bed, steep hillsides, and pine and aspen

forests.   It offered scenic views of the San Francisco Peaks and

the city of Flagstaff.   The dry lake was formed by volcanic

activity over 1,000 years ago.

     The property was owned by Cherry Properties, LLC (Cherry).

Cherry was owned by Rex and Ruth Maughan, who acquired the

subject property in 1994 from the Resolution Trust Corp.

     Ronald Walker (Walker) was Rex Maughan’s real estate broker.

As part of his due diligence, in or before 1994, Walker met with

the Coconino County planning director and reviewed the 1983

Coconino County Board of Supervisors minutes (1983 minutes).

Walker discovered that the subject property was zoned for 1,596

residential units, a golf course, a school, and commercial
                                - 4 -

buildings.    Walker was assured by the Coconino County planning

director that, although the current Zoning Department probably

would not allow 1,596 units to be built on the property, locating

a golf course in and around the dry lake area of the property

would not present a problem.

Real Estate Purchase Agreements

     On December 29, 1995, PCB or its nominee entered into a real

estate purchase agreement (1995 purchase agreement) with Cherry

for the purchase of approximately 240 acres of the subject

property.    Petitioner intended that once FRGC was formed, FRGC

would become PCB’s nominee for the purchase agreement.

     PCB deposited $25,000 with First American Title Co. to open

escrow on the real estate transaction.    On March 14, 1996, PCB

advised Cherry of objections to numerous survey and other title

report exceptions for the subject property.    On April 15, 1996,

escrow for the 1995 purchase agreement was canceled.

     On August 14, 1996, PCB entered into a second real estate

purchase agreement (1996 purchase agreement) with Cherry for the

purchase of the entire 404 acres of subject property.    The sale

also included Cherry’s interest in the Flagstaff Ranch Water Co.

PCB deposited $5,000 with First American Title Co. to open escrow

on the real estate transaction on August 30, 1996, and deposited

an additional $20,000 on November 26, 1996.    The 1996 purchase

agreement required closing escrow on or before December 31, 1997.
                                - 5 -

     The 1996 purchase agreement contained several contingencies,

including approval by the Coconino County Board of Supervisors

(Coconino County Board) for final plat and zoning.      The agreement

also provided that, if the buyer failed to close escrow for any

reason, the buyer agreed to provide the seller with copies of any

and all plans, engineering, plats, studies, surveys, and the

like, if requested by the seller.

     Petitioner presented a general development plan report (1997

plan) for the property to the Coconino County Board in August

1997.   The 1997 plan was a complete zoning change from the zoning

approved in the 1983 minutes.   Petitioner planned to present the

zoning request for the property to the Coconino County Board at a

November 17, 1997, board hearing.    Several weeks prior to the

scheduled board hearing, Walker met with Paul Babbitt (Babbitt),

head of the Coconino County Board.      Babbitt indicated that he

would oppose the zoning request as a result of a groundswell of

protest from the community against development of 260 acres of

dry lake area within the subject property.      On November 17, 1997,

petitioner met with Babbitt, another county supervisor, and a

county attorney before the hearing was to begin.      Petitioner was

told “in no uncertain terms” that the zoning request did not have

the votes to pass.   Petitioner immediately requested an extension

of the December 31, 1997, escrow deadline from Walker, who

rejected the extension because the property had been “tied up”
                               - 6 -

for a significant period and because it was clear to Walker that

petitioner was not going to obtain the requested zoning approval.

Petitioner withdrew the zoning request after the hearing but

before a vote was taken.

     Walker began to market the property to other major

developers after the November 17, 1997, meeting, as he expected

petitioner to cancel escrow on the property.    Petitioner

contacted Joseph Janas (Janas), FRGC’s certified public

accountant, a few days after the hearing and told Janas that the

real estate transaction would not go forward.    Petitioner then

instructed Janas to do a final accounting to determine how much

cash in the partnership was available to distribute to the

investors.

     PCB and Cherry executed mutual cancellation instructions for

the 1996 purchase agreement to the escrow company on December 29,

1997.   The escrow company refunded the $25,000 in earnest money

to PCB upon cancellation of the escrow.   At the time that PCB and

Cherry canceled escrow, petitioner did not attempt to renegotiate

a new purchase agreement for the subject property.

