                              T.C. Memo. 2019-54



                        UNITED STATES TAX COURT



                     MARY BUI, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 20453-16.                       Filed May 21, 2019.


      Ronda N. Edgar, for petitioner.

      Adam B. Landy, Nancy M. Gilmore, and Thomas R. Mackinson, for

respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


      GOEKE, Judge: Respondent issued a notice of deficiency to petitioner

determining an income tax deficiency for 2011 of $173,058 and an addition to tax
                                            -2-

[*2] under section 6651(a)(1) of $66,668.1 After concessions, the sole issue

remaining for consideration is whether petitioner must include in gross income

cancellation of indebtedness of $355,488. We hold that she may properly exclude

$48,151 but must include the remaining $307,337.

                                FINDINGS OF FACT

      This case was tried on September 10, 2018, in San Francisco, California.

The parties have submitted a stipulation of facts and accompanying exhibits,

which are incorporated herein by this reference. When the petition was timely

filed, petitioner resided in California.2

      Petitioner is also known as Nga Thuy Lan Bui. For 2011 petitioner

excluded $355,488 of discharged indebtedness from her gross income and

indicated the excluded indebtedness was qualified principal residence



      1
       Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) as amended and in effect at all relevant times, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
      2
       The petition was received with an illegible postmark on September 19,
2016, five days after the time to file a petition with this Court had expired. Sec.
301.7502-1(c)(1)(iii)(A), Proced. & Admin. Regs., places on the taxpayer the
burden to prove the date an illegible postmark was made. On March 12, 2019, we
issued an order directing petitioner to sustain her burden of establishing that the
postmark was timely made. On March 24, 2019, petitioner responded to our order
and supplemented the record with proof of mailing on September 12, 2016.
Accordingly, we are satisfied of our jurisdiction to hear this case.
                                       -3-

[*3] indebtedness. On June 16, 2016, respondent issued a notice of deficiency to

petitioner for 2011 and proposed an adjustment disallowing her entire exclusion of

discharged indebtedness income. Respondent now concedes that petitioner was

insolvent by $42,852 in 2011.

I.    Residences

      A.    Red River Property

      On June 1, 1981, petitioner, her former spouse, and three other persons

purchased a single-family residence on Red River Way in San Jose, California

(Red River property), for $156,500. Petitioner and her former spouse together

owned a 25% interest in the Red River property. By grant deed dated October 15,

1985, and recorded January 28, 1986, petitioner and her former spouse purchased

the remaining 75% interest in the Red River property for $97,500. By quitclaim

deed dated November 14, 2002, and recorded December 12, 2002, petitioner

acquired sole ownership in the Red River property. Petitioner legally separated

from her former spouse in 2005 or 2006.

      Petitioner lived at the Red River property from its acquisition in 1981

through March 14, 2011, and treated it as her primary residence. On March 14,

2011, petitioner relinquished ownership of the Red River property by short sale for
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[*4] $485,000. At that time, the balance of the mortgage on the Red River

property was $416,000.

      B.    Cedar Grove Property

      On or around June 1, 1988, petitioner and her former spouse purchased a

single-family rental home on Cedar Grove Circle in San Jose, California (Cedar

Grove property). By quitclaim deed dated November 14, 2002, and recorded

December 12, 2002, petitioner acquired sole ownership in the Cedar Grove

property. After petitioner sold the Red River property in March 2011, she moved

into the Cedar Grove property and established it as her new primary residence.

II.   Wells Fargo Lines of Credit

      Before 2011 petitioner obtained three home equity lines of credit with Wells

Fargo Bank, N.A. (Wells Fargo). Petitioner executed a deed of trust dated

February 14, 2007, and recorded March 12, 2007, securing a $250,000 line of

credit for an account ending in 9471 between herself and Wells Fargo with the

Red River property listed as collateral (9471 loan). Petitioner executed a deed of

trust dated March 1, 2007, and recorded March 26, 2007, securing a $40,000 line

of credit for an account ending in 7231 between herself and Wells Fargo with the

Cedar Grove property as collateral (7231 loan). Petitioner also executed a deed of

trust dated March 20, 2007, and recorded April 30, 2007, securing a $101,942 line
                                        -5-

[*5] of credit for an account ending in 5371 between herself and Wells Fargo with

the Cedar Grove property as collateral (5371 loan).

      In 2011 Wells Fargo issued three Forms 1099-C, Cancellation of Debt, to

petitioner indicating that the remaining debt associated with the 9471 loan, the

7231 loan, and the 5371 loan had been canceled. On the Forms 1099-C Wells

Fargo described the debts as “HEQ Secured Installment Loan” and checked the

box indicating petitioner was personally liable for repayment of the debts.

