                        T.C. Memo. 2001-267



                      UNITED STATES TAX COURT



         BERNARD J. PENN AND THELMA I. PENN, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 8521-99.                      Filed October 4, 2001.


     Bernard J. Penn, pro se.

     John F. Driscoll, for respondent.



                         MEMORANDUM OPINION

     GALE, Judge:   Respondent determined a Federal income tax

deficiency for petitioners’ 1996 taxable year in the amount of

$6,269 and a section 6662(a)1 accuracy-related penalty of $1,254.




     1
       Unless otherwise noted, all section references are to the
Internal Revenue Code in effect for the year in issue, and all
Rule references are to the Tax Court Rules of Practice and
Procedure.
                                - 2 -

After concessions,2 we must decide the following issues:

     (1)    Whether petitioners failed to include $28,837 of

taxable interest income in gross income for 1996.      We hold that

they did.

     (2)    Whether petitioners must include Social Security

benefit payments received during 1996 in their gross income as

determined by respondent.    We hold that they must.

     (3)    Whether petitioners are liable for the accuracy-related

penalty as determined by respondent.    We hold that they are to

the extent provided herein.

Background

     Petitioners, husband and wife, resided in Pensacola,

Florida, when the petition in this case was filed.     At the time

of trial, petitioners were both in their late seventies, and

petitioner Bernard J. Penn (Mr. Penn) was diagnosed with stomach

cancer in late 1995.    Mr. Penn was retired from a career as a

practicing attorney and a tax return preparer.    Petitioners

jointly filed their Federal income tax return for the year in

issue on October 15, 1997, and respondent’s examination of such

return began after July 22, 1998.

     For several years, Mr. Penn and petitioner Thelma I. Penn

(Mrs. Penn) purchased tax certificates that were sold at auction


     2
       At trial, respondent conceded that petitioners may deduct
a loss of $3,517.23 for 1996 in connection with the cancellation,
pursuant to Florida law, of certain tax certificates they held.
                                - 3 -

by various Florida counties.    Florida counties are authorized by

law to sell at auction tax certificates on real property for

which real property taxes have not been paid.    Fla. Stat. Ann.

sec. 197.432 (West 1999 & Supp. 2001).    Potential purchasers bid

in terms of the rate of interest they will accept on the

certificate’s face value from the real property owner in the

event of a redemption.   Fla. Stat. Ann. sec. 197.432(5) (West

1999 & Supp. 2001).    The face value of a certificate equals the

unpaid real property taxes, plus interest or other charges due

from the delinquent real property owner at the time of the

certificate’s sale.    Fla. Stat. Ann. secs. 197.102(3), 197.432(5)

(West 1999 & Supp. 2001).

     The purchase of a tax certificate creates a tax lien on the

underlying real property in favor of the purchaser.    Fla. Stat.

Ann. sec. 197.102(3) (West 1999).   Owners of the underlying real

property can extinguish such liens by redeeming the outstanding

tax certificates on their property.3    Fla. Stat. Ann. sec.

197.472 (West 1999).   Outstanding tax certificates are redeemed

when the property owner pays the county tax collector the face

value of the tax certificate, plus interest accrued at the rate



     3
       If a tax certificate is not redeemed by the property
owner, the certificate’s holder can convert the certificate into
a tax deed at any time after 2 years from April 1 of the year of
the certificate’s issuance but before its expiration 7 years
after issuance. Fla. Stat. Ann. secs. 197.482, 197.502 (West
1999 & Supp. 2001).
                                   - 4 -

bid by the certificate’s original purchaser. Id.       Upon redemption

of a tax certificate, the county tax collector must remit the

amounts received, including accrued interest, to the

certificate’s holder, whereupon the certificate is canceled.      Id.

Issue 1. Interest Income

     Petitioners reported $24,082.49 of taxable interest income

and $28,287.52 of tax-exempt interest income on their 1996

Federal income tax return.   Respondent determined that

petitioners failed to report $28,837 of taxable interest income

for that year.    Respondent’s determination was based on several

Forms 1099 received from various entities reporting taxable

interest payments made to petitioners.     The Forms 1099 providing

the basis for respondent’s determination are summarized below:

                 Payor                      Payee       Amount

     Southwest Trust Bank                  Mr. Penn    $   457
     Bank of Pensacola                     Mr. Penn        244
     Tax Collector - Bay County            Mrs. Penn       433
     Tax Collector - Escambia County       Mr. Penn     15,525
     Tax Collector - Escambia County       Mrs. Penn    12,178

                           Total                       $28,837

     At trial, respondent presented the testimony of Richard

Stone, a deputy tax collector with the Escambia County tax

collector’s office, and documentary evidence establishing that

petitioners received $27,703 of interest income from Escambia

County, Florida, tax certificates that were redeemed during 1996.