     Sometime in early January 1998, Walker approached petitioner

and suggested new terms for the purchase that would be acceptable

to Rex Maughan.   The terms included a nonrefundable payment of

$150,000, an increase in the purchase price from $5.25 million to

$5.775 million, closing in 6 months with no contingencies, and
                                 - 7 -

sale of one-half of Cherry’s interest in the Flagstaff Ranch

Water Co. instead of Cherry’s full interest pursuant to the 1996

purchase agreement.

     Petitioner and Walker prepared an offer and submitted it to

Rex Maughan for approval.   Petitioner sent a letter to FRGC’s

investors in early January, calling for a meeting on January 12,

1998, to vote on whether to proceed with the new purchase

agreement.   FRGC’s operating agreement provided that more than

one-half of the 50 outstanding partnership units had to agree to

continue with the partnership.    Although 16 units voted for

redemption of their interests in FRGC, 34 units voted to continue

with the partnership.   Each redeemed unit received $11,000, which

was $14,000 less than what was paid for the unit.

     FRGC and Cherry executed a new real estate purchase

agreement (1998 purchase agreement) on January 15, 1998.

Flagstaff Ranch issued its private offering memorandum on

February 10, 1998.    Cherry conveyed the subject property directly

to Flagstaff Ranch on June 29, 1998, and the parties closed

escrow on June 30, 1998.

General Development Plans

     In March 1999, a new general development plan report (March

1999 plan) was presented to the Coconino County Board that

substantially complied with the zoning approved in the 1983

minutes.   The Coconino County Board approved some of the March
                               - 8 -

1999 plan, but rejected the golf course placement in the middle

of the dry lake area.   In December 1999, a new general

development plan report (December 1999 plan) was presented to the

Coconino County Board that encompassed a land swap with Bob

Simple (Simple), who owned land adjacent to the subject property.

Simple traded 250 acres of his property for the dry lake caldera

and 36 acres of developable sites.     Simple then sold the dry lake

caldera to the Grand Canyon Trust, and it eventually became the

property of the Federal Government under control of the Coconino

National Forest.

FRGC’s Partnership Returns

     On its 1997 Form 1065, U.S. Partnership Return of Income,

FRGC reported interest income of $14,095 and “other deductions”

of $669,126.   The claimed deductions consisted of the following:

          Management and supervision       $158,000
          Marketing expense                 104,851
          Office and overhead               188,000
          Course design                      23,620
          Engineering                        61,435
          Environmental fees                 26,111
          Hydrology                           2,582
          Land planning fees                 24,741
          Zoning fees                        19,901
          Travel                              2,758
          Other fees and expenses            10,000
          Land acquisition                    8,103
          Accounting fees                     5,850
          Planning fees                      31,372
          Amortization expense                1,802
             Total                         $669,126
                               - 9 -

Statement 2 of the 1997 partnership return contained the language

“Activity Disposed of During 1997".

     Prior to the organization of FRGC, PCB incurred overhead and

management expenses for services rendered on behalf of FRGC.     In

June 1997, FRGC paid $110,000 for overhead expenses and $78,000

for management fees to reimburse PCB.

     On its 1998 U.S. Partnership Return of Income, FRGC reported

interest income of $6,921, dividends of $18, and “other

deductions” of $189,447.   The claimed deductions consisted of the

following:

           Management and supervision    $60,000
           Marketing expense              33,835
           Office and overhead            78,000
           Auto expense                      868
           Office supplies                 1,846
           Postage and shipping            2,184
           Travel                          6,972
           Accounting fees                 1,175
           Miscellaneous                     382
           Meals and entertainment           667
           Amortization expense            3,518
              Total                     $189,447

     None of the above expenses were incurred after June 30,

1998.   FRGC paid $78,000 for overhead expenses incurred from

January to June 1998.   FRGC paid $60,000 to FR Management for

January through June 1998 for management fees.     Respondent sent

the FPAA to petitioner on March 15, 2001, disallowing FRGC’s

“other deductions” in the amounts of $669,126 and $189,447 for

1997 and 1998, respectively.
                              - 10 -

                              OPINION

     Respondent argues that FRGC did not sustain a deductible

abandonment loss in 1997 and that all expenses claimed in 1997

and 1998 were capital in nature and are therefore not currently

deductible.   Petitioner acknowledges that a large percentage of

the 1997 expenditures were nondeductible capital expenditures at

the time they were made.   However, petitioner argues that the

expenses became deductible when the failure to obtain the

requisite zoning changes resulted in cancellation of the 1996

purchase agreement.   At trial, petitioner limited his arguments

with respect to allowable deductions for 1997 to whether FRGC

sustained an abandonment loss.