Petitioner’s canceled Wells Fargo debt for 2011 was as follows:

 Date of Form 1099-C        Amount of canceled debt             Account No.
     Mar. 18, 2011                  $243,299                        9471
     Oct. 28, 2011                    11,999                        7231
     Oct. 28, 2011                   100,190                        5371

      Petitioner executed at least four additional deeds of trust with Wells Fargo

before 2011. In addition, petitioner, with and without her former spouse, executed

at least seven deeds of trust between 1986 and 2004 from banking institutions

other than Wells Fargo. The indebtedness indicated by these additional deeds of

trust was not canceled in 2011.
                                       -6-

[*6] III.    Home Improvements

       Petitioner testified to carrying out a number of home improvement projects

before 2011 for the Red River property, but she provided no documentation

relating to when or how expenses of these projects were paid. She did not testify

to any home improvement project expenses related to the Cedar Grove property.

Petitioner paid approximately $10,000 for custom drapes to be installed at the Red

River property in 2007. In addition, she spent approximately $12,000 for

driveway repair and expansion work at the Red River property in 2008. The

remaining home improvement expenditures petitioner testified to were made

before 2007, the year she obtained the Wells Fargo lines of credit. The associated

debts were discharged in 2011.

                                    OPINION

       Generally, the Commissioner’s determinations in a notice of deficiency are

presumed correct, and the taxpayer bears the burden of proving the determinations

are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

However, for the presumption of correctness to attach in an unreported income

case such as this, the Commissioner must base his deficiency determination on

some substantive evidence that the taxpayer received unreported income. Hardy v.

Commissioner, 181 F.3d 1002, 1004 (9th Cir. 1999), aff’g T.C. Memo. 1997-97.
                                        -7-

[*7] There is no dispute in this case that petitioner had debt that was forgiven.

Section 7491(a) shifts the burden of proof to the Commissioner where the taxpayer

has presented credible evidence with respect to any factual issue relevant to

ascertaining the correct tax liability of the taxpayer. Section 7491(a) also requires

that the taxpayer have substantiated all appropriate items, maintained records as

required under the Code, and cooperated with all reasonable requests by the

Commissioner for witnesses, information, documents, meetings, and interviews.

Sec. 7491(a)(2)(A) and (B). Petitioner has not attempted to argue, and the record

does not demonstrate, her compliance with the requirements of section 7491(a);

accordingly, the burden remains with petitioner to show respondent’s

determinations were incorrect.

      This is a dispute over whether petitioner had reportable cancellation of

indebtedness income that she failed to report on her 2011 tax return. The Code

defines income liberally as “all income from whatever source derived”. Sec.

61(a). Specifically, income includes any income from the discharge of

indebtedness. Sec. 61(a)(12); sec. 1.61-12(a), Income Tax Regs. The underlying

rationale for the inclusion of canceled debt as income is that the release from a

debt obligation the taxpayer would otherwise have to pay frees up assets
                                        -8-

[*8] previously offset by the obligation and acts as an accession to wealth--i.e.,

income. United States v. Kirby Lumber Co., 284 U.S. 1, 2 (1931).

      Generally, when canceled debt creates income, the amount includible in

income is equal to the face value of the discharged obligation minus any amount

paid in satisfaction of the debt. Rios v. Commissioner, T.C. Memo. 2012-128,

2012 WL 1537910, at *4, aff’d, 586 F. App’x 268 (9th Cir. 2014); see Merkel v.

Commissioner, 192 F.3d 844, 849 (9th Cir. 1999), aff’g 109 T.C. 463 (1997). The

income is recognized for the year in which the debt is canceled. Montgomery v.

Commissioner, 65 T.C. 511, 520 (1975).

      Petitioner argues that although the cancellation of debt generally creates

reportable income her canceled debt is excludable. Some “accessions to wealth

that would ordinarily constitute income may be excluded by statute or other

operation of law.” Commissioner v. Dunkin, 500 F.3d 1065, 1069 (9th Cir. 2007),

rev’g 124 T.C. 180 (2005). Even so, “given the clear Congressional intent to

‘exert * * * the full measure of its taxing power,’ * * * exclusions from gross

income are construed narrowly in favor of taxation.” Id. (quoting Commissioner

v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955)) (citing Merkel v. Commissioner

192 F.3d at 848). Petitioner argues two exclusions apply to her cancellation of

indebtedness income: section 108(a)(1)(E), which offers an exclusion when the
                                        -9-

[*9] canceled debt is “qualified principal residence indebtedness”; and section

108(a)(1)(B), which provides an exclusion where the taxpayer is insolvent. We

will examine both exclusions as applied to petitioner.

I.    Qualified Principal Residence Indebtedness

      Section 108(a)(1)(E) provides that gross income does not include amounts

which would be includible as cancellation of indebtedness income if “the

indebtedness discharged is qualified principal residence indebtedness”. Qualified

principal residence indebtedness is defined as (1) acquisition indebtedness

(2) with respect to the taxpayer’s principal residence. Sec. 108(h)(2), (5).

Acquisition indebtedness is “incurred in acquiring, constructing, or substantially

improving any qualified residence of the taxpayer” and must be secured by that

residence. Sec. 163(h)(3)(B)(i). If only a portion of a discharged loan obligation

meets the definition of qualified principal residence indebtedness, only the amount

discharged which exceeds the nonqualified principal residence indebtedness is

excludable. Sec. 108(h)(4).