We therefore find that petitioners received interest income in
                               - 5 -

the amount of $27,703 from redeemed Escambia County tax

certificates.   Petitioners offered no evidence or argument

disputing respondent’s determination that they received $433 in

interest from Bay County, Florida, in 1996, and we accordingly

find that they received such interest.4

     Having concluded that petitioners received $28,136 of

interest income in 1996 from Escambia and Bay Counties, Florida,

we must decide whether any portion of this amount may be excluded

from petitioners’ gross income.   Petitioners argue that the

interest reflected on Forms 1099 from Bay County and Escambia

County, Florida, as interest earned on redeemed tax certificates

is tax-exempt interest under section 103.   In general,

subsections (a) and (c)(1) of section 103 exclude from gross

income the interest earned on specified State or local bonds,

provided such bonds represent an obligation of a State or its

political subdivisions.

     This Court has previously held that interest received on

account of taxpayers’ holding Florida tax certificates that are

redeemed is not excluded from gross income under section 103

because the certificates are not obligations of the State of



     4
       As petitioners neither asserted a reasonable dispute nor
introduced credible evidence with respect to their receipt of the
interest income as determined by respondent, the burden of proof
does not shift to respondent in this case. See secs. 6201(d),
(effective for court proceedings on or after July 30, 1996),
7491(a)(effective in connection with examinations commencing
after July 22, 1998).
                                 - 6 -

Florida or its political subdivisions.     Hernandez v.

Commissioner, T.C. Memo. 1998-46, supplemented by T.C. Memo.

1998-329; Barrow v. Commissioner, T.C. Memo. 1983-123.     The

Florida statutes under which the tax certificates at issue in

this case were issued and redeemed have undergone no material

change since they were analyzed for purposes of section 103 in

the foregoing opinions.5    Under the reasoning outlined in

Hernandez and Barrow, which we need not repeat here, we hold that

the interest income petitioners received upon the redemption of

the Florida tax certificates they held is not excluded from gross

income by section 103.     Accordingly, we sustain respondent’s

determination that petitioners must include $28,136 of taxable

interest in their gross income for 1996.

     Petitioners offered no evidence to refute respondent’s

determination that they received taxable interest income in the



     5
       Our analysis in Barrow v. Commissioner, T.C. Memo. 1983-
123, focused on the nature of the obligations that existed
between a tax certificate’s purchaser, the property’s owner, and
the tax collector under Florida law. Specifically, we looked at
secs. 197.116 and 197.156 of the Florida Statutes governing the
issuance and redemption of tax certificates, and sec. 197.241 of
the Florida Statutes governing a certificate holder’s right to
convert the certificate into a tax deed.

     In the period between our opinions in Barrow and Hernandez
v. Commissioner, T.C. Memo. 1998-46, supplemented by T.C. Memo.
1998-329, secs. 197.116, 197.156, and 197.241 of the Florida
Statutes were repealed and replaced by secs. 197.432, 197.472,
and 197.502, respectively. The substance of these provisions,
however, has not changed in any material manner since they were
first analyzed in Barrow or revisited in Hernandez.
                                  - 7 -

aggregate amount of $701 as reflected on Forms 1099 from

Southwest Trust Bank ($457) and Bank of Pensacola ($244).

Accordingly, we find petitioners have failed to meet their burden

of proving that respondent’s determination regarding the

foregoing was erroneous, and we sustain it.     See Rule 142(a);

Welch v. Helvering, 290 U.S. 111 (1933).6

Issue 2. Social Security Payments

     Respondent determined that during 1996 petitioners received

$8,496 in Social Security benefit payments and failed to include

85 percent of such payments ($7,222) in their gross income as

required by section 86.      Section 86 requires the inclusion of a

portion of Social Security benefits in gross income when the sum

of the benefit recipient’s “modified” adjusted gross income plus

one-half of his or her Social Security benefits exceeds certain

threshold amounts.    When, in the case of a joint return, this sum

exceeds $32,000, the lesser of such excess or 50 percent of the

Social Security benefits must be included in income.      Sec.

86(a)(1), (c)(1)(B).    When modified adjusted gross income exceeds

$44,000 in the case of a joint return, up to 85 percent of the

Social Security benefits received during the year must be

included in gross income.     Sec. 86(a)(2), (c)(2)(B).    Under

section 86, modified adjusted gross income in general equals

adjusted gross income plus tax-exempt interest income received



     6
         See supra note 4.
                                  - 8 -

during the year, subject to certain other adjustments not

relevant here.   Sec. 86(b)(2).

     At trial, Mr. Penn admitted that during 1996 petitioners

received Social Security benefit payments totaling $8,496.

Petitioners reported adjusted gross income of $24,082.49 for

1996, and we have found that petitioners failed to report an

additional $28,837 of taxable interest income for that year.

