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and $1,751,372, respectively. Hilltop did not pay interest on
these amounts.
In 1994, Hilltop repaid petitioners $558,000 of the
advances. They did not report any of the $558,000 as income. In
that same year, Hilltop paid $416 to Electronic Keyboard Service
for repair of Mrs. Hoffman’s organ. Hilltop recorded this
transaction as a repayment of petitioners’ advances and reduced
Mrs. Hoffman’s shareholder loan account by $416.
Petitioners prepaid $5,520 of their 1997 real property taxes
and deducted that amount on their 1996 tax return.
Respondent determined that petitioners, pursuant to section
7872, had unreported interest income of $97,589, $106,483, and
$100,076 in 1994, 1995, and 1996, respectively. In addition,
respondent disallowed petitioners’ $5,520 prepaid real property
tax deduction.
OPINION
I. Interest Income From Loans
Section 7872 recharacterizes a below-market loan (i.e., loan
subject to a below-market interest rate) as an arm’s-length
transaction in which the lender made a loan to the borrower in
exchange for a note requiring the payment of interest at a
statutory rate. As a result, the parties are treated as if the
lender made a transfer of funds to the borrower, and the borrower
used these funds to pay interest to the lender. The transfer to
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