      Petitioner’s primary residence was the Red River property until she sold it

in March 2011 and established the Cedar Grove property as her new primary

residence. Three of her Wells Fargo lines of credit--the 9471 loan, the 7231 loan,

and the 5371 loan--were canceled in 2011. Petitioner does not argue that any of
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[*10] these loans, which were obtained in 2007, were used to acquire or construct

either the Red River property or the Cedar Grove property, both of which were

solely acquired by petitioner in 2002. Petitioner instead argues that funds from

these loans were used to substantially improve her primary residence.

      Petitioner provided no evidence regarding substantial improvements made

to the Cedar Grove property. For the qualified principal residence indebtedness

exclusion to apply, the debt must be used to acquire, construct, or substantially

improve the taxpayer’s primary residence, and that residence must secure the loan.

See secs. 108(h)(2), 163(h)(3)(B)(i). Both the 7231 loan and the 5371 loan were

secured by the Cedar Grove property. Therefore, because these loans were not

used to acquire, construct, or substantially improve the Cedar Grove property, they

are not excludable from gross income as qualified principal residence

indebtedness.

      Petitioner offered testimony on a number of improvements made to the Red

River property before she obtained the 9471 loan. These improvements could not

have been financed by a loan that had not materialized at the time they were made.

Thus, they will be disregarded for purposes of determining whether any portion of

the 9471 loan was qualified personal residence indebtedness. Petitioner spent

$12,000 on driveway expansion and repair work at the Red River property in
                                        - 11 -

[*11] 2008. We are satisfied from her testimony that this amount was paid with

the 9471 loan. Accordingly, the portion of the 9471 loan that was used to finance

the driveway project is qualified principal residence indebtedness. Petitioner also

testified that she had custom drapes installed at the Red River property in 2007 for

$10,000. We do not find that this expense constitutes a substantial improvement

to the Red River property, and therefore it is not qualified principal residence

indebtedness.

      We have determined that $12,000 of the 9471 loan was qualified principal

residence indebtedness; however, the amount that petitioner may properly exclude

is limited by section 108(h)(4). Section 108(h)(4) provides that where only a

portion of a discharged loan is qualified principal residence indebtedness, the

amount that may be excluded is only “so much of the amount discharged as

exceeds the amount of the loan (as determined immediately before such discharge)

which is not qualified principal residence indebtedness.” To apply this limitation

we must determine how much of the loan was not qualified principal residence

indebtedness. The original line of credit was for $250,000. We have determined

that $12,000 was qualified principal residence indebtedness; thus $238,000 was

not qualified principal residence indebtedness. Therefore, petitioner may exclude

only $5,299 of the canceled 9471 loan from her income under the qualified
                                       - 12 -

[*12] principal residence indebtedness exclusion ($243,299 canceled debt minus

the $238,000 of the debt that was not qualified principal residence indebtedness).

II.   Insolvency Exclusion

      Petitioner argues that even if her cancellation of indebtedness income is not

excludable as qualified principal residence indebtedness, it should be excludable

because she was insolvent in 2011. Section 108(a)(1)(B) provides an exclusion

from gross income of cancellation of indebtedness amounts where the taxpayer is

insolvent at the time the discharge occurs. A taxpayer is insolvent by the amount

her liabilities exceed the fair market value of her assets, determined immediately

before the discharge of indebtedness. Sec. 108(d)(3).

      Respondent concedes that petitioner was insolvent by $42,852 and,

therefore, admits that amount of cancellation of indebtedness income is

excludable. In the case of a taxpayer who qualifies for the insolvency exclusion,

the excluded amount cannot exceed the amount by which the taxpayer is insolvent.

Sec. 108(a)(3). Petitioner suggests that respondent did not accurately account for

her assets and liabilities when calculating her insolvency. However, petitioner

stipulated respondent’s insolvency calculations and has offered no coherent

argument as to why the calculations are in error. Accordingly, petitioner is

entitled to an insolvency exclusion for her cancellation of indebtedness income of
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[*13] $42,852. Petitioner may exclude a total of $48,151--representing $42,852

under the insolvency exclusion and $5,299 under the qualified principal residence

indebtedness exclusion--of her cancellation of indebtedness income from her gross

income.3

         In reaching our holding, we have considered all arguments made, and, to the

extent not mentioned above, we conclude they are moot, irrelevant, or without

merit.


                                                      Decision will be entered under

                                                 Rule 155.




         3
        Sec. 108(a)(2)(C) provides that the insolvency exclusion does not apply to
any discharge to which the qualified principal residence indebtedness exclusion
applies unless the taxpayer elects the insolvency exclusion to apply in lieu of the
qualified principal residence indebtedness exclusion. Petitioner made no such
election; however, because three debts were discharged we may apply the
insolvency exclusion to the loans not eligible for the qualified principal residence
exclusion.