Taking into account the $3,517.23 loss on canceled tax

certificates, as conceded by respondent, petitioners’ modified

adjusted gross income for 1996 therefore equals $49,402.26.      The

sum of petitioners’ modified adjusted gross income plus one-half

of their Social Security benefits ($4,248) is $53,650.26.     Since

this amount exceeds $44,000, up to 85 percent of petitioners’

Social Security benefits is includable in gross income.     We

anticipate that the precise amount of Social Security benefits

includable in petitioners’ 1996 gross income will be ascertained

by the parties in connection with computations under Rule 155.

Issue 3. Accuracy-Related Penalty

     We must also decide whether petitioners are liable for the

section 6662(a) accuracy-related penalty.     Respondent determined

that petitioners’ entire tax underpayment for the year in issue

was the result of a substantial understatement of tax.     Section

6662(a) provides for an accuracy-related penalty of 20 percent of

any tax underpayment that is attributable to a substantial

understatement of income tax.     Section 6662(d)(1) defines a
                                 - 9 -

“substantial understatement” as an understatement of income tax

for the taxable year that exceeds the greater of 10 percent of

the tax required to be shown on the return or $5,000.

     Section 6664(c)(1) provides an exception to the accuracy-

related penalty as it applies to any portion of an underpayment

where the taxpayer shows that there was a reasonable cause for

such portion, and that the taxpayer acted in good faith with

respect to such portion.

     Regulations interpreting section 6664(c)(1) state:

     The determination of whether a taxpayer acted with
     reasonable cause and in good faith is made on a case-
     by-case basis, taking into account all pertinent facts
     and circumstances. * * * Generally, the most important
     factor is the extent of the taxpayer’s effort to assess
     the taxpayer’s proper tax liability. Circumstances
     that may indicate reasonable cause and good faith
     include an honest misunderstanding of fact or law that
     is reasonable in light of all the facts and
     circumstances, including the experience, knowledge and
     education of the taxpayer. * * * [Sec. 1.6664-4(b)(1),
     Income Tax Regs.]

     In court proceedings that arise in connection with

examinations commencing after July 22, 1998, the Commissioner

bears the burden of producing sufficient evidence to indicate

that it is appropriate to impose any penalty provided for in the

Internal Revenue Code.   Sec. 7491(c); Higbee v. Commissioner, 116

T.C. 438, 446-447 (2001).   Once the Commissioner’s burden is met,

the taxpayer bears the burden of establishing that the section

6664(c)(1) reasonable cause exception is applicable.    Higbee v.

Commissioner, 116 T.C. at 447.
                               - 10 -

     The examination of petitioners’ 1996 Federal income tax

return began after July 22, 1998, making section 7491(c)

applicable.    We find, however, that respondent has met his burden

of production.   Respondent introduced undisputed evidence that

petitioners received $27,703 in interest income and has alleged

that petitioners failed to include such amount in gross income.

We have found for respondent on that allegation.   In petitioners’

circumstances, this omission would produce an understatement

exceeding the greater of $5,000 or 10 percent of the tax required

to be shown on their return.   Accordingly, petitioners bear the

burden of establishing the applicability of the reasonable cause

exception.

     We believe that petitioners’ reporting of the interest

received from the redeemed Florida tax certificates, albeit as

tax-exempt rather than taxable, suggests an “honest

misunderstanding of * * * law” within the meaning of the

regulations.   We further believe that this misunderstanding was

reasonable given all the facts and circumstances, including Mr.

Penn’s advanced age and his health problems arising from a

diagnosis of stomach cancer in late 1995.   These circumstances

constitute reasonable cause and good faith with respect to the

portion of the underpayment attributable to the interest received

from the redeemed Florida tax certificates, in our view.

Accordingly, we find that petitioners are not liable for the

accuracy-related penalty on this portion of their underpayment.
                               - 11 -

     Although we find that petitioners’ underpayment attributable

to the Florida tax certificate interest was due to reasonable

cause, the portion of petitioners’ Social Security benefits

required to be included in gross income is not affected by

whether the tax certificate interest is exempt from taxation.

Both taxable and tax-exempt interest are counted for purposes of

the income thresholds that determine the taxability of Social

Security benefits.    See sec. 86(b)(2).   Thus any misunderstanding

of Mr. Penn’s with respect to the tax-exempt status of interest

petitioners received on tax certificates should have had no

impact on the computation of the amount of petitioners’ Social

Security benefits subject to tax.    Nothing else in the record

suggests that there was reasonable cause for petitioners’ failure

to include the appropriate amount of their Social Security

benefits in income.   Accordingly, we find that petitioners are

subject to the accuracy-related penalty on the portion of their

underpayment attributable to unreported Social Security benefits.

     Finally, in the absence of any evidence of reasonable cause,

we find that petitioners are liable for the accuracy-related

penalty on the portion of their underpayment attributable to

unreported bank interest income of $701.

     To reflect the foregoing,

                                           Decision will be entered

                                     under Rule 155.
- 12 -