     Petitioner also argues that the burden of proof should be

shifted to respondent in accordance with the provisions of

section 7491.   We need not decide whether the conditions of

section 7491 have been met by petitioner in this case, however,

as the resolution of these issues does not depend on which party

has the burden of proof.   We resolve these issues on the basis of

a preponderance of the evidence in the record, giving more weight

to objective events than to subjective characterizations of

intent.

Abandonment Loss

     FRGC incurred expenses totaling $669,126 in 1997 in

connection with its attempt to acquire suitable property for
                              - 11 -

development by Flagstaff Ranch.   After the unsuccessful zoning

meeting in November 1997, PCB and Cherry executed mutual

cancellation instructions for escrow on the 1996 purchase

agreement.   On its 1997 return, FRGC deducted the $669,126 that

was expended on the project as an abandonment loss under section

165(a).

     Section 165(a) permits a deduction for any loss sustained

during the taxable year and not compensated for by insurance or

otherwise.   The loss must be evidenced by a closed and completed

transaction, fixed by identifiable events.   Sec. 1.165-1(b), (d),

Income Tax Regs.   A loss incurred in a business, or in a

transaction entered into for profit, and arising from the sudden

termination of the usefulness in such business or transaction of

any nondepreciable property, in a case where such business or

transaction is discontinued or where such property is permanently

discarded from use therein, shall be allowed a deduction under

section 165(a) for the taxable year in which the loss is actually

sustained.   Chevy Chase Land Co. v. Commissioner, 72 T.C. 481,

487 (1979); sec. 1.165-2(a), Income Tax Regs.   The regulations

also provide that the loss must be bona fide and that substance,

not mere form, shall govern in determining a deductible loss.

Sec. 1.165-1(b), Income Tax Regs.   To be entitled to an

abandonment loss, a taxpayer must show:   (1) An intention on the

part of the owner to abandon the asset and (2) an affirmative act
                                - 12 -

of abandonment.    United States v. S.S. White Dental Manufacturing

Co., 274 U.S. 398 (1927); A.J. Indus., Inc. v. United States, 503

F.2d 660, 670 (9th Cir. 1974); CRST Inc. v. Commissioner, 92 T.C.

1249, 1257 (1989), affd. 909 F.2d 1146 (8th Cir. 1990).     When the

taxpayer has not relinquished possession of an asset, there must

be a concurrence of the act of abandonment and the intent to

abandon, both of which must be shown from the surrounding

circumstances.     A.J. Indus., Inc. v. United States, supra.

Abandonment of an intangible property interest should be

accomplished by some express manifestation,     Citron v.

Commissioner, 97 T.C. 200, 210 (1991), and “the Tax Court [is]

entitled to look beyond the taxpayer’s formal characterization.”

Laport v. Commissioner, 671 F.2d 1028, 1032 (7th Cir. 1982),

affg. T.C. Memo. 1980-355.    That a partnership claimed an

abandonment loss in its tax return for the year in issue is not

sufficient to constitute an overt act.    See Equity Planning Corp.

v. Commissioner, T.C. Memo. 1983-57.

     Petitioner argues that the cancellation of escrow and

petitioner’s conversation with Janas were sufficient events to

demonstrate abandonment.    Additional facts in the record,

however, are inconsistent with a finding that FRGC abandoned the

project in 1997.    Although petitioner testified that, as of

November 17, 1997, he believed that the project was “dead”,

escrow on the 1996 purchase agreement was not canceled until
                              - 13 -

almost 6 weeks later, on December 29, 1997.   In addition, FRGC

continued to pay fees to Susie Mehen for marketing and to FR

Management for overhead for December 1997 and January 1998.

Petitioner did not make a formal notification to FRGC’s investors

that the project or partnership would be abandoned in 1997.    In

fact, petitioner did not meet with the investors until early

January 1998, when he required their approval to enter into a new

purchase agreement with Cherry.

     Petitioner relies upon our decision in Chevy Chase Land Co.

v. Commissioner, supra, in which we allowed an abandonment loss

for the costs of negotiating a prospective long-term lease on an

unimproved tract of land and for the costs of an unsuccessful

attempt to rezone the land.   The rezoning was inextricably tied

to the lease transaction and was limited to the construction of a

specified type of department store for the lessee.   Id. at 488.

