John H. and Mary E. Douglas - Page 7

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          expenses that petitioners deducted as a bad debt in 1992 was not            
          a bona fide debt and, therefore, not deductible as a business bad           
          debt.  Finally, respondent determined that the $2,500 in legal              
          expenses deducted in tax year 1992 and the $3,171 in legal                  
          expenses deducted in tax year 1993 are nonbusiness expenses                 
          properly allowable as miscellaneous itemized deductions.                    
               1.   Bad Debt Deduction                                                
                    (a) Second Deed                                                   
               Section 166(a) generally allows a deduction for any bona               
          fide debt that becomes worthless during the taxable year.  Bad              
          debts may be characterized as either business bad debts or                  
          nonbusiness bad debts.  Sec. 166(d).  A taxpayer is not entitled            
          to a deduction for a worthless debt under section 166 in                    
          connection with an income item unless it has been included in the           
          taxpayer's gross income for Federal income tax purposes either              
          for the year for which the deduction is claimed or for a prior              
          year.  Gertz v. Commissioner, 64 T.C. 598, 600 (1975); O'Meara v.           
          Commissioner, 8 T.C. 622, 633 (1947); sec. 1.166-1(e), Income Tax           
          Regs.  This principle also applies to interest owed to a taxpayer           
          but never reported as income.  W.L. Moody Cotton Co. v.                     
          Commissioner, 2 T.C. 347, 353-357 (1943), affd. 143 F.2d 712 (5th           
          Cir. 1944).                                                                 
               Petitioners sold the Fort Washington property in 1989.                 
          Petitioners do not contend, nor does the record support a                   

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