When the rezoning effort failed, the lessee exercised its rights

and terminated the entire transaction.   The taxpayer in Chevy

Chase Land Co. regarded the future commercial development of the

area as foreclosed, and, because the rezoning efforts had been so

specific, none of the items (except a topographical map) acquired

in the course of rezoning were thought to have any continuing

value once the lease was terminated.   The facts of Chevy Chase

Land Co. are distinguishable from the instant case, however,

because FRGC was successful in obtaining a new purchase agreement
                               - 14 -

just 2 weeks after the cancellation of escrow on the 1996

purchase agreement.

     Although a remote possibility of future use does not

necessarily preclude abandonment, Citizens Bank of Weston v.

Commissioner, 252 F.2d 425 (4th Cir. 1958), affg. 28 T.C. 717

(1957), we cannot ignore the language in section 1.165-1(b),

Income Tax Regs., that requires that substance, not mere form,

shall govern in determining a deductible abandonment loss.    In

substance, FRGC’s sole business purpose was to engage in

predevelopment activities to acquire property for Flagstaff

Ranch.    Although the unfavorable November 1997 zoning meeting and

cancellation of escrow on the 1996 purchase agreement slowed

FRGC’s progress, they were not a bar to prevent FRGC from signing

an agreement to acquire the property in early January 1998.     An

otherwise abandoned expenditure, if part of an integrated plan

that is implemented, is not an abandonment loss under section

165(a).   Nicolazzi v. Commissioner, 79 T.C. 109, 132 (1982),

affd. 722 F.2d 324 (6th Cir. 1983).     Indeed, petitioner withdrew

the zoning request prior to a vote at the November 1997 board

meeting, which indicates that he did not want to foreclose the

opportunity to resubmit the request at a later meeting.

     Although petitioner would have us ignore the realities of

what transpired 2 weeks later, we decline to do so.    Instead, we

view the 1995 and 1996 purchase agreements that were entered into
                                - 15 -

between PCB and Cherry as steps in FRGC’s continuing efforts to

acquire the subject property.     FRGC’s expenses in 1997 were

incurred in negotiating the purchase agreements and in settling

the contingencies and were directly related to acquiring suitable

property for Flagstaff Ranch.

     Our holding is consistent with the decision of this Court in

Nicolazzi v. Commissioner, supra, in which the taxpayer

participated in a lottery program to acquire leases on Federal

lands for oil and gas exploration and development.     The taxpayer

filed applications on approximately 600 leases and was successful

in obtaining a lease.    After applying the “substance over form”

mandate of the regulations to the facts, we concluded that the

relevant transaction was the taxpayer’s investment in the lottery

program and that whether he sustained a loss was measured by

reference to the aggregate of the lease applications.     “To hold

otherwise would simply disregard the realities of the situation.”

Id. at 131.   Accordingly, we held that no portion of the fee that

was paid for the lottery program was deductible as an abandonment

loss, because the taxpayer acquired an interest in a valuable

lease and did not sustain a bona fide loss on his investment

during the taxable year.

     FRGC entered into a new purchase agreement with Cherry on

January 15, 1998, only 2 weeks after the cancellation of the 1996

purchase agreement.     Although we do not dispute petitioner’s
                               - 16 -

claim that, between November 17 and December 31, 1997, he did not

renegotiate an agreement to purchase the property, FRGC’s

execution of a new purchase agreement on January 15, 1998, is

inconsistent with its contention that the project was abandoned

in 1997.   At trial, petitioner stressed the difference in

material terms of the 1998 purchase agreement.   However, FRGC

acquired the same 404 acres of property for which it bargained in

the 1996 purchase agreement.   The increase in purchase price and

decrease in interest obtained in the Flagstaff Ranch Water Co.

did not appear materially to affect FRGC’s ability to enter into

a new purchase agreement to acquire the property for ultimate

development by Flagstaff Ranch.

     As additional evidence that the project was abandoned in

1997, petitioner contends that the general development plan

report that was approved for the project in December 1999 was

substantially and materially different with respect to cost,

ownership, acreage, and design than the original zoning in the

1997 plan, which petitioner presented in November 1997.    However,

we are not persuaded that changes in the development plans that

were made in 1999 prove that the entire project was abandoned in

1997.   We are also mindful that, in the land development and

construction arena, extra expenses due to errors in planning or

design are part of the costs that the builder must bear.     See

Haspel v. Commissioner, 62 T.C. 59 (1974); Driscoll v.
                              - 17 -

Commissioner, 147 F.2d 493 (5th Cir. 1945).    As the Court of

Appeals noted in quoting the Tax Court in Driscoll v.

Commissioner, supra at 494:

     “acceptance of petitioner’s theory would result in a
     deductible loss in practically every construction
     project. Common experience tells us that no
     construction job is carried out with such perfection
     that some material, because of error, mistake, or even
     slight change in design, is not removed and therefore
     does not remain a part of the completed structure.
     Such expenditures are, we think, clearly a cost of
     construction.”

Likewise, the additional costs incurred by FRGC for changes that

were made to the 1997 plan were a part of the development costs

for the property and the project.

     In substance, the 1996 purchase agreement was merely a step

in FRGC’s continuing and successful attempts to acquire the

subject property for Flagstaff Ranch.    Accordingly, we conclude

that FRGC did not sustain a deductible abandonment loss in 1997.

1998 Expenses

     FRGC deducted $189,447 in other expenses on its 1998 return.

Respondent disallowed FRGC’s claimed deductions in 1998, because

they were not ordinary and necessary but were capital in nature.

     Section 162(a) permits a deduction for all “ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on any trade or business”.    Sec. 162(a).   No current

deduction is allowed for a capital expenditure.    Sec. 263(a)(1).

The regulations provide generally that “The cost of acquisition
                              - 18 -

* * * of * * * property having a useful life substantially beyond

the taxable year” is a capital expenditure.   Sec. 1.263(a)-2(a),

Income Tax Regs.   The same expenditure that may be deductible in

one setting might be capitalized in another, if it is incurred in

connection with the acquisition of a capital asset.    Commissioner

v. Idaho Power Co., 418 U.S. 1, 13 (1974); Ellis Banking Corp. v.

Commissioner, 688 F.2d 1376, 1379 (11th Cir. 1982), affg. in part

and remanding in part on another ground T.C. Memo. 1981-123.

     Petitioner recognizes the applicability of the “process of

acquisition” test in this case to decide whether expenditures are

currently deductible or whether they must be capitalized.    See

Honodel v. Commissioner, 76 T.C. 351, 365 (1981), affd. 722 F.2d

1462 (9th Cir. 1984).   The process of acquisition test focuses on

the direct relationship between the cost and the acquisition, so

that costs originating in the process of acquiring a capital

asset are considered capital expenditures.    Woodward v.

Commissioner, 397 U.S. 572 (1970); Lychuk v. Commissioner,

116 T.C. 374, 390 (2001).

     In applying the process of acquisition test to the facts of

this case, we analyze what FRGC was attempting to acquire when it

incurred its expenses in 1998.   FRGC’s operating agreement and

private placement materials specifically state that FRGC’s sole

business purpose was to engage in predevelopment activities to

acquire suitable property for Flagstaff Ranch.   FRGC and Cherry
                               - 19 -

entered into a purchase agreement in January 1998 for the 404-

acre subject property.    Cherry conveyed the subject property

directly to Flagstaff Ranch on June 29, 1998, and the parties

closed escrow on June 30, 1998.    All expenses incurred by FRGC in

1998 were directly connected to closing escrow on the subject

property.    In fact, FRGC did not incur any of the expenses in

issue after June 30, 1998.

       Partnership interests are capital assets pursuant to section

741.    Citron v. Commissioner, 97 T.C. at 213; La Rue v.

Commissioner, 90 T.C. 465, 483 (1988).    Pursuant to Flagstaff

Ranch’s private placement memorandum, upon acquisition of the

subject property, FRGC’s investors would receive interests in

Flagstaff Ranch equal to those held in FRGC.    Although the

expenses in issue that were incurred by FRGC in 1998 could be

considered ordinary and necessary under different circumstances,

the facts of this case reflect that these expenses directly

related to acquiring property for Flagstaff Ranch.    In substance,

FRGC performed services and due diligence to acquire property

that was contributed to Flagstaff Ranch in exchange for the

partnership interests.    FRGC was a mere conduit for Flagstaff

Ranch’s expenses in acquiring the undeveloped land.

       Accordingly, because FRGC’s investors received their

property interest in Flagstaff Ranch in exchange for FRGC’s

contribution of the property and work product, all expenses that
                             - 20 -

were incurred by FRGC in 1998 are directly connected with the

acquisition of a capital asset and therefore must be capitalized

pursuant to section 263.

                                        Decision will be entered

                                   for respondent.
